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William & Mary Annual Tax Conference Conferences, Events, and Lectures

1988

Partnership Operations and DistributionsSteven M. Friedman

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PARTNERSHIP OPERATIONS AND DISTRIBUTIONS

Thirty-Fourth Tax ConferenceMarshall-Wythe School of LawCollege of William and Mary

December 2-3, 1988

Steven M. Friedman, Esq.Tax Principal

Ernst & WhinneyMiami, Florida

Copyright 01988All Rights ReservedErnst & WhinneyNTDBDJ:200

JELU Ernst &Whinney

WILLIAM & MARY TAX CONFERENCEPARTNERSHIP OPERATIONS AND DISTRIBUTIONS

SPEAKER'S OUTLINESTEVEN M. FRIEDMAN, ESQ.

ERNST & WHINNEYDECEMBER 2, 1988

Outline

Topic Reference

I. Introduction ................ .......................... 1

A. Operative theories ............. ...................... 1B. Flexibility ............... ........................ 1

II. Partnership elections, computing partnership taxable incomeand determining the nature of partnership income to thepartners ...... . . . . .... . . .. . .. . . . . . . . .2

IIl. The partners' distributive share of partnership income(or loss) ................ ........................... 9

A. An overview of the partnership allocation regulations . . .. 10B. Practical considerations for the thoughtful partnership

adviser .......... .......................... .17C. Changes in the partners' interests ................. ... 32

IV. Basis of a partner's interest in the partnership ........ .38

A. Significance ......... ......................... ... 38B. General rules for determination .... ............... ... 40C. "Negative" basis ........ ....................... ... 41D. Ordering and timing of adjustments ... .............. ... 41E. The effect of partnership liabilities .. ............ .43

V. The partners' dealings with the partnership: An overview . ... 55

VI. Partnership current distributions .... ................ ... 66

VII. The partnership taxable year rules (in brief) ............... 78

VIII. Limited liability companies: A vehicle for the future? . ... N/A

PARTNERSHIP OPERATIONS AND DISTRIBUTIONS

By

STEVEN M. FRIEDMAN

TABLE OF CONTENTS

Page

I. INTRODUCTION .. ......................................... 1

A. Operative theories ............................... IB. Flexibility ....................................... I

II. PARTNERSHIP ELECTIONS, COMPUTING PARTNERSHIPTAXABLE INCOME AND DETERMINING THE NATURE OFPARTNERSHIP INCOME TO THE PARTNERS ................... 2

A. General rule ..................................... 2B. Elections .. ........................................ 2C. Computing partnership taxable income ............. 3D. Nature of partnership income to the partners ..... 7E. Reporting partnership income ..................... 7

III. COMPUTATION OF A PARTNER'S DISTRIBUTIVE SHARE OFPARTNERSHIP INCOME ................................... 9

A. Overview and historical background ............... 9B. The section 704(b) regulations: General

considerations ................................. 10C. "Substantial Economic Effect" ...................... 13D. Allocations to reflect revaluations .............. 22E. Nonrecourse debt . ................................. 22F. Other considerations ............................. 26G. Contributed property . ............................. 26H. Consequences of changes not resulting in

termination of the partnership ................. 32

IV. BASIS OF A PARTNER'S INTEREST IN THE PARTNERSHIP ..... 38

A. Theory of a partner's basis ....................... 38B. General rule for basis determination ............. 40C. Partnership liabilities .......................... 43D. Limitations on deductibility of partnership

losses by partners ............................. 54

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Page

V. THE PARTNERS' DEALINGS WITH THE PARTNERSHIP .......... 55

A. Payments by a partnership to a partner ........... 55B. Transactions between related persons ............. 63

VI. PARTNERSHIP DISTRIBUTIONS AND LIQUIDATIONS ........... 66

A. General concepts ................................. 66B. Recognition of gain or loss on distribution ...... 67C. Basis of distributed property ..................... 68D. Character of gain or loss on subsequent sale of

distributed property . ........................... 69E. Basis of distributee partner's interest .......... 70F. The treatment of liabilities in a distribution ... 70

VII. OVERVIEW OF SECTION 751(b): THE "HOT ASSET" RULES ... 72

A. General rules . .................................... 72B. Application of section 751(b) .................... 72C. Exceptions to section 751(b) ..................... 73D. Effect of section 751(b) ......................... 73E. The seven step analysis of section 751(b) ........ 74

VIII. TAX YEAR OF PARTNERS AND THE PARTNERSHIP .............. 78

A. When a partner includes partnership income ....... 78B. Partnerships: Permissible taxable years ......... 78C. Use of a nonpermitted year ....................... 83D. Changes in a partner's taxable year .............. 90

IX. CONSIDERATIONS IN USING A TIERED STRUCTURE ........... 90

A. Terminology .. ...................................... 90B. Business and tax considerations .................. 90

X. SELECTED COMPLIANCE CONSIDERATIONS ................... 93

A. Foreign partnership compliance ................... 93B. Withholdings on distributions to foreign

partners .. ....................................... 94C. Reporting requirements associated with the

transfer of a partnership interest ............. 94

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PARTNERSHIP OPERATIONS AND-DISTRIBUTIONS

By

STEVEN M. FRIEDMAN

I. Introduction.

A. Operative theories: The partnership rules of SubchapterK/l/ reflect the inherent tension between the aggregateand entity theories of taxation. As an entity, apartnership must satisfy a number of compliance rules andconsider various reporting requirements. However, in trueaggregate fashion, the tax attributes resulting frompartnership operations typically flow through unchanged tothe partners. The tension between these theories, as towhich should control, in many instances is the primarysource of confusion in partnership taxation.

B. Flexibility: Irrespective of this fundamental tension,the partnership remains the most flexible entity ownershipvehicle in the Internal Revenue Code. No other entitycombines the benefits of:

1. No incidence of entity level Federal tax under anycircumstance;

2. Additional basis at the owner level for entity levelindebtedness;

3. Freedom to make property distributions which oftenmay be structured free of Federal income tax(although possibly at the cost of foregone basis);

4. The ability to receive current cash distributions inmany cases free of tax, irrespective of the entity'searning history;

/i/ All Subchapter and section references are to the InternalRevenue Code of 1986, as amended, unless otherwise indicated.

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5. No restrictions on who may be a partner, althoughcertain classes of partners (e.g., tax-exemptentities) may raise ancillary tax issues (such as thetax-exempt entity leasing rules); and

6. The ability to make special allocations of income orloss and disproportionate distributions among thepartners.

11. Partnership Elections, Computing Partnership Taxable Income andDetermining the Nature of Partnership Income To the Partners.

A. General rule: For purposes of computing and reportingincome, the partnership is considered to be an entityseparate and distinct from its individual members.

I. Reporting responsibility: To determine eachpartner's distributive share of income, thepartnership is responsible for computing andreporting the income earned by the partnership.I.R.C. §§703(a) and 6031(a).

2. Liability for tax: The partnership is not a taxableentity; rather the individual partner is responsiblefor the tax consequences associated with hisdistributive share of partnership profits or losses.I.R.C. §702.

B. Elections.

1. General rule: Under section 703(b), the partnershipis responsible for making all elections which mayaffect the computation of partnership taxableincome. However, the following elections arerequired to be made by the individual partners:

a. Section 108: Discharge of indebtedness. I.R.C.§108(d)(6).

b. Section 617: Recapture of mining expenditures.

c. Section 901: Foreign and U.S. possession taxes.

2. Involuntary conversion: In Demirjian v. Commissioner,457 F.2d 1 (3rd Cir. 1972), the taxpayers were 50percent partners in a realty partnership with anoffice building as the sole operating asset.Pursuant to an involuntary condemnation proceeding,the partnership sold the building and distributed theproceeds to the two taxpayers. The taxpayers electedthe nonrecognition provisions of section 1033. TheIRS issued a deficiency notice, arguing that for thesection 1033 election to be valid, the partnershipmust make the election. The appellate court agreed,citing the specific language of section 703(b). See

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also, Rev. Rul. 66-191, 1966-2 C.B. 300. (However,the election allowed by section 1033 has been appliedat the partner level. See Ltr. Rul. 8527090 and Ltr.Rul. 8735026.)

3. Installment sales and the proportionate disallowancerule: The partnership is required to make theelection under section 10202(e)(3)(A) of the OmnibusBudget Reconciliation Act of 1987 (the "1987 Act")for certain installment obligations to be excludedfrom the application for section 453C (before itsrepeal). In addition, each partner is required toattach a copy of the election and a statement to hisindividual tax return. Notice 88-81, 1988-30I.R.B. 28.

C. Computing partnership taxable income.

1. General rule: Under section 703(a), a partnershipgenerally computes income in the same manner as anindividual, but with two major exceptions:

a. Separately stated items: All items undersection 702(a) are separately stated.

i. Definition: Generally, these items areones that "if separately taken into accountby any partner would result in an incometax liability for that partner differentfrom that which would result if thatpartner did not take the item into accountseparately." Regs. §1.702-I(a)(8)(ii).Regarding this requirement to separatelystate items which could affect a partner'stax liability if not separately stated,see, e.g.:

a. Rev. Rul. 84-131, 1984-2 C.B. 37,concerning investment interestexpense; and

b. Rev. Rul. 86-138, 1986-2 C.B. 84,regarding investment interest andtiered partnerships.

ii. Effect on basis: Although separatelystated, these items are included inpartnership taxable income for purposes ofmaking basis adjustments. I.R.C.

§705(a)(1)(A).

b. Disallowed deductions: Certain deductionsallowed to individuals are disallowed to thepartnership. (Generally these are items ofdeduction allowed only to individual taxpayers

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or subject to special limitation on anindividual's tax return.) I.R.C. §703(a)(2).

These items include:

i. Personal exemptions;

ii. Charitable contributions;

iii. The net operating loss deduction;

iv. Itemized deductions allowed only toindividuals under sections 211 through 219;and

v. Meal, travel and entertainment expensespaid or incurred after 1986 in partnershiptaxable years ending with or within thepartners' taxable years beginning after1986 (Temp. Regs. §1.702-IT); and

vi. Certain other items.

2. Item determinations: For purposes of computingincome (or loss), the partnership is treated as anentity. I.R.C. §703(a). Therefore, all income andexpense items are determined at the partnership leveland not the partner level.

a. Example: A partner takes into accountseparately in his return, as long term capitalgain, his distributive share of thepartnership's long term capital gain from thesale of investment assets, notwithstanding thatthe partner's holding period for his partnershipinterest was not long term. Rev. Rul. 68-79.1968-1 C.B. 310.

b. Basye v. United States, 410 U.S. 441 (1973)("Basye"). Several doctors formed a medicalpartnership that performed services for a healthplan (the "Plan"). The Plan paid for thoseservices by: (1) Direct payments to thepartnership; and (2) Payments to a trust it setup to hold and invest the payments. The trustfunds were to be distributed to the partners andemployees of the partnership upon theirretirement. Individuals covered by the trustdid not receive vested benefits; the amounts putin the trust were contingent and forfeitablewith respect to the individual partners andemployees but not to the partnership. Thepartnership did not include the payments to thetrust in income, and the IRS issueddeficiencies, claiming the payments to the trustwere income to the partnership and thus taxableto the partners.

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i. Lower courts: The District Court and theNinth Circuit decided for the taxpayer,relying on the fact that the partnershipnever actually received the payments to thetrust.

ii. Supreme Court: The Supreme Court reversed,reasoning that income must be taxed to the

person who earns it. The entity earningthe income (in this case a partnership)cannot divert the income to another entity(the trust).

c. The Supreme Court in Basye, supra, succinctlydistinguished the entity concept of section 703and the aggregate theory of sections 701 and702. "For (the purpose of calculating

partnership income), the partnership is regardedas an independently recognizable entity apartfrom the aggregate of its partners. Once itsincome is ascertained and reported, itsexistence may be disregarded since each partnermust pay a tax on a portion of the total incomeas if the partnership were merely an agent orconduit through which the income passed."Basye, supra, at 448.

3. Method of accounting.

a. General rule: A partnership generally is freeto select its own method of accounting,independent of the accounting methods used byits partners. I.R.C. §703(b).

b. Exception: Under section 448, a partnershipthat has one or more corporate partners or apartnership that is a "tax shelter" generallymust use the accrual method of accounting.I.R.C. §448(a).

c. Exception to the exception: A partnership with$5 million or less of average annual grossreceipts generally may use the cash method.I.R.C. §448(b)(3).

i. Application: The $5 million gross receiptstest is an annual one, generally applied tothe immediately preceding three taxable

years. I.R.C. §448(b)(3).

ii. Mandatory accrual accounting: This

exception to allow smaller partnershipscontinued availability of the cash methoddoes not apply to "tax shelters." I.R.C.§448(b)(3). (See the discussion below.)

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iii. Other accounting method rules still apply:Section 448 applies in addition to all ofthe other accounting method provisionscontained in the Code. Thus, for example,a partnership with inventories must stilluse the accrual method to account for thebusiness in which the inventories are kept.

d. "Tax shelter" defined: Section 448 uses thesame definition of a tax shelter as the economicperformance rules of section 461(i)(3). I.R.C.§448(d)(3).

i. Reach of the rule: A tax shelter includes:

a. A partnership in which interests arerequired to be registered with anyFederal or state agency havingauthority to regulate the offering(whether or not the offering in factis registered);

b. Any "syndicate," as defined in section1256(e)(3)(B); and

c. Any "tax shelter," within the meaningof section 6661(b)(2)(C)(ii).

ii. "Syndicate" defined: Section 1256(e)(3)(B)contains a broad definition of a syndicate.Generally, any entity in which more than 35percent of its losses during the year areallocable to limited partners or limitedentrepreneurs is a syndicate.

a. This wording conceivably could trap anewly formed partnership which, underits agreement, allocates more than 35percent of losses to limited partners,even if the partnership anticipatesprofits immediately upon commencingits business. However, the Serviceinterprets this provision to requirethe partnership to incur an actualloss, rather than the theoreticalpossibility of one. Temp. Regs.§1.448-1T(b)(3). See, e.g., Ltr. Rul.

8753032.

b. A limited entrepreneur is a generalpartner who does not activelyparticipate in the management of thepartnership. I.R.C. §464(e)(2).

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D. Nature of partnership income to the partners.

1. General rule: The character of partnership incomeand expense generally is determined at thepartnership level. I.R.C. §702(b).

a. Distinguish: Note that the character orclassification of partnership income isdetermined at the partnership level. Whether aparticular item is included in income or isdeductible by the partner is determined at thepartner level.

b. Example: If a partnership makes a charitable

contribution, the partners are treated as makingthat charitable contribution. However, section170 effectively limits the deduction forcharitable contributions at the partner leveland the contributions passing from thepartnership to the partner are subject tolimitation at that level.

2. Gross income: Where it is necessary to compute thegross income of a partner (e.g., in computingpersonal holding company income), such gross incomeincludes the partner's distributive share of grossincome from the partnership. I.R.C. §702(c).

3. NOL character: In determining whether losses from apartnership create a net operating loss at thepartner level, the regulations provide that thepartner shall take into account his distributiveshare of items of income, gain, loss, or credit ofthe partnership as if such item was realized directlyfrom the source from which realized by thepartnership or incurred in the same manner asincurred by the partnership. Regs. §1.702-2.

a. Distinguish: Business and nonbusiness incomeand deductions are separately taken into account.

b. Status of the partner: No distinction is madein the regulations between general and limitedpartnership interests. This is significantbecause limited partners will be treated asreceiving business income and deductions unlessthe income and deductions are nonbusiness at the

partnership level.

E. Reporting partnership income.

1. General rule: Every partnership generally must filean information return on Form 1065 for each taxableyear. The return specifically must state the itemsof gross income and deduction allowable under the

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Code, as well as any other information required by

the tax forms and the regulations. I.R.C. §6031(a).

a. When the obligation commences: The obligation

to file a partnership return for a taxable year

arises in the first year in which the

partnership receives income or incurs any

expenditures which are deductible for Federal

tax purposes. Regs. §1.6031-1(a)(1).

2. Copies to partners: A Schedule K-I must be furnished

to each partner by the due date of the Federalinformation return (including extensions). The

Schedule K-1 must show the partner's distributiveshare of income, gain, loss, deduction or credit. In

addition, other information may be required by the

form or its instructions. Prop. Regs. §1.6031-1(b).

3. Nominee reporting: A partnership must furnish a copy

of Schedule K-1 and any other information required bythe regulations to a nominee of any person who holds

a beneficial interest in the partnership. Likewise,the nominee must furnish the information received

from the partnership to the person for whom he is a

nominee. I.R.C. §6031(c). In addition, the nomineemust disclose to the partnership certain informationregarding the person for whom he is a nominee.

a. Purpose: One goal of the nominee reportingrequirements is to make compliance easier forpublicly traded partnerships.

b. Administrative guidance: Temporary regulations

issued on September 6, 1988 amplify and extendguidance provided earlier through Notice 87-10,1987-1 C.B. 422, regarding the manner in which a

nominee can comply with the requirements under

section 6031(c)(1). Temp. Reg. §l.6031(c)-IT.

4. Penalties: A partnership that fails to timely file a

return or files an incomplete return may be liable

for a penalty. I.R.C. §6698(a). The penalty is $50per partner per month for any person who was a

partner in the partnership at any time during thetaxable year. This penalty can be assessed for each

month the partnership return is late, up to a maximumperiod of five months. Although nominal on its face,this penalty, if successfully assessed, can be quite

expensive for the partnership. For example, a

partnership with 100 partners that is four monthslate in filing its return may be assessed a penalty

of $20,000 ($50 x 100 partners x 4 months). I.R.C.§6698(b).

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III. Computation of a Partner's Distributive Share of Partnership

Income.

A. Overview and historical background.

1. Statutory language.

a. General rule: A partner's share of partnership

income, gain, loss, deduction or credit is

determined by the partnership agreement. I.R.C.

§704(a).

i. Form: The agreement may be either oral orwritten (although oral agreements may cause

evidentiary problems).

ii. Modification: Generally, the agreement

between the partners can be modified.

a. Permission: The agreement must allowmodification.

b. Timing: The amendments must be made

on or before the due date (excludingextensions) of the partnershipreturn. I.R.C. §761(c).

b. The partner's interest in the partnership: If

the partnership agreement is silent (i.e., it

does not provide for an allocation), or if the

purported allocation in the agreement lacks"substantial economic effect," then a partner's

distributive share of profit (or loss) isdetermined in accordance with the "partner'sinterest in the partnership." I.R.C. §704(b).

2. Historical background.

a. General rule: The substantial economic effecttest found in section 704 was adopted by the Tax

Reform Act of 1976 (the "1976 Act") as the solemeasure for determining whether or not

allocations contained in the partnership

agreement would be respected.

b. Proposed regulations: Regulations were proposed

under section 704(b), as amended by the 1976Act, on March 8, 1983. Among other things, theproposed regulations provided that:

i. Capital accounts: Partnerships were tomaintain capital accounts on a tax (rather

than a fair market value) basis;

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ii. Nonrecourse debt: Allocations attributable

to nonrecourse debt were allowed if, among

other things, the partnership agreement

provided for either a "deficit restoration"

or an allocation of "minimum gain"; and

iii. Contributed property: Property contributed

by a partner generally was reflected in the

contributing partner's capital account at

its adjusted tax basis.

c. Final regulations: The proposed regulations

were substantially modified by the final

regulations, which were published on December

31, 1985. T.D. 8065, 1986-1 C.B. 254. The

final regulations "reserved" discussion of

allocations attributable to nonrecourse debt.

The nonrecourse debt portion of the final

section 704(b) regulations was published on

September 9, 1986. T.D. 8099, 1986-2 C.B. 84.

B. The section 704(b) regulations: General considerations.

1. Effective dates.

a. Transition rule: The final regulations

generally apply to partnership tax years ending

after 1975. For partnership tax years beginning

before May 1, 1986, allocations will berespected if they have substantial economic

effect under relevant case law, the legislativehistory of §704(b), as amended by the 1976 Act,

and certain provisions of the new regulations in

effect for taxable years beginning before May 1,

1986. Regs. §l.704-1(b)(1)(ii).

b. Prospective application: The effect of thetransition rule is that the final regulations

were generally prospective in application from

issuance and apply to tax years beginning after

April 30, 1986. Calendar year partnerships,therefore, were first required to address the

issue of compliance with the final regulations

for the taxable year beginning January 1, 1987.

c. Nonrecourse debt: Due to their belatedissuance, the nonrecourse debt provisions first

applied for partnership taxable years beginning

after December 31, 1986. Regs.§l.704-1(b)(1)(ii). Thus, calendar year

partnerships should have addressed compliancewith all provisions of the regulations for the

taxable year beginning January 1, 1987.

(However, for those partnerships that failed to

comply, it may be possible to limit the

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partners' potential risks under the subjective"partner's interest" standard only to 1987. AnIRS reprieve, discussed below at C. 4. c. i. b.,allows a calendar year partnership untilNovember 1, 1988 to satisfy the initialrevaluation requirement of the regulations.)

2. Satisfying the requirements of the section 704(b)regulations.

a. General rule: In following the statutoryframework, the regulations provide that, for anallocation to be recognized for tax purposes,the allocation must either:

i. Have "substantial economic effect"; or

ii. Be made "in accordance with the partner'sinterest in the partnership." Regs.§l.704-1(b)(1)(i).

b. Default provision: If the partnership agreementprovides no allocation or if the attemptedallocation lacks substantial economic effect,then the partnership item is allocated accordingto the partner's interest in the partnership.

c. Allocations subject to section 704(b): Theprovisions of the regulations apply to allallocations (not just to "special" allocations)including:

i. "Item" allocations: A separate allocationof an item of income, gain, loss, deductionor credit (partnership "items"); and

ii. "Bottom line" allocations: An allocationof partnership net income (or loss) to apartner is treated as an allocation to thatpartner of each item used in computing thepartnership's "bottom line" income (orloss). Regs. §l.704-1(b)(1)(vii).

d. Nonrecourse debt: Allocations attributable tononrecourse debt are subject to some additionalrequirements. These are discussed in E., below.

3. Reviewing the partnership agreement.

a. Timing: Because the final regulations divergedramatically from the proposed regulations, eachand every partnership existing before adoptionof the final regulations should have examinedits agreement in light of the finalregulations. The general partner then should

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have decided if (and to what extent) thepartnership agreement may have needed to beamended so that any allocation would berespected.

b. Does that mean that every partnership agreementhad to be amended? The answer is NO. Both the

Code and the regulations provide alternative

tests. If an allocation lacks "substantialeconomic effect," it still may be in accordancewith the partner's interest in the partnership.

So long as the partner's interest test is met,the partnership need not concern itself withsubstantial economic effect.

c. What is "the partner's interest in the

partnership"?

i. Economic sharing: The partner's interestin a partnership refers to the manner inwhich the partners have agreed to share theeconomic burdens and benefits of each itemof income, gain, loss or deduction. Regs.§1.704-l(b)(3)(i). Since each item istreated separately, the partners' sharingarrangement for any specific item may notmatch the overall economic arrangement ofthe partners. The regulations contain arebuttable presumption that each partnerhas an equal interest in the partnership(on a per capita basis). Regs.§l.704-1(b)(3)(i).

ii. Factors: The regulations list severalfactors to consider (e.g., relative capitalcontributions and interests in cash flow).Regs. §1.704-i(b)(3)(ii). However, giventhe complexity of sophisticated businesstransactions, as a practical matter thefactors many times cannot be applied withcertainty.

iii. The value of partnership assets as afactor: Although the safe harborprovisions allow and at times requirepartnerships to revalue capital accounts,fair market value may not, in and ofitself, be a factor in determining apartner's interest in a partnership. Theregulations do not identify inherent value

as an appropriate factor for applying thefacts and circumstances test. Additionally,the Tax Court has refused to consider fairmarket value in determining a partner'sinterest in a partnership under section

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704(b) prior to its amendment in 1976. Indicta, the court has said that the fairmarket value of assets as a factor " . . .is contrary to the principles of taxationthat refuse to give effect to unrealizedappreciation or loss." Young v.Commissioner, 54 TCM 119 (1987).

iv. "Plain vanilla" partnerships: Partnershipswith simple capital structures (in which apartner has the same capital and profitsinterest and that interest does not varyfrom year to year) that do not have partnerfunded or guaranteed nonrecourseindebtedness should satisfy the "partner'sinterest in the partnership" test.Consequently, these partnerships may notneed to amend their agreements.

C. "Substantial Economic Effect."

1. General rule: For an allocation to have "substantialeconomic effect," the allocation must have "economiceffect" and this economic effect must be"substantial." Regs. §1.704-l(b)(2)(i).

2. Economic effect.

a. General rule: An allocation of income, gain,loss or deduction (but not credit) has economiceffect if throughout the full term of thepartnership three requirements are met. Regs.§l.704-1(b)(2)(ii)(b).

i. Capital account maintenance: Partners'capital accounts are maintained inaccordance with the rules found in theregulations (See C. 4., below);

ii. Liquidation proceeds: Proceeds inliquidation must be distributed accordingto the positive capital accounts balancesof the partners; and

iii. Obligation to restore: Any partner with adeficit capital account balance followingthe liquidation of his interest in thepartnership is unconditionally obligated torestore the deficit in his capital account.

a. Limited obligation to restore: Absentan unconditional obligation to fullyrestore any deficit in capital, apartner is treated as having a limitedobligation to restore the deficit

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balance in his capital account to theextent of:

i. Any promissory note of thepartner contributed to thepartnership which is due andpayable by the end of thepartnership year in which thatpartner's interest is liquidated(or, if later, within 90 days ofthe date the interest isliquidated); or

ii. Any unconditional obligation ofthe partner to make additionalcapital contributions (withinsimilar time constraints). Regs.§1.704-I(b)(2)(ii)(c).

b. Minimum gain chargeback: Under thenonrecourse rules (discussed at E.,below), a partner's share of minimumgain is considered a limitedobligation to restore a deficit incapital. Regs. §l.704-l(b)(4)(iv)(e).

b. Alternate test for economic effect -- Qualifiedincome offset: If the first two requirements ofthe economic effect test, above, are satisfied,but the partners do not have an unconditionalobligation to restore a deficit in capital, theallocation will still have economic effect if:(1) The allocation does not cause (or increase)a deficit in the partner's capital account (inexcess of any limited dollar amount of deficitthat the partner must restore); and (2) Thepartnership agreement contains a "qualifiedincome offset." Regs. §1.704-l(b)(2)(ii)(c).

i. Definition: Under a qualified income

offset provision, any deficit causedunexpectedly by certain special adjustmentsis eliminated as quickly as possiblethrough subsequent allocations of incomeand gain (possibly even gross income).

ii. Future events: In determining whether ornot an allocation will "cause or increase"a deficit in capital, the partner's capitalaccount must be debited to the extent thatreasonably expected post year enddistributions will exceed certainoffsetting future allocations of income andother credits to the partner's capital.

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c. Economic equivalence test -- The"Dumb-but-lucky" rule: If the above rules arenot met, an allocation will still have economiceffect if the partnership agreement ensures thata liquidation of the partnership, as of the endof each partnership year, would produce the sameeconomic results that would occur if the threerequirements had been met. Regs. §1.704-1(b)(2)(ii)(i). As a practical matter, the economiceffect equivalence test is not the province ofthe prudent tax planner. Rather, it is morelike a last resort viewed with hindsight.

3. Substantiality.

a. General rule: The economic effect of anallocation is substantial if there is areasonable possibility that the allocation willsubstantially affect the dollar amounts that thepartners will receive from the partnership,independent of tax consequences.Notwithstanding, the economic effect of anallocation is not substantial if, at the time itbecomes part of the partnership agreement:

i. Benefit: Any partner's after-tax positionmay. in present value terms, be improved bythe allocation; and

ii. Absence of detriment: There is a "stronglikelihood" that no partner's after-taxeconomic position (again, in present valueterms) will be substantially worse as aresult of the allocation. (In other words,if Treasury is the only loser, theallocation may fail this present valuetest.) Regs. §l.704-1(b)(2)(iii).

b. Shifting tax consequences.

i. General rule: The economic effect of anallocation is not substantial if there is a"strong likelihood" that:

a. Tax reduction: The allocation willcreate a net decrease in the partners'total tax liability; and

b. Minimal capital impact: The increasesand decreases to capital accounts ofthe partners for the year (the test isan annual one) will not be muchdifferent than if the allocation hadnot been made. Regs.§l.704-1(b)(2)(iii)(b).

- 16 -

ii. "Character" allocations: This type ofshifting occurs where the type of incomeallocated to each partner is based on adesire to minimize the partners' overall

tax liabilities. For example, a dollaramount of operating income is allocated to

a low-bracket partner, while an equal

amount of tax-exempt interest income is

allocated to a high-bracket partner.

Similarly, a special allocation of section1231 losses away from a partner with

section 1231 gains with an offsettingallocation of ordinary losses to thatpartner would be a character allocation.

Character allocations generally are not

substantial.

c. Transitory allocations: Transitory allocationsare not substantial. Regs.§l.704-1(b)(2)(iii)(c).

i. Definition: An allocation in one year istransitory where it will be largely offsetby allocations in other years and there isa "strong likelihood" that:

a. Minimal capital impact: The partners'respective capital accounts with the

allocations will not differsubstantially from their capitalaccounts without the allocations; and

b. Tax reduction: The resulting totaltax liability of the partners will bereduced.

ii. Exception -- The 5-year rule: Even if anallocation otherwise would be consideredtransitory, it will not be insubstantial ifthere is a strong likelihood that theoffsetting allocation, in large part, willnot be made within five years after theoriginal allocation.

d. Value equals basis: In determining whether ornot an allocation is substantial, theregulations presume that the fair market valueof partnership property equals the property'sadjusted tax basis. (If the book value of theproperty differs from its tax basis, however,the fair market value is presumed equal to theasset's book value.) Regs.§l.704-1(b)(2)(iii)(c). This presumption mayprove highly significant. For example, aspecial allocation of depreciation coupled with

- 17 -

a gain chargeback provision generally should besubstantial because of the "value equals basis"rule.

4. Maintenance of capital accounts.

a. General rule: For an allocation to haveeconomic effect, the partnership, among otherthings, must maintain the partners' capitalaccounts on a "book" basis rather than on a taxbasis. Regs. §l.704-1(b)(2)(ii)(b).Contributions and distributions of property mustbe reflected in capital at fair market value,rather than adjusted tax basis. This is asignificant departure from the proposedregulations, which focused primarily on taxbasis capital accounting.

i. Increases: A partner's capital account is

increased by:

a. Money contributed to the partnership;

b. The fair market value of property socontributed, net of liabilities; and

c. Allocations of partnership income andgain.

ii. Decreases: A partner's capital account isdecreased by:

a. Partnership distributions of money;

b. The fair market value of property sodistributed, net of liabilities;

c. Expenditures which are nondeductibleunder §705(a)(2)(B) or which aresyndication costs; and

d. Allocations of partnership loss and

deduction. Regs.§l.704-l(b)(2)(iv)(b).

b. Multiple capital accounting: For partnershipswhich issue audited financial statements on a

GAAP basis, the above capital accounting ruleswill result in a third set of books that mustbe kept by the partnership (i.e., GAAP, tax and"book").

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c. Revaluations of property.

i. Timing -- First revaluation: If apartnership existing as of April 30, 1986wishes its agreement to have substantial

economic effect, the partnership generally

must revalue its capital accounts

(and,therefore, its assets) for the first

partnership tax year beginning after that

date. Regs. §1.704-1(b)(1)(ii). Thus,

calendar year partnerships which decided to

comply with the regulations and revaluetheir partners' capital accounts must have

revalued their capital accounts as of

January 1, 1987. This does not mean that

every asset must have been physicallyvalued (e.g, appraised) onJanuary 1, 1987. Rather, the value of thepartnership's assets must have beenestablished as of January 1, 1987. Thevaluation process may occur after that date,

a. Exception -- Differences which are not"significant": In lieu of therevaluation date, the regulationsprovide that a partnership existing asof that date may instead be allowed torestate capital from the date offormation of the partnership where thedifferences between the balance in

each partner's capital account and thebalance that would exist if thepartnership satisfied the regulationssince its inception are notsignificant. Regs. §1.704-1(b)(2)(iv)(r)(2). This would occur, forexample, where a partnership generallyhas followed the capital accountingrules since inception, except that the

partners' capital accounts have notbeen reduced for the syndication costsincurred by the partnership.

b. Amendments adopted by calendar yearpartnerships after April 15, 1988.

i. The conundrum of section 761(c):

A calendar year partnership thatfailed to amend its agreement on

or before April 15, 1988 tocomply with the final section704(b) regulations generally lost

forever its ability to make useof the initial revaluationallowed by the regulations. This

- 19 -

results because section 761(c)requires that any modification ofa partnership agreement must bemade no later than the due date(not including extensions) of thepartnership returns. Thus, forthose partnerships that did notfully comply with the economiceffect requirements of theregulations, it was unclearwhether an amendment to theagreement in a later year coupledwith an asset revaluation as ofJanuary 1, 1987 would satisfy theeconomic effect safe harbor.

ii. Extension of time for the initialrevaluation: To give apartnership a second opportunityat the initial revaluation, theService has extended the time formaking modifications topartnership agreements to complywith the capital accountrevaluation rules to amendmentsadopted on or before November 1,1988. Notice 88-87, 1988-34I.R.B. 20.

iii. Practical implications: Thereare a number of practicalimplications to Notice 88-87,supra. First, the administrativeextension of time until November1, 1988 applies only to extendthe time for amending anagreement so that the partnershipmay adopt the capital accountrestatement provisions of Regs.§l.704-1(b)(2)(iv)(r). Thenotice is not a blanket extensionof time to allow a partnership toadopt all of the requisites ofthe economic effect safe harbor.However, it does provide anopportunity for a dilatorypartnership to revalue itscapital accounts as of January 1,1987. This revaluation maycreate positive capital accountbalances for certain partners(principally limited partners)who otherwise might haveimpermissible deficits incapital, thus allowing the

- 20 -

partnership to allocate losses tothem. Assuming the partnershipconducts a passive activity inwhich these partners holdpre-enactment interests, thepartnership could amend its 1987return so that these partnerscurrently could avail themselvesof at least 65 percent of theirrespective shares of thepartnership's losses reallocatedto them. I.R.C. §469(m). (Ofcourse, a restatement of capitalaccounts under no circumstancecreates additional basis undersection 752 for the partners.Thus, any additional lossesallocated to these partnerspotentially will be subject tothe basis limitation of section704(d).)

ii. Timing -- Additional revaluationconsiderations: A partnership agreement may(but is not required to) adjust thepartners' capital accounts to reflect thefair market value of all partnershipproperty, if "made principally for asubstantial nontax business purpose," uponthe occurrence of any of three triggeringevents. Regs. §l.704-1(b)(2)(iv)(f):

a. Contribution: A contribution of moneyor property to the partnership by apartner for an interest in thepartnership;

b. Distribution: A distribution of moneyor property to a partner asconsideration for an interest in thepartnership; or

c. "Mark to market": If GAAP is utilizedand substantially all the assets ofthe partnership are securities andsimilar instruments which are readilytradable on an established market.

iii. How to revalue: The adjustments mustreflect the manner in which the unrealizedincome, gain, loss or deduction inherent inthe partnership's property would beallocated if there were a sale of theproperty on the date of the revaluation

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(i.e., a "deemed sale" rule). Regs.§l.704-1(b)(2)(iv)(g).

iv. "Fair market value": The partners mayagree among themselves to the fair marketvalue assigned to partnership assets. Theregulations presume such a valuation iscorrect, provided:

a. The agreed-upon value resulted fromarm's length negotiations; and

b. The partners have sufficiently adverseinterests. Regs.§1.704-1(b)(2)(iv)(h).

v. Fair market value on the firstrevaluation: Unofficially, a formerTreasury official extensively involved inthe regulations project has indicated thatthe existing partners in a partnership havesufficiently adverse interests to agreeupon the value of partnership propertywithout an appraisal. However, cautiouspartners may wish to use independent thirdparty appraisers for the firstrevaluation. While the Service is free tochallenge an appraisal, the use of acompetent third party should assist thepartners in defending any valuationchallenge eventually raised by the IRS.

vi. Advisability of optional revaluations: Inthose situations in which a partnership mayelect to revalue its property, itfrequently will be prudent to do so. Forexample, where partnership property has atax basis different from its fair marketvalue, a revaluation would allow thecapital accounts to reflect the trueeconomic interests of the partners.Similarly, where the value of partnershipassets exceeds the adjusted tax basis ofthe assets, a revaluation will increase thecapital accounts of the partners, thuscreating additional capital against whichlimited partners could claim theirrespective share of partnership losses(subject, of course, to other limitationscontained in the tax laws). In othersituations, however, the administrativeproblems may outweigh any perceivedbenefits.

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d. Transfers of partnership interests: The capitalaccount of a partner who transfers his (or her)

interest in a partnership will normally carry

over to the transferee partner. However, if

there is a technical termination of the

partnership within the meaning of section

708(b), the capital accounts will be adjusted asif there had been a taxable sale of the

partnership's assets. Regs.

§l.704-1(b)(2)(iv)(l).

e. Section 754 adjustments: Section 743(b) basis

adjustments (transfers of partnership interests)

generally are not reflected in capitalaccounts. However, section 734(b) basis

adjustments (distributions of partnershipproperty) are generally reflected in the capital

account of the partner receiving the

distribution or, in certain cases, in thecapital accounts of all partners. Regs.

§1.704-1(b)(2)(iv)(m).

D. Allocations to reflect revaluations.

1. General rule: The regulations state that the capital

accounts of the partnership must be maintained on abook basis. Accordingly, for purposes of maintainingcapital accounts, book depreciation and gain (or

loss) with respect to revalued property must becomputed on a fair market value basis, and

depreciation is charged against that basis until a

subsequent revaluation. This often will create abook/tax disparity. If the disparity arises due to a

contribution of property, section 704(c) governs the

allocation. However, if the difference arises from arevaluation of assets, capital accounts must be

adjusted only for book amounts. Regs.§1.704-l(b)(4)(i). Thus, separate tax allocations

cannot have economic effect and, consequently, must

follow the book allocations.

E. Nonrecourse debt.

1. Partner's interest in the partnership: Allocations

of loss and deduction attributable to nonrecourse

debt are economically borne by the lender. Since no

partner can bear this economic loss, allocations of

loss and deduction attributable to nonrecourse debt

cannot have substantial economic effect and these

deductions must be allocated in accordance with the

partners' interests in the partnership. Regs.

§l.704-1(b)(4)(iv)(a).

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2. Safe harbor: The regulations provide thatallocations of loss and deduction attributable tononrecourse debt are deemed to be in accordance withthe partner's interest in the partnership if fourrequirements are met. Regs. §l.704-1(b)(4)(iv)(d):

a. Economic effect: The first two requirements of"economic effect" (discussed at C. 2. a., above)are present. Regs. §l.704-1(b)(4)(iv)(d)(1).

i. Capital account maintenance: Partners'capital accounts are maintained inaccordance with the rules found in theregulations; and

ii. Liquidation proceeds: Proceeds inliquidation are distributed according tothe positive capital account balances ofthe partners.

b. Consistency with other allocations which havesubstantial economic effect: The partnershipagreement allocates deductions attributable tononrecourse debt among the partners in a mannerthat is "reasonably consistent" with allocations(which have substantial economic effect) of someother significant partnership item attributableto the property securing the nonrecourseliability. Regs. §l.704-l(b)(4)(iv)(d)(2).

i. Example -- Inconsistent allocation of costrecovery deductions: In a two personlimited partnership which owns fullyleveraged depreciable property secured bynonrecourse debt, the general and limitedpartner share all items equally, exceptthat 100 percent of the cost recoverydeductions are allocated to the limitedpartner. If the cost recovery deductionsare attributable to the nonrecourse debt(which in many instances they are), theallocation fails the consistencyrequirement.

c. Deficits in capital: The partnership agreementmust provide for either: (1) The partners'unconditional obligation to restore deficits incapital (See, C. 2. a. iii., above); or (2) Aminimum gain chargeback provision. Regs.§l.704-l(b)(4)(iv)(d)(3).

i. Minimum gain: In general, a partnership'sminimum gain is the amount of gain realizedif encumbered property is disposed of infull satisfaction of the nonrecourse

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liability securing the property. Regs.

§1.704-1(b)(4)(iv)(f).

ii. Minimum gain chargeback: If there is a net

decrease in the partnership's minimum gain

during a taxable year, all partners with a

deficit capital account balance at the end

of that year are allocated partnershipincome and gain to the extent of the

decrease in the minimum gain.

a. Timing: The allocation of minimum

gain under the chargeback provisionoperates before any other allocation

of income (or loss) for the current

year.

b. Deficit in capital: In determiningthe extent to which partners have

deficit capital account balances, any

amount a partner is obligated torestore is added back to their capitalaccount, but the amount of anticipatedfuture distributions in excess ofcertain offsetting increases to

capital accounts will serve to

increase the deficit.

d. Compliance: Aside from nonrecourse debtdeductions, all other material allocations andcapital adjustments must satisfy all otherrequirements of the final regulations. Regs.§l.704-l(b)(iv)(d)(4).

3. Nonrecourse loans by a partner: The partner whomakes a nonrecourse loan to his partnership bears the

burden of economic loss, rather than thepartnership. Accordingly, any allocationattributable to that nonrecourse loan generally mustbe allocated to the lending partner. Regs.§l.704-1(b)(4)(iv)(g).

a. Guarantees: This rule applies as well tononrecourse debt guaranteed by a partner. Thus,

allocations attributable to the guaranteedportion of the nonrecourse liability must be

allocated to the guarantor partner.

b. Absence of regulations integration: Theexisting liability sharing regulations undersection 752 currently lack any provision similarto the partner-lender rules found in Regs.§l.704-l(b)(4)(iv)(&). This regulatoryinconsistency may create some interesting tax

anomalies for which the prudent tax practitioner

- 25 -

should be prepared. For example, the limitedpartner in a partnership composed of two Ccorporations who makes a nonrecourse loan to thepartnership will be allocated all deductionsattributable to that loan. However, theexisting regulations under section 752 may beread to allocate only one-half of the debt tothe lending partner for basis purposes. Regs.§1.752-1(e). Consequently, if the loan is ofsufficient size and the partnership is notprofitable, at some point in time the partnerwill be allocated losses for which it lacksbasis, causing those losses to becomesuspended. I.R.C. §§704(d) and 705. TheService and Treasury currently are at work on arevision of the section 752 regulations which,when issued, presumably will integrate theseprovisions. LR-229-84.

c. Related party nonrecourse debt: The regulations"reserve" for a future date the proper treatmentof partnership nonrecourse liabilities where thelender is a person related to a partner. Regs.§l.704-1(b)(4)(iv)(h). (When issued, it isreasonable to expect that this portion of thesection 704(b) regulations will be integratedwith the liability sharing rules in theforthcoming revision to the section 752regulations.)

4. Multiple secured assets and multiple nonrecourseliabilities: The regulations provide special rulesfor properties securing more than one liability andfor one debt encumbering multiple assets. Regs.§1.704-1(b)(4)(iv)(c).

a. Single asset and multiple liabilities: Theadjusted basis of an asset securing two or moreliabilities of equal priority is allocatedbetween the debts according to their respectiveoutstanding principal balances.

b. Single asset -- Multiple liabilities of unequalpriority: The adjusted basis of an assetsecuring two or more liabilities of unequalpriority is allocated in full first to the debtwith a priority claim. Any adjusted tax basisof the asset remaining is then allocated to theinferior liability.

c. Multiple assets -- Single liability: If asingle nonrecourse obligation is secured bymultiple assets, the adjusted tax basis of allof the assets is used to compute thepartnership's minimum gain, if any.

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F. Other considerations.

1. Tax credits: Special allocations of credits do nothave substantial economic effect because theseallocations do not affect capital accounts. Theinvestment tax credit is allocated according to thepartners' profits interests. All other creditsgenerally are allocated according to the partners'interest in the partnership. However, if thepartnership expenditure which generates the creditalso gives rise to allocations of loss or deduction,then the partners will share the credit in the sameproportion as they share in that loss or deduction.Regs. §1.704-I(b)(4)(ii).

2. Oil and gas partnerships: The regulations containspecial rules for computing depreciation, depletionand gain or loss for oil and gas properties. Regs.§1.704-1(b)(4)(v).

3. Partnership agreement amendments: For purposes ofthe regulations, the partnership agreement includesall agreements and amendments (whether written ororal) among the partners.

a. Necessity of a writing: Where the partnershipagreement provides that it may not be amendedorally, each of the partners generally mustconsent in writing on a timely basis for anamendment to the agreement to be effective.Tapper v. Commissioner, 52 T.C.M. 1230 (1986).

b. Subsequent amendments: Amendments to theagreement made subsequent to the time anallocation is made will be considered indetermining whether or not prior allocationswill be reallocated. In other words, theamendment may be treated as if it always was apart of the agreement. Regs.§l.704-1(b)(4)(vi).

4. Requests for a ruling: For those partnerships thatwish some degree of certainty for the allocationsmade by their agreement, the Service has stated thatit will entertain rulings on the economic effect ofthe allocations (but not whether those allocationsare substantial). This willingness on the part ofthe IRS to issue a ruling extends to existingpartnerships, as well as newly formed entities. Rev.Proc. 88-1, 1988-1 I.R.B. 7.

G. Contributed property.

1. Prior to the Tax Reform Act of 1984 (the "1984Act"): Contributions of appreciated property.

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a. General rule: The partnership takes a carryover

basis in the contributed property. I.R.C. §723.

i. Distortion: A distortion in income and

deduction could result between partnerswhich could continue until the partnership

is liquidated.

ii. Example I: Individuals A and B form

partnership AB. A contributes depreciableproperty worth $50,000 with a tax basis of$10,000. B contributes $50,000 in cash. A

and B share profits and losses equally. ABtakes A's basis of $10,000 in theproperty. A has a basis of $10,000 in his

interest and B has a basis of $50,000 inher interest. If the depreciable propertywas sold immediately for $50,000 in year 1,

and the partnership was liquidated in year2 by distributing its $100,000 equally to Aand B, the following results would occur,

absent any special provisions in the Code:

a. To A: A would pick up $20,000 of gainin year I (his portion of the gain)

and $20,000 in year 2 ($50,000

distribution less his $30,000 basis).

b. To B: B would also pick up $20,000 of

gain in year 1, but she would have a$20,000 loss in year 2 ($50,000

distribution less her $70,000 basis).

c. Recognition with no "economic" gain:In this situation, B is reporting

$20,000 of tax gain in year 1, whenthe partnership has recognized no"teconomic" gain. In fact, the value

of B's interest has remained $50,000,despite the fact that B has reported

$20,000 in gain. B, however, doesreport an offsetting $20,000 loss in

year 2 when AB is liquidated.

iii. Prior law: Under section 704(c), as in

effect prior to the 1984 Act, the partnerscould have provided in the partnershipagreement that gain, loss, or depreciationwith respect to appreciated (or

depreciated) property contributed to the

partnership by a partner be shared amongthe partners so as to take account of the

variation between the income tax basis of

the property and its fair market value atthe time of contribution. See, I.R.C.

- 28 -

§704(c)(2) (as in effect prior to the 1984Act).

a. Example 2: If the AB agreement in theabove example was amended to providefor allocations to the partners totake account of the difference betweenthe fair market value of the propertyand its tax basis on the date ofcontribution, then the $40,000 gain inyear 1 would be allocable entirely toA. Upon a liquidation in year 2, eachpartner would receive $50,000 andneither partner would recognize gainnor loss.

b. Under section 704(c) prior to the 1984Act amendments, the result in a.,above, could be achieved only if thepartnership agreement specificallyprovided for these allocations.

2. The 1984 Act: Mandatory allocation of "built-in" gainor loss.

a. General rule: Section 704(c), as amended by the1984 Act, generally requires that income, gain,loss and deduction with respect to contributedproperty be shared among the partners to accountfor the variation between the basis and fairmarket value of the property at the time ofcontribution. Except as noted below, this mayrequire property by property allocations.

i. Effect: The optional rule formerlycodified in old section 704(c)(2) is nowmandated as section 704(c).

ii. Reliance: Congress intended that taxpayersare entitled to rely on the regulationsexisting under old section 704(c)(2) untilthe new section 704(c) regulations areissued. H. Rep. No. 861, 98th Cong., 2dSess. 857 (1984).

iii. Timing of deductions: Depreciation anddepletion deductions generally must beallocated disproportionately to thenoncontributing partner(s). See, Regs.§l.704-l(b)(2)(iv)(d)(3) and§l.704-l(b)(2)(iv)(&). This is illustratedby the example at C., below.

- 29 -

iv. Accrued but unpaid items: The section704(c) regulations also are to provide thatcontributions by a partner using the cashmethod of accounting of accounts payableand other accrued but unpaid items will besubject to rules similar to those forcontributions of property. See, Staff ofthe Joint Committee on Taxation, GeneralExplanation of the Revenue Provisions ofthe Tax Reform Act of 1984 (P.L. 98-369)(the "1984 General Explanation"), 215-216.

v. Anticipated regulations: The legislativehistory to the 1984 Act provides someindication of what the new section 704(c)regulations, when issued, will provide.See, e.g., 1984 General Explanation,211-216. These regulations my ease someof the administrative burden of new section704(c). Among the provisions which may beincluded are:

a. Appreciated properties: Aggregationof properties with fair market valuesgreater than their respective basisthat are contributed by a singlepartner.

b. Depreciated properties: Aggregationof properties with fair market valuesless than their respective adjustedbasis that are contributed by a singlepartner.

c. De minimis amounts: Differences ofless than 15 percent (but notexceeding $10,000) between theadjusted basis and the fair marketvalue of any aggregated properties areto be accounted for in a mannerconsistent with section 704(c)(1) asit existed under prior law (i.e., toallocate items in the manner in whichthey would be allocated if thepartnership had purchased the propertyfor its fair market value).

d. Timing: Differences between theadjusted basis and fair market valueof contributed properties are to beeliminated more slowly than otherwiserequired by the new rules throughallocations solely of gain or loss onthe disposition of such properties(thereby permitting allocations of

- 30 -

depreciation, depletion or similaritems with respect to such property tobe governed solely by section 704(b)),so long as this flexibility is notlikely to result in the contributingpartner avoiding the effect of theallocation of built-in gain or loss(such as when the property is expectedto be held by the partners until ithas little, if any, fair market value).

vi. Interplay with section 704(b): The newsection 704(c) regulations take on addedimportance since the section 704(b)regulations generally require that section704(c) principles be followed in makingallocations to partners where thepartnership's assets and capital accountshave been revalued. Regs.§l.704-l(b)(2)(iv)(f).

3. How the rules work.

a. Example: The workings of section 704(c) may beillustrated, in part, by an example.

i. Example: Cash Partner and Property Partnerform an equal partnership to produce andmarket highly specialized equipment. Cashcontributes $10,000 in cash and Propertycontributes depreciable property with abasis of $6,000 and a fair market value of$10,000. Profits and losses of thepartnership will be shared equally. Thepartnership will depreciate the property ona straight line basis (assuming no salvagevalue) over a period of ten years for bothbook and tax purposes. The partnershipdepreciates the contributed property fortwo years and then sells it for $11,000 atthe end of the second year.

b. The resulting allocations: The allocations forboth book and tax purposes for the period oftime from contribution by the partners throughoperation and sale are as follows:

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Cash's Capital Property's Capital

Tax Book Tax Book

Contribution $10,000 $10,000 $ 6,000 $10,000

Depreciation - Year 1 <500)(l) <500>(1) (I00>(I) <500>(l)

Capital at the end of

Year 1 $ 9,500 $ 9,500 $ 5,900 $ 9,500Depreciation - Year 2 (500> <500> (100) <500>

Capital prior to sale $ 9,000 $ 9,000 $ 5,800 $ 9,000Book gain 1,500 1,500(2) 1,500 1,500(2)

Additional tax gain - - 3,200(3) -

Capital after sale at

end of Year 2 il50i500 $10,500 0 I0.500

I Book depreciation is calculated as 10 percent of $10,000 and tax

depreciation as 10 percent of $6,000.

2 Book gain on sale is calculated as the sales price, $11,000, less

the adjusted basis, $8,000 ($10,000 - (2 X $1,000)) or $3,000.

3 Tax gain on sale is calculated as the sales price $11,000, less the

adjusted basis, $4,800 ($6,000 - (2 x $600)), or $6,200.

c. Points of worthwhile note: The above example

illustrates a number of interesting points,

including:

i. Disparity upon contribution: The built-in

gain of the contributed property is

reflected in the difference between the tax

and book capital accounts of the

contributor. The inherent appreciation isnot, and cannot be, reflected in the

contributor's tax basis for his partnership

interest.

ii. Subsequent allocations: The section 704(b)regulations mandate that book/tax

disparities be eliminated as quickly aspossible. In theory, this would be

accomplished by allocating all depreciationwith respect to the contributed property to

the noncontributing partner. However, thiswould violate the section 704(b)

regulations. Regs. §l.704-l(b)(2)(iv)(&).

iii. Gain on sale: Any remaining inherent gain

that has not been eliminated by partnership

operations is first allocated the gain on

sale. The remaining gain on sale, if any,may be allocated between the partners asthey may agree, subject to the constraints

imposed by section 704.

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4. The ceiling rule: The current regulations limit themandatory allocations of income, gain, loss anddeduction with respect to contributed property,discussed above, to the amount of gain or lossrealized by the partnership or the depreciation ordepletion allowable to it for Federal tax purposes.Regs. §1.704-l(c)(2)(i).

a. Effect: Application of the ceiling rule maylimit the degree to which the mandatoryallocations eliminate contributed propertydistortions.

b. Continued vitality: Some tax practitioners haveargued for the elimination of the ceiling rule.See, e.g., Turlington, "Section 704(c) andPartnership Book-Tax Disparities: The CeilingRule and the Art of Tax Avoidance," 46th N.Y.U.Institute on Federal Taxation 1[26.00 (1988).

H. Consequences of changes not resulting in termination ofthe partnership.

1. Partnership allocations.

a. Inclusion in income: The computation of apartner's taxable income requires the inclusionof that partner's share of partnership income,gain, loss, deduction or credit and guaranteedpayments for the taxable year of the partnershipthat ends with or within the taxable year of thepartner. I.R.C. §706(a).

b. Closing of taxable year: Certain events maycause the partnership's taxable year to closewith respect to a partner before its normal yearend closing. I.R.C. §706(c).

2. General rule: Unless the partnership terminatesunder section 708(b) and except to the extentprovided in section 706(c)(2)(A) (dispositions of apartner's entire interest in the partnership),section 706(c)(1) provides that a partnership'staxable year does not close as a result of:

a. The death of a partner;

b. The entry of a new partner;

c. The liquidation of a partner's interest; or

d. The sale or exchange of a partner's interest inthe partnership.

- 33 -

3. Closing of the taxable year for all partners: If thepartnership terminates under section 708(b), thetaxable year of the partnership closes with respectto all partners.

4. Closing of the partnership taxable year for apartner: The taxable year of the partnership closesfor a partner who disposes of his entire partnershipinterest through a sale or exchange of the interestor by a liquidation of the interest by thepartnership. I.R.C. §706(c)(2)(A); Regs.§1.706-I(c)(2)(i).

a. Events: Sale or exchange transactions includeboth taxable and nontaxable events such as:

i. Like kind exchanges under section 1031;

ii. Contributions of partnership interests tocontrolled corporations (section 351) andpursuant to corporate reorganizations(section 368);

iii. Arguably, contributions of partnershipinterests to other partnerships (but seeLtr. Rul. 8819083, which holds that thecontribution of a partnership interest toanother partnership is not a sale orexchange for purposes of section 708(b));

iv. Distributions of partnership interests bycorporations or partnerships; and

v. Sales to a related party under section 267.

b. Death of a partner: The death of a partnergenerally is not a disposition that closes thetaxable year of the decedent partner prior tothe end of the partnership's taxable year.I.R.C. §706(c)(2)(A)(ii).

i. Buy/sell agreements: However, a buy/sellagreement between the partnership or theother partners and the decedent partner,effective at the date of decedent's death,will result in a closing of the tax yearfor the decedent's interest.

c. Disposition of less than entire interest: Thetaxable year of a partnership does not closewith respect to a partner who sells, exchanges,or reduces (by entry of a new partner, partialliquidation of a partner's interest or gift)less than his entire partnership interest.I.R.C. §706(c)(2)(B).

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i. Terminations: However, the partnershiptaxable year could close for all of thepartners as a result of a sale or exchangeby one partner. For example, if A owns a70 percent interest in the ABC Partnershipand sells 80 percent of his interest(resulting in the sale of a 56 percentinterest in the partnership), thepartnership will terminate pursuant tosection 708(b)(1)(B).

5. Consequences to the partner whose taxable year closes.

a. Partnership's year closes for partner: If thedisposition of a partnership interest results inthe closing of a partner's taxable year, thepartner must include in taxable income, for histaxable year within or with which suchmembership in the partnership ends, thedistributive share of income, gain, loss,deduction or credit, as well as any guaranteedpayment. Regs. §1.706-I(c)(2)(ii).

b. "Bunching" of income may result: If the taxableyear of the partnership is different from thetaxable years of the partners, there may be a"bunching" of income. That is, the inclusion ofmore than 12 months of partnership income in theselling partner's taxable income in the year ofsale. This possibility of the bunching ofpartnership income results in a number ofplanning opportunities or potential pitfalls forthe selling partner, including:

i. Timing of the sale: If the sale occurs,for example, one day after the close of thepartnership's year, no bunching will result.

ii. Staged Sale: A partner also may avoid aclosing of the taxable year (and possible"bunching" of income) by selling 90 percentof the interest in one year and theremaining 10 percent in a future year.See, e.g., Ltr. Rul. 7902086.

iii. Tax rate changes: If the tax rate of theselling partner is expected to varysignificantly from year to year, the salecan be structured to trigger any bunchingin a low rate year. Thus, bunching is notalways a negative, but may be used as aplanning tool.

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a. Example: Planning Partners has a June30 taxable year (its natural businessyear) and reasonably expects to earnapproximately $10,000 of taxableincome each month for the next threeyears. Tired Partner has a 10 percentinterest in partnership profits andlosses and he will sell his interestto an unrelated third party, either inlate 1989 or early 1990. Tired'smarginal Federal tax rate in 1989 willbe 28 percent. However, the taxreforms enacted as part of theanticipated Deficit Reduction Act of1989 will boost his 1990 marginal rate

to 50 percent. If he sells anDecember 31, 1989, Tired's share ofpartnership income will be $18,000((10 percent x $120,000) + (10 percentx $60,000)), which will generate aFederal tax liability of $5,040($18,000 x 28 percent). Should hesell on January 2, 1990, Tired willhave a Federal tax liability from hisshare of partnership income of $6,360(($12,000 x 28 percent in 1989) +($6,000 x 50 percent in 1990)). Thus,

selling his interest three daysearlier saves Tired $1,320 in Federaltaxes, a savings of more than 26percent.

b. Observations: The above examplewarrants a number of observations.Obviously, in addition to the bunchingof income phenomenon, any gain on thesale of the interest must beconsidered, including the value ofdeferring the incidence of taxation.Secondly. state income taxconsiderations may reduce or magnifythe savings illustrated above.Finally, the selling partner must havethe cash with which to pay the tax.Cash flow and other businesspracticalities may outweigh the

potential tax savings.

iv. Uneven income stream: If the partnershiphas an uneven stream of earnings (or largecapital transactions) during the year, thepartnership's method of closing its booksmay be of extreme importance. If thepartnership use the pro rata method allowedby Regs. §1.706-i(c)(2)(ii), the prorationmay skew the amount of income allocated to

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the selling partner, either to his benefitor detriment. (These allocation methodsare discussed below.)

6. Computing the partner's distributive share.

a. Date of closing: If a partner's taxable yearcloses as a result of a disposition of apartnership interest, the first computationinvolves determining the date the partnershipyear closes. §706(c)(2)(A).

i. Sale of interest: If a partner sells orexchanges his entire interest, the date thepartnership year closes for the sellingpartner occurs when the benefits andburdens of ownership actually shift.

ii. Liquidation of interest: If a partner'sinterest is liquidated, the partnershipyear closes on the date that the partnerreceives the final payment in liquidationof the interest. Until then, thepartnership interest is treated only asbeing reduced. Regs. §1.761-1(d).

b. Allocation of income: The second computationinvolves the allocation of partnership income(or loss) with respect to the partner'sinterest. I.R.C. §706(d).

i. Varying interests rule: Where there is achange in any partner's interest in thepartnership, each partner's distributiveshare of any item of income, gain, loss,deduction or credit is allocated to eachpartner in a manner which takes intoaccount the varying interests of thepartners in the partnership during thetaxable year. I.R.C. §706(d)(1). See,Rev. Rul. 77-310, 1977-2 C.B. 217.

ii. Methodology: Allowable methods todetermine a partner's varying interestinclude:

a. Interim method: Where less than anentire partnership interest is sold,exchanged, or liquidated (includingthe entry of a new partner), thepartnership may close the books on aninterim basis in order to determinethe share of income, gain, lossdeduction, and credit to be allocatedto the outgoing partner. Regs.

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§1.706-i(c)(2)(ii). An interimclosing of the partnership books:

i. Can be expensive and is notfeasible in publicly tradedpartnerships.

ii. Allows the partnership to use asemi-monthly convention.Partners entering in the first 15days of the month are consideredas entering at the beginning ofthe month. Partners enteringafter the 15th day of the monthare treated as entering at thebeginning of the next month.IR-84-129 (December 13, 1984).

b. Monthly pro rata method: To avoid aninterim closing, the partners mayagree to estimate the outgoingpartner's share of income by proratingthe entire year's income. Reg.§I.706-I(c)(2)(ii). The outgoingpartner's pro rata share of income canbe determined by either:

i. The number of days he was apartner of the partnership; or

ii. Any other reasonable method.Regs. §1.706-1(c)(2)(ii). Apartnership that uses theproration method is not permittedto use a semi-monthlyconvention. IR-84-129 (December13, 1984).

c. Any other reasonable method: Thepartners may also use any otherreasonable method (e.g., a hybrid ofthe interim closing and monthly prorata methods) for allocating itemsamong the partners.

d. Special rule for cash methodpartnerships: A special rule appliesfor the allocation of certain items bya cash method partnership.Specifically, this rule was enacted toprevent a cash method partnership fromdelaying payment of certain "accrued"expenses in order to shift theallocation of such items to incomingpartners. I.R.C. §706(d)(2).

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i. The particular "allocable cashbasis items" are: Interestexpense, taxes, payments forservices or for the use ofproperty, and any other item thatmay result in a significantmisstatement of income. I.R.C.§706(d)(2)(B).

ii. Income items, along with items ofdeduction, are also subject tothis special rule.

iii. These cash basis items must beallocated on an economic"accrual" basis to the day onwhich the item was incurred andmust be allocated only topartners that were in factpartners of the partnership onthe close of the day the item wasincurred. I.R.C. §706(d)(2)(A).

iv. If the item is deductible in ayear other than in the year inwhich it is incurred, any amountsthat would be allocated topartners who are no longerpartners of the partnership atthe time of payment must be

capitalized and allocated toother assets. I.R.C.§706(d)(2)(D).

IV. Basis of a Partner's Interest in the Partnership.

A. Theory of a partner's basis.

1. Nature of a partnership interest: A partner'sinterest in a partnership is similar to ashareholder's stock ownership in a corporation. Thepartnership interest gives the partner a proprietaryclaim against the assets of the partnership.

2. Purpose: The purposes for determining a partner'sbasis in a partnership essentially are threefold:

a. Measure gain or loss on sale: A partner's basisis used to measure the gain or loss from a saleor taxable exchange of a partner's interest inthe partnership or the liquidation of apartner's interest in the partnership (I.R.C.§§741 and 736);

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b. Determine basis of property received inliquidation: A partner's basis is used indetermining the basis of partnership property(other than money) received in liquidation ofthe partner's interest in the partnership(I.R.C. §732(b)); and

c. Set limit on deductibility of losses: Apartner's basis is important because it is usedto limit the deductibility of a partner's shareof partnership losses. I.R.C. §704(d).

3. "Outside" versus "inside" basis: Many times, apartner's basis for his partnership interest (the"outside" basis) does not equal his share of thepartnership's basis for its assets (the "inside"basis).

a. Reasons for the discrepancy: This inequalitymay occur, for example, as a result of theacquisition of a partnership interest throughpurchase (or inheritance).

b. Purchase of partnership interest: If apartnership interest is acquired from anexisting partner, the purchasing partner willtake a cost basis in the partnership interest,which may be higher or lower than the basis ofthe partnership interest in the hands of theselling partner.

i. Result: As a result, the purchasingpartner's basis in the partnership interestwill differ from his share of the basis ofthe partnership's assets.

ii. Section 754 election as a remedy: Toequalize the inside and outside bases, thepartnership may elect to adjust the basisof its assets. I.R.C. §743(b). (However,in many circumstances, the basis allocationrequired by a section 754 election will notmirror the value of the partner's undividedinterest in partnership property. Regs.§1.755-1(a).)

4. Capital account not determinative: A partner's basisin his partnership interest is determinedindependently of the partner's capital account.Regs. §1.705-1(a)(1).

a. Capital accounts maintained under section704(b): However, capital accounts must beproperly maintained to demonstrate the "economiceffect" of an allocation of income (or loss).I.R.C. §704(b).

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b. At risk amounts separately computed:Additionally, for purposes of determining thelimitation of loss deductions, partners mustseparately compute their amounts at risk inpartnership activities. I.R.C. §465.

B. General rule for basis determination.

I. Basis upon acquisition: A partner's initial basisfor his partnership interest is determined in one oftwo ways.

a. Substituted basis: If the partnership interestis acquired as a result of a contribution ofmoney or other property, the contributingpartner's basis equals the amount of moneycontributed plus the adjusted basis to thecontributor of any property contributed. I.R.C.§722.

b. Cost basis: If a partnership interest isacquired other than as a result of acontribution of property (e.g., by purchase ofan existing partner's interest or acquisition ofa partnership interest from a decedent), thepartner's basis is determined under the generalbasis rules of sections 1011, 1012, 1014, etc.I.R.C. §742.

2. Adjustments to basis -- Partnership operations: As aresult of the operations of the partnership, thebasis of a partner's interest in the partnership willeither increase or decrease. I.R.C. §705.

a. Increases to basis: The basis of a partnershipinterest is increased by:

i. Contributions: Additional contributions tothe partnership or other forms ofacquisition (e.g., purchases) (I.R.C. §§722and 742);

ii. Distributive share of income items: Thepartner's share of partnership taxableincome, tax-exempt income, and depletiondeductions in excess of the basis of theproperty subject to depletion (I.R.C.§705(a)(1)); and

iii. Increases in liabilities: An increase inthe partner's share of partnershipliabilities (including partnershipliabilities assumed by the partner).I.R.C. §752(a).

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b. Decreases to basis: A partner's basis isdecreased by:

i. Distributions: Distributions of money orother property from the partnership (I.R.C.§733);

ii. Distributive share of losses: Thepartner's share of partnership losses andnondeductible, noncapitalized expenditures(I.R.C. §705(a)(2));

iii. Decreases in liabilities: Any reduction ina partner's allocable share of partnershipliabilities (I.R.C. §752(b));

iv. Depletion deductions: The partner'sdeduction for depletion with respect tocertain oil and gas property of thepartnership (but not in excess of thepartner's proportionate share of adjustedbasis of such property) (I.R.C.§705(a)(3)); and

v. ITC property basis adjustments. (I.R.C.§ 48(q)).

3. Additional considerations.

a. No negative basis: The basis of a partner'sinterest in a partnership cannot be reducedbelow zero. I.R.C. §705(a)(2) and (a)(3).Instead of reducing basis below zero, a partneris fully taxed on distributions of cash(including constructive liability relief) inexcess of basis, and then takes a zero basis inany noncash property distributions. I.R.C.§§731 and 732.

b. Ordering and timing of basis adjustments.

i. Purpose: The ordering rules are designedto prevent a partner from deductingpartnership losses prior to reducing thatpartner's basis by distributions.

a. Losses considered last: Indetermining a partner's basis forpurposes of the limitation of section704(d), a partner's basis is firstincreased for his distributive shareof partnership income items undersection 705(a)(1). and decreased bydistributions and other items undersection 705(a)(2) except for losses.

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The partner's basis thus determinedserves as the limitation on thededuction of partnership losses.Regs. §1.704-1(d)(2).

b. Illustration: Rev. Rul. 66-94, 1966-1C.B. 166, illustrates the orderingrules for determining a partner'sbasis for partnership loss purposes.Distributions from the partnership(including cash distributions) reducea partner's basis before partnershiplosses are allocated. Rev. Rul.66-94, supra.

c. Losses suspended on pro rata basis:If losses exceed the partner's basis,the deductible losses are deemed toconsist of a pro rata share of eachtype of loss (e.g., ordinary andcapital loss). Regs. §1.704-1(a)(2).(A different ordering rule exists forlosses suspended under the at riskrules. Prop. Regs. §1.465-38. Thisdichotomy may be corrected in anamendment to the at risk regulations.)

ii. Determination date.

a. General rule: Normally, in computingthe partner's basis for purposes ofcalculating gain on a cashdistribution the partner's basis mustbe determined through the date of thedistribution.

b. Exception: Advances or drawingsagainst a partner's distributive shareof partnership income are treated asmade on the last day of the year.Regs. §l.731-1(a)(1)(ii).

c. Practical point: Distributions otherthan a draw may trigger a gain undersection 731(a), even if the recipientpartner anticipates sufficientpartnership income by year end tocover the draw. For example, A and Bform a partnership, AB, to provideservices. AB adopts the cash methodof accounting and does not include adraw provision in its partnershipagreement. A and B agree to shareincome equally and they each make a$10,000 capital contribution to the

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partnership. On March 31, thepartnership distributes $25,000 to A.Partnership income of $120,000 is

earned ratably during the year. Thepartnership has no liabilities. Ifthe March distribution is not

considered an advance against currentyear earnings, A will recognize a gainunder section 731(a) of $15,000, inaddition to his distributive share ofpartnership income of $60,000. A'sbasis at March 31 is $10,000 becausehe is not credited for any portion ofcurrent year earnings until the end ofthe year. Regs §1.705-1(a)(1).

Therefore, his gain is equal to$15,000. As a practical matter, many

partnerships (especially professionalservice firms) should considerincorporating a draw provision intotheir partnership agreement.

c. Charitable contributions: A partner's share ofpartnership charitable contributions is notsubject to the basis limitation. See, Regs.§1.704-1(d)(2) where charitable contributions

separately stated under section 702(a)(4) areomitted from the partner's basis computation.See also, Ltr. Rul. 8753015.

d. Dual interests: A partner holding both ageneral and limited interest in the samepartnership is treated as having a single(combined) basis for both interests. Rev. Rul.84-53, 1984-1 C.B. 159. (A similar rule appliesto combine a partner's multiple interests forcapital accounting purposes. Regs.§l.704-l(b)(2)(iv)(b).)

C. Partnership liabilities.

1. General rule: As discussed previously, partnershipliabilities affect the bases of the individualpartners. This ability of a partner to includeentity level liabilities in basis is a primary

distinction between partnerships and S corporations.

a. Increases to basis: A partner's basis in hispartnership interest is increased by:

i. Any increase in the partner's share ofpartnership liabilities; or

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ii. Any increase in a partner's personalliabilities by reason of the assumption ofpartnership liabilities. I.R.C. §752(a).

b. Decreases to basis: A partner's basis in hispartnership interest is decreased by:

i. Any decrease in the partner's share ofpartnership liabilities; or

ii. Any decrease in the partner's personalliabilities by reason of their assumptionby the partnership. I.R.C. §752(b).

c. Nonrecourse debt: The basis attributable tononrecourse indebtedness encumbering contributedor distributed property is limited to the fairmarket value of the encumbered property. I.R.C.§752(c).

i. Commissioner v. Tufts: Section 752(c)applies only to transactions betweenpartners and the partnership under sections752(a) and (b) and not to sales ofpartnership interests. Commissioner v.Tufts, 461 U.S. 300 (1983) ("Tufts"). InTufts, supra, the taxpayers sold theirinterests in a partnership to an unrelatedthird party, who assumed the partnership'snonrecourse mortgage which was in excess ofthe partnership's property's fair marketvalue. The taxpayers argued that section752(c) limited their amount realized on thesale to the fair market value of theproperty sold. The Supreme Court, however,held that section 752(c) did not apply tothe sale of partnership interests and wasrestricted to section 752(a) and (b)transactions.

d. Sale of an interest: If a partnership interestis sold, the selling partner is required toinclude his share of partnership liabilities inthe amount realized. A partner's share ofpartnership liabilities is similarly included inthat partner's basis. I.R.C. §752(d).

2. A partner's share of partnership liabilities.

a. General rule: The regulations under section 752set forth the rules, as prescribed by theTreasury, for allocating partnership liabilities

among the partners. As noted below, the

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Treasury has been instructed by Congress torevise these regulations.

b. Two factors considered: The current regulationsdifferentiate a partner's share of partnershipliabilities, depending upon two factors:(I) The type of liability involved (i.e.,recourse or nonrecourse); and (2) The characterof the interest held by the partner (i.e.,general or limited).

i. Recourse liabilities.

a. Loss ratios: Recourse liabilities areallocated according to the partners'respective loss sharing ratios.

b. Limited partners. A limited partner'sshare of partnership recourseliabilities is limited to the lesserof:

i. The total capital contributionsthat the limited partner isobligated to make under thepartnership agreement in excessof actual contributions; or

ii. The partner's share of suchliabilities based upon his (orher) loss sharing ratio. Regs.§1.752-1(e).

ii. Nonrecourse liabilities: All partners(both general and limited) share the basisattributable to nonrecourse liabilitiesaccording to their profit sharing ratios.Regs. §1.752-1(e).

a. Definition: Nonrecourse liabilitiesare defined as partnership debts forwhich none of the partners has anypersonal liability.

b. Example: A nonrecourse debt includesa mortgage on real estate acquired bythe partnership without the assumptionby the partnership or any of thepartners of any liability on themortgage.

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3. Interpretations of section 752.

a. Liabilities of cash method partnerships, etc.

i. Accounts payable: Accrued but unpaidexpenses and accounts payable are not"partnership liabilities" for purposes ofcomputing the adjusted basis of a partner'sinterest in a cash basis partnership. Rev.Rul. 88-77, 1988-38 I.R.B. 8.

ii. Contributions of accrued liabilities: The1984 General Explanation indicates thatcontributions of accrued but unpaidliabilities (e.g., accounts payable) by acash method partner to a partnership willbe treated similarly to section 357(c)items in a corporate tax context. Thus,those items should not be treated asliabilities for purposes of section 752.1984 General Explanation, supra, at 215.

iii. Deferred income: Unrestricted progresspayments received by a partnership usingthe completed contract method of accountingrepresent deferred income rather than apartnership liability. Rev. Rul. 73-301,1973-2 C.B. 215.

b. Contributions to capital versus loans.

i. Loans to partners: A partner's receipt ofmoney from a partnership under anobligation by the partner to repay thefunds constitutes a loan, and thus aliability of the partnership, rather than adistribution. To the extent suchobligation is cancelled, the obligorpartner will be considered as havingreceived a distribution at the time of thecancellation. Regs. §1.731-1(c).

ii. Loans by the general partner: Nonrecourseloans by the general partner to either thelimited partners or the partnership mayconstitute capital contributions to thepartnership by the general partner, ratherthan loans. Rev. Rul. 72-135, 1972-1 C.B.200.

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iii. Convertible debt: A nonrecourse loan by anunrelated third party to a partnership,secured by the partnership's property andconvertible at the option of the lenderinto an interest in the partnership'sprofits may be treated as a capitalcontribution rather than as a loan. Rev.Rul. 72-350, 1972-2 C.B. 394.

iv. Advances to the partnership by the partnersconsidered equity: Advances to apartnership by a partner have been held tobe capital contributions (rather thanloans) where the loans werenoninterest-bearing, unsecured,subordinated debt. Hambuechen v.Commissioner, 43 T.C. 90 (1964).

v. Advances to the partnership by the partnersconsidered loans: Advances to apartnership by a partner were held to beloans (rather than capital contributions)where repayments were made regularly, noteswere given, the advances were notsubordinated, and the partnership'scapitalization was not abnormal. Kingbayv. Commissioner, 46 T.C. 147 (1966).

c. Tiered partnerships: A limited partner's basisfor his interest in a first tier limitedpartnership includes that partner's share of thesecond tier partnership's nonrecourseliabilities which are allocated to the firsttier partnership. Rev. Rul. 77-309. 1977-2 C.B.216.

d. Partner guarantees, indemnifications, andassumptions of nonrecourse debt of thepartnership.

i. Definition: As noted above, a nonrecoursedebt is defined as a debt for which none ofthe partners has any personal liability.If the liability qualifies as nonrecourseunder this definition, it is shared inaccordance with the partners' profitsharing ratios. Regs. §1.752-1(e).

ii. Guarantees by general partner: The Servicehas ruled that where a general partnerpersonally guarantees partnershipnonrecourse debt, the debt is treated asrecourse, thus preventing a basis increaseto the limited partners. Rev. Rul. 83-151,1983-2 C.B. 105.

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a. Congress overturns Raphan: A courtdecision contrary to this result,Raphan v. United States, 3 Cl.Ct. 457(1983), rev'd, 759 F.2d 879 (Fed. Cir.

1985), cert. denied, 106 S.Ct. 129("Raphan"), was legislatively

overturned by section 79 of the 1984

Act. See, C. 4., below.

b. Partial guarantees: The Service holdsthat a guarantee of only a portion of

a nonrecourse debt permits the

nonguaranteed portion to retain its

status as a separate nonrecourseliability, thereby allowing a basis

increase to the nonguarantorpartners. Rev. Rul. 84-118, 1984-2C.B. 120.

c. Congressional mandate: As part of the1984 Act, Congress directed theTreasury to revise the section 752regulations to specify that a general

partner's primary or secondaryliability on partnership indebtednessprecludes its classification asnonrecourse debt for purposes of

determining limited partners' bases.1984 General Explanation, at 251.

iii. "Ultimate liability" standard: Recently,the Tax Court has applied an "ultimate

liability" test in allocating nonrecourseindebtedness for basis purposes where theliabilities have been guaranteed by

partners.

a. Assumption agreement by generalpartner: The court applied the"ultimate liability" test to determinewhether a general partner in a

partnership was entitled to include inbasis the entire amount of a"nonrecourse" partnership debt forwhich he assumed personal liability

through the execution of an"fassumption agreement" with thepartnership. The court held that,despite the fact that thepartnership's assets were subject tothe debt, the partnership could lookto the partner for indemnification,

and thus the partner was "ultimatelyliable" to pay the debt. The partnertherefore, was entitled to include the

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liability in basis. Smith v.Commissioner, 84 T.C. 889 (1985).

b. Guarantees by limited partners: InAbramson v. Commissioner, 86 T.C. 360(1986) ("Abramson"), the courtpermitted limited partners to increasetheir bases as a result ofguaranteeing a "nonrecourse" debt.The limited partners were "ultimatelyliable" for the portion of the debtthat they guaranteed because thegeneral partners were not primarily orsecondarily liable.

c. Ultimate liability doctrinecircumscribed: A limited partner wasnot at risk for his guarantee of aportion of partnership nonrecourseindebtedness in an equipment leasingtransaction. The taxpayer limitedpartner guaranteed a portion of thepartnership's nonrecourse debt in anamount approximating his expectedshare of partnership losses, less hiscapital contribution. The guaranteewas not required by the lender and thetaxpayer had a right under state lawof subrogation against thepartnership. The partnership, inturn, had a guarantee from the parentof the lessee for the lease paymentson the partnership's equipment.Therefore, the taxpayer was not theprimary obligor on the partnershipdebt and did not have ultimateliability for the debt. Peters v.Commissioner, 89 T.C. 423 (1987)("Peters"). (The decision in Petersmarks the court's first attempt toreign in the broad reach some taxpractitioners had given to guaranteesand the "ultimate liability" doctrineespoused in Abramson, supra.)

e. Partner guarantees, indemnifications, andassumptions of recourse debt of the partnership.

i. Current regulations: The current section752 regulations deny a limited partnerbasis for recourse obligations of apartnership, except to the extent of thedifference between the contributioncredited to the limited partner by thepartnership and the total contribution

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which the limited partner is obligated tomake. Regs. §1.752-1(e).

a. "Outside" indemnifications: TheService has interpreted theregulations to provide that a limitedpartner's agreement (outside of thepartnership agreement) to indemnify ageneral partner with respect to thegeneral partner's share of partnershiprecourse liabilities does not entitlethe limited partner to a basisincrease. Rev- Rul. 69-223, 1969-1C.B. 184.

b. "Outside" guarantees: Similarly, themere guarantee by a limited partner ofpartnership recourse debt did notallow the limited partner to include aportion of the recourse debt in basis,where the guarantee was outside thepartnership agreement. See, e.g.,Block v. Commissioner, 41 TCM 546(1980); and Brown v. Commissioner, 40T.C.M. 725 (1980), aff'd, 698 F.2d1228 (9th Cir. 1982).

ii. "Ultimate liability" standard: Recently,the Tax Court and the Internal RevenueService have interpreted the regulations asallowing a limited partner to increase thebasis in his partnership interest to theextent the partner is "ultimately liable"for a pro rata portion of the recourse debtof the partnership.

a. Limited partner guarantee with noright of indemnification: In Gefen v.Commissioner, 87 T.C. 1471 (1986)("Gefen"), the court held that alimited partner was entitled toinclude in basis her allocable shareof partnership recourse liabilitieswhich she had guaranteed. The courtfocused on the fact that the limitedpartner was not a mere guarantor ofher pro rata share of the partnershipdebt, but was ultimately liable sinceshe was required under the partnershipagreement to made additional capitalcontributions in the event thepartnership was called upon to satisfythe debt. Furthermore, she had noright of indemnification from thegeneral partner (or anyone else) if

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she was called upon to make theadditional capital contributions or tosatisfy the guarantee.

b. Limited partner's recourse notepledged as collateral forpartnership's recourse loan: The TaxCourt has applied the "ultimateliability" analysis set forth inGefen, supra, to allow a limitedpartner to increase his amount at riskby the amount of recourse liabilitiesfor which he was ultimately liable."The critical inquiry should be who isthe obligor of last resort, and indetermining who has the ultimateeconomic responsibility for the loan,the substance of the transactioncontrols." In Melvin v. Commissioner,88 T.C. 63 (1987) ("Melvin"), thetaxpayer incurred an obligation tocontribute additional capital whichwas represented by a recourse note hehad contributed to the partnership.The note, in return, was pledged ascollateral for a recourse loan takenout by the partnership. The courtfound that the limited partner had noright of reimbursement for any amountwhich he was required to contribute tothe partnership as evidenced by thenote. Accordingly, he could includeas an amount at risk and in basis hispro rata share of the recourse debt.

c. Limited partners assume liability forproportionate share of partnershiprecourse debt: In a Technical AdviceMemorandum, the Service found that alimited partner was entitled toinclude in basis his pro rata share ofa recourse debt of the partnership.Under the partnership agreement, eachlimited partner agreed to assumeliability for a proportionate share ofcertain recourse debt of thepartnership. The Service, afterexamining the partnership agreement,noted that the assumption ofpartnership indebtedness was to betreated as a capital contribution.Citing Abramson, supra, the Serviceaccepted the concept of ultimateliability and concluded that thelimited partner incurred direct and

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ultimate liability for his pro ratashare of the recourse liability. The

Service found that the partner'sassumption of the debt was made as

part of his agreed upon contributionto the partnership. Tech. AdviceMemo. 8702006. See also Tech. Advice

Memo. 8749009 where the limited

partners' shares of the partnership'srecourse bank loan were evidenced byrecourse notes contributed to the

partnership (and assigned to the bank

as security for the line of credit)

and assumption agreements between the

partners and the bank.

4. Revision of the section 752 regulations.

a. Congressional mandate: As part of the 1984 Act,

Congress directed the Treasury to revise the

section 752 regulations to ensure that thepartner receiving a basis increase attributableto a partnership liability bears the economicrisk of loss with respect to such liability.1984 General Explanation, at 250-251.

i. Claims Court decision in Rapha overturnedby Congress: Congress legislativelyoverturned the decision in Raphan, supra,which held that a general partner was not

to be treated as personally liable withrespect to an otherwise nonrecourse debt

because he guaranteed repayment of thedebt. The court held that the debt was anonrecourse liability and the limitedpartners were entitled to increase theirrespective bases by their proportionate

share of the liability-

ii. Raphan reversed by Federal Circuit: Asindicated above, the decision reached by

the Claims Court in Raphan, supra, holdingthat the general partner had no personal

liability with respect to the guarantee ofa nonrecourse debt, was subsequentlyreversed. Raphan v. United States, 759

F.2d 879 (Fed. Cir. 1985).

b. Guarantees: As currently written, theregulations do not directly address the

consequences of a partner (either general or

limited) guarantee of a nonrecourse partnership

liability. Regs. §1.752-1(e).

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General partner: The revised regulationspresumably should (but do not yet) providethat if a general partner is eitherprimarily or secondarily liable (as in thecase of a guarantee) for a nonrecourse debt

of the partnership, the debt will betreated as a recourse debt of thepartnership to the extent of the guarantee.

a. Ramifications: As a result, a limitedpartner's share of the liability willbe subject to the rules set forth inthe current regulations for sharingrecourse debt. Unless the limited

partner is required to make additionalcapital contributions which could beused to satisfy the guaranteed debt

(or is otherwise ultimately liable forthe debt), he will not be entitled to

share in the liability for basispurposes.

11. Limited partner: Where a limited partner

guarantees a nonrecourse liability, therevised regulations should (but do not yet)provide that the limited partner will beentitled to a basis increase equal to theliability guaranteed.

a. Current regulations: Under thecurrent regulations, a guarantee byany partner converts the liability toa recourse debt. Since limitedpartners typically do not share inpartnership recourse liabilities, thelimited partner would not be entitledto a basis increase despite thepartner's potential economic loss as aresult of guaranteeing the liability.

b. Revised regulations: It isanticipated, however, that the revisedregulations will adopt the "ultimateliability" theory as expressed inAbramson, Gefen, and Melvin, supra.

Accordingly, to the extent the limitedpartners are ultimately liable theyshould receive a corresponding

increase in basis.

iii. Nonrecourse loans by a partner to a

partnership: The regulations, oncerevised, should provide that the basisattributable to a nonrecourse loan made tothe partnership by a partner is treated in

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the same manner as if that partnerguaranteed a third party nonrecourse debtof the partnership. As previouslydiscussed, the guarantee of a nonrecoursepartnership debt by a partner shouldgenerally entitle the guarantor partner toa basis adjustment equal to the amount ofthe guarantee.

iv. Other commercial practices: The newregulations should also take into accountcurrent commercial practices andarrangements relating to partnershipliabilities, including assumptions,indemnity agreements and other similaragreements. The partner(s) ultimatelyliable for such indebtedness should beentitled to include the debt in basis.

v. Effective dates: The revised regulations,to the extent they overrule the Raphandecision, are to be effective retroactivelyfrom March 1, 1984.

a. However, to the extent the regulationsapply to transactions other than thatin Raphan, supra, the regulations areto apply prospectively.

b. It is uncertain whether theregulations will apply prospectivelyto debts incurred after theireffective date or taxable yearsbeginning after their effective date.

D. Limitations on deductibility of partnership losses bypartners.

1. Section 704(d): The basis limitation.

a. Loss limitation: A partner's distributive shareof partnership loss shall be allowed as adeduction only to the extent of the adjustedbasis of the partner's interest at the end ofthe partnership year in which the loss occurs.I.R.C. §704(d).

b. Carryforward of suspended losses: Anydisallowed loss carries forward, and will beallowed as a deduction in a following year tothe extent such partner's basis shows a netincrease after considering all other itemsaffecting basis for that year,

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i. Methods to increase basis: For thosepartners who may be subject to a possiblebasis limitation, there are a number ofways in which a partner may increase his(or her) basis. Methods to accomplish anincrease in basis include:

a. Additional cash contributions by apartner.

b. Increases in a partner's share ofpartnership liabilities.

c. Contributions of property by a partner.

d. Assumption by a partner of partnershipdebt.

e. Partnership earnings.

ii. Timing: The partner's basis must increaseprior to the date the person ceases to be apartner in the partnership.

a. One taxpayer has argued that acontribution of capital to apartnership after a sale of hispartnership interest should allow thepartner to deduct any suspendedlosses. The Tax Court has denied adeduction for the suspended losses.Sennett v. Commissioner, 80 T.C. 825(1983).

b. Planning: Once again, timing isimportant. Partners should makeplanned capital contributions to apartnership prior to selling theirpartnership interests in order to beable to deduct any suspended losses.

c. Scope: Unlike the "at risk" rules, the basislimitation applies to all taxpayers, not just toindividuals and certain corporations.

V. The Partners' Dealings With the Partnership.

A. Payments by a partnership to a partner.

1. Categories of payments.

a. General rule: A partner may engage in businesstransactions with a partnership in which he is amember. For example, the partner may perform

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services for the partnership, the partner andthe partnership may engage in lendingtransactions, or the parties may enter intoleasing agreements. The applicable taxtreatment depends upon the type and substance ofthe transaction involved.

b. Categories: The Code categorizes three classesof transactions between a partner and thepartnership and subjects each to a different setof rules. The three classes of transactions are:

i. Payments to a partner not acting in hiscapacity as a partner (I.R.C. §707(a));

ii. Guaranteed payments to a partner, acting inhis capacity as a partner, for services orthe use of capital to the extent determinedwithout regard to the income of thepartnership (I.R.C. 707(c)); and

iii. All other payments to a partner acting inhis capacity as a partner. I.R.C. §§702and 704.

c. Tax treatment: The tax treatment of thetransaction depends upon whether the governingprovision is section 707(a), section 707(c). orsection 704. Generally, if section 707(a)applies to a transaction, the partner is treatedfor tax purposes as an unrelated party and thetransaction is governed by the Code provisionsgoverning income inclusions and expensedeductions. A guaranteed payment (under section707(c)), on the other hand, always results inthe recognition of ordinary income by therecipient and a deductible or capitalizableexpenditure for the partnership. Finally, ifthe transaction falls within the provisions ofsections 702 and 704, the payment is treated asa distribution of the partner's distributiveshare of the partnership income.

i. Timing of income and deduction.

a. Section 704: A partner recognizes hisdistributive share of partnershipincome (or loss) in the partner'staxable year which contains or endswith the partnership's taxable yearend, regardless of whether anydistributions are received. I.R.C.§706; Regs. §1. 706-i(a)(I).

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b. Section 707(a): A recipientrecognizes income from a section707(a) payment according to his methodof accounting (e.g., in the year inwhich it is received if the partner ison the cash method or in the yearearned if on the accrual method.) Thepartnership deducts (if the item isdeductible) or capitalizes the itemaccording to its general method ofaccounting. However, if the partneris a cash method taxpayer and thepartnership uses the accrual method,the partnership is only entitled to adeduction in the year in which therecipient includes the payment inincome. I.R.C. §267(a)(2).

c. Section 707(c): The recipient mustinclude the guaranteed payment inincome in his taxable year whichcontains or ends with the end of thepartnership taxable year in which thepartnership deducts such payments aspaid or accrued under its method ofaccounting. Regs. §1.707-1(c).Significantly, this may result in cashfree taxable income to a cash basispartner if the accrual basispartnership accrues a guaranteedpayments.

2. Characterization of certain payments: The propercharacterization of payments between partnerships andpartners has frequently been the subject oflitigation.

a. Payments as a percentage of gross income: TheTax Court has held that payments to a partnerbased on a percentage of partnership grossincome are not guaranteed payments. However,since the payments were made to a partner forservices performed in his capacity as a partner(per the partnership agreement), the paymentswere not section 707(a) payments. Rather, theyrepresented a portion of the partner'sdistributive share of partnership income undersection 704. Pratt v. Commissioner, 64 T.C. 203(1975), aff'd, 550 F.2d 1023 (5th Cir. 1977)("Pratt").

i. IRS position: The Service has taken a viewcontrary to that in Pratt, supra, and hasheld that the payments were guaranteedpayments under section 707(c). The Service

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indicated that the term "guaranteed

payment" should not be limited to fixedamounts. Rather, in the Service's view, apayment for services determined byreference to an item of gross income is aguaranteed payment if, on the basis of all

of the facts and circumstances, the paymentis compensation rather than a share of

partnership profits. Rev. Rul. 81-300,1981-2 C.B. 143. (However, see, Tech.Advice Memo. 8642003 comparing Pratt,supra, and distinguishing Rev. Rul. 81-300,supra.)

ii. Congressional response: As part of the1984 Act, Congress addressed the problem ofthe proper characterization of certain

payments between partners and the

partnership. In choosing a middle ground,Congress agreed with the Service that thepayments should not represent a portion ofthe partner's distributive share, butdisagreed that the distribution representeda guaranteed payment under section 707(c).Rather, the transaction should be treated

as a payment to a partner not acting in hiscapacity as a partner under section707(a). Senate Committee Report, TaxReform Act of 1984, S. Rep. No. 169, 98thCong., 2d Sess. (the "Senate Report") at224-225.

b. Section 707 payments as disguised fees: In afairly recent decision, the Tax Court found thatorganization and syndication costs, labeled asmanagement fees, paid to the general partner bya limited partnership were paid while thegeneral partner was acting in his capacity as apartner and therefore, did not qualify assection 707(a) payments. Because the paymentswere for organization and syndication costs, thecourt held that section 709(a) applied. Section709(a) precludes a partnership from currentlydeducting partnership organization andsyndication expenses whether paid directly orindirectly through payments to a partner. Egolf

v. Commissioner, 87 T.C. 34 (1986).

3, Disguised payments for services or property.

a. Background: Among other things, Congress feltthat partnerships had been used effectively to

circumvent the requirement to capitalize certainexpenses by making allocations of income andcorresponding distributions in place of direct

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payments for property or services. As a result,

Congress mandated that certain incomeallocations (and subsequent relateddistributions) be capitalized. Senate Report,

at 225.

i. Creating "deductible" section 709 fees:The Senate Report expressed concern that an

allocation and distribution of gross or netincome to an organizer or syndicator who isa general partner may have the effect ofallowing a partnership to deduct amountswhich are properly nondeductibleorganization and syndication costs.

b. General rule: As a result of this Congressionalconcern, the Code now provides that if a partnerperforms services for a partnership or transfersproperty to a partnership and there is a relatedallocation or distribution to that partner, theallocation will be ignored if the facts and

circumstances indicate that the recipient wasnot acting in his capacity as a partner. I.R.C.

§707(a)(2)(A).

i. Reach of the rule: Under appropriate

circumstances, the purported partnerperforming the services or transferring theproperty may not be deemed to be a partner

at all for tax purposes.

ii. Example: The Senate Report provides an

example of when an allocation ofpartnership gross income should be treatedas a section 707(a) payment. A commercialoffice building constructed by a

partnership is projected to generate grossincome of at least $100,000 per yearindefinitely. Its architect, whose normal

fee for such services is $40,000,contributes cash for a 25 percent interestin the partnership and receives both a 25

percent distributive share of net income

for the life of the partnership and anallocation of $20,000 of partnership grossincome for the first two years of

partnership operations after lease-up. The

partnership is expected to have sufficientcash available to distribute $20,000 to thearchitect in each of the first two years,

and the agreement requires such a

distribution.

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iii. Character: The purported gross incomeallocation and partnership distribution inthe above example should be treated as afee under section 707(a), rather than as adistributive share because as to thosepayments the architect is presumablyinsulated from the risk of the jointenterprise.

iv. Factors: Factors which contribute to thisconclusion are:

a. The special allocation to thearchitect is fixed in amount and thereis a substantial probability that thepartnership will have sufficient grossincome and cash to satisfy theallocation/distribution;

b. The distribution relating to theallocation is fairly close in time tothe rendering of the services; and

c. It is not unreasonable to concludefrom all the facts and circumstancesthat the architect became a partnerprimarily for tax reasons.

v. Alternative: On the other hand, if theagreement allocates to the architect 20percent of gross income for the first twoyears following construction of thebuilding, a question arises as to howlikely it is that the architect willreceive substantially more or less than hisimputed fee of $40,000. If the building ispre-leased to a creditworthy tenant under alease requiring the lessee to pay $100,000per year of rent, or if there is a lowvacancy rate in the area for comparablespace, it is likely that the architect willreceive approximately $20,000 per year forthe first two years of operations.Therefore, the architect assumes limitedrisk as to the amount or payment of theallocation and, as a consequence, theallocation/distribution should be treatedas a disguised fee. If, on the other hand,the project is a "spec building," and thearchitect assumes significantentrepreneurial risk that the partnershipwill be unable to lease the building, the

special allocation (even though a grossincome allocation), depending on allthe facts and circumstances, might beproperly

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treated as a distributive share and agenuine partnership distribution. SenateReport, at 229-230.

C. Six factors: If the service performer orproperty transferor is actually a partner fortax purposes, the legislative history providessix factors that should be considered indetermining whether the allocations anddistributions are made to the partner in his (orher) capacity as a partner:

i. Risk: Whether the payment is subject to anappreciable risk as to the amount and factof the payment based upon the success orfailure of the joint undertaking.

ii. Transitory status: Whether the status of apartner is transitory.

iii. Timing: Whether the distribution andallocation made to the partner are close intime to the performance of services for orto the transfer of property to thepartnership.

iv. Tax motivation: Whether it appears thatthe recipient became a partner primarily toobtain tax benefits individually or for thepartnership as a joint undertaking.

v. Relative value: Whether, in the servicecontext, the value of the recipient'sinterest in general and continuingpartnerships profits is small in relationto the allocation in question.

vi. Whether in the property context, thesubstantial economic effect requirement ofsection 704(b) makes income allocations,which are disguised payments of capital,unlikely to occur. Senate Report, at227-228.

4. Disguised sales: The Senate Report also addressesthe issue of disguised sales. Specifically, when apartner transfers money or property to a partnershipand there is a "related" transfer of money orproperty by the partnership to the partner, thetransaction will be treated as a sale between thepartners or as a partial sale and contribution of theproperty to the partnership. I.R.C. §707(a)(2)(B).

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a. Reason for the rule: This provision is designedto prevent the parties from characterizing asale or exchange of property as a contributionto the partnership followed by a tax-freedistribution from the partnership. See, e.g.,Otey v. Commissioner, 70 T.C. 312 (1978), aff'dper curiam, 634 F.2d 1046 (6th Cir. 1980); ParkRealty Co. v. Commissioner, 77 T.C. 412 (1981).

b. Reach of the rule: Because of the potentiallybroad reach of the statutory language, prudenttax planners should carefully consider section707(a)(2)(B) in structuring transactions inwhich there is even the appearance of a"related" transfer. For a further discussion ofthe provision, see Bobrow and Friedman, "Section707(a)(2)(B): Some Considerations in theAnti-Otey Provisions, 3 J. Partnership Tax. 346(Winter 1987).

5. Guaranteed payments.

a. General rule: An amount is a guaranteed paymentif it is payable in all events, regardless ofwhether it exceeds the partnership's net income.

b. Services or capital: Guaranteed payments mustbe for services (e.g., salary payments) or forthe use of capital (e.g., interest on partners'capital) and must be made to a partner acting inhis capacity as a partner.

C. Compare with other types of payments: Aguaranteed payment should be distinguished,under a facts and circumstances test, from othertypes of payments such as:

i. Loans: A loan in which a partner has anobligation to repay the partnership; and

ii. Profits: Distribution of a partner'sprofit share, which is charged against thepartner's capital account.

d. Inclusion in income.

i. General rule: Guaranteed payments areincluded in the recipient's gross income asordinary income. Regs. §1. 707-1(c).

a. The general rule applies even though apartnership has no taxable income orits income consists entirely ofcapital gains.

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b. Furthermore, the general rule applies

even if a partnership is required to

capitalize the payment. Rev. Rul.

80-234, 1980-2 C.B. 203.

ii. Timing of the inclusion in income: Section

707(c) requires a matching of the incomeand deduction. The recipient must include

the guaranteed payment in "his taxable yearwithin or with which ends the partnershiptaxable year in which the partnership

deducts such payments as paid or accruedunder its method of accounting." Regs.§1.707-1(c). For the recipient partner,this may result in the recognition ofincome even though an actual distribution

has not been made by the partnership. (Inshort, cash free taxable income.)

e. Deductibility by the partnership: Guaranteedpayments are generally deductible by thepartnership. In some cases, however, thepayments may represent capital costs or othernondeductible costs which must be capitalized.I.R.C. §§162(c) and 263. See, also, I.R.C.

§§709 and 195.

B. Transactions between related persons.

1. Matching of certain expenses.

a. General rule: In the case of expenses andinterest, section 267 requires an accrual method

partnership to take a deduction for expenses orinterest paid to cash method partners only whenthose partners include the payments in income.

I.R.C. §267(a)(2).

b. Rationale: This rule ensures that there is amatching of income and expenses between a

partnership and its partners.

i. Exceptions to section 267.

a. Section 707(c): To the extent apartner is required by section 707(c)to include a guaranteed payment in

income for the year in which the

partnership deducts the payment underits method of accounting, section267(a)(2) does not apply. I.R.C.

§267(e)(4).

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b. Other: Section 267(a) also does notapply to certain resyndications oflow-income housing projects. I.R.C.§267(e)(5).

c. Related parties: For purposes of section267(a)(2), a partnership and each of itspartners are related persons. I.R.C.§267(e)(1)(A) and (B). The scope of section 267reaches beyond just the partners and thepartnership. Any person related to a person ora partnership under section 707(b)(1) is alsosubject to the related party rules. I.R.C.§267(e)(1)(D).

2. Sales or exchanges of property to/from controlledpartnerships.

a. General rule: Section 707(b) provideslimitations on the character of gain andrecognition of loss as a result of a sale orexchange of property between a person and acontrolled partnership or between twopartnerships that are controlled by the samepersons.

i. 1986 change: Prior to the Tax Reform Actof 1986 (the "1986 Act"), sections707(b)(1)(A) and 707(b)(2)(A) applied onlyto sales or exchanges of property between apartnership and partners owning, directlyor indirectly, more than a 50 percentcapital or profits interest in thepartnership.

a. Expanded reach: The 1986 Act deletedthe word "partner" and inserted theword "person." This change wasintended to expand the scope oftransactions subject to thelimitations of section 707(b) byincluding not only partners of apartnership but also persons relatedto the partners pursuant to section267. Thus, for example, a sale orexchange of property between apartnership and the spouse ofpartner is subject to the limitationsof section 707(b) if the interestownership of the spouse exceeds 50percent.

b. Watch section 267: The fact thatsections 707(b)(1)(A) and (b)(2)(A)have been expanded to include personsrelated to a partner does not affect

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the applicability of Regs.§l.267(b)-l(b). These regulationstreat transactions between apartnership and a nonpartner as atransaction between the nonpartner andthe partners of the partnership. Ifthe nonpartner and any of the partnersare related parties pursuant tosection 267(c), the loss disallowancerules under section 267(a) apply withrespect to the portion of the saletreated as made between relatedparties.

b. Disallowance of losses.

i. General rule: No deduction is allowed forlosses from the sale or exchange ofproperty (other than an interest in thepartnership), directly or indirectly,between:

a. A partnership and a person owning,directly or indirectly, more than 50percent of the capital or profitsinterest in the partnership (I.R.C.§707(b)(1)(A)); or

b. Two partnerships in which the samepersons own directly or indirectly,more than 50 percent of the capital orprofits interest. I.R.C.§707(b)(1)(B).

ii. Subsequent sale: However, if thetransferee later sells the property at again, the gain may be offset by the amountof loss disallowed in the original sale.Therefore, the transferee will onlyrecognize gain to the extent it exceeds thepreviously disallowed loss. I.R.C.§§707(b)(1) and 267(d).

c. Character of gain: If the sale or exchangeresults in the recognition of gain, the gain isconsidered to be ordinary income if the propertyin the hands of the transferee is not a capitalasset, as defined in section 1221. I.R.C.§707(b)(2).

i. Significance: The 1986 Act repealed the

section 1202 deduction for long-termcapital gains recognized by individualtaxpapers. As a result, capital gains aretaxed at the same rate as ordinary income.

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However, the characterization of the incomeis still important for purposes of thecapital loss limitation rules. If the gainrecognized is characterized as ordinaryincome, the transferor will not be entitledto use the gain to offset any capitallosses incurred during the year pursuant tosection 1211(b). Section 1211(b) permitscapital losses for individuals to bededucted only to the extent of thetaxpayers capital gains plus $3,000.I.R.C. §1211(b)(1) and (2).

d. Ownership interests: For purposes ofdetermining ownership, the attribution rules ofsection 267(c) apply, except for section267(c)(3). I.R.C. §707(b)(3).

i. Entity: A partnership interest owned,directly or indirectly, by or for acorporation, partnership, estate, or trustis considered as being ownedproportionately by or for its shareholders,partners, or beneficiaries. I.R.C.§267(c)(1).

ii. Family: An individual is considered asowning the partnership interest owned,directly or indirectly, by or for his (orher) family. I.R.C. §267(c)(2). Anindividual's family includes only brothersand sisters, spouse, ancestors, and linealdescendants. I.R.C. §267(c)(4).

V1. Partnership Distributions and Liquidations.

A. General concepts.

1. Current distributions: Current distributionsgenerally reflect an aggregate approach topartnership taxation.

2. Liquidating distributions: In contrast, liquidatingdistributions generally reflect an entity approach topartnership taxation.

3. Exceptions.

a. Section 751(b) distributions: Adisproportionate distribution of unrealizedreceivables or substantially appreciatedinventory is treated in part as a currentdistribution of partnership assets and in partas an exchange of partnership property.

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b. Section 736(a) payments: Payments made to aretiring partner in excess of that partner'sshare of partnership property are treated eitheras guaranteed payments or as a distributiveshare of partnership income.

4. Current versus liquidating distributions.

a. Liquidating distributions: The regulationsdefine liquidating distributions asdistributions in termination of a partner'sentire interest in a partnership, whether in asingle distribution or a series ofdistributions. Regs. §1.761-1(d).

b. Current distributions: A current distributionis any distribution that is not a liquidatingdistribution.

i. Amount: Current distributions may beeither pro rata among all of the partnersor disproportionate.

ii. Relationship to income: Currentdistributions may be greater or less thanpartnership income for the year.

5. Asset character: Any distribution may be made ineither cash or property or in some combination of thetwo.

B. Recognition of gain or loss on distribution.

1. Recognition of gain or loss to the partner.

a. Current distributions.

i. General rule: No loss is ever recognized.I.R.C. §731(a)(2).

ii. Measure of gain: Gain is recognized to theextent the amount of money received exceedsthe basis of the partner's partnershipinterest immediately before thedistribution.

iii. Character: Any gain recognized is treatedas capital gain from the sale or exchangeof the partnership interest (unless section751(b) applies). I.R.C. §§731 and 741.

iv. Priority rules: The provisions of sections736 and 751 override section 731.

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b. Liquidating distributions.

i. General rule: Ordinarily, loss is notrecognized. However, where no propertyother than cash, unrealized receivables,and inventory is distributed, loss will berecognized to the extent the basis of thepartner's interest in the partnershipexceeds the amount of money received plusthe basis to the partnership of the otherproperty distributed. I.R.C. §731(a)(2).

ii. Measure of gain: Gain is recognized to theextent the amount of money received exceedsthe basis of the partner's partnershipinterest immediately before thedistribution.

iii. Character: Any gain recognized is treatedas capital gain from the sale or exchangeof the partnership interest (unless section751(b) applies). I.R.C. §§731 and 741.

iv. Trap for the unwary: This provision mayprove a trap for the unwary. Consider thepartner who receives assets with a fairmarket value of $1 million in liquidationof his interest, which has a basis of $10million. If the distributee receives onlycash and inventory, the loss of $9 millionis realized and recognized. Conversely, ifhe takes cash of $950,000 and section 1231property that lacks a section 751 taint,the loss if deferred. Prudent planningrequires a review of the asset mix prior tothe liquidating distributions.

2. Recognition of gain or loss to the partnership: Thedistributing partnership ordinarily does notrecognize gain or loss on a distribution. I.R.C.§731(b). However, gain or loss may be recognized ifsection 751(b) applies.

C. Basis of distributed property.

1. Current distributions.

a. General rule: The basis of distributed property(other than money) generally is the same to thedistributee partner as it was to the partnership(i.e., a carryover basis). I.R.C. §732(a)(1).

b. Limitation: The basis of the distributedproperty to the distributee partner cannotexceed the basis of his partnership interest as

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reduced by any money distributed in the sametransaction. I.R.C. §732(a)(2).

2. Liquidating distributions.

a. General rule: Generally, the basis of property(other than money) distributed in liquidation ofa partner's interest is equal to the basis ofthe partner's interest in the partnership, lessany money distributed to the partner in the sametransaction. I.R.C. §732(b).

b. Limitation: However, where the only propertydistributed (other than money) is unrealizedreceivables and inventory, the distributeepartner's basis in the property distributed islimited to the partnership's basis in thedistributed items. See, B. 1. b. i., above,regarding loss recognition in this situation.

3. Allocation of basis among distributed assets.

a. Unrealized receivables and inventory: Theaggregate basis of the distributed assets isallocated first to unrealized receivables andinventory in proportion to the basis of eachasset to the partnership. However, the basis ofthese assets to the partner may not exceed theirbasis to the partnership. I.R.C. §732(c)(1).

b. Other distributed property: If the basis to beallocated among the distributed assets exceedsthe basis of the distributed unrealizedreceivables and inventory, any remaining basis(as determined under sections 732(a) and (b)) isallocated among the other distributed propertyin proportion to the bases of these assets tothe partnership. I.R.C. §732(c)(2).

D. Character of gain or loss on subsequent sale ofdistributed property.

1. Unrealized receivables: Gain (or loss) on the saleof unrealized receivables subsequent to the partner'sreceipt of them in a distribution from a partnershipconstitutes ordinary income (or loss), regardless ofhow long the receivables are held by the distributeepartner. I.R.C. §735(a)(1).

2. Inventory: Gain (or loss) on the sale of inventorythat was received in a distribution from apartnership is considered ordinary income or loss ifthe sale by the distributee partner occurs withinfive years of the distribution. I.R.C. §735(a)(2).

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3. Other property: The character of gain or loss fromthe sale of any other property received indistribution from a partnership depends on theholding period and character of the property in thehands of the distributee partner. A partner'sholding period of property distributed to him by apartnership generally includes the period theproperty was held by the partnership. I.R.C. §735(b).

E. Basis of distributee partner's interest.

1. Significance: This computation is only relevant inthe context of a current distribution.

a. Computation: A partner's interest is firstreduced by any cash received. If the partnerstill has basis after reduction for cashdistributions, the partner's basis is reduced(but not below zero) by the basis of otherproperty distributed, as determined in section732(a). I.R.C. §733(2).

F. The treatment of liabilities in a distribution.

1. The equivalent of cash: A decrease in a partner'sshare of liabilities is treated as a distribution ofcash. Therefore, a partner may recognize gain on adistribution of partnership property even if noactual cash is distributed. I.R.C. §752(b).

a. Examples: A partner's share of liabilities candecrease in several ways. For example, alimited partner's share of liabilities usuallywill decrease when nonrecourse liabilities areconverted to recourse liabilities.Additionally, a partner's share of liabilitiesalso may decrease upon admission of a newpartner. In this case, the liability shares ofall of the old partners generally willdecrease. This may cause recognition of gain tothe old partners and may even invoke theapplication of section 751(b), at least in thecollective minds of the IRS. Rev. Rul. 84-102,1984-2 C.B. 119.

2. Contributions of encumbered property: A liability towhich a property is subject is treated as a liabilityof the owner of the property. I.R.C. §752(c). Thus,if a partner contributes property to the partnershipthat is subject to a mortgage or other liability, thepartner will be considered as having received a cashdistribution in an amount equal to the reduction inhis share of the liability, as determined under Regs.§1.752-1(e).

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a. Contributing partner: If a partner contributesproperty subject to liabilities to apartnership, the partner's basis in hispartnership interest is reduced (but not belowzero) by the amount of the liabilities assumedby the partnership. I.R.C. §§752(b) and 733.

i. Possible gain: If the amount ofliabilities allocated to the other partnersexceeds the contributing partner's basisfor his interest in the partnership, thecontributing partner will recognize gain tothe extent of this excess. I.R.C.§731(a)(1).

b. Other partners: To the extent they are deemedto assume the contributing partner'sliabilities, the other partners are treated asthough they contributed money to thepartnership. Thus, they are entitled toincrease their respective bases by the amount ofthe deemed contribution. I.R.C. §§752 (a) and722.

c. Collateral consequences: If the contributionaffects the other partners' profit and lossinterest, their individual shares of partnershipliabilities may also change. As a consequence,two results may occur:

i. Partners whose shares in the partnershipprofits and losses increase are consideredto have contributed cash and are entitledto a basis increase. I.R.C. §§752(a) and722.

ii. Partners whose shares decrease are treatedas having received cash distributions fromthe partnership. I.R.C. §752(b).

3. Distributions of encumbered property: A distributionof encumbered property to a partner is treated asboth a distribution of cash to all partners sharingin the liability and a contribution of cash by thedistributee partner in an amount equal to theliability secured by the property. I.R.C. §§752(a)and (b). The distribution and contribution aredeemed to occur simultaneously. Rev. Rul. 79-205,1979-2 C.B. 255.

a. Significance: Absent this timing rule, anydistribution of encumbered property conceivablycould result in the recognition of gain to thepartner receiving the property subject to theliability.

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b. Partnership terminations: A similar resultoccurs when more than one encumbered asset isdistributed in a technical termination of apartnership. In this case, as long as theassets are distributed as part of a singletransaction within one taxable year, all section752(b) distributions and section 752(a)contributions are deemed to occursimultaneously, even if the encumbered assetsare distributed among the various partners.Rev. Rul. 87-120, 1987-2 C.B. 161.

VII. An Overview of Section 751(b): The "Hot Asset" Rules.

A. General rules.

1. Sale or exchange: Money or other property receivedin exchange for all or a part of an interest in apartnership that is attributable to either"unrealized receivables" or "substantially

appreciated inventory" is considered to be an amountrealized from the sale or exchange of the underlyingtainted receivables or inventory. I.R.C. §751(a).

2. Non pro rata distributions: If a partner receives adistribution of partnership property in liquidationof all or a portion of his partnership interest, andthe property received does not constitute a pro ratashare of the partner's interest in unrealizedreceivables and substantially appreciated inventory,as well as other partnership property. thedistribution will be treated as a sale or exchangebetween the distributee partner and the partnershipof the non pro rata portion of the distribution.I.R.C. §751(b).

B. Application of section 751(b).

I. When does section 751(b) apply?: The partnershipmust hold unrealized receivables or substantially

appreciated inventory (so-called "hot assets" or"section 751 assets").

2. Deemed exchange: The distributee partner mustreceive hot assets in exchange for other property, orother property in exchange for his share ofpartnership hot assets. Thus, an exchange occursonly if the distributee's interest in the value ofone class of partnership property is increased andhis interest in the value of the other class is

decreased.

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C. Exceptions to section 751(b).

1. Section 736(a): Liquidating distributions.

2. Self-contributed property: Distributions of propertycontributed by the distributee.

3. "Nondistributions": Drawings, advances, gifts, andpayments for services or for the use of capital.Regs. §l.751-1(b)(1)(ii).

D. Effect of section 751(b).

1. Increase in distributee's interest in section 751(b)property.

a. Deemed exchange: The excess section 751property is treated as acquired by thedistributee in exchange for his surrender of aportion of an interest in the partnership's"other property-"

b. Recognition event: Both the distributee partnerand the partnership may recognize gain. Thedistributee's gain generally will be capitalgain, while the partnership's gain generallywill be ordinary income. All "exchanged" assetshave a cost basis to the recipient.

c. Other rules apply: The balance of the propertyactually received by the distributee is treatedas received in a distribution subject tosections 731-735.

2. Increase in distributee's interest in other property.

a. Deemed exchange: The excess "other property" istreated as received or acquired by thedistributee in exchange for his surrender of aportion of an interest in section 751 property.

b. Recognition event: The exchange generallyproduces ordinary income to the distributeepartner, who is viewed as disposing of a portionof his interest in section 751 property, andcapital gain (or loss) to the continuingpartnership, which is viewed as transferring theexcess "other property" to the distributee in ataxable exchange.

c. Other rules apply: The remainder of theproperty actually distributed is subject to thegeneral distribution provisions of sections731-735.

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E. The seven step analysis of section 751(b).

1. Classify the partnership assets.

a. First class: Unrealized receivables andsubstantially appreciated inventory constituteone class.

b. Second class: A second class is composed of allother property.

c. Only one class: If the partnership has only oneclass of property, section 751(b) isinapplicable.

2. Determine the gross value of the distributee'sinterest in each asset.

a. Pre-distribution: Determine the gross value ofthe distributee's pre-distribution interest ineach partnership asset in each class. The grossvalue is the value before reduction forliabilities to which the assets are subject.

b. Post-distribution: Determine the gross value ofthe distributee's post-distribution interest ineach undistributed partnership asset in eachclass. In the case of a complete liquidation,this would be zero.

c. Partner share: Determine the gross value of allproperty actually distributed to the partner.

d. "Vanilla" allocations: If the distributee hasthe same percentage interest in partnershipprofits, losses and capital, his share of thevalue of each class of property is simply hispercentage interest in the partnershipmultiplied by the gross value of the property ineach class.

3. Determine the partnership exchange table.

a. Comparison: Compare the distributee'spre-distribution interest in the value of eachasset class with the sum of: (1) The value ofthe distributee's post-distribution interest inthe undistributed assets in each class; and(2) The value of the assets in each classactually received by the distributee.

b. Result: This comparison reveals whether thedistribution results in an exchange of assets ofone class for assets of the second class. Theasset class from which the partner has received

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an excess distribution is referred to as the"purchased class." The asset class from whichthe partner has received a disproportionatelysmall distribution is called the "relinquishedclass."

c. If an exchange results, the comparison alsoreveals the value of the assets involved in theexchange.

d. Liabilities.

i. Reduction: A reduction in liabilities dueto a section 752(b) constructive cashdistribution is considered to be adistribution of other property (i.e., cash).

ii. Assumption: If the distributee assumespartnership liabilities in connection withthe distribution, or receives propertysubject to partnership liabilities, theamount of liabilities assumed or takensubject to must be subtracted from theamount of constructive cash distribution sothat only the net reduction in thedistributee's liabilities is accounted forin the comparison.

4. Determine which assets are involved in the section751(b) exchange.

a. Determine which assets are "sold" by thedistributee.

i. General rule: Generally, the distributeeis treated as selling a proportionateamount of each asset in the relinquishedclass in which he had an interest.

ii. If the distributee receives an actualdistribution of more than his share of apartnership asset in the relinquishedclass, the distributee is treated as havingreceived it in exchange for other assets inthe relinquished class. This exchange hasno tax consequences since only exchangesbetween classes are taxable under section751(b).

b. Determine which assets are "purchased" by thedistributee.

i. General rule: Generally, the distributeeis treated as "purchasing" the excess ofthe assets of the purchased class received

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over the proportionate share of each assetin the purchased class.

ii. Although the distributee may acquire morethan a proportionate share of some of theassets in the purchased class, he may haveacquired less than his share of otherassets in the purchased class. Sincesection 751(b) applies only to exchangesbetween classes, the exchange of assetswithin a particular class of assets isignored. Only the net excess amount of theassets in the purchased class is treated ashaving been purchased.

5. Determine the basis of the relinquished assets.

a. Deemed distribution: The relinquished assetsare treated as having been received by thedistributee in a fictional current distributionimmediately before the exchange.

b. Basis: The distributee's basis in these assetsis generally the same as their basis in thehands of the partnership. I.R.C. §732(a)(1).

c. Caveat: The basis limitation and allocationrules of section 732(a)(2) and (c) may come intoplay-

6. Consequences of the section 751(b) exchange.

a. Recognition of gain or loss.

i. The distributee: The section 751(b)exchange is a taxable event in which thedistributee recognizes gain or loss undersection 1001 equal to the differencebetween the value of the property receivedin the exchange (i.e., the purchasedproperty) and the basis in the relinquishedassets.

ii. The partnership: Similarly, thepartnership recognizes gain or loss undersection 1001 equal to the differencebetween the value of the property receivedin the exchange and its basis in the assetsthat it relinquishes.

iii. Continuing partners: Gain or lossrecognized by the partnership is allocatedamong the partners (other than thedistributee) in accordance with theirrelative post-distribution interests in

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partnership profits or losses and isseparately stated as a section 702(a)(7)item. Regs. §1.751-I(b)(2)(ii).

iv. Loss: A loss realized in the section751(b) exchange is fully recognized, evenif section 707(b)(1)(A) would otherwisepreclude such recognition. Regs.§1.751-i(b)(I)(i).

b. Character of gain or loss recognized.

i. "Sale" of section 751 property.

a. The distributee: The character of thegain or loss recognized by thedistributee is ordinary income or loss.

b. The partnership: The gain or lossrecognized by the partnershipgenerally is capital gain or loss, asdetermined by reference to thecharacter of the assets deemed to besold by it.

ii. "Sale" of other property.

a. The distributee: The character ofgain or loss recognized by thedistributee is determined by referenceto the character of the property whichhe relinquished in the exchange.

b. The partnership: The gain or lossrecognized by the partnership isordinary income or loss.

c. Timing of gain or loss recognition: Generally,gain or loss realized by the distributee and thepartnership in a section 751 exchange must berecognized immediately.

7. Treatment of the portion of the distribution notincluded in the section 751 exchange: These assetsare treated as in a normal distribution.Consequently, their treatment is determined under thegeneral rules for distributions of sections 731through 735.

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VIII. Tax Year of Partners and the Partnership.

A. When a partner includes partnership income.

1. General rule: A partner must include in income hisdistributive share of partnership items andguaranteed payments for the taxable year of thepartnership that ends within or with the partner'staxable year. I.R.C. §706(a).

2. Constructive distribution: Section 706(a), ineffect, deems a distribution of these items to occurwhen the partnership's taxable year ends.

3. Example: X, a calendar year taxpayer, is a partnerin XYZ partnership, which has a June 30 year end.(Assume for purposes of this example that section706(b) allows the partnership a June 30 taxable yearend.) Thus, partner X would report on his 1988Federal income tax return his distributive share ofpartnership items for the partnership year endingJune 30, 1988. X does not have to recognize in 1988his share of partnership items for the period fromJuly I to December 31, 1988 (which are reported onthe partnership's return for its year ending June 30,1989). Rather, X will include his share for thatperiod on his 1989 return.

a. Deferral benefit: The potential value of thissix month deferral has not gone unnoticed by theCongress. The limitations on a partnership'sselection and retention of a taxable year arediscussed immediately below.

B. Partnerships: Permissible taxable years.

1. General rule: A partnership adopts a taxable year asif it were a taxpayer. I.R.C. §706(b)(1)(A).However, its selection and retention of a taxableyear is subject to the limitations discussed below.I.R.C. §706(b).

2. Limitations: Section 706(b)(1)(B), as amended by the1986 Act, severely limits the ability of apartnership to adopt or retain a tax year other thanthe tax year of its majority partners. Section706(b)(1)(B) provides a priority pyramid, so that apartnership may not have a taxable year other than:

a. Majority partners: The taxable year of one ormore of its partners who have an aggregateinterest in partnership profits and capital ofgreater than 50 percent;

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b. Principal partners: If there is no common taxyear among partners owning greater than 50percent of partnership profits and capital, thetaxable year of all of its principal partners(defined as partners with a five percent or moreinterest in partnership capital or profits); or

c. Default: If the principal partners do not allhave the same tax year, the partnership mustadopt a calendar year as its tax year unless adifferent period is prescribed either in theregulations promulgated under section 706 or isallowed by the IRS.

i. Least aggregate deferral: If the principalpartners do not have the same tax year, andno majority of partners have the same taxyear, the partnership must adopt the taxyear of one or more of the partners thatresults in the least aggregate deferral ofincome to the partners. Temp. Regs.§1.706-IT.

ii. Definition: The aggregate deferral for aparticular year is equal to the sum of theproducts determined by multiplying themonths of deferral (measured from the endof the partnership's tax year forward tothe end of the partner's tax year) for eachpartner and each partner's interest inpartnership profits. The partner's taxyear which produces the lowest sum whencompared to the other partners' tax yearsis the tax year that results in the leastaggregate deferral.

d. "Business purpose" exception: A partnership mayadopt or retain an otherwise nonpermissible yearif it establishes, to the satisfaction of theSecretary, a business purpose for that taxableyear. I.R.C. §706(b)(I)(C).

e. "Enhanced estimated payments" exception: Withincertain limitations, a partnership may adopt orretain other than a required year if it agreesto make certain "required payments." I.R.C.§§444 and 7519.

3. Application: Section 706(b), as amended by the 1986Act, generally applies to tax years beginning afterDecember 31, 1986 (and not simply to partnershipsformed after 1986). Thus, the amendments affect bothnewly formed and existing partnerships.

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a. Existing partnerships: An existing partnershipwith a nonconforming year (e.g., a partnershipwith only individuals as partners which adopteda fiscal year ending on September 30, October31, or November 30, as allowed under prior law

by Rev. Proc. 72-51, 1972-2 C.B. 832) generally

must have changed to a permitted year for itsfirst tax year beginning after December 31,1986. The change required a short taxable yearreturn to conform the partnership's year to a

permitted year. Partners in a partnershiprequired to change its year end under new

section 706(b) are entitled to relief since thechange resulted in more than 12 months ofpartnership income otherwise included in thepartners' 1987 income tax returns. The reliefprovision, section 806(e)(2) of the 1986 Act,provides that:

i. Taxpayer initiated: The required change inthe partnership's year end shall be treatedas initiated by the taxpayer;

ii. Consent: The change will be treated ashaving been made with the consent of theSecretary; and

iii. Timing of the adjustment: With respect toany partner required to include income frommore than one year of the partnership in

one taxable year, income in excess ofexpenses for the short taxable year of thepartnership shall be taken into accountratably in each of the first four taxable

years of the partner (including the shorttaxable year) beginning after December 31,1986, unless the partner elects to includeall income from the short period in theshort taxable year.

a. Basis increase: Any income of thepartnership for the short yearincreases the partner's basisimmediately, even though the partner

includes the short period income inhis (or her) individual income tax

return over a four year period. Temp.

Regs. §l.702-3T(e).

iv. Dispositions: The effect of a dispositionof all or part of a partnership interest towhich the four year spread applies isdetermined by the amount of the interest

retained by the disposing partner. Temp.Regs. §I.702-3T(g)(1).

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a. If less than or equal to one-third ofthe interest held in the year ofchange is retained, all of theunamortized adjustment is recognizedin the year of disposition.

b. If greater than two-thirds isretained, the unamortized adjustmentcontinues to be recognized ratablyover the four year period.

C. Finally, if greater than one-third butless than or equal to two-thirds isretained, a ratable portion of theunamortized adjustment plus one-halfof the remaining balance is recognizedin the year of disposition. Temp.Regs. §l.702-3T(g)(2).

4. Business purposes and the retention or adoption ofother fiscal years.

a. General rule: As noted above, a partnership mayretain or adopt an otherwise nonpermissiblefiscal year if it establishes, to thesatisfaction of the Secretary, a businesspurpose for the year.

b. IRS guidance: The Service has issued temporaryregulations regarding the adoption ofpartnership taxable years. Temp. Regs.§1.442-3T. The temporary regulations generallyare effective only for partnerships whose firsttaxable year began before 1987, but shouldprovide some guidance regarding the Service'seventual position regarding adoption orretention of partnership taxable years forsubsequent years. Following the legislativehistory of the 1986 Act, the regulations providethat the following factors generally will not besufficient to establish a substantial businesspurpose:

i. The use of a particular year for regulatoryor financial accounting purposes;

ii. The hiring patterns of a particularbusiness (e.g., the fact that a firmtypically hires staff during certain timesof the year);

iii. The use of a particular year foradministrative purposes, such as foradmission or retirement of partners,promotion of staff, and compensation or

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retirement arrangements with staff, orpartners; and

iv. The fact that a particular businessinvolves the use of price lists, modelyear, or other items that change on anannual basis. Temp. Regs. §1.442-3T(c)(2).See, e.g., Staff of the Joint Committee onTaxation, General Explanation of the TaxReform Act of 1986 (the "1986 GeneralExplanation"), at 537.

c. Procedure: Rev. Proc. 87-32, 1987-2 C.B. 396,provides expeditious approval provisions for anypartnership desiring to retain or change to atax year that coincides with a natural businessyear. Special notification provisions are alsoprovided for any partnership that intends toadopt, retain or change its tax year as requiredby the 1986 Act, and for any partnership thatwants to retain a "grandfathered" fiscal year.The revenue procedure also includes instructionsfor adopting, changing or retaining a tax yearby establishing a business purpose.

i. Elements: Under Rev. Proc. 87-32, supra, apartnership establishes a business purposefor the use of a requested tax year if: (1)The tax year is a natural business year;and (2) Certain other conditions are met.

ii. Natural business year: A natural businessyear is determined by a 25 percent test,determined as follows: Compute grossreceipts from sales and services for themost recent 12-month period ending beforethe request is filed and that ends with thelast month of the requested fiscal year.Divide this amount by the gross receiptsfrom sales and services for the last twomonths of the 12-month period. Then repeatthe same computation for the two 12-monthperiods preceding the period computedabove. If each of the three results is atleast 25 percent, then the requested fiscal

year is the natural business year. If thepartnership qualifies for more than onenatural business year, the fiscal yearproducing the highest percentage is used.

d. Legislative history: The legislative history ofthe 1986 Act also provides useful guidanceregarding what will or will not constitute abusiness purpose.

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i. Income deferral: A deferral of income tothe partners does not constitute a businesspurpose. I.R.C. §706(b)(i)(C). Underprior law, Rev. Proc. 72-51, supra,provided that partnerships generally couldadopt a year which provided a three monthor less deferral of income (e.g., aSeptember, October, or November year endwhere all the partners are individuals).However, under the 1986 Act, the deferralof income for a limited time to thepartners, such as the three months rule ofRev. Proc. 72-51, supra, is not to betreated as a business purpose. ConferenceCom nittee Report, Tax Reform Act of 1986(H.R. 3838), H. Rep. No. 861, 99th Cong.,2d Sess. (the "Conference Report"), 11-318.

ii. Prior approval: Partnerships that receivedpermission to use a fiscal year end (otherthan a year end that resulted in a threemonth or less deferral of income) under theprovisions of Rev. Proc. 74-33, 1974-2 C.B.489, will be allowed to continue such yearwithout obtaining approval of theSecretary. Conference Report, supra, 11-319.

C. Use of a nonpermitted year.

1. General rule: Under the 1987 Act, a partnership thatdoes not meet the business purpose test maynevertheless elect a fiscal year, within certainlimitations, providing the partnership agrees to makea "required payment", due in a single installmenteach May 15th. Temp. Regs. §l.7519-2T(a)(4)(ii).(However, see the discussion at C. 13., below, forthe first required payment date.)

2. Benefits and detriments: There are severalsituations in which a section 444 election mayeconomically advantageous or disadvantageous to ataxpayer.

a. Proportionality: The calculation of a requiredpayment under section 7519 for a partnershipassumes proportionality (i.e., a proportionalamount of the year's income is earned in thedeferral period). Therefore, if a partnershipearns a disproportionately large amount of itsincome in the "deferral period," a section 444election will generally be advantageous.

b. Income trend: The required payment is computedusing prior years' income. Therefore, if thepartnership is experiencing a growth trend, the

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required payment will usually be less than theamount of tax paid if the partnership changes toits required year.

c. Rate arbitrage: A cash flow benefit can beattained if the partners are in a 33 percentbracket for years after 1987. Under Temp. Regs.1.7519-1T(b)(2)(i), the rate used in computingthe required payment for applicable electionbeginning after 1987 is computed using a 29

percent rate.

d. Compliance burden: These savings must beweighed against the administrative costs of

adhering to the rules under section 7519. Itshould be noted that taxpayers in the situationsopposite of those above (e.g., where an entity'sbusiness is declining or a disproportionatelysmall amount of income is earned in the deferralperiod) will suffer economically from making thesection 444 election.

3. Election: Both the election of other than a requiredyear under section 444 and the required payment ofsection 7519 are made at the entity level, ratherthan by or on behalf of the partners. The electiondoes not require IRS approval and, once made, isvalid for all future years until either revoked orterminated. I.R.C. §444(d)(2)(A).

a. Failure to pay: If the electing partnershipdoes not make the required payment, the IRS mayterminate the election. I.R.C. §7519(f)(4)(C);

Temp. Regs. §l.444-IT(a)(5)(i)(C).

b. Revocation: The electing partnership may revokeits election at any time without the permissionof the IRS, in which case the partnership mustthen change to a permitted year. I.R.C.§444(d)(2)(A); Temp. Regs. §l.444-1T(a)(5)(i)(A).

c. Subsequent election: An electing partnershipwhose election has been either revoked orterminated cannot re-elect a fiscal year under

these provisions. I.R.C. §444(d)(2)(B); Temp.

Regs. §l.444-1T(a)(5)(i).

4. Deferral period -- Adoption of a year: Generally, apartnership may not adopt a fiscal year that resultsin a deferral to the partners of more than threemonths. Thus, if the partnership is otherwiserequired to use a calendar year, it generally mayadopt a September 30, October 31, or November 30 yearend. I.R.C. §444(b)(1); Temp. Regs. §l.444-1T(b)(1).

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5. Deferral period -- Change of a year: If thepartnership is changing its year end, it may changeto a taxable year resulting in a deferral period ofthe lesser of: (1) Three months; or (2) Its currentdeferral period. Thus, a partnership with an October31 fiscal year (under section 706 prior to itsamendment by the 1986 Act) and a required year ofDecember 31 could change to a November 30 year butnot a September 30 year end. I.R.C. §444(b)(2);Temp. Regs. §l.444-1T(b)(2)(i). This rule generallyprohibits existing partnerships on a calendar yearfrom changing to some other year.

6. Transitional rules: Special transitional rules applyto a partnership that wished to retain a fiscal yearfor its first taxable year beginning after 1986.These rules applied to an entity that would have beenrequired to change to a calendar year in 1987 undersection 806 of the 1986 Act. The partnership isallowed to retain its fiscal year, even if it resultsin a deferral period of more than three months.Temp. Regs. §l.444-lT(b)(3).

7. Tiered structures: A partnership that is part of atiered structure generally cannot make a section 444election unless the tiered structure is composedsolely of S corporations and/or partnerships (but notpersonal service corporations) and all of theentities have the same taxable year. Temp. Regs.§§l.444-2T(e) and 1.444-2T(f), Example 8.

8. Required payment: If a partnership elects a fiscalyear under section 444, it must make a requiredpayment under section 7519. This payment is in thenature of a deposit by the partnership. The requiredpayment essentially is intended to approximate thebenefit of tax deferral resulting to the partnerswhich results from the use of the elected fiscalyear. The required payment is not a deductibleexpense of either the partners or the partnership,nor may the partners claim it as a credit againsttheir individual tax liabilities.

a. Calculation: The payment is calculated at a"tax rate" of 36 percent for base years endingin 1987 and at the highest individual statutoryrate plus one percent (currently 29 percent) inthe following years. I.R.C. §7519(b); Temp.Regs. §l.7519-2T(b)(2)(i). This depositpercentage of the section I tax rate plus onepercent applies even if the partners are all Ccorporations otherwise subject to the rate oftax imposed by section 11.

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b. Phase-in of the payment: There is a four-yearphase-in of the amount of the required payment,which generally corresponds to the four-yearincome spread under section 806(e)(2) of the1986 Act. I.R.C. §7519(d). The phase-in isavailable to all partnerships, and not justthose whose partners would have been entitled tothe four-year income spread of the transitionrule of the 1986 Act. Temp. Regs. §1.7519-lT(b)(1)(i) and (ii). (However, section 204(d) ofthe pending Technical Corrections Bill of 1988would eliminate the phase-in after 1987 forthose partnerships whose partners would not havebeen entitled to the four-year spread.)

c. Threshold amount: A partnership does not haveto make a required payment if the total ofrequired payments for the current and allpreceding election years does not exceed $500.I.R.C. §7519(a)(2); Temp. Regs. §l.7519-lT(a)(2).

d. No payment: A partnership has no obligation tomake required payments if it uses a year forwhich it has established a business purpose oruses a grandfathered fiscal year. Temp. Regs.§§1.7519-1T(a)(1) and 1.444-lT(a)(3).

9. Computation of the payment: In general, thecalculation of the required payment under section7519 for any year in which the section 444 electionis in effect is made as follows:

a. Multiply the partnership's net income from thepreceding fiscal year (the "base year") by aratio, the numerator of which is the number ofmonths in the deferral period and thedenominator of which is the total number ofmonths in the base year (usually 12);

b. Multiply the result in a., above, by thestatutory rate (36 percent for base years endingin 1987, 29 percent thereafter);

c. Multiply the result in b., above, by thefour-year phase-in factor (25 percent for yearsbeginning in 1987, 50 percent for yearsbeginning in 1988, 75 percent for yearsbeginning in 1989 and 100 percent for yearsbeginning in 1990 or later); and

d. Subtract the cumulative balance of all previousrequired payments for prior years from theresult obtained in c., above. Temp. Regs.§l.7519-1T(a)(3)(i) and (ii).

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10. "Applicable payments": If the partnership makespayments to its partners that are includible in theirincome (e.g., salary, rent, etc.), the requiredpayment formula must include an additional element

that effectively spreads these payments (called"applicable payments") equally over the fiscal year.

I.R.C. §7519(d). Applicable payments do not includethe gain from the sale or exchange of propertybetween a partner and the partnership or guaranteed

payments under section 707(c). I.R.C.§7519(d)(3)(B); Temp. Regs. §l.7519-1T(b)(5)(iv)(B).

This component is computed as follows:

a. Multiply the total applicable payments made

during the base year by the ratio referred to in9. a., above, and subtract the actual applicablepayments made during the deferral period of thepreceding year (the "base year");

b. Multiply the result in a., above, by the

statutory rate;

c. Multiply the result in b., above, by thefour-year phase-in factor; and

d. Subtract the cumulative balance of theapplicable payment component for all previous

years from c., above.

11. Total: The combination of the deferred base year net

income component calculated in 9., above, and theapplicable payment component calculated in 10.,

above, equals the total required payment.

12. Reduction in the required payment: If the

calculation of the required payment for a yearresults in a negative amount, the partnership isentitled to a refund of that amount. I.R.C.§7519(c). Additionally, a refund may be obtained forthe total cumulative payment in the year the

partnership revokes its section 444 election. Temp.Regs. §1.7519-IT(c). However, no interest will be

paid on any refunds of section 7519 payments.

§7519(f)(3); Temp. Regs. §l.7519-2T(a)(6)(iii).

13. Compliance aspects of the election: An electionunder section 444 generally must be made by the

earlier of: (I) The 15th day of the fifth monthfollowing the month that includes the first day ofthe taxable year for which the election will take

effect; or (2) The due date (without regard toextensions) of the income tax return resulting fromthe section 444 election. Temp. Regs.

§l.444-3T(b)(1). (However, in no instance was the

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filing date before July 26, 1988.) Temp. Regs.§l.444-3T(b)(2).

a. Form of the election: The election is made byfiling Form 8716, Election to Have a Tax YearOther Than a Required Tax Year, with the ServiceCenter indicated in the instructions to theform. Temp. Regs. §l.444-3T(b)(1).

i. Duplicate filing: A copy of Form 8716 mustbe attached to Form 1065 for the first yearfor which the election is made. Temp.Regs. §l.444-3T(b)(1).

ii. Signature: Form 8716 must be signed by aperson authorized to sign the partnershipreturn. Temp. Regs. §1.444-3T(b)(1).

b. Tax return due dates: The temporary regulationsextended the original due date of a return thatresults from making a section 444 election (forthe first taxable year that began after December31, 1986), to August 15, 1988, if later. (Arequest to extend the original due date was notrequired). However, the wording "Section 444Return," should have been typed or legiblyprinted at the top of the Form 1065. Temp.Regs. §1.444-3T(c)(I).

c. Form and timing of payments: For applicableelection years beginning after 1987, paymentsare made with Form 720, Quarterly Federal ExciseTax Return, unless another form is prescribed bythe Commissioner and are due on or before May 15of the calendar year following the calendar yearin which the applicable election year begins.Temp. Regs. §§1.7519- 2T(a)(2)(i) and1.7519-2T(a)(4)(ii).

14. Tiered structures: Section 444(d)(3) generallyprohibits an entity which is part of a "tieredstructure" from making an election under section 444to retain or adopt a taxable year other than itsrequired year.

a. Definition: A partnership is a part of a tieredstructure if it directly owns any portion of a"deferral entity" or a deferral entity directlyowns any portion of it. A deferral entity isdefined as an entity which is a partnership, Scorporation, personal service corporation, ortrust. Temp. Regs.§l.444-2T(b)(2)(i). Agrantor trust or qualified Subchapter S trust isnot included in the definition. Temp. Regs.§1.444-2T(b)(2)(ii).

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b. Exceptions: There are two significantexceptions under which a partnership may make anelection under section 444, notwithstanding anownership relationship with a deferral entity:(1) The de minimis exception; and (2) The "sametaxable year" exception. These exceptions aredescribed briefly below.

i. De minimis exception: Irrespective of thegeneral prohibition of an ownershiprelationship between an entity electingunder section 444 and a deferral entity,certain de minimis amounts of ownershipwill not cause an entity to be considered amember of a tiered structure. If apartnership owns an interest in one or moredeferral entities, and in the aggregatethose deferral entities do not account formore than five percent of the partnership'sadjusted taxable income and two percent ofits gross income, then the ownership isdisregarded for purposes of the tieredstructure definition. Temp. Regs.§1.444-2T(c)(2)(i).

a. If one or more deferral entities ownsa portion of a partnership and, in theaggregate, that ownership is fivepercent or less of the current profitsof the partnership, then thisownership is also disregarded forpurposes of the tiered structuredefinition. Temp. Regs.§1.444-2T(c)(3).

b. Each entity that falls under thegeneral definition of a tieredstructure must be consideredseparately for purposes of the deminimis exception. For example, apersonal service corporation may ownan interest in a partnership that isconsidered de minimis to thepartnership, but not the PSC.Therefore, while the partnership would

be allowed an election under section444, the PSC would not.

ii. Same taxable year: In general, if a tieredstructure is composed entirely of S

corporations, partnerships or both (but notPSCs), all of which are on the same taxableyear, then the entities in that structuremay make an election under section 444 toretain that year. However, for purposes of

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this rule, there is a special definition of

a tiered structure and provisions thatgovern the interaction of the same taxableyear exception with the de minimis rule.Temp. Regs. §l.444-2T(e)(5). Two or more

entities are considered to have the sameyear if their taxable years end on the sameday, even though they begin on differentdays. This rule allows certain Scorporations or partnerships to changetheir years to qualify for this exception.Temp. Regs. §§l.444-2T(e)(3) and1.444-2T(f), Example (11).

D. Changes in a partner's taxable year.

1. General rule: Section 706 prohibits a principalpartner from changing his taxable year to any yearother than the partnership's taxable year unless thepartner establishes a business purpose for thechange. I.R.C. §706(b)(2).

2. Reach of the rule: The Commissioner's consent isrequired for any change in a partner's taxable year.This rule applies to all partners and not justprincipal partners. Regs. §1.706-1(b)(2).

IX. Considerations in Using a Tiered Partnership Structure.

A. Terminology: In its simplest form, an "upper-tier"partnership (also called a "parent" or "investing"partnership) invests in the "lower-tier" partnership(sometimes referred to as a "subsidiary" or "operating"partnership), which, in turn, owns the operating assets ofthe group.

B. Business and tax considerations.

1. In general: A tiered partnership structure may offera number of business advantages. For example, theowners can almost accomplish the Subchapter Kequivalent of a holding company structure, isolateliability exposure through the tiering of limitedpartnership interests, and obviate the need foramending state law limited partnership filings.

2. Other forms of tiered ownership: The use of a tieredstructure is not limited only to a chain ofpartnerships. For example, the Internal RevenueService has respected a partnership composed ofsubsidiaries of the same parent corporation. Rev.Rul. 75-19, 1975-1 C.B. 382. Additionally, thepartners in a partnership may consist of S

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corporations, each of which is wholly-owned by adifferent individual or group of individuals.

a. Caveat: The idea of a partnership of Scorporations cannot be a means to avoid the35-shareholder restriction of section1361(b)(1)(A). Rev. Rul. 77-220, 1977-1 C.B.263.

b. Planning: Assuming the caveat of Rev. Rul.77-220, supra, is not problematic, the structureof a partnership including one or more Scorporations creates a series of creativeplanning possibilities. For example, thepartnership agreement can contain specialallocations that would not be possible in asimple S corporation because of the one class ofstock limitation. I.R.C. §1361(b)(1)(D). Sucha tiered structure also may create estateplanning possibilities not otherwise availableto the S corporation shareholder (subject, ofcourse, to the valuation freeze rules of section2036(c)).

c. Federal income tax considerations: The use of atiered partnership structure involves a seriesof additional Subchapter K considerations,including:

1. A partner's share of partnership liabilities: Alimited partner's basis for his (or her) interest ina first tier limited partnership includes thatpartner's share of the second tier partnership'snonrecourse liabilities which are allocated to thefirst tier partnership. Rev. Rul. 77-309, 1977-2C.B. 216.

2. Availability of other than a permitted year: See thediscussion at VIII. C. 14., above for limitations onthe taxable year of a partnership that is part of atiered structure.

3. Partnership terminations due to changes inownership: The sale of an interest in an upper-tierpartnership which results in a termination undersection 708(b)(1)(B) will cause the upper-tierpartnership to be deemed to have distributed all ofits assets to its partners. If one of the assetsdistributed is a 50 percent partnership interest in alower-tier partnership, that distribution will causethe termination of the lower-tier partnership, as theupper-tier partnership is treated as having exchangedits entire partnership interest. Rev. Rul. 87-50,1987-1 C.B. 157. See, Rev. Rul. 87-51, 1987-1 C.B.158, which holds that the sale of an interest in an

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upper-tier partnership which does not cause thatpartnership to terminate does not result in a sale ofan interest in a lower-tier partnership which couldcause the termination of the lower-tier partnership.

4. Section 754 elections:

a. Distribution of a partnership interest: Nosection 734(b) adjustment is allowed unless thedistributor partnership and the partnershipwhose interest is distributed both have section754 elections in effect. I.R.C. §734(b) (lastsentence).

b. Upper-tier and lower-tier partnership each havea section 754 election in effect: A sale orexchange of an interest in a partnership whichis also a partner in a partnership results in asection 743 adjustment to both partnerships(i.e., it flows through) if both partnershipshave a section 754 election in effect. Rev Rul.78-2, 1978-1 C.B. 202.

c. Only the upper-tier partnership has a section754 election in effect: If the upper-tierpartnership has a section 754 election in effectbut the lower-tier partnership does not, thepurchase of a partnership interest in theupper-tier partnership will adjust the basis ofthe upper-tier partnership's assets, but willnot affect the lower-tier partnership's adjustedbasis in its property. Rev. Rul. 87-115, 1987-2C.B. 163.

d. Only the lower-tier partnership has a section754 elections in effect: If the lower-tierpartnership has a section 754 election in effectbut the upper-tier partnership does not, thepurchase of a partnership interest in theupper-tier partnership will not lead to anyinside basis adjustments. Rev. Rul. 87-115,1987-2 C.B. 163.

5. Flow through of partnership items: Lower-tierpartnerships in a multitiered structure mustseparately state those items of income, gain, loss,deduction, and credit which if separately taken intoaccount by any partner of any partnership in themultitiered structure would result in an income taxliability for that partner different from that whichwould result if that partner did not take those itemsinto account separately. Rev. Rul. 86-138, 1986-2

C.B. 84.

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6. Retroactive allocations: To prevent the use oftiered partnerships to avoid the retroactiveallocation rules, an upper-tier partnership's shareof any item of income, gain, loss, deduction, orcredit of a lower-tier must be prorated equally overthat portion of the taxable year during which theupper-tier had an interest in the lower-tier. I.R.C.§706(d)(3).

X. Selected Compliance Considerations.

A. Foreign partnership compliance.

1. Partner filings.

a. The Tax Equity and Fiscal Responsibility Act of1982 (the "1982 Act") added the requirement thatUnited States persons who are partners inforeign partnerships file a return if:

i. They acquire any interest in a foreignpartnership,

ii. They dispose of any portion of theirinterest in a foreign partnership, or

iii. Their proportional interest in a foreignpartnership changes substantially. I.R.C.§6046A(a).

b. Guidance: The Service has not providedregulatory guidance as to the information orform to be filed and has extended the time tofile the required returns. Announcement 83-5,1983-2 I.R.B. 31.

2. Partnership filings: The 1982 Act clarified that allpartnerships with United States partners must file apartnership return. Conference Committee Report, TaxEquity and Fiscal Responsibility Act of 1982 (P.L.97-248) H. Rep. No. 760, 97th Cong., 2d Sess., at 611.

3. Section 754 election: The U.S. person that seeks toavail itself of a section 754 election from theacquisition of an interest in a foreign partnershipneeds to exercise a degree of planning. If theforeign partnership fails to satisfy its complianceobligation vis-a-vis the U.S. partner, it falls uponthe U.S. partner to satisfy, in English, all thesection 754 disclosures. Failure to disclose inEnglish the election and the corresponding basisadjustments on the U.S. partner's return has beenheld as grounds to disallow the basis adjustments.Atlantic Veneer Corp. v. Commissioner, 85 T.C. 1075

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(1985), aff'd, 812 F.2d 158, 87-1 USTC 9192 (4thCir. 1987). See, Regs. §1.6031-1(d)(2).

B. Withholdings on distributions to foreign partners.

1. Income: A domestic partnership is required towithhold 30 percent of fixed or determinable annualor periodic income which is included in a foreignpartner's distributive share. I.R.C. §§1441 and 1442.

2. Real property: Where a partnership holds a U.S. realproperty interest ("USRPI"), it is required towithhold 34 percent of the gain realized on thedisposition of the USRPI which is included in aforeign partner's distributive share (under section1445(e)(1)) or 10 percent of the value of a USRPIdistributed to a foreign partner in a taxabledistribution under section 897. I.R.C. §1445(e)(4).

a. Sale of an interest: Where a partnershipinterest is sold by a foreign partner and theunderlying partnership assets include a U.S.real property interest, the transferee isrequired to withhold 10 percent of the amountrealized. I.R.C. §1445(e)(5).

3. Other distributions: A partnership must withhold 20percent of amounts distributed to a foreign partneron income which is effectively connected with theconduct of a U.S. trade or business. I.R.C. §1446.

C. Reporting requirements associated with the transfer of apartnership interest.

1. Exchanges of partnership interests described insection 751(a): A partnership is required to fileForm 8308, Report of Sale or Exchange of CertainPartnership Interests, with its partnership return tonotify the Service of any exchange described insection 751(a) of any of its interests during thecalendar year which ends during the partnership'staxable year. I.R.C. §6050K.

a. Statements furnished by partnership totransferor and transferee: The partnership isalso required to provide a written statement tothe transferee and transferor of its partnershipinterest in a section 751(a) exchange on orbefore January 31 of the calendar year followingthe calendar year in which the transfer occurredor, if later, 30 days after the partnership isnotified of the transfer.

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i. Form of statement: The partnership mustuse the completed Form 8308 unless the Form8308 contains information with respect tomore than one section 751(a) exchange. IfForm 8308 is not used the statement mustinclude all information shown on Form 8308with statements indicating that theinformation has been provided the I.R.S.and other reporting requirements.

b. Partnership's notification: The partnership isnot required to file Form 8308 until it receivesnotification of a transfer of one of itsinterests. I.R.C. §6050K(c)(2).

i. The partnership is considered notified whenit receives written notification from thetransferor or has knowledge that a transferhas occurred and that it had section 751property- Regs. §l.6050K-l(e).

ii. If the partnership receives notification ofa transfer after it has filed itspartnership return in which the noticeshould have been reported, it must fileForm 8308 with the Service Center or otherInternal Revenue office with which it filedits partnership return within thirteen daysof receiving notification of the transfer.Regs. §l.6050K-l(f)(2)

c. The partner's responsibility: The transferor of

any partnership interest in a section 751(a)exchange must notify the partnership of thetransfer in writing by the earlier of 30 daysfrom the date of the transfer or January 15 ofthe calendar year following the calendar year inwhich the transfer occurred. The transferormust provide the following information:

i. The names and addresses of the transferorand transferee;

ii. The taxpayer identification numbers of thetransferor and, if known, of thetransferee; and

iii. The date of the transfer.

d. Notification not required: The partnership isnot required to file Form 8308 if the transferof its interests is not considered a section751(a) exchange. Regs. §l.6050K(e)(2).

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i. The partnership can rely on a writtenstatement from the transferor as to whetheror not the transfer was a section 751(a)exchange, absent knowledge to thecontrary. Regs. §l.6050K(e)(2).

2. Section 1060 and certain basis adjustments: Theresidual method of determining goodwill or goingconcern value will be used in determining theallocation of basis adjustments made under sections743(b) and 732(d) if the assets of the partnershipconstitute a trade or business for purposes ofsection 1060(c). Regs. §l.755-2T(a)(2).

a. Trade or business: A group of assetsconstitutes a trade or business if the use ofthe assets would constitute an active trade orbusiness for purposes of section 355 or there isa chance that goodwill or going concern valuecould under any circumstances attach to theassets. The latter is based upon all the factsand circumstances surrounding the transaction.

b. Disclosure: The reporting requirements of§1060(b) are not applicable to transfers ofpartnership interests. Thus, the effect ofsection 1060 upon the transfer of partnershipinterests is to graft section 338 allocationrules onto section 755.

i. Statements are required to be attached to apartner's tax return showing thecomputation and allocation of the specialbasis adjustments under sections 743(b) and732(d). Regs. §§1.743-1(b)(3) and1.732-1(d)(3).

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