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CLASSIFICATION Partnerships & LLCs: unlike corporations, not federal taxpaying entities.

Gains and losses flow through to partners. Losses can be used as flowing through as deductions as against other items of income. Capital losses of partnership flow through to returns of partners. These losses retain their character as capital losses. Unused losses in current year can be carried forward indefinitely. Limitations: (a) 465: a taxpayer can use a loss from an activity to offset or shelter other unrelated income only to the extent that the TP was economically at risk in the losing activity. Generally, not considered to be at risk w.r.t. nonrecourse debt, because no economic exposure to pay back debt. (b) 469: passive activity loss rules. We'll see this later. S Corporation 1361 o Single taxation scenario. Business losses can flow through by S Corp to its SHs for use by SHs on their own individual returns subject to 465 and 469 o S Corps are limited to corporations that have 100 or fewer Shs o each SH has to be an individual who is either (a) a US Citizen or (b) a US Resident o all SHs will share all gains, losses, deductions, etc. based on % of outstanding stock owned o Distribution of appreciated property by S Corp to SHs subject to gain recognition rule discussed earlier. While S nontaxable corp, will flow through to SHs. General Rules: Check-the-Box System Reg. 1.7701-3 ????? this is response to gov't attacking status of unincorporated business and arguing that since it functions so similarly to a corporation it should be taxed as a corporation Separate Entities o General Rule: A noncorporate business entity (an eligible entity) with at least two (2) members is classified as a partnership unless an election is made for the entity to be classified as an association o If an organization recognized as a separate entity for federal tax purposes is not a trust, it is a business entity under the regulations o Certain business entities are automatically classified as corporations Single-Owner Organizations o A single-owner entity is disregarded for tax purposes and treated as an extension of its owner (i.e. sole proprietorship) unless the entity elects to be classified as an association and thus taxed as a C corporation o includes single owner LLCs Publicly Traded Partnerships 7704 o Classification Corporations o Definition Any partnership whose interests are 1

Traded on an established securities market, or Readily tradable on a secondary market (or its substantial equivalent o An interest is readily tradable if taking into account all of the facts and circumstances, the partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market

o Exception Provided for partnerships if 90 percent or more of their gross income consists of certain passive-type income items (e.g., interest, dividends, real property rents, gains from the sale of real property and income and gains from certain natural resources activities) FORMATION OF A PARTNERSHIP Background: Tax consequences of contributions of cash and property to a partnership in return for an ownership interest. Also tax consequences for owners who contribute services to the business in return for an ownership interest in the partnership. In problems, we want to keep track of not only tax consequences but also book/financial consequences resulting from the contributions made to the business. To do this, we create a financial statement for the business that keeps track of both tax and financial consequences. Partnerships book value will reflect assets at their FMV @ time of contribution. Partners' individual book capital accounts represent their financial interests in the business, and equal FMV of what partner contributed to business (i.e. economic-financial interest; tells us what partner would get if business were to liquidate and sell off all of its assets for their book values and pay off all of the businesses' liabilities). Contributions of Property rules do NOT apply to contributions of services Nonrecognition o Section 721(a) provides that not gain or loss shall be recognized to a partnership or to any of its partners on a contribution of property to the partnership in exchange for an interest in the partnership EXCEPTION: Section 721(b) provides for recognition of gain when a partner contributes property to a partnership which would be treated as an investment company (within the meaning of Section 351) if the partnership were incorporated o Investment company - a partnership form of a mutual fund where the contributor is seeking diversification of its investments AND more than 80% of the business assets are in marketable securities. Property The term is broadly defined to embrace money, goodwill, and even intangible service-flavored assets such as accounts receivable, 2

patents, unpatented technical know-how and favorable loan or lease commitments embodied in a letter of intent secured through the efforts of the contributing partner. Does not include services rendered to the partnership and a partner who receives a partnership interest in exchange for services generally realizes ordinary income under Section 61. Control Section 721 does not require the transferors of property to be in control of the partnership immediately after the exchange Noncompensatory Option A noncompensatory option includes a call option or warrant to acquire a partnership interest, the conversion feature in a partnership debt instrument, and the conversion feature in a preferred equity interest in a partnership Under the regulations, Section 721 does not apply to the transfer of property to a partnership in exchange for a noncompensatory option, but it does apply to the exercise of that option Generally, an individual holding a noncompensatory option to acquire a partnership interest is not treated as a partner for purposes of allocating partnership income but if the option provides the holder with rights substantially similar to the rights afforded a partner, then the option holder is treated as a partner in allocating income Basis and other Tax Attributes o Property Contributed to the Partnership (Inside Basis) Section 723 provides that the partners basis in the contributed property = adjusted basis that contributor had in that property (i.e. carryover) Section 1223(2) provides that the partners holding period in the property carries over to the partnership Section 724 provides that, in certain situations, the partnership will recognize the same character of gain or loss that the contributing partner would have recognized on a sale of the property Section 704(c)(1) generally prevents the precontribution gain or loss from being shifted to the other partners by requiring the partnership to allocated that gain or loss solely to the contributing partner when it subsequently disposes of the property or distributes it to another partner depreciable property note: 168(i)(7): partnership inherits whatever depreciation method contributing partner was using and continue to use of whatever is left of contributing partners recovery period. Unrealized receivables haven't taken it into income yet; no income upon immediate contribution (outside & inside basis of 0) when collected, for book purposes, cash increases; tax wise, 100 income to pship; no change to book cap accts of partners b/c 3

aggregate value of assets remained unchanged b/c collected cash and got rid of receivables o 724(a): contributed receivable (ordinary asset in partner's hands) retains character as ordinary property when in partnership's hands; contribution of unrealized receivables will cause the partnership to realize ordinary income upon a later disposition of that receivable inventory assets o ordinary asset and will retain its status as ordinary asset to the partnership for the first 5 years. o Partnership Interest Received by Partner (Outside Basis) Basis Section 722 provides that a partners basis in his partnership interest = the sum of the cash and adjusted basis of any property contributed to the partnership Holding Period significant sometimes; might need to determine whether LT or ST cap asset; this becomes significant if/when partner sells partnership interest (741 generally treats resulting gain from sale of partnership as though it arose from sale of a capital asset) The partners holding period in the partnership interest is determined by Section 1223(1), which permits the partner to tack his holding period for the contributed property if that property was a capital or Section 1231 asset. o Recall: 1231 property is real property and depreciable property that had been used in As business and held for more than one year To the extent the contributed property consists of cash or ordinary income assets, the holding period begins on the date of the exchange. o For this purpose, recapture gain (e.g., under Section 1245) is treated as a separate asset which is not a capital or Section 1231 asset If the partner contributes a mix of assets, the holding period in the partnership interest is fragmented in proportion to the fair market value of the portion of the interest received for the property to which the holding period relates, divided by the fair market value of the entire interest. o Ex: A contributes 10 cash and 90 land (fmv). 90% of As partnership interest would include As holding period for the land. But As holding period for other 10% starts fresh. So, assume A sold his partnership interest 9 months after acquiring the partnership interest. Then 90% of the interest would be considered long term capital asset, then 10% short term. If he sold it after 16 months, then since he held

all of it for more than 1 year, all of it is a long term capital asset. Depreciation Recapture Recall 1245(a) says if section 1245 property is disposed of: ordinary income = lesser of (Bs recomputed basis OR Bs amount realized) minus adjusted basis. o Recomputed basis = adjusted basis @ disposition + all depreciation deductions taken 1245(b)(3) says that in a section 721 transaction, the partner only has to report the recapture income to the extent that the partner had to recognize gain in this transaction apart from section 1245 Operation of the Rules Revenue Ruling 99-5 o A is single owner of LLC, which is disregarded as an entity separate from its owner Situation 1 Facts o B purchases 50% of As ownership interest in the LLC for $5,000. o A does not contribute any portion of the $5,000 to the LLC o A and B continue to operate the business of the LLC as coowners of the LLC Application o The LLC is converted to a partnership when the new member, B, purchases an interest in the disregarded entity from A o Bs purchase of 50% of As ownership interest in the LLC is treated as the purchase of a 50% interest in each of the LLCs assets, which are treated as held directly by A o Immediately thereafter, A and B are treated as contributing their respective interests in those assets to a partnership in exchange for ownership interests in the partnership o so, when A sells interest, A is treated as having sold 50% stake interest in each asset to B; this is a taxable sale of assets A would have to recognize gain or loss on sale under 1001 and B at least initially viewed as owner of 50% of each asset, and would take a cost basis of 5k, representing 50% of each asset. After accounting for sale, we value A & B each contributing 50% interest of each asset to a new partnership in return for a 50% partnership interest. This contribution governed by 721-23 Situation 2 Facts

o B contributes $10,000 to the LLC in exchange for a 50% ownership interest in the LLC o The LLC uses all of the contributed cash in its business o A and B continue to operate the business of the LLC as coowners of the LLC Application o The LLC is converted from an entity that is disregarded as an entity separate from its owner to a partnership when a new member, B, contributes cash to the LLC o Bs contribution is treated as a contribution to a partnership in exchange for an ownership interest in the partnership B takes basis under 722 of 10k o A is treated as contributing all of the assets of the LLC to the partnership in exchange for a partnership interest A takes basis to whatever basis old LLC had o new pship's basis in assets contributed straight up carryover (723) bottom line: no immediate gain recognition

Treatment of Liabilities Impact of Liabilities on Partners Outside Basis o General Rule Section 752(a) treats any increase in a partners share of partnership liabilities as if it were a cash contribution by the partner to the partnership, increasing the partners outside basis under Section 722. Section 752(b) treats any decrease in a partners share of liabilities, including the partnerships assumption of a partners liability, as if it were a cash distribution to the partner, decreasing his outside basis under 705(a) and 733. Note: Suppose partner contributes encumbered property to partnership. As a result, other partners will get an outside basis increase to the extent of their respective dollar share of the new partnership liability. At the same time, contributing partner generally having his share of the debt reduced b/c of the contribution. B4 contribution, partner was 100% responsible for debt, but after contribution, partner is sharing responsibility of debt w/ other partners. One way to look at it is net benefit for contributing partner is constructive cash distribution to that partner under 752(b). What happens is two-fold: constructive cash distribution reduces that partners outside basis under 733 and then theres the possibility that to extent partner received a benefit that exceeded what otherwise his outside, that benefit beyond his outside basis can produce immediate gain recognition by that partner under 731. 731(a) creates gain recognition to a partner upon cash distribution only to the extent it exceeds partners outside basis in his partnership interest. In effect, when a partner contributes encumbered property, three things happen simultaneously: (1) partner gets

722 basis derived from basis he had from contributed asset; (2) partner increases his outside basis by his share of what is now the partnerships liability (752(a)); and (3) 752(b) effect in that partner will have to reduce outside basis by total debt that partnership is taking off his hands. o Scope of Liability For purposes of Section 752, liabilities that would be deductible when paid (e.g., accounts payable of a cash basis taxpayer) are disregarded Section 752(c) provides that a liability to which property is subject shall be treated as a liability of the owner, at least to the extent of the fair market value of the property o Share of Partnership Liability A partners share of partnership liabilities for purposes of Section 752 generally depends on the status of the partner (general or limited) and nature of the liability (recourse or nonrecourse) Nature of Liability o Recourse A partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for the liability o Nonrecourse If no partner bears the economic risk of loss, the liability is classified as nonrecourse A partners share of recourse liabilities equals the portion of the liability for which the partner bears the economic risk of loss A partner bears the economic risk of loss to the extent that the partner (or a person related to the partner) would be required to pay the liability if the partnership were unable to do so This determination is made by asking who would be obliged to pay the liability if all the partnerships liabilities are payable in full and all of the partnerships assets, including cash, are worthless o basically decrease capital accounts of partners by amount of assets divided up and see if there is a negative balance in individual accounts; if so, and obligated to pay (i.e. general partner), that amount required to pay off liability is their share in the partnership's liability (these are hypothetical losses). This is the amount partner's outside basis increases when pship takes on a liability. 453B Installment obligations Context: selling property before contributing to business, at a gain under circumstances were sale proceeds were to be received from buyer in a later taxable year; can defer recognition until payments received 453B says when you dispose an installment obligation of a buyers, at that point, gain has to be recognized.; reg says 721 (nonrecognition) trumps 453B

Contributions of Encumbered Property o In General The regulations under Section 722, incorporating the approach taken by Section 752, recharacterize such a contribution as a cash transaction To the extent that a contributing partner is relieved of a liability, he is treated as having received a distribution of cash from the partnership A deemed distribution of money resulting from a decrease in a partners share of the liabilities of a partnership is treated as an advance or drawing of money to the extent of the partners distributive share of income for the partnerships taxable year. An amount treated as an advance or drawing of money is taken into account at the end of the partnership taxable year. Under Sections 731 and 733, a distribution of cash is considered a return of capital, which reduce the partners outside basis (but not below zero) by the amount of the distribution If the amount of the liability exceeds the basis of the property contributed, Section 731(a) treats the excess of the constructive cash distribution over the outside basis as gain from the sale or exchange of the newly acquired partnership interest, which is treated as capital gain under Section 741. The portion of debt from which the contributing partner is relieved is then allocated to the other partners, who are considered to have contributed cash to the partnership, and the outside basis of each is increased accordingly o Nonrecourse Liabilities The regulations allow the partners to specify their interests in partnership profits for purposes of allocating nonrecourse liabilities, and those interests will be respected if they a reasonably consistent with allocations of other significant items of partnership income or gain that are respected for tax purposes The section 752 regulations provide that a partner who contributes property encumbered by nonrecourse debt is first allocated that portion of the liability equaling the gain that would be allocated to that partner under section 704(c) if the property were sold at the time of the contribution for an amount equal to the liability The balance of the liability is allocated under the flexible general rule that is, in accordance with the partners share of partnership profits Contributions of Services Introductory note: not w/in 712 b/c services are not property; instead compensation w/in gross income Receipt of a Capital Interest for Services o Capital Interest An interest in both the future earnings and the underlying assets (i.e., the capital) of the partnership.

A partner who has a capital interest will be entitled to a share of the partnerships net assets in the event the partner withdraws or the partnership is liquidated o Consequences to Partner A service partner who receives a capital interest realizes ordinary income in an amount equal to the value of the interest less the amount, if any, paid for the interest Current Reg 1.721-1(b) if a partner gives up his right to be repaid his contributions of property to pship in favor of another partner as compensation for services, 721 (nonrecognition) does NOT apply o e.g. D joins existing pship w/ A, B, and C and obtains interest in return for services; A, B, C give up of their capital to D in return for D's services 1.722-1 says D takes a basis in pship interest equal to income D had to recognize upon receipt (so he's not taxed again) value of capital interest shifted to service provider is gross income Proposed Reg 1.721-1(b) transfer of any partnership interest in return for services is governed by 83 (next bullet goes into this) The timing of the income is determined under Section 83 If the interest is received without restrictions o Income is realized upon its receipt If the interest is transferred subject to substantial restrictions o Section 83(a) provides that its fair market value is included in gross income when the restrictions lapse. o The amount to be included in income is the excess of the fair market value of the interest at the time the partners rights have vested over the amount, if any, paid for the interest. o A transferee of restricted property is permitted to elect to include the value of the property in income at the time of its receipt. If the election is made, the transferee may not take any deduction (except for the amount actually paid) if the property is subsequently forfeited valuing the interest (similar stuff in previous two bullets) o partnership can elect that the interest transferred for services would be treated as having an FMV equal to its liquidation value o Liquidation value is amount of cash service provider would receive if business immediately liquidated, assets were sold for then FMV and then creditors paid off and distributed remainder in accordance w/ partnership agreement 83(h) deductions 9

o compensation paid often deductible; see more on allocations later o Consequences to Partnership Proposed Reg 1.721-1(b)(2) no gain or loss is recognized by partnership itself on the transfer of a compensatory partnership interest Deduction The partnership may take an ordinary and necessary business deduction, unless the services were for the formation of the partnership Gain Potential The transfer is viewed as a two-step transaction o The transfer of an undivided interest in partnership assets from the partnership to the service partner, and o The contribution of that interest back to the partnership by the service partner Receipt of a Profits Interest for Services o Profits Interest A share of future earnings (including, perhaps, gain on the sale of property) but no current right to a distribution of a share of the partnerships capital in the event of a withdrawal or liquidation o Consequences Revenue Procdure 93-27 Other than as provided below, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will NOT treat the receipt of such an interest as a taxable event for the partner or the partnership; tax consequences deferred until profits actually earned in future and allocated to partner pursuant to partnership agreement This does not apply If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; If within two years of receipt, the partner disposes of the profits interest; or If the profits interest is a limited partnership interest in a publicly traded partnership Disguised Sales Section 707(a)(2)(B) (& 1.707-3) provides that if (1) a partner transfers money or other property to a partnership, (2) there is a related transfer by partnership to partner, and (3) transfers viewed together are properly characterized as a sale, then the two transfers shall be treated as a sale or exchange of property between the partnership and partner acting in a nonpartner capacity, or between the two partners acting as outsiders (i.e. it's a sale) 1

o In the case of simultaneous transfers where it is clear that the partnership would not have made a distribution if the partner had not made a contribution, the transactions are likely to be viewed as a sale o A transfer will not be treated as the first step in a disguised sale if, based on all the facts and circumstances, the transferring partner is converting equity in the property into an interest in partnership capital and the transfer is subject to the entrepreneurial risks of the enterprise o Transfers within two (2) years of each other are presumed to be a sale while transfers made more than two years apart are presumed not to be a sale. Both presumptions are reubuttable. o If the consideration treated as transferred to a partner in a sale is less than the fair market value of the property transferred to the partnership, the transaction is treated as part sale / part contribution, and the transferring partner must pro rate his basis in the property between the sale and contribution portions o If a liability incurred by a partner in anticipation of a transfer is assumed (or taken subject to) by a partnership, the partnership is treated as transferring consideration to the partner (as part of the sale) to the extent that responsibility for repayment is shifted to the other partners. The same two-year presumptions exist for liabilities. o The regulations require disclosure on a prescribed form when a partnership transfers money or property to a partner within two years of a transfer of property by the partner to the partnership and the partner has treated the transfer as other than a sale for tax purposes PARTNERSHIP ACCOUNTING General The partners interests in the assets of the partnership, their responsibility for partnership liabilities, and their respective rights to profits and losses and to operating and liquidating distributions, are determined by the partnership agreement. The financial condition of a partnership on formation and each partners ownership interest in the firm are depicted on an opening day balance sheet which lists the partnerships assets on the left and the liabilities and partners capital on the right side Under the principle of Fundamental Equation, the two sides must always be equal that is Assets = Liabilities + Net Worth Terminology o Book Value On the left side of the balance sheet, partnership assets are recorded at their book value During the life of the partnership, book value is not necessarily the same as fair market value or basis It will not change until some event occurs that warrants a revaluation of the partnerships assets o Capital Account Each partners interest in partnership assets is reflecting in the partners capital account

The capital account represents the partners equity in the firm It generally identifies what each partner would be entitled to receive upon liquidation of his interest in the partnership A partners capital account begins with the amount of money and fair market value of any property contributed to the partnership by the partner, and is increased by the partners share of profits of the firm and is decreased by the partners share of partnership losses and the amount of cash and the fair market value of any property distributed to the partner

The Partnership as an Entity Section 703(a) requires a partnership to determine its own taxable income and provides rules designed to preserve the character of capital gains, charitable contributions, foreign taxes and other items that may be subject to special treatment in the hands of the partners Section 702(b) provides that the character of a partnership item taxed to the partners is to be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership Section 703(b) provides, with limited exception, that the partnership will select its accounting method and make various elections affecting the computation of taxable income The partnership will have its own taxable year, which may be separate from the taxable years of some of its partners Note: Pship could use accrual accounting method notwithstanding fact that partners use cash. Can pship use cash method? 448 requires certain pships to use accrual. 448(a)(2): prohibits use of cash method when partnership has a C corporation as one of its partners. Exception to prohibition in 448(b)(3): permits a small partnership to use cash method even if it has C corporations as partners. Exception applies if partnerships average annual gross receipts over last three years dont exceed $5M. The Taxable Year Section 706(a) requires a partner to include his share of partnership income, losses and other items in his tax return for the taxable year in which the partnerships year ends Section 706(b)(1)(B) generally requires a partnership to determine its taxable year by reference to a series of mechanical rules related to the taxable years of its partners unless the partnership can establish a business purpose for using a different taxable year. Under the mechanical rules o If one or more partners having a majority (greater than 50 percent) interest in partnership profits and capital have the same taxable year, the partnership must use that year o If partners owning a majority interest in partnership profits and capital do not have the same taxable year, the partnership must use the same taxable year as all of its principal partners (i.e., those having a 5 percent or more interest in profits or capital)

o If nether of these first two rules applies, the regulations require the partnership to use the taxable year that results in the least aggregate deferral of income to the partners o Alternatively, partnership may use a different year if it can establish a business purpose Tax Consequences to the Partners Reporting Requirements o Section 703(a) provides that a partnership computes its taxable income in the same manner as an individual except that certain items described in Section 702(a) must be separately stated and certain deductions are disallowed o three categories of separately stated items variable effect items The most common separately stated items are capital and Section 1231 gains and losses, tax exempt interest, dividends taxed as net capital gain, charitable contributions, and foreign taxes. (702(a)(1)(8)) Recall 1231 says if total 1231 gain exceeded losses, result in capital gain, but if flipside true, then ordinary loss o special consideration for 1231: suppose partner used it and sold it at a profit but is a dealer in the equip, i.e. he sells it to customers in the ordinary course of his own business. This is inventory and does not fall w/in 1231. Ordinary income. 1231 gains treated as LTCG. Issue: does As dealer status affect partnerships characterization of its gain resulting from sale of equipment, i.e. is character determined at partnership level, or do we look through partnership by asking what character of asset would be if held by individual partner. General rule: characterization generally determined at partnership level. Reg 1.702-1(b): character determined by status of asset to partnership. So if 1231 to partnership, then 1231 gain to all partners, including dealer in similar types of equipment. o exception to rule in previous bullet: 724: character of gain or loss on contributed unrealized receivables, inventory items, and capital loss property. 724(b): if a partner contributes an inventory item in his or her own hands, and then partnership later sells it, all resulting gain or loss from disposition is ordinary. 724(a): if partner contributes unrealized receivables to partnership and it later disposes or collects, retains ordinary status. Difference between (a) & (b): in (a), retains ordinary status forever, in (b) contributed status retains ordinary status 5 years following contribution. So if item contributed had been inventory held for more than 5 years, it will lose its automatic ordinary status and instead will be instead based on 1

partnership. Still inventory to partnership or not at that point. o Similar idea in 724(c): applies if a partner contributes capital loss property to partnership. If partnership uses land in business with basis upon acquisition of 100 for a period of time and ultimately sells the land for $60, when it sells the land, loss of 40. 724(c) address character. Another 5 year rule: if partnership later sells property at a loss w/in 5 years of contribution, then loss recognized up to the amount of the built in loss at contribution, continues to be characterized as a capital loss regardless of propertys status to the partnership. Since built in loss was $40, all of that $40 loss later recognized treated as a capital loss. After 5 years, land used in partnerships business, b/c it is a 1231 loss, and possibly an ordinary loss depending on partners other 1231 transactions 702(a)(5) dividends: different tax rules apply to dividend income depending on whether an individual or corporation receiving the dividend income. Individual partners taxed on partners dividend income at 15% (i.e. NCG treatment). Corporate partners do NOT get capital gain tax rate preference. But, corporate recipient of dividend income entitled to a dividends received deduction under 243 specially allocated items I.e. anything allocated among partners in a way that is different from partnerships general allocation method amongst partners E.g. If in AB partnership, they share everything 50-50, except that all depreciation is allocable to A, has to be separately stated (a)(8) any remaining items of gross income and deductions which are not otherwise separately stated are just combined into a net income or loss figure that is then allocated among various partners ordinary income or loss b/c already separately stated all items that would qualify for preferential tax treatment. o Any items of partnership income or loss which may have potentially different tax consequences to the partners, or any other person, are commonly referred to as separately stated or variable effect items, and each partner must separately take into account his or her distributive share of such items. The regulations also require that any specially allocated items must be separately stated. (this is what was just discussed in last few bullets) o All remaining partnership items of income or loss are combined into one aggregate income or loss amount, and each partner reports his or her distributive share of that lump sum amount ((a)(8) again) Tax Effect o A partner is taxed on his distributive share of partnership income or loss in his taxable year in which the partnerships tax year ends 1

distributive does NOT mean distributed; picks up income whether or not actually distributed to partner; think of distributive more like allocable o Taking into account, distributive share, partner has to separately account for his or her share of partnerships items listed in 702(a)(1)(8) Basis Adjustment o Section 705(a) provides that a partners outside basis is increased by his share of the partnerships (1) taxable income, and (2) tax-exempt income, and decreased (but not below zero) by (1) distributions from the partnership as provided in Section 733, (2) the partners share of partnership loss, and (3) his share of partnership expenditures which are not deductible in arriving at taxable income and are not properly capitalized. Advances or draws are treated as current distributions made on the last day of the taxable year When making basis calculations at the end of the year, make all the increases first, then all the decreases except for losses second, then do the losses 731(a) says have to report gain to extent distribution exceeds outside basis immediately before the distribution o some relief: 1.731-1(a)(1)(ii) says advances or drawing against the partners share of income will be treated as if they were distributions made on the last day of the pships taxable year so if in fact this is an advance or draw agains this partners income for the year, then we treat it as a distribution made on the last day of the year o One of the treatise writers (McKee) says that this regulation is prob limited only to situations where t he partner getting the advance against income agrees to return the distribution to the pship to the extent that the distribution turns out to exceed what turns out to be her share of pship income for the year. we increase the outside basis when reporting income and having taxexempt so when he won't get taxed when he disposes his partnership interest PARTNERSHIP ALLOCATIONS SPECIAL ALLOCATIONS In General Section 704(a) provides that a partners distributive share of income, gain, loss, deduction or other tax items shall be determined by the partnership agreement This permits partners to make special allocations, which are allocations that differ from the partners respective interests in partnership capital

If there is no allocation agreement Section 704(b) provides that distributive shares are determined for tax purposes in accordance with the partners interest in the partnership, taking into account all facts and circumstances The Section 704(b) Regulations: Basic Rules In general: book capital accounts are financial measuring rods that keep track of each partners equity interest in the business o book capital accounts measure the book value of the partners equity intrest in the business o they are not measuring rod for fmv bc typically they do not include the unrealized appreciation that assets may have had while held by the pship o The balance in these accts tell us what a partner would receive if the pship sold all its assets for their book value, took the resulting cash from that sale paid of the pships creditors and then distributed whatever cash remained to the partners in a liquidating distribution for the business Maintenance of Partners Capital Accounts o Capital accounts are considered properly determined and maintained only if each partners capital account is increased by: (1) the amount of money contributed to the partnership by the partner; (2) the fair market value of property contributed by the partner to the partnership (net of liabilities securing the property that the partnership is considered to assume or take subject to under Section 752); and (3) allocations to the partner of partnership income and gain, including tax-exempt income; (4) liabilities assumed that partnership previously was responsible for requirements: 1. The partner must be personally and ultimately liable for the debt, 2. the lender must be aware of the partners assumption of liability and 3.the lender has to have a right to go directly against the assuming partner for collection of the debt o And is decreased by (1) the amount of money distributed to the partner by the partnership; (2) the fair market value of property distributed to the partner by the partnership (net of liabilities secured by the property that the partner is considered to assume or take subject to under Section 752); (3) allocations to the partner of partnership expenditures that are neither deductible in computing taxable income nor properly chargeable to capital account, including Section 705(a)(2)(B) items (e.g., gambling losses, bribes, charitable contributions), Section 709 organizational and syndication expenses that are not amortized under Section 709(b) and losses disallowed under Section 267(a)(1); and (4) allocations of partnership loss and deduction (excluding the items listed in (3) above). Note: just b/c can't use portion of loss for tax purposes doesn't necessarily mean you don't decrease for book purposes 1

o The regulations provide that a fair market value reasonably agreed to among the partners in arms length negotiations will control if the partners have sufficiently adverse interests o The regulations also allow partnerships to restate assets at their current fair market value on certain occasions if the partnership provides Substantial Economic Effect: Brief Overview o how do we properly distribute partners' shares of income and loss? 704(a) sas partners can allocate pship items among themselves for tax purposes in whatever proportion they agree to (e.g. via partnership agreement). BUT, 704(b)(2) says that agreed upon allocations must have substantial economic effect to be respected for tax purposes. In a nutshell, it means that to the extent possible, the tax consequences amongst the partners should track whats happening economically amongst the partners (***tax should mirror book***). o If they don't have substantial economic effect, statute and regs may alter allocations so that allocations will be based on partners' interest in the partnership under 704(b) test allocations at the end of each pship taxable year o The three (3) ways for allocation to be respected 1.704-1(b)(1) Substantial Economic Effect safe harbor (b)(2) Economic Effect + Substantiality Allocation consistent w/ partners' interest in partnership (b)(3) test allocation by seeing whether it mirrors the differences in the partners rights on a hypothetical liquidation of the partnership at the start of the year being examined and the end of the year. These liquidation rights are determined by assuming the partnership will be selling its assets at the end of yr for book value (i.e. NOT FMV). Allocation consistent w/ special rules in (b)(4) or some parts of 1.704-2 o If allocation doesn't fall into one of three methods, items reallocated so that allocation will be consistent with each partners interest in the pship Economic Effect o Basic Test An allocation will have economic effect if, and only if, throughout the life of the partnership, the partnership agreement provides that: (1) Capital accounts must be determined and maintained in accordance with the rules of Section 1.704-1(b)(2)(iv) of the regulations; (2) Upon a liquidation of the partnership, or of any partners interest, liquidating distributions must be made in accordance with the positive capital account balances of the partners; AND (3) If a partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, he must be unconditionally obligated to restore the deficit (negative balance back to 0), if any, by the later of: (a) the end of the taxable year of

the liquidation of the partners interest, or (b) 90 days after the date of the liquidation. o Ultimately an unlimited AND unconditional obligation to restore deficits in the future o Alternate Test Basic Rules If the first two requirements of the Basic Test are met, an allocation will have economic effect to the extent that it does not create or increase a deficit in the partners capital account (in excess of any limited deficit restoration obligation that the partner may have) and the agreement includes a provision known as a qualified income offset. o Limited Deficit Restoration Obligation A partner will be treated as obligated to restore a deficit to the extent of (1) the outstanding principal balance of any promissory note contributed by the partner to the partnership and (2) the amount of any unconditional obligation (whether imposed by the partnership agreement or local law) of the partner to make subsequent contributions to the partnership o Qualified Income Offset Provision in the partnership agreement stating that any partner who has a deficit capital account as a result of unexpectedly receiving a distribution (or the other specialized adjustments listed in the regulations) must be allocated items of future income or gain in an amount and manner sufficient to eliminate any remaining deficit balance as quickly as possible Special Rules The regulations provide that, for purposes of the alternate test, the partners must reduce their capital accounts by distributions that are reasonably expected (to the extent those distributions exceed reasonably expected offsetting increases, other than recognized gains) as of the end of the partnership year in which the loss allocation was made o Economic Effect Equivalence 1.703-1(b)(3) Under this final fallback, allocations are deemed to have economic effect if the partnership agreement ensures that a liquidation of the partnership as of the end of each partnership taxable year will produce the same economic results as if the Basic Test were satisified. facts and circumstances analysis Substantiality o In General (3 ways)

The economic effect of an allocation is considered to be substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences This covers first two ways: shifting & transitory (discussed below) Notwithstanding the above rule, the economic effect of an allocation is not substantial if, at the time the allocation becomes part of the partnership agreement: o Third way ((b)(2)(iii)(a)) (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation were not contained in the partnership agreement; AND (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement. In other words, an allocation fails the substantiality test if its effect is to benefit one or more partners after taxes and not to effect adversely any partnerin both cases, comparing the effect of the allocation to the result if no allocation had been contained in the agreement might see this if one partner has a net operating loss from another venture; pship will try to allocate income first to partner who has this loss for that year, and then allocate other income to another partner next year o see what their income tax liability would be with and without the special allocation (in doing w/o, just follow pship agreement) and see if one is improved and other is not adversely affected as a result of the allocation if this happens, wed have to reallocate w/ the facts and circumstances test of partners interests in the partnership. We would still allocate the same amount of income to the partners as per their agreement, it just won't all be allocated to one partner first o Shifting and Transitory Allocations Shifting (1.704-1(b)(2)(iii)(b)) o deals w/ allocations in a single taxable year The economic effect of an allocation (or allocations) within one partnership taxable year is not substantial if, at the time the allocation becomes part of the partnership agreement, there is a strong likelihood that the capital accounts of the partners will be unaffected by the allocation (normally because of and equal and offsetting allocation in the same year), AND the total tax liability of the partners will be less than if there had been no such allocations, taking into account any tax consequences that result

from the interaction of the allocation with tax attributes of the partner that are unrelated to the partnership If the conditions for a shifting allocation are in fact met, then there was a presumption that there was a strong likelihood that they would occur Transitory Allocations (1.704-1(b)(2)(iii)(c)) o deals w/ allocations over multiple taxable years Allocations lack substantial economic effect if the partnership agreement provides for the possibility, over two or more taxable years, that an original allocation will be largely offset by one or more offsetting allocations AND, at the time the allocations became part of the agreement, there is a strong likelihood that (i) the partners capital accounts will emerge unaffected by the allocations (relative to what would have occurred had there been no allocations) and (ii) the partners enjoy a reduction in their total tax liability for the period involved. o The same presumption of strong likelihood applies o Assess likelihood at the time of the agreement e.g., oil drilling risky, so not likely; leasing equipment not risky o ex: Income chargeback provision: costs allocable to partner A in year 1, and profits allocable to partner A that year and subsequent years only until costs restored Safe harbor 1 (1.704-1(b)(2)(iii)(c)(2)): An allocation and subsequent offsetting allocation will not be considered transitory if there is a strong likelihood that the offsetting allocation will not, in large part, be made within five years from the original allocation o i.e. most of income from chargeback not expected to exist until five or more years after chargeback was made. If you can reasonably make this income projection, then can be certain that loss allocation will be considered substantial. So we should expect to see income projections at time partnership agreement was entered into Safe harbor 2: The regulations presume for purposes of the substantiality test that the adjusted tax basis of partnership property will be equal to its fair market value and that adjustments to tax basis of the property will be matched by corresponding changes in its fair market value. o i.e. there's never a gain upon disposition of partnership property w.r.t. substantiality analysis o ex. if the chargeback provision says that depreciation allocations will be later offset by gain from disposition of land, we have substantiality b/c there will never be gain under this safe harbor

Default Reallocations: The Partners Interest in the Partnership 1.703-1(b)(3) (objective test: in (iii), if first two elements of basic economic effect test satisfied, but third element failed, AND you have substantiality, in determining interest in pship, all you have to look @ is changes in book liquidation rightsonly get there if you fail economic test and alternate testif this test fails, but you have substantiality, then have to use facts and circumstances test) o If a partnership agreement is silent as to the partners distributive shares OR an allocation lacks substantial economic effect, then the partners share of gain, loss, deduction or credit is determined in accordance with the partners interest in the partnership There is presumption of equal interests in the partnership, which is rebuttable by the taxpayer or the Service. Among the factors to be considered in making this determination are The relative contributions of the partners to the partnership The interests of the partners in economic profits and losses if they differ from their interests in taxable income or loss The interests of the partners in cash flow and other nonliquidating distributions The rights of the partners to distributions of capital upon liquidation o The regulations include a special rule if an allocation is upset because the partnership agreement fails to include an unlimited deficit make-up provision. If the first two prongs are met and the substantiality requirement is met, this rule provide that the partners interests in the partnership with respect to the disallowed portion of the allocation are to be determined by comparing: The manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated following the end of the taxable year in which the allocation relates with, The manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the prior taxable year Allocations of Depreciation Recapture o Allocations of depreciation recapture cannot have substantial economic effect because classifying a portion of the gain as recapture merely changes its tax character o Under the regulations, a partners share of recapture gain generally is equal to the lesser of (1) the partners share of the total gain from the disposition of the property, or (2) the total amount of depreciation previously allocated to the partner with respect to the property Allocations of Tax Credits o Allocations of tax credits are generally not reflected in the partners capital accounts and, therefore, they cannot have economic effect. As a result, tax credits and recapture of tax credits generally must be allocated in accordance with the partners interests in the partnership

Allocations Attributable to Nonrecourse Debt 704(2) Context o When there is nonrecourse debt, creditor takes risk that if the value of security puts up for debt falls below the outstanding nonrecourse debt, risk is that partnership debt may walk away from the debt, and lender will get paid less than the outstanding debt. Partners in this situation dont bear this risk o So, as depreciation pushes props AB to below amount of of outstanding nonrecourse debt, issue is who as among the partners should get those deductions when in fact none of them is bearing the economic risk of loss represented by that depreciation? Code permits a loss w/o a corresponding economic loss being sustained b/c it foresees in the future a tax gain w/o economic effect. Suppose creditor forecloses on prop when AB is less than nonrecourse debt. There is tax gain to partners in this case under Tufts b/c amount realized is nonrecourse debt. But there's no economic gain b/c foreclosure took place and partners get nothing. Ultimately it's this potential lurking in the asset that offsets the deductions taken despite Note: this analysis doesn't come into play when prop's AB is still above amount of nonrecourse debt b/c deductions attributable to depreciation thrown off by whatever generated positive balances in partner's accounts I THINK. Terms o Partnership Minimum Gain 1.704-2(d) The amount of gain that a partnership would realize if it disposed of each of its properties that is subject to a nonrecourse liability for no consideration other than satisfaction of the debti.e., the excess of the nonrecourse liability over the adjusted basis of the property securing the debt. Tufts. If a partnership has more than one nonrecourse liability, total partnership minimum gain is the aggregate of minimum gain on all properties of the partnership encumbered by nonrecourse debt Partnership minimum gain is created in two situations: As the adjusted basis of the encumbered property is reduced below the amount of the nonrecourse liability, or As the amount of the nonrecourse liability is increased in excess of the adjusted basis of the property o Nonrecourse Deductions 1.704-2(c) All of a partnerships increases and decreases in minimum gain during a taxable year are netted to determine it there is a net increase in minimum gain. Both nonrecourse deductions and nonrecourse distributions only arise if there is a net increase in partnership minimum gain during the year Deductions that relate to a net increase in partnership minimum gain

They most commonly are cost recovery deductions that reduce the adjusted basis of depreciable property below the amount of nonrecourse debt secured by the property Nonrecourse deductions also can arise on a refinancing where the proceeds of a nonrecourse liability are not distributed (or treated as not distributed) by the partnership. Since these proceeds are not distributed, the regulations assume that they will be spent by the partnership and generate deductions that are attributable to the additional nonrecourse borrowing o Distribution of Nonrecourse Liability Proceeds Allocable to an Increase in Minimum Gain Where the proceeds of a nonrecourse loan are distributed, the minimum gain generated by the borrowing is allocated to the partners to whom the loan proceeds are distributed o A Partners Share of Partnership Minimum Gain A partners share of partnership minimum gain at the end of any taxable year is equal to the sum of the nonrecourse deductions allocated to the partner throughout the life of the partnership and the partners share of distributions of nonrecourse liability proceeds allocable to an increase in minimum gain, reduced by the partners share of any prior net decreases in minimum gain o Minimum Gain Chargeback Provision For any taxable year in which there is a net decrease in a partners share of minimum gain, that partner must be allocated in the same year, by a provision in the partnership agreement, income and gain in an amount equal to the net decrease The most obvious transaction that triggers a decrease in partnership minimum gain is the disposition of property subject to nonrecourse debt o Any minimum gain chargeback consists first of gains recognized from the disposition of partnership property subject to a nonrecourse liability. o Only where the gain from the disposition of the property is less than the decrease in partnership minimum gain for the year does the partnership need to allocated income or gain from other sources o If the amount of the minimum gain chargeback exceeds the partnerships income and gain for the year, the excess carries over A decrease in partnership minimum gain also can occur when the principal amount due on a nonrecourse liability is reduced or when a partnership liability is converted from nonrecourse to recourse. In those situations the rules operate differently o The regulations provide that a partner is not subject to a minimum gain chargeback to the extent that the decrease in

the partners share in minimum gain is attributable to the partners own capital contribution that is used to pay the partnerships nonrecourse debt o When partnership debt is converted from nonrecourse to recourse as a result of guarantee or similar arrangement, there is not minimum gain chargeback to a partner to the extent that the partner bears the economic risk of loss for the new recourse liability Under a final exception, a minimum gain chargeback is not triggered if it would cause a distortion in the economic arrangement among the partners and there is insufficient other income to correct the distortion Safe Harbor (a special partners' interest in the partnership rule when 1.707-2 applies) o Allocations of nonrecourse deductions will be respected if the following four requirements are satisfied: (Reg 1.704-2(e)) (1) Throughout the life of the partnership, the partnership agreement must satisfy the requirements of the basic or alternative test for economic effect (2) Beginning in the first taxable year in which the partnership has nonrecourse deductions and thereafter for the life of the partnership, nonrecourse deductions must be allocated in manner that is reasonably consistent with allocations (having substantial economic effect) of some other significant partnership item attributable to the property securing the liabilities of the partnership (other than allocation of minimum gain) Where the partnership allocated all other items relating to a property 90:10, and then 50:50, any proportion in that range would be reasonably consistent (3) Beginning in the first year in which the partnership has nonrecourse deductions or make a distribution of proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain, the partnership agreement must contain a minimum gain chargeback (4) All other material allocations and capital account adjustments under the partnership agreement must comply with the basic Section 704(b) regulations ALLOCATIONS WITH RESPECT TO CONTRIBUTED PROPERTY General 704(c) Allocation Principles Section 704(c)(1)(A) provides that items of income, gain, loss and deduction with respect to property contributed by a partner to a partnership shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. Because this is a tax allocation that lacks substantial economic effect, it is not accomplished by any change in the partners capital accounts The regulations permit these allocations to be done under three methods, each subject to a general anti-abuse provision

No more than one method may be used with respect to each item of Section 704(c) property and, although a different method may be used with respect to different items of property, a partner and partnership must use a method or combination of methods that is reasonable under the facts and circumstances In general, Section 704(c) must be applied on a property-by-property basis except that property with identical tax characteristics may be aggregated for purposes of determining whether built-in gains and losses exist A partnership may disregard or defer the application of Section 704(c) in a single year if there is a small disparity between the book value and the adjusted basis of the contributed property. A small disparity exists if the total fair market value of all property contributed by a partner during the taxable year does not differ from the total adjusted basis of the property by more than 15 percent of the adjusted basis, and the total gross disparity does not exceed $20,000. Sales and Exchanges of Contributed Property Section 704(c) Allocation Methods o Traditional Method 1.704-3(b) The traditional method generally requires a partnership to allocate any built-in gain or loss to the contributing partner Built in gain = amount book value exceeds adjusted basis upon contribution (1.704-3(a)(3)) by doing so, outside basis increases, and then becomes in sync with capital account after built in gain allocated, 704(a) and (b) govern remaining gain, if any (i.e. appreciation after contribution) The traditional method, however, imposes a ceiling rule, under which the total gain or loss allocated to the partners may not exceed the tax gain or loss realized by the partnership. 1.704-3(b) Comes up if partner contributes appreciated property but then prob goes down in value but not below AB prop takes (i.e. pship sells it for a gain but for less than the original built in gain; 704(c) says to give all built in gain to contributing partner) o Traditional Method with Curative Allocations 1.704-3(c) The traditional method with curative allocations permits a partnership to make reasonable curative allocations of other partnership tax items of income, gain, loss or deduction to correct ceiling rule distortions basically we want non-704(c) partner to wind up w/ tax allocations that mirror book allocations has to be included in pship agreement to use it A curative allocation is an allocation made solely for tax purposes that differs from the partnerships allocation of the corresponding book item. As such, a curative allocation has no economic effect and is not reflected in the partners capital accounts A curative allocation is reasonable only if (1) it does not exceed the amount necessary to offset the effect of the ceiling rule and (2) the income

or loss allocated is of the same character and has the same tax consequences as the tax item affected by the ceiling rule Curative allocations may be made to correct ceiling rule distortions from a prior taxable year if they are made over a reasonable period of time (e.g., the economic life of the property) and were authorized by the partnership agreement in effect for the year that the property was contributed o Remedial Method 1.704-3(d) Under the remedial method, if the ceiling rule results in a book allocation to a noncontributing partner that differs from the partners corresponding tax allocation, the partnership may make a remedial allocation to the noncontributing partner equal to the full amount of the disparity and a simultaneous offsetting remedial allocation to the contributing partner these allocations are made for tax purposes only; no affect on book capital accounts A remedial allocation must have the same effect on each partners tax liability as the item limited by the ceiling rulefor example, if the tax item limited by the ceiling rule is a loss from the sale of a contributed capital asset, the offsetting remedial allocation to the contributing partner must be capital gain Characterization of Gain or Loss on Disposition of Contributed Property o Section 724 applies to three categories of contributed property: unrealized receivables, inventory items and capital loss property. Different rules are provided for each category Unrealized Receivables Generally defined as rights (contractual or otherwise) to payment for goods or services that have not been previously included in income, provided in the case of goods that the sales proceeds would be treated as received from the sale or exchange of noncapital assets Section 724(a) provides that any gain or loss recognized by the partnership on the disposition of unrealized receivables will be ordinary Inventory Items Broadly defined in Section 751(d)(2) to include not only the familiar category of noncapital assets but also any other property which, upon sale by the contributing partner, would not be considered as a capital or Section 1231 asset Inventory items retain their ordinary income taint under Section 724(b) for five years after their contribution to the partnership. After that period, the character of contributed inventory items is determined at the partnership level Capital Loss Property

Any capital asset held by the contributing partner which had an adjusted basis in excess of its fair market value immediately before it was contributed to the partnership If the partnership sells the capital loss property at a loss, Section 724(c) requires the built-in loss at the time of the contribution to retain its character as a capital loss for a period of five years from the date of the contribution. Any additional loss accruing while the property is held by the partnership is characterized at the partnership level o Section 724(d)(3) provides that the Section 724 taint applies to any substituted basis property, whether held by the transferor-partnership or a transferee unless that property is the stock of a C corporation acquired in an exchange governed by Section 351. In the case of substituted basis property, the five-year taint period commences as of the date that the original property was contributed to the partnership Depreciation of Contributed Property Traditional Method o Under the traditional method, tax depreciation on contributed property is allocated first to the noncontributing partner in an amount equal to his share of book depreciation to the extent possible, and the balance of tax depreciation is allocated to the contributing partner. o Book and tax depreciation must be computed using the same depreciation method and recovery i.e. uses whatever remaining useful life there is (basically stepping into partner's shoes w.r.t. depreciable asset that has been contributed by A to pship) use same method of depreciation for book purposes as being used for tax 1.704-1(b)(2)(iv)(g)(3); must have same proportionate effect (so if depreciating 25% of book value per year, must depreciate 25% of basis each year) o Allocation of depreciation under Section 704(c)(1)(A) using the traditional method also can be affected by the ceiling rule Traditional Method with Curative Allocations o Partnership may use another item to offset the distortion caused by the ceiling rule The Remedial Method o Under the remedial method, ceiling rule distortions from depreciation of contributed property are corrected by a tax allocation of additional deprecation to the noncontributing partner in an amount equal to the full amount of the limitation caused by the ceiling rule and a simultaneous offsetting allocation of ordinary income to the contributing partner o Under the remedial method, the portion of the partnerships book basis in contributed property at the time of contribution is depreciated under the same method used for tax depreciationgenerally over the propertys remaining recovery period at the time of contribution.

o The amount by which the book basis exceeds the tax basis (the excess book basis) is depreciated using any applicable recovery period and depreciation method available to the partnership for newly acquired property Other Applications of Section 704(c) Principles A problem analogous to allocations with respect to contributed property may arise when a new partner is admitted to an existing partnership and there is built-in gain in the property owned by the partnership. The Section 704(b) regulations require application of Section 704(c) principles in those situations Partners can put into their agreement an allocation provision that when gain is recognized from the sale of assets that were existence at the time a new partner is admitted, all of the gain relating to the period before the new partner's entry is allocated for tax purposes to the other partners o while the other partners will pay more in tax, in doing so their capital accounts will increase more than if all of the gain is distributed evenly (Unit IV.B(a)) o another way to do this is by booking up @ time of new partner's entry partners are permitted to book up pship assets as well as book cap account balances to FMV at the time someone contributes money or property to the partnership in return for a partnership interest o Note: If dealing w/ an acquired property, 704(b), not 704(c), applies, BUT, 1.704-1(b)(4)(i): if you've properly booked up partnership assets and gain is now being realized on the sale of that booked up asset, have to allocate that gain in same manner as you make 704(c) allocations. i.e. has to reflect built-in gain of the asset as of the time of new partner's entry o Consider: What happens if property sold for less than bookup amount? Loss occurred subsequent to bookup, so allocated according to agreement. BUT might have a tax gain b/c that doesn't get booked up, which will be less than built in gain. So, all of it goes to prior partners. Thus, no loss allocated to new partner b/c of the ceiling rule. Curative or remedial allocations, anyone? Anti-Abuse Rules for Loss Property Section 704(c)(1)(C) provides that if contributed property has a built-in loss then (1) the built-in loss is to be taken into account only in determining the amount of items allocated to the contributing partner, and (2) in determining the amount of items allocated to other partners, the partnerships basis in the contributed property shall be treated as being the fair market value of the property at the time of contribution. ALLOCATIONS OF PARTNERSHIP LIABILITIES Context: under 752(a), any dollar increase in a partner's share of pship liabilities considered to be a contribution of money by a partner to the partnership, i.e. constructive cash contribution. This as a result increases partner's outside basis under 722. Conversely, reduction in partnership liability is a constructive cash distribution to partner, reducing partner's outside basis. Partnership assumption of a partner's liability also decreases partner's outside basis. Liability Defined 2

A liability is defined in 1.752-1(a)(4): for debt to be pship liability for 752, incurring obligation has to do one of three things: (1) it creates or increases basis of pship property, including cash; (2) gave rise to an immediate deduction; or (3) gave rise to an expense that is not deductible at all and does not produce basis Ex of (3) is an obligation to make a political contribution. Note: incurring an obligation to pay an expense that produces a deduction only on payment itself is NOT considered a liability for 752. Ex: cash method pships incurring obligations to pay deductible expenses not liabilities for 752; no immediate deductions here. For purposes of Section 752, all legally enforceable partnership obligations are liabilities except accounts payable of a cash basis partnership, which are not deductible until paid, and certain contingent or contested liabilities or obligations that are devoid of economic reality Recourse Liabilities Economic Risk of Loss Concept o A partnership liability is a recourse liability only to the extent that a partner bears the economic risk of loss with respect to that debt. 1.752-1(a)(1) o In the case of recourse liabilities, the extent to which a partner bears the economic risk of loss also must be determined in order to allocate the debt o In general, a partner bears the economic risk of loss for a partnership liability to the extent that he ultimately would be obligated to pay the debt if all partnership assets were worthless and all partnership liabilities were due and payable. 1.7522(b) o In determining the risk of loss, the regulations take into account not only each partners obligations under the partnership agreement to pay the creditor or contribute funds to the partnership, but also all other economic arrangements or legal obligations between partners and between any partners and the partnerships creditors. Constructive Liquidation 1.752-2(b) o The regulations assume that all of the partnerships liabilities become due and payable in full, any separate property pledged (directly or indirectly) by a partner to secure a partnership liability is transferred to the creditor in full or partial satisfaction of that liability, and all the rest of the partnerships assets (including cash) become worthless o The partnership is deemed to dispose of all of its now worthless assets in a taxable transaction for no consideration (other than the relief of any nonrecourse debt to which any asset is subject). o The gains and losses on these deemed dispositions, along with any actual income or loss items as of the date of the constructive liquidation, are then allocated among the partners in accordance with the partnership agreement; the partnership books and capital accounts are adjusted accordingly, and the partnership is deemed to liquidate.

o The regulations assume that a partner bears the economic risk of loss for the net amount that he must pay directly to creditors or contribute to the partnership at the time of the deemed liquidation since a limited (L) partner's book cap account can't go below 0 unless he agrees to be liable to an extent, general partner's book cap account takes the entire hit; we respect shares in partnership to L only up to L's cap account balance being zeroed out Note: If L guarantees repayment, L doesn't get basis anyway. Regs assume that each partner will meet whatever its financial obligations are. Then, never even get to L's guarantee. We assume G will meet its obligation. Different result if L assumes the liability 752(a) o The amount of a partners gross payment obligation is reduced to the extent of any right to reimbursement, leaving the partners net payment obligation as the ultimate measure of his economic risk of loss o The amount of a partner's gross payment obligation is increased to the extent he agreed to contribute cash to the partnership in the future. Nonrecourse Liabilities Def: 1.752-1(a)(2): nonrecourse to extent that no partner bears no economic risk of loss for that liability o If a partner guarantees repayment, treat partner as if he assumed recourse debt; partner should get entire basis derived from that liability In General o The regulations in 1.752-3(a) adopt a three (3) step approach under which a partners share of nonrecourse liabilities is the sum of (1) the partners share of partnership minimum gain, if any, determined in accordance with the Section 704(b) regulations, (2) in the case of nonrecourse liabilities secured by contributed property (i.e. doesn't apply to acquired property), the amount of gain that the partner would recognize under Section 704(c) if the partnership disposed of that property in a taxable transaction in full satisfaction of the liabilities and no other consideration; and (3) the partners share of any remaining (excess) nonrecourse liabilities, determined in accordance with his share of partnership profits Partners Share of Partnership Minimum Gain o Where the partnership has generated minimum gain (i.e. Tufts gain-excess of the nonrecourse liability over the adjusted basis of the property securing the debt), the rule for allocation of nonrecourse liabilities directly follows the rule for allocation of the deductions and distributions attributable to those nonrecourse liabilities and the allocation of the minimum gain chargeback equals the share of nonrecourse deductions allocated to those parties. The liabilities are first allocated in accordance with each partners share of partnership minimum gain. Significance of shifting of nonrecourse to L over time (i.e. minimum gain chargeback increases each year is you take depreciation each year) is that L has been shifted enough outside basis from nonrecourse debt so that

704(d) will permit L to be able to use depreciation deductions properly allocated to L him each year. o The basis increase attributable to the allocation of the nonrecourse liability should be deemed to occur immediately before the allocation of the nonrecourse deduction or distribution which caused an increase in minimum gain Partners Shares of Section 704(c) Gain (tier 2) o When property contributed to a partnership is subject to a nonrecourse liability in excess of its adjusted basis, the property has a built-in gain (equal to the excess of liabilities over basis) similar to partnership minimum gain o Under the regulations, however, the built-in gain is not partnership minimum gain under Section 704(b) but instead is potential Section 704(c) gain. o The regulations provide that, to the extent of the minimum Section 704(c) gain, the nonrecourse liability secured by the contributed property is allocated to the same partner to whom this minimum built-in gain is allocated under Section 704(c) If a partnership holds multiple properties subject to a single nonrecourse liability, it may allocate the liability among those properties under any reasonable method, and then the portion of the liability allocated to each property is treated as a separate loan for purposes of determining the minimum built-in gain in the property Partners Share of Partnership Profits (tier 3) o Absent any special allocations, nonrecourse liabilities simply are allocated in accordance with the partners interests in the partnership (i.e. according to their agreement???) o If the partnership purchases an asset subject to a nonrecourse liability, the regulations provide that any specification of the partners interests in the partnership agreement will be respected for Section 752 purposes as long as it is reasonably consistent with an allocation (having substantial economic effect) of any significant item of partnership income or gain o Absent such a direction, the partners interests in partnership profits are determined by taking into account all the facts and circumstances relating to the economic arrangement of the partners o The regulations also provide some alternative methods for allocating nonrecourse liabilities Excess nonrecourse liabilities may be allocated in accordance with the manner in which it is reasonably expected that the deductions attributable to those liabilities will be allocated In the case of contributed property subject to a nonrecourse liability, the partnership may first allocate an excess nonrecourse liability to the contributing partner to the extent that Section 704(c) gain on the property is greater than the gain resulting from the liability exceeding the basis of the property o The method selected for allocating excess nonrecourse liabilities may vary from year to year

Part-Recourse, Part-Nonrecourse Liabilities After properly bifurcating the debt, the recourse portion is allocated under the rules for recourse liabilities, and the nonrecourse portion is allocated separately under the rules for nonrecourse liabilities LOSS LIMITATIONS When can a partner use their respective shares of loss in the partnership during a given year as a deduction against income they may have from other sources? First apply 704(b) to see it will be respected. Then proceed... Limitation 1: Basis Limitations 704(d) Section 704(d) provides that a partners distributive share of partnership loss, including capital loss, is allowable as a deduction only to the extent of the partners outside basis at the end of the partnerships taxable year in which the loss occurred. o In computing the adjusted basis of a partners interest for the purpose of ascertaining the extent to which a partners distributive share of partnership loss shall be allowed as a deduction for the taxable year, the basis shall first be increased under 705(a)(1) (contributions) and decreased under section 705(a)(2) (distributions), except for losses of the taxable year and losses previously disallowed If the limitation applies (i.e. basis reduced to 0 and loss leftover), any excess loss may be carried forward indefinitely and utilized when the partner acquires additional basis (doesn't matter how basis is increased). If the partnership has both ordinary and capital losses, the regulations provide that the partners loss is allocated to reflect the composition of the partnerships loss. 1-704-1(d) o Note: Don't get to 1211 and 1212 limitations for capital loss carryover until after 704(d) is applied It is likely that the carryover loss is generally personal to each individual partner. Thus, if a partner sells his partnership interest, the sellers previously deferred losses will disappear and not carry over to the buyer. The carryover loss also apparently terminates if a partner dies, but it is not totally certain whether a carryover loss may be sues by a donee partner. Limitation 2: At-Risk Limitations 465 465 limits the deduction of a taxpayer's loss from an activity to the amount that the taxpayer has at-risk in that activity. o Under 465, a loss is defined as the excess of the total deductions from the activity beyond the total income derived by that activity. This means that can always use deductions from an activity to extent of that activities' income. But when you want to take a new loss and use it shelter other unrelated income sources, 465 may come into play. In the partnership setting, the at-risk rules are applied on a partner-by-partner basis rather than at the partnership level. In general, the rules are applied separately to each activity in which a partnership is engaged, but exceptions may require certain trade or business activities to be aggregated 3

A taxpayers initial at-risk amount generally includes: o (1) his cash contributions to the activity o (2) the adjusted basis of other property contributed by the taxpayer to the activity; and o (3) amounts borrowed for use in the activity for which the taxpayer is personally liable or which are secured by property of the taxpayer (not otherwise used in the activity) to the extent of the fair market value of the encumbered property A partner is considered at risk with respect to his share of recourse debt A taxpayer is not considered at risk with respect to nonrecourse loans, except with respect to certain nonrecourse loans secured by real property which constitute qualified nonrecourse financing. The exception applies if: It is non-convertible debt for which no person is personally liable and which is incurred by the taxpayer with respect to the holding of real estate and is borrowed from a qualified person A qualified person is any person actively and regularly engaged in the business of lending money who is not related to the borrower and is not the seller of the property, a relative of the seller or a person who receives a fee (e.g., a promoter or broker) with respect to the taxpayers investment in the real property, or a relative of such a fee recipient A partners share of qualified nonrecourse financing is determined on the basis of the partners share of partnership liabilities under Section 752, provided the financing is qualified with respect to both the partner and the partnership. The amount for which partners may be treated at risk, however, may not exceed the total amount of qualified nonrecourse financing at the partnership level. Any loss disallowed by Section 465 may be carried over and deducted when either the taxpayer becomes at risk, the partnership disposes of the activity, or the taxpayer disposes of his partnership interest If a partners loss is deferred by Section 465, the partners outside basis is nonetheless reduced by the amount of the loss Limitation 3: Passive Loss Limitations 469 In General o Section 469 disallows the current deductibility of losses and the use of credits from passive activities o The income and losses from each of a taxpayers passive activities are first computed and then all are combined; in any taxable year, passive activity losses can be deducted only to the extent of the taxpayers income from passive activities for that year o To the extent that losses from passive activities for the taxable year exceed the taxpayers passive income, that excess may be carried forward and deducted (subject to the same limitation) against future net income from passive activities

o Disallowed losses from a particular activity may be deducted in full on a taxable disposition of the entire activity Ultimately, will be able to use passive loss, but may have to wait until you dispose of interest in the losing activity o The passive-loss limitations are applied on a partner-by-partner basis, not at the partnership level o The limitations are applied only after application of the Section 704(d) and Section 465 limitations The Material Participation Standard o A passive activity is any activity involving the conduct of any trade or business in which the taxpayer does not materially participate o A taxpayer materially participates in an activity only if he is involved on a regular, continuous and substantial basis in the operation of the activity o Participation generally includes work done by the taxpayer in all capacities except as an investor in the activity unless the taxpayer is directly involved in day-to-day management or operations o A taxpayer is treated as materially participating in an activity if any one of these tests is met (1) the taxpayer participates in the activity for more than 500 hours during the year (2) the taxpayers participation in the activity constitutes substantially all of the participation in the activity by any individual for the year; (3) the taxpayer devotes more than 100 hours to the activity during the year and his participation is not less than that of any other person; (4) the activity is a significant participation activitythat is, a trade or business activity in which the taxpayer participates for more than 100 hours and the taxpayer does not satisfy any of the other tests for material participationand the individuals aggregate participation in all significant participation activities for the year exceeds 500 hours; (5) the taxpayer materially participated in the activity for any five of the ten taxable years immediately preceding the taxable year; (6) the activity is a personal service activitythat is, an activity principally involving the performance of services in fields such as health, law, engineering, architecture and accountingand the taxpayer materially participated in the activity for any three taxable years preceding the taxable year; or (7) based on all the facts and circumstances, the taxpayers participation in the activity during the taxable year is regular, continuous and substantial Rental Activities o With a few limited exceptions, Section 469 presumes that all rental activities are passive regardless of the extent of participation by the taxpayer. Exceptions Individual taxpayers may deduct up to $25,000 of losses attributable to rental real estate activities if they actively participate and own at least a 10 percent interest in the activity 3

The real estate rental activities of taxpayers other than C corporations are treated as active trades or businesses if more than half of the personal services performed by the taxpayer in all trades or businesses during the year, and more than 750 hours, are in real property trades or businesses in which the taxpayer materially participates

Working Interests o Regardless of the taxpayers material participation, a passive activity does not include a working interest in any oil or gas well in which the taxpayer holds directly or through an entity that does not limit the taxpayers liability with respect to the drilling or operation of the property o The exception does not apply to a limited partnership in which the taxpayer is not a general partner Portfolio Income o Section 469 provides that portfolio income (interest, dividends, annuities, royalties not derived in the ordinary course of trade and business and gains or losses from assets that produce such income, less related expense) shall not be considered as arising from a passive activit o Portfolio income earned by a partnership is separately stated and retains its character when it passes through to the partners General Partners o Whether or not a general partners share of income or loss is treated as derived from a passive activity requires a separate analysis of each general partner and of each separate activity in which the partnership engages. The critical issues narrow to: (1) when are different pursuits of the partnership classified as separate activities in which a partner must materially participate in order to avoid the passive loss limitations, and (2) what degree of participation by a partner in an activity is material? Limited Partners o Section 469 presumes that all limited partnership interests are activities in which a taxpayer does not materially participate o Limited partners are considered to materially participate only if (1) they participate in the activity for more than 500 hours during the taxable year, (2) they materially participated in the activity for any five tax years during the ten years preceding the taxable year, or (3) the activity is a personal service activity and the limited partner materially participated in the activity for any three tax year (whether or not consecutive) preceding the taxable year o A limited partner who is also a general partner and who meets one of the seven tests for material participation is treated as materially participating with respect to both the limited and general partnership interests o A limited partners share of income received for the performance of services is not treated as income from a passive activity 3

SALES OF OWNERSHIP INTERESTS CONSEQUENCES TO THE SELLING PARTNER The Operation of Section 751(a) In General o Section 741 provides that gain or loss from the sale or exchange of an interest in a partnership shall be considered as gain or loss from the sale of a capital asset o Section 741 yields to Section 751(a) to the extent that the amount received by a selling partner is attributable to unrealized receivables or inventory items Mechanics o The selling partner must first apply the general rules of Section 1001(a) and compute the total realized gain or loss on the sale Section 752(d) includes in the amount realized the selling partners share of all partnership liabilities along with the cash and fair market value of other property received by the seller The adjusted basis of the sellers interest is his outside basis under Section 705(a), adjusted to reflect the sellers pro rata share of partnership income or loss from the beginning of the current taxable year up to the date of sale Although a partnerships taxable year generally does not close when a partner sells an interest, it closes with respect to a partner immediately upon the sale or exchange of his entire interest in the partnership The income or loss arising from that short taxable period then passes through to the partner and is reflected in his outside basis o The next step is to determine what portion, if any, of the sellers total realized gain or loss is characterized as ordinary income under Section 751(a) Section 751 assets include unrealized receivables and inventory items, as defined in Sections 751(c) and (d), respectively Unrealized receivables generally include rights (contractual or otherwise) to payment for goods and services which have not previously been included in income, provided, in the case of goods, that the sales proceeds would be treated as received from the sale or exchange from non-capital assets. In addition, unrealized receivables include certain short-term debt obligations and an array of assets to the extent that their disposition at fair market value would trigger recapture of cost recovery and certain other prior deductions (e.g. depreciation recapture) o could depend on whether pship uses cash or accrual method o Re: work in progress on matters not completed: Reg 1.7511(c): unrealized receivable includes rights to payment for work begun but incomplete at time of partner's sale, where right to payment for that work arises under K in existence at time of partner's sale.

o Re: depreciation recapture (1245): unrealized receivables includes 1245 property of pship to the extent there would be ordinary depreciation recapture income if the pship sold the property for its FMV at the time the partner sells his pship interest if FMV > AB, then there's recapture (RIGHT?). B/c giving back those earlier ordinary depreciation deductions on equipment, b/c they were premised on assumption that equipment was going down in value equal to depreciation deductions. Yet, equipment didn't go down at all The term inventory items falls into any of the following categories: o (1) dealer property, i.e. held by pship for customers for sale in ordinary course of business; o (2) any other property of pship that is not a capital asset, or not 1231 property (e.g. account receivable), or o (3) property which, if held by selling partner directly, would have been inventory in selling partner's hands, or property that is not capital asset of section 1231 property in selling partner's hands (i.e. selling partner's status could trigger being inventory) If unrealized receivables fall within both Section 751(c) and (d), they are treated as Section 751(c) assets o 1.751-1(a)(2): If part of the amount realized is attributable to Section 751 assets, the tax consequences of the sale must be bifurcated by determining the amount of income or loss from Section 751 property that would have been allocated to the selling partner if the partnership had sold all of its property in a fully taxable transaction for cash in an amount equal to the fair market value of such property. The fair market value of property shall not be less than the amount of any nonrecourse debt to which the property is subject. The selling partners share of income or loss from Section 751 property in this hypothetical sale takes into account special allocations and allocations required under Section 704(c), including any remedial allocations The gain or loss attributable to Section 751 property will be ordinary gain or loss Note: No ceiling rule if sale of ordinary assets produce a loss o After determining the gain or loss under Section 751(a), the final step is to determine the difference between the selling partners total gain or loss and the ordinary gain or loss determined under Section 751(a). That difference is the selling partners section 741 capital gain or loss on the sale of the partnership interest o Anti-abuse rule: Multi-Tiered Partnerships Section 751(f) provides that in determining a partnerships Section 751 assets, the partnership shall be treated as owning its proportionate share

of the property of any other partnership in which it is a partner. This rule applies regardless of the number of tiers between the selling partner and the ordinary income property. o Like-Kind Exchanges of Partnership Interests There once was substantial controversy over whether an exchange of partnership interests could qualify as a like-kind exchange. Congress silenced the debate by disallowing nonrecognition on such exchanges Transfers of partnership interests to a controlled corporation normally qualify for nonrecognition under Section 351, but problems may arise in determining the nature of the incorporation transaction Capital Gains Look-Through Rule In order to apply the Codes different rates for taxing long-term capital gains, the regulations apply a look-through rule for sales or exchanges of interests in a partnership As a result a partner who sells a partnership interest held for more than one year may recognize Section 751 ordinary income and up to three different types of long-term capital gains: collectibles gain, unrecaptured Section 1250 gain, and residual capital gain Holding Period A partner may have a divided holding period in a partnership interest The regulations integrate the holding period rule and the look-through rule for capital gains by first identifying the portions of the selling partners Section 741 capital gain or loss that are long-term or short-term capital gain or loss. Then a proportionate amount of any collectibles or unrecaptured Section 1250 gain is deemed to be part of the long-term capital gain or loss The regulations contain a few special rules for determining the holding period of a partner selling a partnership interest o First, if a partner both makes cash contributions and receives cash distributions during the one-year period before the sale or exchange of the partnership interest, the partner may reduce the cash contributions made during the year by the cash distributions on a last-in-first-out basis, treating all cash distributions as if they were received immediately before the sale or exchange o Also, contributions of Section 751(c) unrealized receivables and Section 751(d) inventory items within one year of a sale or exchange of a partnership interest are disregarded for purposes of determining the holding period of the partnership interest if the partner recognizes ordinary income or loss on such Section 751 assets in a fully taxable transaction. The taxable transaction can be either a sale of all or part of the partnership interest or a sale by the partnership of the contributed section 751 asset. CONSEQUENCES TO THE BUYING PARTNER Introduction

Section 742 provides that a partner takes a cost basis for a partnership interest acquired by purchase; for this purpose, cost includes the partners share of any partnership liabilities when computing buyer's share of pship liabilities, and when trying to figure out buyer's rights should pship liquidate, buyer simply takes over seller's book capital account w.r.t. that interest being sold. i.e. no booking up of cap accounts in this situation; just step into shoes of seller. 1.704-1(b)(2)(iv)(l) Section 743(a) generally provides that the basis of partnership property (i.e. inside basis) shall not be adjusted as the result of a transfer of an interest in a partnership by sale or exchange, subject to two exceptions: (1) To avoid taxing the buying partner on the appreciation of his proportionate share of partnership assets prior to the date of purchase, the partnership may elect under Section 754 to adjust the basis of its assets under Section 743(b) o A Section 754 election also may require a downward adjustment to the bases of partnership assets which have declined in value as of the time of the sale or exchange of the partnership interest. Specifically, Section 742(b)(2) requires that the partnership must decrease the adjusted bases of its assets with respect to any partner if that partners proportionate share of the partnerships total inside basis in its assets exceeds the buying partners outside basis. The amount of the adjustment is the excess of that partners proportionate share of the partnerships inside bases over the partners outside basis in his partnership interest o Note: Once the election is made, it's binding on all subsequent transfers. Election analysis is applied to any subsequent transfer by any partner. (2) where partnership has a substantial built-in loss immediately after transfer takes place. In this case adjustment to inside basis is mandatory. 743(d): a substantial builtin loss is when immediately after transfer of pship interest, inside basis of all of its assets exceeds their total value by more than 250k. Mandatory Inside Basis Adjustment for Partnership with Substantial Built-in Loss Section 743 requires an adjustment to the basis of partnership property on the transfer of a partnership interest if the partnership has a substantial built-in loss immediately after the transfer o A partnership has a substantial built-in loss if the adjusted basis in its property at the time of the sale exceeds the propertys fair market value by more than $250,000. In patrolling the $250,000 threshold for abuse, the Service has the authority to aggregate related partnerships or disregard acquisitions of property designed to avoid the limit A special rule is provided for an electing investment partnership, such as venture capital and buyout funds formed to raise capital from investors pursuant to a private offering and to make and hold investments for capital appreciation. o An electing investment partnership is allowed to use a partner-level loss limitation instead of making basis adjustments to its assets. o Under the limit, a transferee partners share of losses (without regard to gains) from the sale or exchange of partnership property is not allowed except to the

extent it is established that such losses exceed any loss recognized by the transferor on the transfer of the partnership interest Another special rule is provided for securitization partnerships, which generally are partnerships whose sole business is to issue securities backed by the cash flow of receivables or other financial assets. o Such partnerships are deemed to not have a substantial built-in loss and thereby avoid both adjustments to the bases of property and the loss-limitation rule Calculating the Section 743(b) Adjustment to Inside Basis The new partner first must determine the amount of the overall basis adjustment, which is the difference between the partners outside basis (generally, the partners cost plus his share of partnership liabilities) and his share of the partnerships inside basis in its assets (note: happens then prior to pship's sale, its assets appreciated or depreciated in value) o A transferee partners share of the adjusted basis to the partnership of its property = the sum of the transferees interest in the partnerships previously taxed capital, + the transferees share of partnership liabilities. The transferees interest in the partnerships previously taxed capital is determined by considering a hypothetical disposition by the partnership of all of its assets immediately after the buyer became a partner in a fully taxable transaction for cash equal to the fair market value of the assets The transferees interest in the partnerships previously taxed capital is equal to the cash the transferee would receive on a liquidation following the hypothetical transaction (don't forget to pay back creditors first), increased by the amount of tax loss and decreased by the amount of tax gain that would be allocated to the transferee from the transaction o Notice: in 743(b): statute says that these adjustments to inside basis, whether positive or negative, only affect the buyer, not the other partners. o To differentiate pship's original basis from adjustment, refer to original basis as the common basis. Allocation of the Adjustment to Partnership's Basis (for buyer only) under Section 755 Once the total Section 743(b) adjustment is determined, that adjustment must be allocated among the partnerships assets under Section 755 o The Section 755 regulations provide that the partnership first must determine the value of its assets o Next, the partnerships assets are first divided into two classes: (1) Capital assets and Section 1231(b) property (depreciable prop used in a business & held for 1+ yr) (2) Any other property (ordinary income property) o The basis adjustment is then allocated between those classes of property and within each class based on the allocations of income, gain, or loss (including remedial allocations) that the transferee partner would receive if, immediately after the transfer, all of the partnerships assets were disposed of in a fully taxable transaction for fair market value

The regulations specifically permit an increase to be made to one class or one property while a decrease is made to the other class or a different property within the class Basis is first allocated to the class of ordinary income property and then to the class of capital gain property Adjustments to two broad categories of properties under 755 can be conceivably positive to one class and negative to another Note: So, it's possible that even though a new inside adjustment is 0, can still allocate adjustment between two types of property so long as allocated adjustments to each property net out to zero. 1.755-1(b) A decrease in basis allocated to capital gain property may not produce a negative basis in any asset. Thus, if the entire decrease allocated to capital gain property reduces the basis of those assets to zero, any excess reduces the basis of the class of ordinary income property

Effect of the Section 743(b) Adjustment The regulations provide that a basis adjustment under Section 743(b) is personal to the transferee partner o No adjustment is made to the common basis of the partnership property and a Section 743(b) adjustment has no effect on the partnerships computation of any Section 703 item o A partnership first computes all partnership items at the partnership level and each partner, including the transferee, is allocated those items under Section 704 o The partnership then adjusts the transferees distributive share of partnership income, gain, loss or deduction to reflect the Section 743(b) basis adjustment o These basis adjustments do not affect the transferees capital account If depreciable or amortizable property acquires an upward basis adjustment under Section 743(b), the property generally is treated as two separate assets for depreciation or amortization purposes o The first asset retains the original depreciation remaining in the depreciable or amortizable property prior to the adjustment o The amount of the adjustment is treated as being attributable to a newly purchased asset for depreciation or amortization purposes Relationship to Section 704(c) (i.e. when someone contributes appreciated property to partnership) The regulations generally provide that a transferees income, gain, or loss from the sale or exchange of a partnership asset in which the transferee has a basis adjustment is equal to the transferees share of the partnerships gain or loss from the sale of the asset (including any remedial allocations of gain or loss), minus the amount of any positive Section 743(b) basis adjustment or plus the amount of any negative Section 743(b) adjustment One other aspect of Section 704(c) may also come into play in connection with the transfer of a partnership interest. Section 704(c)(1)(C) provides that in the case of property that was contributed to a partnership with a built-in loss, no other partner may be allocated

that precontribution loss. Thus, the purchaser of a partnership interest may not obtain the benefit of a built-in loss contributed by the seller of the interest for purposes of making allocations to other partners, basis of lost property will be treated as being equal to property's FMV at the time of its contribution. NON-LIQUIDATING DISTRIBUTIONS Non-liquidating distribution occurs when partnership and partner do not get fully liquidated. Liquidating distribution takes recipient partner out of the partnership, either by liquidating entire business or liquidating that partner's entire interest. NONRECOGNITION RULES ON THE DISTRIBUTION Distributions of Cash Section 731(a) generally provides that a partner will recognize neither gain nor loss on a current distribution of cash, and Section 733 provides that the partners outside basis will be reduced, but not below zero, by the amount of the distribution Section 731(a)(a) provides that the excess of cash received over the distributee partners outside basis is treated as gain from the sale or exchange of a partnership interest normally capital gain, unless Section 751 applies These rules embrace both actual cash distributions and transactions that are treated as cash distributions, such as reductions in a partners share of partnership liabilities 731(b) general rule is that no gain or loss is recognized by pship on that distribution Distributions of Property Neither the partnership nor the distributee partner will generally recognize gain or loss on an operating distribution of property Any gain inherent in the distributed property is preserved by assigning the distributee a transferred basis under Section 732(a) Any gain inherent in the partners interest in the partnership is preserved by Section 733, which reduces the partners outside basis by his transferred basis in the distributed property Section 732(a)(2) provides that if the partners share of the inside basis in the distributed property exceeds his outside basis, reduced by any cash distributions in the same transaction, the transferred basis is limited to that outside basis, which then would be reduced to zero under Section 733 Allocation of Basis to Distributed Properties If the special basis limitation rule in Section 732(a)(2) applies and several assets are distributed, the basis to be allocated (i.e., the partners outside basis less cash received in the transaction) must be allocated among the distributed properties under Section 732(c) using a multi-step process o First, any distributed unrealized receivables and inventory items are tentatively assigned a basis equal to the partnerships basis in each of those assets

o If the sum of the partnerships basis in the unrealized receivables and inventory items exceeds the basis to be allocated, the partnerships bases in those properties must be decreased by the amount of the excess The reduction is achieved first by allocating basis decreases among the properties with built-in loss (i.e., properties with an assigned basis greater than their value) in proportion to the amounts of such loss and only to the extent of each propertys built-in loss If needed, additional decreases are allocated in proportion to the remaining adjusted basis of the unrealized receivables and inventory items o If the basis to be allocated exceeds the partnerships basis in the distributed unrealized receivables and inventory items, then each other distributed property is tentatively assigned a basis equal to the partnerships basis in that asset. The partnerships bases in those properties then must be reduced so that the sum of their basis is equal to the remaining basis to be allocated. Again, the reduction is accomplished by first allocating basis decreases in proportion to the built-in loss in the properties (but only to the extent of such loss) and then in proportion to the remaining adjusted bases of the properties Section 732(d) Section 732(d) provides an exception to the foregoing basis rules by permitting certain distributee partners to elect to treat any distributed properties as though the partnership had a Section 754 election in effect when the partner purchased or inherited his interest o As a result, assets distributed to the new partner are eligible for a Section 743(b) adjustment, and a special inside basis then may be used to determine the partners basis in the distributed assets under Sections 732(a) and (c) o This election is available only if the distribution is made within two years of the distributee partners acquisition of his interest by purchase, exchange or inheritance and the partnership had no Section 754 election in effect at the time of the acquisition of his interest There are some critical differences between the effects of a Section 732(d) and Section 754 election o Section 732(d) only applies for purposes of determining the bases of distributed assets o And unlike a Section 754 election, a Section 732(d) election does not apply for purposes of partnership depreciation, depletion, or gain or loss on disposition A Section 732(d) adjustment may be required, whether or not the distribution occurs within two years from the partners acquisition of his partnership interest, if the fair market value of the partnership property (other than money) as the time the partner acquired his interest exceeds 110 percent of its adjusted basis to the partnership. o The regulations limit application of this rule to cases where lack of a Section 732(d) election would cause a shift in basis from nondepreciable to depreciable property Deemed Distributions of Money

A deemed distribution of money under Section 752(b) resulting from a decrease in a partners share of the liabilities of a partnership is treated as an advance or drawing of money to the extent of the partners distributive share of income for the partnership taxable year. o An amount treated as an advance or drawing of money is taken into account at the end of the partnership taxable year. A deemed distribution of money resulting from cancellation of debt may qualify for advance or drawing treatment In a distribution of encumbered property, the resulting liability adjustments will be treated as occurring simultaneously, rather than occurring in a particular order o Therefore, on a distribution of encumbered property, the amount of money considered distributed to a partner for purposes of section 731(a)(1) is the amount (if any) by which the decrease in the partners share of the liabilities of the partnership under Section 752(b) exceeds the increase in the partners individual liabilities under Section 752(a) o The amount of money considered contributed by a partner for purposes of Section 722 is the amount of (if any) by which the increase in the partners individual liabilities under Section 752(a) exceeds the decrease in the partners share of the liabilities of the partnership under section 752(b) o The increase in the partners individual liabilities occurs by reason of the assumption by the partner of partnership liabilities, or by reason of a distribution of property subject to a liability, to the extent of the fair market value of such property CONSEQUENCES ON SUBSEQUENT SALES OF DISTRIBUTED PROPERTY Characterization Under Section 735(a), gains or losses recognized by a distributee partner on the disposition of unrealized receivables received in a distribution are treated as ordinary income or loss, and gains or losses on the sale or exchange of distributed inventory items suffer a similar character taint if they are sold or exchanged by the partner within five years from the date of their distribution. In the case of unrealized receivables, the character taint remains with the assets as long as they are held by the distributee partner o If an item is both an unrealized receivable and an inventory item, the more stringent rules governing receivables are applicable o The Section 735 taint cannot be removed in a nonrecognition transaction or a series of such transactions o Except in the case of C corporation stock received in a Section 351 corporate formation, the taint carries over to the exchanged basis property received in the transaction The Section 735(a) taint rules do not apply to recapture property. But the recapture gain which the partnership would have recognized on a sale of the property carries over to the distributee partner, who recognizes ordinary income on a subsequent sale or exchange. This is accomplished through the definitions of recomputed basis and additional depreciation in the applicable recapture provisions

Tacked Holding Periods Section 735(b) allows the distributee partner to tack the partnerships holding period with respect to property with a transferred basis from the partnership, and also any distributed property which has some special type of basis Tacking is not permitted, however, in measuring the five-year taint applicable to distributed property items LIQUIDATING DISTRIBUTIONS What changes in a liquidating distribution is that a recipient partner can conceivably recognize a loss under 731(a)(2). Only way to do this is if the liquidating distributing to him consists of only cash, unrealized receivables, or inventory. If he gets anything else, he can't recognize a loss. If he does only get cash, unrealzied receivables or inventory, 731(a)(2) says amount of loss he can recognize will be equal to his outside basis less the sum of the cash that he receives, plus the partner's basis in the unrealized receivables and/or inventory. Then, last thing to focus on is his basis in distributed property. There, 732(b) applies: basis in distributed property overall will be equal to outside basis for pship interest less any money received. And then, if you get multiple assets, 732(c) says how to allocate the available basis among the various assets received. It says the first thing to do is allocate available basis to hot assets in an amount up to but not exceeding partner's basis interest in the partnership. Then, remaining outside basis available goes to any other assets received as a result of liquidating distribution. In terms of basis being taken, if getting hot assets in pship, basis can never step up from partnership to hands of partner, but could conceivably step down. As to other assets, it is conceivable to step up basis of cold assets as they leave the pship. If there is unused basis, recognizable loss under 731(a)(2) only if receiving cash, unrealized receivables, and inventory. Pro-Rata Liquidating Distributions As with operating distributions, a partner recognizes gain on a liquidating distribution only to the extent that the cash received exceeds the partners outside basis If both cash and other property are distributed, Sections 731 and 732 work in tandem to treat the distribution as a nonrecognition transaction o First, the partners reduces his outside basis by the cash received, and, in effect, he exchanges his remaining partnership interest for the other assets received in the distribution o Section 731 provides nonrecognition treatment to the partner and the partnership on the distribution, and Section 732(b) provides the partner with an aggregate basis in the distributed property equal to his predistribution outside basis less any cash received in the liquidation If more than one asset is distributed Section 732(c) once again prescribes the method for allocating the aggregate exchanged basis to the distributee partner o If inventory items or unrealized receivables have been distributed, those properties are first tentatively assigned a basis equal to the basis of such property to the partnership

If the sum of the partnerships bases in the distributed unrealized receivables and inventory items exceeds the basis to be allocated (the partners outside basis less cash received in the transaction, then the partnerships bases in those properties must be reduced by the amount of the excess The reduction is achieved by first allocating basis decreases among the properties with unrealized built-in loss in proportion to the amounts of such loss and only to the extent of the built-in loss of each property If needed, additional decreases are allocated in proportion to the remaining adjusted bases of the unrealized receivables and inventory items If the basis to be allocated exceeds the partnerships basis in the distributed unrealized receivables and inventory items, then each other distributed property is next assigned a basis equal to the partnerships basis in that property o Basis increases or decreases then must be allocated to the other distributed properties if the partners remaining basis (i.e., the basis remaining after any unrealized receivables or inventory items are assigned basis equal to their bases in the hands of the partnership) is greater or less than the sum of the partnerships bases in those properties If an overall increase is required, the increase is accomplished by first allocating basis increases among the properties with unrealized appreciation in proportion to such appreciation and only to the extent of each propertys unrealized appreciation. Any additional increases are allocated in proportion to the respective fair market values of the properties If an overall decrease is required, the decrease is accomplished by first allocating basis decreases in proportion to the unrealized built-in loss in the properties (again, only to the extent of such loss) and then in proportion to the remaining adjusted bases of the properties o The distributee partner may tack the partnerships holding period under Section 735(b), and Section 735(a) preserves the ordinary income character in the hands of the partner indefinitely for any unrealized receivables and five years for inventory items If the partner receives solely cash, unrealized receivables and inventory items in a liquidating distribution, Section 731(a)(2) provides that the partner recognizes a loss to the extent that his outside basis exceeds the sum of the cash distributed plus the partners Section 732 transferred basis in the receivables and inventory items o The loss is considered as incurred on the sale or exchange of a partnership interest and thus is a capital loss under Section 741 Where a partner receives only cash, any realized gain or loss must be recognized because the partner may not defer recognition by way of an exchanged basis Effects of Distributions on Adjusted Basis of Undistributed Assets

734. Issue is to what extent might a pship distribution affect pship's basis in its remaining assets. Relevant only if pship continues after distribution takes place. It's sort of like 743, where pship adjusts basis of inside assets as a result of a sale of pship interest. General rule 734(a): pship inside basis will not be adjusted as result of distribution unless an election of 754 in effect by pship or unless there would be a substantial basis reduction, i.e. reduction of more than 250k. If basis adjustment is elected or required, then pship will adjust the inside basis of remaining assets when one of the situations described in 734(b) exists Problem 1 (a) A receiving cash in excess of outside basis and as a result has to recognize a gain of $2. Pship retains two parcels w/ only B and C as partners in business. Also notice @ time of distribution, there was 6 of unrealized appreciation lurking in pship assets. On the liquidating distribution to A, A picks up two of gain. BUT, if pship does not have a 754 election in effect, pships basis in land going forward remains unchanged. So if later on partnership sells parcel 2 for fmv of 10, there will be 6 of gain to pship as a result of sale allocated among B and C. So, w/o an election and adjustment to inside basis, what had been 6 of unrealized appreciation in pship assets has transformed itself into 8 of gain; 2 to A, 6 split btw B and C. To remove that disparity, 734(b)(1)(A): assuming 754 election in place, partnership can or will increase basis of its undistributed property by the amount of the 731 gain recognized by the recipient partner. Here, the adjustment would be a positive one of $2. Then, have to allocate basis adjustment among the assets remaining w/in pship under 755. Regs thereunder however say that an adjustment resulting from gain recognized on a distribution has to be allocated to pships cap assets or 1231 property. Also, under 755 regs, basis increase is allocated among the cap assets first to assets that have unrealized appreciation @ time of distribution. Here, 2 positive adjustment goes to land 2 b/c has unrealized appreciation. Unlike 743, that basis adjustment is for the benefit of all of the remaining partners. If pship thereafter sells land, pship will only have 4 of gain, and add to it 2 gain that A reported on distributed to him, you have the 6 gain mirroring unrealized appreciation at time liquidation distribution was made.