Getting the benefit of your bargain in partnership acquisitions: proposed regulations under sections 743 and 755. , 755 - b - IRC s. 743b

Eric B. Sloan

I. Introduction

A. Generally. Little more than a decade ago, the vast majority of businesses organized as partnerships(1)(*) were real estate ventures and professional services firms. As a result, partnership taxation was largely a backwater discipline. Now, due to widespread acceptance of the limited liability company and promulgation of the "check-the-box" regulations(2) (signaling the IRS and Treasury's concession of defeat in the entity classification wars), partnerships and partnership taxation are hot.

As a result, taxpayers and their advisers now approach transactions with the same question those versed in the mysteries of subchapter K have been asking for years: why incorporate?(3) This growth in the use of partnerships has led to increasing frustration with the outdated subchapter K regulations (many of which were promulgated in 1955). Among the most vexing regulations are those governing basis adjustments on the sale or exchange of a partnership interest. Indeed, those regulations -- which permit the purchaser of a partnership interest to reflect the purchaser's acquisition cost in partnership assets -- are among the most confused and deeply flawed aspects of partnership taxation.

In January 1998, to address these problems, the IRS and Treasury issued proposed regulations under section 734(b) (basis adjustments on certain distributions),(4) section 743(b) (basis adjustments on transfers of partnership interests), section 751(a) (the "collapsible partnership rule" requiring recognition of ordinary income on the disposition of certain partnership interests), and section 755 (allocation of basis adjustments under sections 734(b) and 743(b))? This article focuses on the proposed regulations under section 743(b) and section 755 (the "Proposed Regulations").

B. Sections 743 and 755. The basis of partnership property is generally unaffected when a partner sells or exchanges its interest.(6) As a result, if a person acquires a partnership interest by sale or exchange for an amount that exceeds the transferee's share of the adjusted basis of partnership property, the excess purchase price is not reflected in the partnership's asset basis, i.e., the purchaser is not able to "push down" its purchase price to the partnership's assets.(7) When a partnership makes a timely election under section 754, however, a transferee partner's share of the partnership's adjusted basis in its assets ("inside basis") is adjusted to reflect the partner's basis in the acquired partnership interest ("outside basis").(8)

The rules for computing the amount of the adjustment and allocating the adjustment among the partnership's assets are set forth in sections 743(b) and 755, respectively. In enacting these sections, Congress intended to permit taxpayers acquiring partnership interests to eliminate any disparity between their outside bases and their inside bases.(9) The underlying Treasury Regulations(10) -- scarcely adequate when written in 1956(11) -- provide little assistance to the tax professional dealing with contemporary partnerships, particularly those with complex provisions regarding the sharing of profits and losses or with "section 704(c) property."(12)

The Proposed Regulations dramatically improve the current regulations. While merely clarifying the current rules would have been cause enough for celebration, the Proposed Regulations go farther, adopting new rules that should prevent some of the income distortions that occurred in the past. Thus, the Proposed Regulations not only include long-awaited guidance on how to determine a partner's share of inside basis and how to report basis adjustments, but also amend the previous rules to allow partnerships: (i) to allocate a net basis adjustment among both loss and gain properties; (ii) to recover basis adjustments from certain section 704(c) property at the same rate as built-in gain from the property is recognized; and (iii) to treat a negative basis adjustment as an item of built-in gain that can presumably be amortized over a longer period than the remaining useful life of the property.

II. Transfers Giving Rise to Basis Adjustment

Although only a transfer constituting a "sale or exchange" gives rise to a basis adjustment,(13) the Proposed Regulations surprisingly do not define the term "sale or exchange." While a taxable transfer should qualify as a sale or exchange,(14) the status of nontaxable transfers is less clear. Each of the following nontaxable transfers has been held to constitute a sale or exchange for certain purposes: (i) the distribution by a corporation of a partnership interest;(15) (ii) the distribution by a partnership of an interest in a different partnership;(16) (iii) the contribution of a partnership interest to a corporation in a section 351 exchange;(17) (iv) the contribution of a partnership interest to another partnership in a section 721 exchange;(18) and (v) the transfer of a partnership interest in a tax-free reorganization.(19) Whether such transactions also constitute sales or exchanges for purposes of section 743(b) is less clear, although most advisers believe they should.(20)

Treating nonrecognition transactions as sales or exchanges for purposes of section 743(b) provides significant planning opportunities. For example, assume a transferee acquires its partnership interest but is unable to persuade the partnership to make a section 764 election. If the partnership later makes a section 754 election, the transferee can obtain a basis adjustment at that later time merely by contributing its interest to a corporate or partnership subsidiary. This tax planning technique remains available under the Proposed Regulations. Moreover, because the Proposed Regulations permit basis adjustments even if the net adjustment is zero,(21) this planning technique permits taxpayers to shift basis between assets in a manner not available under current law. The authors understand that the IRS is considering addressing this issue in the final regulations.

III. Determining the Section 743(b) Adjustment

A. Overview. If a transferee acquires a partnership interest in a transaction qualifying as a "sale or exchange" under section 743 and the partnership has a section 754 election in effect, then the transferee must adjust the basis of partnership property under section 743(b). The amount of adjustment is equal to the difference between the transferee's "outside basis" and its "inside basis." If the transferee's outside basis is greater than its inside basis, then the transferee will have a positive adjustment that increases the basis of partnership property. On the other hand, if the transferee's inside basis is greater than its outside basis, then the transferee will have a negative adjustment that decreases the basis of partnership property. Once the amount of adjustment is determined, it is allocated among the partnership's assets: first, to ordinary income assets, then, to capital gain assets.

One of the flaws in the current regulations is that they do not account effectively for a transferee's varying interests in different partnership properties. The amount of a transferee's basis adjustment is based simply on the difference between the transferee's outside basis and its share of inside basis, which the regulations do not define. The adjustment is then allocated among the partnership properties -- not based on the transferee's share of gain or loss from those properties, but on the difference between the adjusted basis and the fair market value to the partnership of those properties. Under these rules, determining the amount of the basis adjustment is more of an art than a science, leading to varying -- and often inaccurate -- results.(22) This inaccuracy is magnified when the adjustment is allocated among the partnership's properties, because, for example, a transferee's snare of gain from contributed property or property subject to a minimum gain chargeback may be greater than its share of gain from partnership properties as a whole.

To remedy some of these problems, the Proposed Regulations adopt a new construct called a "hypothetical transaction," which is defined as the disposition by the partnership of all of the partnership's assets, immediately after the transfer of the partnership interest, in a fully taxable transaction for cash equal to the fair market value of the assets.(23) The amount of the basis adjustment, as well as the allocation of that basis adjustment among the partnership properties, is based on the transferee's distributive share of gain or loss from this hypothetical transaction.

The importance of the hypothetical transaction cannot be understated. Under this construct, if the amount the transferee pays for its partnership interest equals the fair market value of its share of the partnership's assets, the transferee's share of any gain or loss on a subsequent sale of partnership assets should be limited to its share of any increase or decrease in the value of the partnership assets that occurs after the transferee's entry into the partnership.(24) This should be the case even if the partnership agreement includes minimum gain chargebacks(25) or other complicated profit-and-loss-sharing ratios. When the transferee pays less for the partnership interest than its share of the fair market value of the partnership assets, the transferee may be taxed on the gain attributable to the discount. The rules for computing and allocating a basis adjustment under the Proposed Regulations are discussed below.

B. Determining the Amount of the Basis Adjustment. Like the current regulations, the Proposed Regulations provide that a transferee's outside basis is equal to the transferee's adjusted basis in the transferred partnership interest.(26) Replacing the uncertainty of the current regulations, however, the Proposed Regulations provide that a transferee's inside basis is equal to the sum of (i) the transferee's interest as a partner in the partnership's "previously taxed capital," plus (ii) the transferee's share of partnership liabilities.(27)

As a general matter, if a partnership properly maintains capital accounts under the section 704(b) safe harbor regulations,(28) a transferee's interest in the partnership's previously taxed capital is the amount of the transferee's capital account,(29) decreased by any remaining built-in gain (and increased by any remaining built-in loss) that would be allocable to the transferee under the principles of section 704(c)(1)(A) if the partnership sold the contributed property at the time of the transfer of the partnership interest.(30) The specific rule in the Proposed Regulations provides that a transferee's interest in the partnership's previously taxed capital generally is the sum of the following:

(i) The amount of cash that the transferee would receive on the liquidation of the partnership following a "hypothetical transaction," plus

(ii) The amount of tax loss (including any remedial allocations under Treas. Reg. [sections] 1.704-3(d)) that would be allocated to the transferee from the hypothetical transaction, minus

(iii) The amount of tax gain (including any remedial allocations under Treas. Reg. [sections] 1.704-3(d)) that would be allocated to the transferee from the hypothetical transaction.(31)

As under the current regulations,(32) a transferee's basis adjustment is determined without regard to any prior transferee's basis adjustment.(33)

The following example illustrates this rule:

Example 1. A, B, and C form equal partnership

PRS, to which A contributes land ("Asset 1") worth

$1,000 with an adjusted basis of $400, and B and

C each contributes $1,000 in cash. Each partner

has $1,000 credited to it on the books of the partnership.

During the partnership's first taxable

year, Asset i appreciates in value to $1,300. A

sells its one-third interest in the partnership to T

for $1,100, when the partnership has an election

in effect under section 754.

If all of PRS's assets were sold for cash equal to

their fair market values and the cash were distributed

to the partners in a liquidating distribution,

T would receive $1,100. The amount of tax

gain that would be allocated to T from such a sale

would be $700 ($600 of section 704(c) gain,(34) plus

one-third of the $300 post-contribution appreciation).

Thus, T's interest in the partnership's previously

taxed capital is $400 ($1,100, the amount of

cash T would receive if PRS liquidated immediately

after T's acquisition of its interest, decreased

by $700, T's share of the gain from the hypothetical

transaction). The amount of T's basis adjustment

to partnership property is therefore $700

(the excess of $1,100, T's cost basis for its interest,

over $400, T's share of the adjusted basis of partnership

property).(35)

C. Allocating the Basis Adjustment Among Partnership Assets. Once the adjustment is determined, it must be allocated among the partnership's assets. Under section 755(b), a basis adjustment is initially allocated between the two statutory classes: (i) capital assets and assets described in section 1231(b), and (ii) other property. Restating this general rule, the Proposed Regulations provide that the adjustment, once allocated between the two asset classes, is allocated among the assets within each class.(36) In reality, however, the Proposed Regulations largely eviscerate the two-class regime.(37) As a result, if the amount the transferee pays for its interest equals the fair market value of the transferee's share of partnership assets, the transferee will receive a basis adjustment in each partnership asset equal to the tax gain or loss that would be allocated to the transferee if the partnership sold that asset in a taxable transaction immediately after the transferee's acquisition of its interest.(38) Under these rules, a transferee may receive positive basis adjustments with respect to some assets while receiving negative basis adjustments with respect to other assets.(39) In addition, a transferee may receive a positive and negative basis adjustment to specific partnership properties even if its net basis adjustment is zero.(40)

Additional rules apply when a partnership interest is purchased at a discount or a premium. It is not uncommon, for example, for a transferee to discount the purchase price of a partnership interest to reflect either the lack of marketability or the minority position of the interest. This discount is effectively allocated first to goodwill to the extent of the transferee's share of the partnership's basis in the goodwill.(41) Any remaining discount is allocated to other capital gain assets in accordance with their relative fair market values (as determined under Temp. Reg. [sections] 1.755-2T) to the extent of the partnership's basis in its capital gain assets.(42) To the extent that the partnership's basis in its capital gain assets is not sufficient to absorb the discount, any remaining discount is allocated to ordinary income assets in accordance with their relative fair market values (as determined under Temp. Reg. [sections] 1.755-2T).(43) This ordering rule should be favorable to taxpayers, because, if the partnership sells generally all of its assets immediately after the transferee acquires its interest, the transferee will recognize capital gain rather than ordinary income. The Proposed Regulations contain no special rule on allocating any premium paid by the transferee for the partnership interest, but, under the applicable temporary regulations, the premium should be allocated to goodwill and going-concern value.(44)

The following example, drawn from the Proposed Regulations,(45) illustrates the allocation of the basis adjustment where the partnership interest is not purchased at a discount:

Example 2. A and B form equal partnership PRS.

A contributes $50 in cash and Asset 3 (a capital

asset) with a fair market value of $50 and an

adjusted basis of $25. B contributes $100 in cash.

PRS uses the cash to acquire Assets 1, 2, and 4.

After a year, A sells its interest to T for $120.(46) At

that time, A's inside basis is $75 (determined under

the hypothetical transaction approach).

Immediately after the transfer, the fair market value and adjusted bases of the properties are as follows:

                       Fair                  T's share of
                      Market      Adjusted   hypothetical
Asset                 Value        Basis      gain(loss)

Asset 1 (ordinary)    $45.00       $40.00        $2.50
Asset 2 (ordinary)      2.50        10.00        (3.75)
Asset 3 (capital)      75.00        25.00        37.50
Asset 4 (capital)     117.50       100.00         8.75
Total                $240.00      $175.00       $45.00

T's basis adjustment is $45, the excess of T's $120

outside basis over T's $75 inside basis.

If PRS sold all of its assets in a fully taxable

transaction, T would recognize ordinary income of

$2.50 from Asset 1, $3.75 of ordinary loss from

Asset 2, $37.50 of capital gain from Asset 3 ($25 of

section 704(c) gain plus T's distributive share of

$12.50), and $8.75 of capital gain from Asset 4.

Therefore, each asset will be allocated a basis

adjustment equal to T's share of the hypothetical

gain or loss. Note that the excess of the positive

adjustments, $48.75, over the negative adjustments,

$3.75, is $45. This is, not coincidentally,

the net amount of T's section 743(b) basis adjustment.

The following example illustrates the effect of a discounted purchase price on these rules:

Example 3. Assume the same facts as in Example

2, except that A sold its interest to T for $110 to

reflect a $10 discount for lack of marketability. T's

basis adjustment is $35. Because T's adjustment

is less than T's share of gain from the hypothetical

transaction, the adjustment is first allocated

to the ordinary income property and the difference

is allocated to the capital gain property.(47)

Therefore, of the $35 basis adjustment, a negative

adjustment of $1.25 is allocated to the ordinary

income property, and a positive adjustment of

$36.25 is allocated to capital gain property.

                       Fair                  T's Hypo-
                      Market     Adjusted    thetical    Discount
Asset                 Value       Basis        Gain       Amount

Asset 1 (ordinary)    $45.00      $40.00       $2.50         --
Asset 2 (ordinary)      2.50       10.00       (3.75)        --
Asset 3 (capital)      75.00       25.00       37.50       $3.90
Asset 4 (capital)     117.50      100.00        8.75        6.10
Total                $240.00     $175.00      $45.00      $10.00

Assets i and 2 are ordinary income assets. Because

no discount has been allocated to the ordinary-income

class, the basis adjustment to each of

these assets will equal T's gain or loss on the

hypothetical sale of the assets. Accordingly, a $2.50

positive adjustment will be allocated to Asset 1.

and a $3.75 negative adjustment will be allocated

to Asset 2.

Assets 3 and 4 are capital-gain assets. The total

amount of gain that would be allocated to T from

the sale of capital-gain assets is $46.25. Because

T successfully negotiated a $10 discount in its

purchase from A, however, T may adjust the capital-gain

assets by only $36.25. Therefore, the

adjustment that would normally apply to each

capital-gain asset is reduced by the portion of the

discount allocable to that asset. Thirty-nine percent

($7.50/$19.25, the relative fair market value

of Asset 3 to the fair market value of all capital

assets)(48) of the $10 discount, or $3.90, is allocable

to Asset 3. The remaining 61 percent is allocable

to Asset 4. Accordingly, the basis adjustment to

Asset 3 is $33.60 (the hypothetical gain from Asset

3 of $46.25 less the $3.90 discount), and the

basis adjustment to Asset 4 is $2.65 (the hypothetical

gain from Asset 4 of $8.75 less the $6.10

discount).

IV. Recovery of a Basis Adjustment

A. Problems under the Current Regulations. Another significant change made by the Proposed Regulations is to coordinate more effectively the recovery period for the basis adjustment with the recovery period for built-in gain property under section 704(c). The purpose of section 704(c) is to ensure that a partner contributing property to a partnership is taxed on any gain or loss inherent in that property at the time of the contribution.(49) The section 704(c) regulations generally do so by requiring the partnership to specially allocate depreciation away from (in the case of built-in gain property) or toward (in the case of built-in loss property) the contributing partner.(50) Thus, as a general matter, a partner that contributes built-in gain property will have net taxable income from the partnership that exceeds its net book income from the partnership. In contrast, a noncontributing partner will have net taxable income from the partnership that equals its net book income from the partnership.

The section 704(c) regulations provide that a partner purchasing the interest of a contributing partner steps into the shoes of the contributing partner with respect to the section 704(c) property.(51) Accordingly, the transferee -- like the contributing partner -- will be taxed on the section 704(c) gain from the contributed property, unless the transferee's special basis adjustment can absorb this gain.

In a perfect world, the transferee's special basis adjustment would protect the transferee from any built-in gain it inherits from the contributing partner and place the transferee in the same tax position as it would have been in had it purchased the interest from a noncontributing partner. For example, assume that A contributes to a partnership property with a $10 adjusted tax basis and a fair market value of $100, and then sells its partnership interest to T for $100 at a time when the partnership's only assets are cash and the property contributed by A. T's special basis adjustment should be $90 -- the difference between T's outside basis ($100) and T's share of inside basis ($10). If the partnership sells the property contributed by A for $100, recognizing $90 of gain on the sale, all of the gain will be allocated to T under section 704(c)(1)(A). T may offset this gain, however, by the $90 special basis adjustment, so that T's net gain from the sale is $0.

Unfortunately, the world is not perfect, and a transferee must consider the impact of section 704(c) in purchasing its partnership interest. As a result, partnership interests generally are not fungible. There are a number of reasons for this.

The first reason stems from "ceiling rule distortions" with respect to contributed property. This occurs when the contributed property does not generate sufficient tax items to match the noncontributing partners' book allocations of depreciation, gain, or loss from contributed property with tax allocations of those amounts.(52) When a ceiling rule distortion occurs, the contributing partner will not be taxed on the entire built-in gain from the property; some of that gain will be shifted to the noncontributing partners.(53) The section 704(c) regulations allow partnerships to make curative or remedial allocations to correct ceiling rule distortions, but generally do not require them to do so.(54) If a partnership does not correct the ceiling rule distortion, persons interested in acquiring a partnership interest may prefer to purchase the contributing partner's interest because the transferee will not be allocated income equal to the entire amount of the contributing partner's remaining built-in gain, but will nevertheless receive a basis adjustment equal to the entire amount of the remaining built-in-gain. As a result, if the transferee purchases the contributing partner's interest, the transferee will receive a windfall (by way of an "artificial" positive adjustment attributable to the built-in-gain asset).

The second reason is the misallocation of the basis adjustment. The current regulations do not allow a partnership with a basis adjustment to make both positive and negative adjustments to the basis of partnership property.(55) As a result, if a person purchases a partnership interest from a contributing partner and the partnership has less property, the transferee's adjustment will be reduced by its share of the loss, and the transferee may not be able to allocate to the contributed property sufficient basis to protect it from the contributing partner's section 704(c) allocations.

The third reason is that built-in gain and the special basis adjustment are usually recovered over different time periods. Under the section 704(c) regulations, the contributing partner generally recovers the built-in gain ratably over the remaining useful life of the contributed property.(56) Because a special basis adjustment is recovered over a new useful life under current regulations,(57) it will not fully protect a transferee from built-in gain recovered in this fashion, at least in the first few years after the transfer. Instead, the transferee's taxable income will exceed its book income in earlier years, but will be less than its book income in later years. Thus, persons interested in acquiring a partnership interest may prefer to purchase the interest of a noncontributing partner.

In 1993, section 704(c) regulations were issued that permitted partnerships to correct ceiling rule distortions by making remedial or curative allocations.(58) Until now, however, there has been no way for partnerships to remedy fungibility problems caused by either: (i) the lack of basis adjustment to allocate to the contributed property, or (ii) different recovery periods for built-in gain and special basis adjustments. Unlike their predecessors, the Proposed Regulations allow a partner's net basis adjustment to create both positive and negative adjustments to specific partnership properties. By doing so, the Proposed Regulations resolve many fungibility problems that stem from the lack of a basis adjustment to allocate to the contributed property. As discussed in the next section, the Proposed Regulations also provide some relief for partnerships that experience fungibility problems because built-in gain from 704(c) property is recovered over a different time period than are basis adjustments under section 743(b). Unfortunately, the relief is limited to properties subject to the remedial allocation method; therefore, many partnerships will still encounter fungibility problems when partnership interests are transferred.

B. Proposed Regulations. Like the former Prop. Reg. [sections] 1.168-2(n)(1), the Proposed Regulations provide that a positive basis adjustment made to depreciable or amortizable property "is taken into account as if it were newly-purchased recovery property placed in service when the transfer occurs."(59) Unlike a positive basis adjustment, however, a negative basis adjustment is recovered over the remaining recovery period of the property.(60)

Basis adjustments attributable to built-in gain, like other positive basis adjustments, are generally recovered over a new useful life. The Proposed Regulations make an exception to this general rule, however, for partnerships that use the remedial allocation method under section 704(c)(1)(A) with respect to an item of depreciable or amortizable property.(61) Under this exception, any positive basis adjustment to such a property that is attributable to section 704(c) built-in gain is recovered over the remaining recovery period for the partnership's "excess book basis" in the property, as determined under the rules governing remedial allocations? Any remaining basis adjustment is recovered as newly purchased property. The following example demonstrates this seemingly complex rule:

Example 4. A and B form equal partnership PRS.

A contributes property with an adjusted basis of

$100 and a fair market value of $500. B contributes

$500 in cash. When PRS is formed, the property

has 5 years remaining in its recovery period.

PRS elects to use the remedial allocation method

to account for the built-in gain attributable to the

property. If PRS had purchased the property at

the time of the partnership's formation, the basis

would have been recovered over 10 years. Under

the remedial method, the $100 of carryover tax

basis will be recovered over the 5 years remaining

in the property's recovery period, generating $20

of book and tax depreciation each year. The $400

of built-in gain will be amortized over a 10-year

period beginning at the time of the partnership's

formation, generating $40 of book depreciation

and no tax depreciation each year.(63) Consequently,

PRS's book depreciation is $60 for each of the

first 5 years, and $40 for each of the next 5 years.

PRS's tax depreciation is $20 for each of the first

5 years and $0 for each of the last 5 years.

Except for depreciation deductions, PRS's expenses

equal its income in each of the first 2 years

after formation. After 2 years, A's share of the

adjusted basis of partnership property is $120,

while B's is $440.(64) A sells its interest in PRS to T

for its fair market value of $440 at a time when

PRS has an election in effect under section 754.

Accordingly, PRS makes an adjustment under section

743(b) to increase the basis of partnership

property by $320.(65) Under section 755, the entire

adjustment is allocated to the property.

At the time of the transfer, $320 of built-in gain

from the property was still reflected on the partnership's

books (i.e., its book basis exceeded its

tax basis by $320). As a result, all of the basis

adjustment is attributable to the built-in gain.

Therefore, the basis adjustment will be recovered

over the 8 years remaining in the recovery period

for the built-in gain.(66) In this case, the adjustment

will put T in the same position as T would

have been had he purchased his interest from a

noncontributor. The basis adjustment will offset

any remedial allocations of income that T receives

as the transferee of A's interest and will generate

tax depreciation that matches T's share of the

partnership's book depreciation.(67)

If, on the other hand, the property were worth

$450 at the time of the sale to T, T's share of the

adjusted basis of partnership property would still

be $120, and T's basis adjustment would be $330

(the excess of $450, T's outside basis, over $120,

T's inside basis). Because only $320 of the basis

adjustment is attributable to built-in gain,(68) only

$320 of the adjustment would be recovered over 8

years. The remaining $10 adjustment would be

recovered over a new 10-year recovery period under

the general rule for positive adjustments.

As this example demonstrates, the Proposed Regulations allow a transferee to recover its basis adjustment over the same period as the recovery of built-in gain, at least where the partnership makes remedial allocations. In conjunction with the other provisions of the Proposed Regulations -- most notably the provision allowing positive and negative basis adjustments to partnership property -- this rule should allow partnerships using the remedial method for all contributed properties to have fungible partnership interests.

V. Effect of Basis Adjustment on Partner's Taxable Income or Loss

A. Overview. If a basis adjustment is allocated to depreciable or amortizable property, the transferee generally will capture the benefit, or suffer the detriment, of the basis adjustment through cost recovery. If the partnership sells the adjusted asset before the adjustment is fully recovered (or if the adjusted asset is not subject to cost recovery), the transferee will capture the benefit, or suffer the detriment, of the adjustment on the sale of the asset. The Proposed Regulations clarify how basis adjustments are taken into account in actually determining the partners' shares of the partnership's taxable income or loss. Under the new rules, the partnership initially determines its income or loss under section 703 without regard to any basis adjustments? These items are then allocated among the partners, including the transferee, under section 704. Only then does the partnership adjust the transferee's distributive share of income, gain, loss, or deduction to reflect the effect of the basis adjustment on the partner's distributive share of gain or loss on the sale of the adjusted asset or of cost recovery deductions?

B. Effect of Adjustment on Transferee's Distributive Share of Cost Recovery. The amount of a positive adjustment recovered in any year is simply added to the transferee's distributive share of the partnership's depreciation or amortization for the year.(71) The rules for recovery of negative adjustments, however, are more complex.

As a general rule, the recovery of a portion of a negative basis adjustment has the following effect:(72) First, the transferee's distributive share of the partnership's cost recovery deductions from that item is reduced. Second, to the extent the negative adjustment exceeds the transferee's distributive share of cost recovery deductions from that particular item, the transferee's distributive share of cost recovery from other partnership items(73) is reduced. Third, to the extent the negative adjustment exceeds the transferee's distributive share of all partnership cost recovery deductions, the transferee must recognize ordinary income.

A transferee partner may recognize income from a negative basis adjustment if: (i) its share of loss from the property differs from its share of the property's depreciation, and (ii) its share of depreciation from the property changes after the acquisition of the partnership interest. The partners' shares of depreciation could vary from year to year due to, for instance, preferred return provisions or section 704(b) limitations.

In addition, a transferee might recognize income from a negative basis adjustment because its discount in purchasing the partnership interest exceeds its share of the inside basis of the partnership's capital assets. As discussed previously, a purchase price discount is first applied to reduce a positive (or create a negative) adjustment to the basis of the partnership's capital assets. The discount will only affect the partnership's basis in ordinary income assets if the partnership's basis in its capital assets cannot absorb the discount.(74) Because the partnership's basis in its capital assets is likely to be larger than the transferee's share of that basis, it is possible that a transferee's negative basis adjustment to the partnership's capital assets could exceed the transferee's inside basis in those assets.

Apparently recognizing the harshness of a rule that would require a transferee to recognize the entire negative adjustment over the remaining useful life of the partnership's assets, the Proposed Regulations offer an alternative. Specifically, the partnership may elect to treat the amount of the negative basis adjustment as an item of built-in gain that decreases the amount of depreciation or amortization that the partnership may allocate for tax purposes.(75) This method does not decrease the amount of depreciation or amortization that the partnership allocates for book purposes.(76) Although not set forth in the text of the Proposed Regulations, an example makes clear that the negative adjustment is treated as an item of built-in gain with respect to the transferee partner only, and that tax depreciation must be allocated under the principles of section 704(c)(1)(A).(77)

The following example illustrates the impact of this alternative:

Example 6. A and B are equal partners in partnership

PRS. PRS has one depreciable asset it purchased

with cash. On the first day of a year, A

transfers its interest to T for $25, when the fair

market value of the asset is $50 and its adjusted

basis is $200. The partnership has an election

under section 754 in effect, resulting in a negative

$75 basis adjustment to T, all of which is allocable

to the asset. The depreciable asset has a remaining

recovery period of 2 years.

The partnership elects to treat the negative adjustment

as an item of section 704(c) gain. For tax

purposes, this decreases the adjusted basis of the

property -- and the amount of depreciation that

the partnership can allocate -- from $200 to $125.

The election has no effect on allocations of book

depreciation. Thus, the partnership will recover

$100 of book depreciation each year, but only

$62.50 of tax depreciation. Under section 704(c)

principles, T is treated as the contributor, and B

is treated as the noncontributor. Over each of the

next 2 years, the partnership must allocate to B

$50 of book and tax depreciation. In each of these

years, the partnership will allocate to T $50 of

book depreciation, but only $12.50 of tax depreciation.(78)

For a number of reasons, the transferee typically will want to treat the negative basis adjustment as an item of built-in gain. For the same reasons, the other partners typically will not want such treatment. First, the transferee may be able to shift some of the tax consequences of the negative adjustment to the other partners. For instance, assume that, after T was admitted to the partnership in Example 6, the partnership agreement was amended to allocate all depreciation deductions to B. If the partnership did not make an election to treat the basis adjustment as an item of built-in gain, T would have to recognize $37.50 (1/2 of $75) of income in each year as a result of the negative basis adjustment. On the other hand, if the partnership made the election, T would not recognize any income as a result of the basis adjustment, but B's depreciation in each year would be reduced from $75 to $62.50.

Second, even if the transferee cannot shift the effect of the negative basis adjustment to another partner (because the partnership makes curative or remedial allocations), the election might permit the transferee to extend the period for recognizing the negative adjustment. For example, the partnership could presumably use the remedial allocation method to make allocations attributable to the adjustment and recover the negative adjustment over a new useful life, rather than over the remaining useful life of the asset. Such an election might also permit the transferee to change the character of some of the adjustment by electing to make curative allocations of gain on sale.(79)

A few issues concerning the application of this alternative are not clear. First, is the basis reduction permanent or is basis restored if the transferee sells or exchanges its interest at a gain? (Presumably, the reduction is permanent.) Second, is there any situation in which the IRS would view making this election as "abusive"? (Presumably, no.) Third, may this alternative be employed whenever there is a negative adjustment, or only in the event ordinary income would otherwise be recognized? (It appears, as should be the rule, that the Proposed Regulations contemplate that the alternative is always available.)(80) Fourth, may the partnership make curative or remedial allocations with respect to this deemed built-in gain? (Presumably, yes.) It would be helpful if the final regulations address these issues.

C. Effect of Adjustment on Transferee's Distributive Share of Gain or Loss. If a partnership sells an asset with respect to which a transferee has a basis adjustment (an "adjusted asset"), the transferee's distributive share of gain or loss equals:

(i) The transferee's share of the partnership's

tax gain or loss from the sale of the asset (including

remedial allocations of gain or loss under

Treas. Reg. [sections] 1.704-3(d)), less

(ii) The amount of the transferee's positive basis

adjustment (determined by taking into account

any prior recovery of the basis adjustment), or

plus

(iii) The amount of the transferee's negative basis

adjustment for the partnership asset (determined

by taking into account any prior recovery of the

basis adjustment)?

The following example illustrates this provision:

Example 5. In Year 1, A and B form equal partnership

PRS. A acquires its interest by contributing

nondepreciable, nonamortizable property with a

fair market value of $100 and an adjusted basis of

$150. B contributes $100 of cash. PRS elects to

make section 704(c) allocations under the remedial

allocation method. In Year 2, A sells its interest

to T for $100. Because the partnership has a section

754 election in effect at the time, T receives a

negative basis adjustment of $50.

The property is subsequently sold for $120, creating

a book gain of $20 and a tax loss of $30. The

book gain is allocated equally between B and T.

Under section 704(c)(1)(A), the entire tax loss of

$30 is allocated to T. To match B's $10 share of

book gain with tax gain, PRS makes a remedial

allocation of $10 of gain to B and an offsetting

allocation of $10 of loss to T. T's tax loss is therefore

$40 ($30 of loss allocated under normal section

704(c) principles plus a $10 remedial allocation

of loss). Under the Proposed Regulations, T's

$50 negative basis adjustment is "added" to T's

$40 loss, causing T to recognize a $10 gain.(82)

The result is logical from an economic perspective. The property appreciated by $20 after T acquired its partnership interest. Because T's share of that appreciation was $10, T should recognize $10 of gain on the disposition of the property.

The result is also logical from a tax perspective. T's share of the property's sale price was $60 (one-half of $120), and T's share of the partnership's basis in the property (taking into account T's $50 negative basis adjustment) was $50. The excess of $60 amount realized over $50 adjusted basis is T's $10 gain.

Note what the consequences would have been in Example 5 had PRS used the traditional allocation method. As in the example, the sale of the property for $120 would create a book gain of $20 and a tax loss of $30. The book gain would be allocated equally between B and T. Under Treas. Reg. [sections] 1.704-3(b), the entire tax loss of $30 would be allocated to T. Under the Proposed Regulations, T's $30 loss becomes a $20 gain because of the $50 negative basis adjustment.(83)

This result is also correct in light of the use of the traditional allocation method. The property appreciated by $20 since T's acquisition of its interest in PRS, and that $20 of economic appreciation should be recognized for tax purposes by the partners. But for the ceiling rule limitation, B and T would share equally the taxable gain, as this is how as they share the economic appreciation. Because of the limitation, however, T -- as the successor to the partner that contributed built-in loss property -- bears the entire burden of the gain, just as a contributor of built-in gain property would receive the entire tax benefit of any subsequent decline in the value of the contributed property.(84)

Although this result is consistent with the traditional method, it is inconsistent with the economics of the transaction. Whereas B and T share equally in the $20 economic appreciation from the property, T bears the entire tax burden for that amount. (This result would be corrected if the partnership liquidated immediately after the sale: B would receive $100 of cash, recognizing a $10 gain under section 731; T would also receive $100 of cash, but would recognize a $10 loss under section 731.)

VI. Transfers of Adjusted Property

The preceding discussion accounts for situations in which the partnership either holds the adjusted assets until they are fully depreciated or amortized or sells the assets in a taxable transaction. The Proposed Regulations also address situations in which the partnership disposes of adjusted assets in a tax-free transaction.

A. Distributions under Section 732. As under current law,(85) the Proposed Regulations provide that if a partnership distributes property to a partner and the partner has a basis adjustment with respect to such property, the basis adjustment is taken into account in determining the partner's basis in the distributed property under section 732.(86) Conversely, if a partner receives property with respect to which another partner has a basis adjustment, the distributee does not take the adjustment into account in computing its basis in the distributed property under section 732.(87) In that situation, the Proposed Regulations, like the current regulations,(88) provide that the adjustment is reallocated to other partnership properties in accordance with the regulations under section 755.(89)

Like the current regulations, the Proposed Regulations also provide that, if a partner receives property in liquidation of its interest in the partnership, any basis adjustment in undistributed property will be reallocated to property to be distributed to the partner. The partner will take such reallocated basis adjustments (and its previously allocated adjustments) into account in determining its basis in the distributed property under section 732. This provision ensures that the partner's basis in the distributed property reflects the partner's aggregate basis adjustment, regardless of whether the distributed property actually carries with it the partner's basis adjustment.

At first glance, it might not appear that these basis adjustment rules are particularly significant, because the partner's basis in any property distributed by the partnership will ultimately be determined under section 732.(90) These basis adjustment rules could affect the amount of basis allocable to ordinary income assets, however, because a partner's basis in such assets is limited under section 732(c) to the partnership's basis in those assets. Furthermore, the Proposed Regulations allow both positive and negative basis adjustments, whereas section 732(c) does not. Consequently, a partner's basis in distributed assets is more likely to approximate the fair market value of those assets if the partner's basis adjustment under section 743(b) is taken into account in determining its basis under section 732(c).

B. Contribution of Adjusted Property to a Corporation under Section 351. Until recently, it was unclear what happened to basis adjustments when a partnership contributed the adjusted property to a corporation m a section 351 transfer. The Proposed Regulations end this uncertainty by providing that the basis adjustment will carry over if a partnership elects to be classified as a corporation.(91) As a result, if a partnership incorporates, the corporation's basis in the contributed assets will generally include basis adjustments to the property, except for basis adjustments that reduce gain recognized under the rule discussed below.(92)

1. Positive Adjustments. Although the partners' basis adjustments generally carry over to the corporation, the Proposed Regulations provide that, in determining whether the partnership recognizes gain on the section 351 transaction, the partnership's basis in the contributed assets is determined without regard to any basis adjustment. If the partnership recognizes gain on the exchange, the amount of gain allocated to the partner with the basis adjustment in the transferred property is adjusted to reflect the basis adjustment. As a corollary, the Proposed Regulations provide that the partnership's basis in the stock received is determined without reference to the basis adjustment. Instead, the partnership's stock basis is determined under section 358(93) by reference to its basis in the contributed assets. A partner's basis adjustment in the contributed property, however, will carry over and attach to the stock received in the section 351 transfer, but will be reduced by the portion of the adjustment that reduced the partner's gain recognized on the transfer.(94)

The following example illustrates the mechanics of these rules:(95)

Example 7. A, B, and C are equal partners in

partnership PRS. PRS's only asset is Asset 1,

which has a value of $120. The partnership's adjusted

basis in Asset i is $60. Partner A has a

positive $20 basis adjustment in Asset 1. A's basis

in its PRS interest is $40. B and C both have

bases of $20 in their PRS interests. In a transaction

that qualifies under section 351, the partnership

contributes Asset I to

Newco, a domestic corporation,

in exchange for (i) 80

percent of Newco's stock with

a fair market value of $105

and (ii) $15 in cash. The partnership

realizes $60 of gain

on the transfer of Asset 1

($120 amount realized less

$60 adjusted basis), but recognizes

only $15 of that gain

-- the amount of boot received

in the transfer? Five

dollars of the partnership's

gain is allocated to A.

How much of A's basis adjustment is used to shield A from recognizing gain on the transfer? Although the intuitive answer is $5, this is probably not correct. Compare the situation in which PRS distributes undivided interests in Asset 1 to its partners and they contribute their interests to Newco in exchange for stock and $5 of cash. On the distribution from PRS, A would take a $40 basis in its interest in Asset 1.(97) When it contributed Asset 1 to Newco in exchange for Newco stock and $5 cash, A would recognize gain equal to the lesser of: (i) the gain realized on the transfer, that is, the fair market value of Asset 1 less its adjusted basis, or (ii) the amount of boot received? Because the value of A's interest in Asset 1 ($40) would not exceed A's basis in Asset 1 ($40), A would realize no gain on the transfer, and therefore A would recognize no gain on the transfer, despite the receipt of boot. If, on the other hand, A's basis in Asset i had only been $35, the entire $5 of boot would have been taxable to A, because A's gain on the transfer would have been $5. This comparison demonstrates that basis does not directly offset boot, it only reduces the gain realized on the transfer. Thus, to avoid recognition of any gain on the transfer, A's basis adjustment must be sufficiently large to prevent A from realizing any gain on the transfer, not just large enough to absorb the boot.

As mentioned above, the partnership realizes $60 of gain on its transfer to Newco, but recognizes only $15. A's share of the gain realized is $20 and its share of the boot is $5. To reduce its gain realized, and consequently, its gain recognized to $0, A must use the entire basis adjustment of $20.

To continue with the analysis, Newco's basis in Asset I equals the partnership's common basis in the asset ($60), plus A's special basis adjustment ($20), less the portion of the adjustment used to shelter A's gain on the section 351 transfer ($20).(99) Accordingly, Newco's basis in Asset I is $60. The partnership's basis in the Newco stock under the Proposed Regulations equal its basis in Asset 1 ($60), plus the gain it recognizes on the transfer. It appears from the Proposed Regulations that the gain the partnership recognizes on the transfer is computed before taking into account the basis adjustment, so that the partnership's gain in this example would be $15. Accordingly, the partner ship's basis in the Newco stock would be $75. A would have a special basis adjustment with respect to the Newco stock equal to its special basis adjustment in Asset 1 ($20), less the amount of the adjustment that reduced partner A's gain on the transfer ($20). Thus, A would have no special basis adjustment with respect to the Newco stock.(100)

The proposed requirement that the transferee corporation's carryover basis and the partner's basis adjustment be reduced by basis "that reduced the partner's gain" on the section 351 exchange is not consistent with the concepts underlying sections 351,358, and 743. Outside of the section 743 context, there is no rule that would require either the transferee corporation or the transferring shareholders to reduce basis to account for the fact that the shareholder's basis in the contributed assets shielded it from recognizing gain on the transfer. Hopefully, this inconsistency will be corrected in the final regulation. If it is not, most partnerships that receive boot in a section 351 transaction will be better off if they liquidate before incorporating. If the distribution occurs first, the corporation's basis in its assets and the partners' bases in the stock should at least equal the partnership's bases in the assets transferred, plus any basis adjustment the partners may have in those assets.

2. Negative Adjustments. Although the Proposed Regulations do not directly address the tax treatment of a negative basis adjustment in a section 351 transaction, the language strongly implies that the transferee corporation in a section 351 transaction takes a negative basis adjustment into account in its entirety, and that the additional gain inherent in the adjustment is not triggered on the exchange. This implication (or the authors' inference) arises from the language of the Proposed Regulations that excepts from the general carryover basis rule only basis adjustments that reduce gain.(101) A negative adjustment reduces loss or increases gain, it never reduces gain.

If this interpretation is correct, partnerships whose partners have negative basis adjustments and who will receive boot in a section 351 exchange will generally find that it is preferable to incorporate before liquidating. If the partnership liquidates before it incorporates, then the partners' lower bases in the partnership assets will be taken into account. As a result, some partners may not have enough basis to absorb the gain that would otherwise be recognized on the receipt of boot.

C. Contribution of Adjusted Property to Another Partnership under Section 721. The Proposed Regulations also address the consequences of a partnership's contribution of adjusted property to another partnership.(102) As is the case with transfers to corporations, the Proposed Regulations provide that, if a partnership contributes adjusted property to another partnership, the lower-tier partnership's basis in the contributed property is determined "with reference to the basis adjustment," regardless of whether the lower-tier partnership has a section 754 election in effect. Similarly -- in contrast with the rule regarding section 351 transfers -- the Proposed Regulations provide that the upper-tier partnership's basis in the lower-tier partnership is determined with reference to the basis adjustment. The Proposed Regulations further provide, however, that the portion of the upper-tier partnership's basis in the lower-tier partnership interest attributable to the basis adjustment must be "segregated" and allocated solely to the transferee partner in respect of whom the basis adjustment was made.(103) In addition, the lower-tier partnership must segregate that portion of its basis in its assets attributable to the basis adjustment and allocate it solely to the upper-tier partnership.(104)

VII. Information-Reporting Requirements

Under current law, the information-reporting requirements with respect to basis adjustments are not entirely clear. The Proposed Regulations clarify, however, that, if a partnership has a section 754 election in effect and is notified of a transfer (or the death of a partner), the partnership bears the record-keeping and information-reporting burdens.

To meet its reporting requirements, the partnership must attach a statement to its return for the year of the transfer that sets forth the name and taxpayer identification number of the transferee as well as the computation of the basis adjustment and the partnership properties to which the adjustment is allocated under section 755.(105) In determining the amount of the basis adjustment, a partnership may rely on written notice provided by a transferee to determine the transferee's basis unless the tax matters partner or any other partner responsible for tax filings has knowledge of facts indicating that the statement is clearly erroneous.(106)

To ensure that the partnership has the information it needs to meet these burdens, the Proposed Regulations require that a transferee that acquires, by sale or exchange, an interest in a partnership must notify the partnership within 30 days of the sale or exchange (or, if earlier by January 15th of the calendar year following the calendar year in which the exchange took place).(107) The statement must include the names, addresses, and taxpayer identification numbers of the transferee and transferor, the date of the transfer, and the amount of money or fair market value of property transferred for the interest.(108) Apparently, no penalties apply to a transferee that fails to provide this statement.

Significantly, a partnership is not required to adjust the basis of partnership property until it has been notified of the transfer. For this purpose, a partnership is considered notified when (i) the partnership receives notice as required under the Proposed Regulations, or (ii) the tax matters partner or any other partner having filing responsibility has knowledge that there has been a transfer.(109) Unfortunately, the Proposed Regulations do not explain what circumstances would cause a partner having filing responsibility to be deemed to have knowledge of a transfer. Nor do the Proposed Regulations explain what would cause a partner having filing responsibility to have knowledge that a transferee's notice as to the basis of its partnership interest is clearly erroneous.

If a transferee fails to notify a partnership, the partnership must attach a statement to its return for the year that the partnership is otherwise notified. This statement must set forth the transferee's name and taxpayer identification number (if known). In addition, the following statement must be prominently displayed in capital letters on the first page of the partnership's return for such year, and on the first page of any schedule or information statement relating to such transferee's share of income, deduction, or credits: "RETURN FILED PURSUANT TO TREAS. REG. [sections] 1.743-1(k)(5)."(110) The partnership will then be entitled to report the transferee's share of partnership items without adjusting those shares to reflect the transferee's basis adjustment in the partnership property. If, in a subsequent year, the transferee provides the applicable written notice to the partnership, the partnership must make such adjustments as are necessary to adjust the basis of partnership property (as of the date of transfer).(111) Although the Proposed Regulations are not entirely clear, if a positive basis adjustment should have been made to the basis of depreciable or amortizable property, the adjustment will presumably be treated as having been made as of the date of the transfer,(112) and the only way for the transferee to claim the entire benefit of the adjustment will be for the transferee to amend its tax returns for open years. Query whether the Proposed Regulations intend to require transferees to amend their returns if negative adjustments should have been made. As these rules place a premium on ensuring that transferee partners timely notify partnerships of their acquisition of partnership interests, partnerships may want to consider including in their partnership agreements a provision that voids transfers of partnership interests if the transferee does not notify the partnership of the transfer within 30 days.

Another issue related to reporting requirements is the manner in which the recovery of a transferee's basis adjustment should be presented on Form 1065 and Schedule K-1. IRS officials have indicated that the recovery of a transferee's basis adjustment should be netted with or added to the appropriate distributive share item, and only the total amount should be reflected on the appropriate line on Schedule K-1.(113) For example, a transferee's additional depreciation expense resulting from the recovery of a positive basis adjustment would be added to the transferee's distributive share of depreciation expense. The total depreciation expense would then be incorporated into the transferee's ordinary income or loss from the partnership (line i of Schedule K-1 for trade or business activities). Thus, there is apparently no need to state separately the recovery of a transferee's basis adjustment on Schedule K-1. This conflicts, however, with the statement in the Preamble on the interaction of remedial allocations and the recovery of basis adjustments:

If a partnership [sic] receives remedial allocations

of income under [sections] 1.704-3(d) with respect to an

item of adjusted partnership property, the partner

does not offset the cost recovery deductions

from the property against the remedial allocations

of income. Rather, the partner will receive

an allocation of remedial income and a separate

cost recovery deduction.(114)

The final regulation should specifically address this compliance issue.

These rules seem sensible from a tax policy perspective, for the partnership is more likely than the transferee-partner to have the information necessary to compute, allocate, and recover a basis adjustment. On the other hand, the new recordkeeping requirements add to an already burdensome and expensive compliance process and ultimately may prove to be unworkable for some partnerships, particularly those that are publicly traded. Moreover, the rule may be impractical in the international context. Even if a taxpayer that acquires an interest in a foreign partnership is able to convince that partnership to file a Form 1065 for the sole purpose of making a section 754 election,(115) it is unlikely that the foreign partnership will undertake the necessary compliance burdens. Therefore, the final regulation should provide alternative means for taxpayers to claim the benefits of a basis adjustment.

VIII. Conclusion

The Proposed Regulations are a dramatic improvement over the current regulations and a piece of handiwork in their own right. With a few exceptions, the methodology of the Proposed Regulations is logical and provides results that should be contemplated by a transferee of an interest. Moreover, the Proposed Regulations largely achieve the original intention of section 743(b) -- the application of the aggregate concept to partnership interest transfers where the partnership makes a section 754 election. Although the Proposed Regulations will be welcomed by most taxpayers, they represent a dramatic change from more than four decades of practice. Therefore, the IRS and Treasury should provide that partnerships may use either the current or new regulations for a one-year period(116) and should permit partnerships that have section 754 elections in effect for years ending before the regulations are issued in final form to revoke those elections.

Notes

(1) As used in this article, the term "partnership" includes any entity or business arrangement classified as a partnership for federal income tax purposes.

(2) Treas. Reg. [subsections] 301.7701-2 and -3.

(3) For the lamentations of a consolidated return expert, see Lawrence M. Axelrod, Are Consolidated Returns Obsolete?, 74 Tax Notes 89 (1997).

(4) Unless otherwise indicated, all references are to the Internal Revenue Code of 1986, as amended.

(5) 63 Fed. Reg. 4408-4426 (Jan. 29, 1998) (the "Preamble"). (References are to the page numbers of the "hard copy" of the regulations available from the Federal Register.) Proposed regulations under section 1017 were also issued dealing with the computation of a partner's proportionate share of the adjusted basis of depreciable property.

(6) I.R.C. [sections] 743(a).

(7) This general rule reflects the "entity" as opposed to the "aggregate" view of partnerships. The exception set forth in section 743(b), which is the subject of this article, reflects the aggregate view. For a discussion of the entity and aggregate theories of partnership taxation, see Alfred D. Youngblood & Deborah B. Weiss, Partners and Partnerships -- Aggregate vs. Entity Outside of Subchapter K, 48 Tax Law. 39 (Fall 1994); see also James L. Dahlberg, Aggregate vs. Entity: Adjusting the Basis of Stock in a Subsidiary Filing a Consolidated Return, 42 Tax L. REV. 547 (Spring 1987); Bradley M. Seltzer & J. Randall Buchanan, The Consequences of Electing Out of Subchapter K, 44 The Tax Executive 4 (July-August 1992).

(8) I.R.C. [sections] 743(b). If a transferee pays less for its partnership interest than its share of inside basis, section 743(b) acts to decrease the transferee's share of inside basis. There are various planning techniques to avoid such a decrease.

(9) S. Rep. No. 1622, 83d Cong., 2d Sess. 406 (1954). Pre-1954 case law generally supported an entity approach. See, e.g., Wasson v. United States, 56-2 U.S.T.C. [paragraph] 9886 (N.D. Tex. 1956); Estate of Lowenstein v. Commissioner, 12 T.C. 694 (1946).

(10) Treas. Reg. [subsections] 1.743-1(b)(1) and 1.755-1(a). For detailed discussions of sections 743(b), 755, and the current regulations, see Arthur B. Willis, John S. Pennell, & Philip F. Postlewaite, Partnership Taxation (Warren, Gorham & LaMont 4th ed. 1997) ("Willis") [paragraph] 12.03 (section 743(b)), [paragraph] 12.04 (section 755)); William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships And Partners (Warren, Gorham & LaMont 3d Ed. 1997) ("McKee, Nelson & Whitmire") [paragraph] 24.02 (section 743(b)), [paragraph] 24.04 (section 755); John B. Palmer III, Dispositions of Partnership Interests-Sales and Exchanges, 32 Tax Mgt. (BNA) Portfolio No. 237 (1986)); Alan T. Barber, Optional Basis Adjustments to Partnership Property: An Analysis of the Special Election, 3 J. P. Tax. 242 (Fall 1986); John S. Pennell & Philip F. Postlewaite, Adjusting the Basis of Assets in Tiered Partnerships Under the IRS' Questionable New Ruling, 77 J. Tax. 4 (July 1992).

(11) T.D. 6175, 1956-1 C.B. 211.

(12) Section 704(c) property generally is property that was contributed to the partnership with a fair market value different from its adjusted basis. Such property is subject to the provisions of section 704(c)(1)(A), which requires that partnerships specially allocate tax items to account for built-in gain or loss. Built-in gain is the excess of a property's 704(b) book value over its tax basis, as adjusted for allocations of depreciation and other cost recovery. Built-in loss is the excess of the property's adjusted tax basis over its 704(b) book value. Treas. Reg. [sections] 1.704-3 provides three methods for accounting for such amounts, two of which address "ceiling rule" limitations. For a brief description of these methods and the ceiling rule limitation, see Eric B. Sloan, Partnerships After the Taxpayer Relief Act of 1997: A Review, 76 Tax Notes 1747, 1755 nn. 86-89 (1997). For a more detailed discussion of section 704(c)(1)(A), see Laura Cunningham, Use and Abuse of Section 704(c), 3 Fla. Tax Rev. 93-94 (1996); John G. Schmalz, Mark B. Brumbaugh, & Roger F. Pillow, Section 704(c) and Related Issues: Tax Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures, and Other Strategic Alliances, 621 (Practising Law Institute 1997).

(13) I.R.C. [sections] 743(b). Certain transfers (such as gifts) do not constitute sales or exchanges or permit the transferee to receive a basis adjustment. If a partnership interest transferred in a non-sale or exchange transfer has a basis adjustment attached to it, however, the basis adjustment will carry over to the transferee. Prop. Reg. [sections] 1.743-1(f). See Treas. Reg. [sections] 1.1015-1(b) (suggesting a similar result under current law).

(14) I.R.C. [sections] 1001(b).

(15) I.R.C. [sections] 761(e).

(16) I.R.C. [sections] 761(e); Rev. Rul. 92-15, 1992-1 C.B. 15.

(17) Rev. Rul. 87-110, 1987-2 C.B. 159; See also Temp. Reg. [sections] 1.367(a)-1T(c)(3).

(18) Private Letter Ruling 8229034 (Apr. 20, 1982); Private Letter Ruling 8116041 (Jan. 21, 1981); but cf. Private Letter Ruling 8819083 (Jan. 12, 1988) (holding that the creation of a holding company partnership is not a sale or exchange for purposes of section 708(b)(1)(B)).

(19) Rev. Rul. 87-110, 1987-2 C.B. 159. See General Counsel Memorandum 39673 (Oct. 23, 1987).

(20) Some commentators believe that nonrecognition transactions should not constitute sales or exchanges for purposes of section 743(b) on the theory that a transferee's basis adjustment "offsets" the transferor's gain. See Willis at [paragraph] 12.0319]. There is, however, no requirement that the sale or exchange be taxable to the seller; indeed, it is absolutely clear that the buyer's basis adjustment is determined without regard to the gain recognized by the seller. See also Treas. Reg. [sections] 1.1002-1(c)(describing certain nontaxable transactions as "exchanges").

(21) Prop. Reg. [sections] 1.755-1(b)(1).

(22) The two leading treatises appear to take somewhat differing approaches in determining the amount of the adjustment. Compare Willis at [paragraph] 12.0315] with McKee, Nelson & Whitmire at [paragraph] 24.02.

(23) Prop. Reg. [sections] 1.743-1(d)(2).

(24) Of course, the transferee also will be subject to tax to the extent that its share of the partnership's depreciation is recaptured.

(25) See Treas. Reg. [sections] 1.704-2(f) (regarding partnership minimum gain chargeback); Treas. Reg. [sections] 1.704-2(i)(4) (regarding partner nonrecourse debt minimum gain chargeback).

(26) Prop. Reg. [sections] 1.743-1(c). If a partner acquires its partnership interest other than by contribution, the partner determines its basis in its interest under the rules generally applicable to the acquisition of property, i.e., I.R.C. [subsections] 742, 1011 to 1015. For example, the basis of a purchased interest is its cost under Treas. Reg. [sections] 1.742-1, plus the share of partnership liabilities allocated to that interest under section 752.

(27) Prop. Reg. [sections] 1.743-1(d). Because liabilities are also included in determining the partners' outside basis, they cancel out in determining the amount of the basis adjustment. Therefore, the basis adjustment is actually the difference between the purchase price for the partnership interest (disregarding the transferee's share of partnership liabilities) and the transferee's interest in the partnership's previously taxed capital.

(28) Treas. Reg. [sections] 1.704-1(b)(2)(iv).

(29) Under Treas. Reg. [sections] 1.704-1(b)(2)(iv)(l), the capital account of the transferor that is attributable to the transferred interest carries over to the transferee.

(30) Prop. Reg. [sections] 1.743-1(d)(2)(i)-(iii).

(31) Prop. Reg. [sections] 1.743-1(d)(2)(i)-(iii).

(32) Treas. Reg. [sections] 1.743-1(b)(2)(iv).

(33) Prop. Reg. [sections] 1.743-1(f).

(34) When A contributed Asset I to PRS, the asset had $600 of unrealized, or "section 704(c) gain." As A's transferee, T succeeds to A's section 704(c) gain with respect to Asset 1. Treas. Reg. [sections] 1.704-3(a)(7).

(35) Prop. Reg. [sections] 1.743-1(d)(3), Example (2).

(36) Prop. Reg. [sections] 1.755-1(a).

(37) Indeed, much of the complexity of the Proposed Regulations seems to stem from the drafters' desire (or need) to pay lip service to the language of the Code.

(38) Treas. Reg. [sections] 1.755-1(a)(1)(i).

(39) Prop. Reg. [sections] 1.755-1(b)(1). Some commentators have suggested that the IRS has no authority to permit partnerships to make both positive and negative adjustments under section 755 with respect to a section 743(b) adjustment, citing the 1954 legislative history underlying section 755. Partnerships have had such latitude, with the consent of the District Director, for almost 40 years. See Treas. Reg. [sections] 1.755-1(a)(1)(i).

(40) Prop. Reg. [sections] 1.755-1(b)(1).

(41) This occurs because the value of goodwill determined under Temp. Reg. [sections] 1.755-2T, which employs a residual method, will reduce the value of partnership goodwill to reflect the discount until the value of goodwill is reduced to zero. To the extent that the transferee's inside basis in goodwill exceeds this deemed value, the Proposed Regulations will require a negative basis adjustment.

For example, assume that A sells a 50-percent partnership interest to T for $200 when the partnership has two capital assets: Asset 1, with a fair market value of $600 and an adjusted basis of $400, and goodwill, with a basis of $200. Under Temp. Reg. [sections] 1.755-2T(a)(2), the value of Asset I would be deemed to be $600, and the value of the partnership's goodwill would be deemed to be $0. Because the value of T's share of partnership assets is $300, but T only paid $200 for its interest, T acquired its interest at a $100 discount.

Absent the discount, T's positive basis adjustment to Asset 1 would be $100 (1/2 of $200 unrealized gain), and T's negative basis adjustment to the goodwill would be $100 (1/2 of $200 unrealized loss). T must, however, reduce its basis adjustment to reflect the $100 discount. Because the goodwill has a fair market value of zero, all of the discount is allocated to Asset 1. As a result, T's positive basis adjustment to Asset 1, which would otherwise be $100, is reduced to $0, and T's entire $100 negative basis adjustment is allocated to the goodwill.

(42) Prop. Reg. [sections] 1.755-1(b)(2)(i). Under Temp. Reg. [sections] 1.755-2T(a)(2) (applying the residual method for valuing goodwill to basis adjustments), any discount will first reduce the transferee's basis in the partnership's goodwill.

(43) Prop. Reg. [sections] 1.755-1(b)(2)(i)(B).

(44) Temp. Reg. [sections] 1.755-2T(a)(2).

(45) Prop. Reg. [sections] 1.755-1(b)(2)(ii), Example 1.

(46) Although this would cause a technical termination of the partnership under section 708(b)(1)(B), the termination is ignored for purposes of this example.

(47) See Prop. Reg. [sections] 1.755-1(b)(3)(ii), Example (2).

(48) Notwithstanding the complicated formula in the Proposed Regulations, an asset shares the cut-back in accordance with its fair market value. In the example above, the discount is $10.00, Asset 3 is worth $75, and Asset 4 is worth $117.50. Asset 3 therefore shares 39 percent of the $10 discount, or $3.90, and Asset 4 shares 61 percent of the $10 discount, or $6.10.

(49) I.R.C. [sections] 704(c)(1)(A); Treas. Reg. [sections] 1.704-3(a)(1).

(50) See, e.g., Treas. Reg. [sections] 1.704-3(b)(1) (describing the "traditional" allocation method).

(51) Treas. Reg. [sections] 1.704-3(a)(7).

(52) Treas. Reg. [sections] 1.704-3(b)(1).

(53) Regardless of whether a ceiling rule distortion occurs, the contributing partner ultimately will recognize the built-in gain or loss, either on the disposition of its partnership interest for cash or on the disposition of any property received from the partnership in liquidation of its partnership interest. When it works properly, section 704(c) only causes the partner to recognize the built-in gain faster.

(54) See Treas. Reg. [sections] 1.704-3(c)(1) (permitting use of curative method); [sections] 1.704-3(d)(1) (permitting use of remedial method).

(55) Treas. Reg. [subsections] 1.755-1(a)(1)(ii) & (iii).

(56) Depreciation and other cost recovery are items of deduction from the contributed property that must be allocated to take into account the built-in gain or loss. See, e.g., Treas. Reg. [sections] 1.704-3(b)(1).

(57) Prop. Reg. [sections] 1.168-2(n) (withdrawn by the recent Proposed Regulations); Prop. Reg. [sections] 1.743-1(j)(4), (i)(B).

(58) See supra note 12. This solution probably works, however, only if the partnership opted for fungibility when it was formed. If the partnership did not make remedial or curative allocations before the transfer by one of its partners of a partnership interest, the partnership probably cannot start making those allocations when the transferee enters the partnership. Treas. Reg. [sections] 1.704-3(a)(2) requires that a partnership consistently apply a single method for each item of contributed property.

(59) Prop. Reg. [sections] 1.743-1(j)(4)(i)(B)(1). Any applicable recovery period and method may be used to determine the recovery allowance with respect to the basis adjustment. Id.

(60) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(B). Although the Proposed Regulations are not clear on this point, the applicable recovery period should, as a technical matter, be the book recovery period.

(61) Treas. Reg. [sections] 1.704-3(d). Under the remedial method, book basis is recovered by bifurcating the contributed property into two parts. The carryover basis portion is depreciated for book and tax purposes over the property's remaining recovery period. The built-in gain portion (or "excess book basis") is recovered for book purposes over a new recovery period as if the partnership purchased the property on the day the property was contributed to the partnership. Treas. Reg. [sections] 1.7043(d)(2).

(62) Prop. Reg. [sections] 1.743-1(j)(4)(i)(B)(2); see also Treas. Reg. [sections] 1.7043(d)(2).

(63) This example ignores applicable depreciation conventions.

(64) The partners' capital accounts would be as follows: AB

(65) T's basis adjustment is equal to the excess of T's basis in its partnership interest, $440, over T's share of the adjusted basis of partnership property, $120.

(66) The preceding portion of this example is drawn from Prop. Reg. [sections] 1.743-1(j)(4)(ii)(C), Example 2.

(67) In each of the first 3 years after T acquires its interest, T's net depreciation deduction from the property (after taking into account the basis adjustment and remedial allocations of income to T) is $30 ($40 of depreciation from the basis adjustment less $10 remedial allocation of income). In each of the next 5 years, T's net depreciation deduction from the property will be $20 ($40 of depreciation from the basis adjustment less $20 remedial allocation of income).

(68) The Preamble states that the "first" dollars of a basis adjustment are deemed to be attributable to section 704(c) amounts. Thus, section 704(c) amounts attract basis adjustments in much the same manner as minimum gain (and "section 704(c) minimum gain") attracts debt under Treas. Reg. [sections] 1.752-3(a)(1). Preamble at 11.

(69) Prop. Reg. [sections] 1.743-1(j)(1).

(70) Prop. Reg. [sections] 1.743-1(j)(2).

(71) Prop. Reg. [sections] 1.743-1(j)(4)(i)(A). The amount of the basis adjustment, which is treated as additional basis, is adjusted under section 1016 to reflect the recovery of the basis adjustment.

(72) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(A)(1).

(73) This presumably includes cost recovery attributable to positive basis adjustments to other properties, although the Proposed Regulations are not clear on this point.

(74) Prop. Reg. [sections] 1.755-1(b)(2)(i)(B).

(75) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(A)(2). The election must be made by the partnership on the "statement of adjustment" attached to the partnership's tax return for the year in which the adjustment is initially made.

(76) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(A)(2). Basis adjustments generally do not affect a partner's section 704(b) capital account. Treas. Reg. [sections] 1.704-1(b)(2)(iv)(m)(2). But see Treas. Reg. [sections] 1.704-1(b)(2)(iv)(m)(4) (providing for capital account adjustment where unused basis adjustment is transmuted into a section 734(b) adjustment pursuant to Treas. Reg. [sections] 1.743-1(b)(2)(ii)).

(77) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(C), Example 4(iii).

(78) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(C), Example 4.

(79) This option would be available only to the extent that the adjustment recovered in any year exceeded the transferee's share of depreciation for that year. Furthermore, this option would be unfavorable to the other partners because it would convert their depreciation deductions to capital loss (or reduced capital gains).

(80) Prop. Reg. [sections] 1.743-1(j)(4)(ii)(A)(2).

(81) Prop. Reg. [sections] 1.743-1(j)(3)(i).

(82) Prop. Reg. [sections] 1.743-1(j)(3)(i).

(83) Prop. Reg. [sections] 1.743-1(j)(3)(i). Interestingly, this result would not occur if the contributed property had appreciated before T purchased the partnership interest so that T purchased its interest for $110. In that case, T would have had only a $40 negative basis adjustment and would have recognized $10 of gain on the subsequent sale of the property.

(84) See Prop. Reg. [sections] 1.743-1(j)(3)(ii), Example 2 (confirming this result).

(85) Treas. Reg. [sections] 1.743-1(b)(2)(ii).

(86) Prop. Reg. [sections] 1.743-1(g)(1)(i).

(87) Prop. Reg. [sections] 1.743-1(g)(2)(i).

(88) Treas. Reg. [sections] 1.743-1(b)(2)(ii).

(89) Prop. Reg. [sections] 1.743-1(g)(2)(ii).

(90) Prop. Reg. [sections] 1.743-1(g)(1)(i).

(91) Prop. Reg. [sections] 1.743-1(h)(2)(i). The same rule is included in the recent proposed regulations relating to conversions under the check-the-box entity classification rules. Prop. Reg. [sections] 1.743-2(a) (Oct. 28, 1997).

(92) Prop. Reg. [sections] 1.743-1(h)(2)(i).

(93) Under section 358, the partnership's basis in the stock received would generally equal the basis of the assets transferred, decreased by the amount of money or fair market value of property other than stock that the partnership received in the exchange, and increased by the gain the partnership recognized on the exchange.

(94) Prop. Reg. [sections] 1.743-1(h)(2)(iii).

(95.) This example is based on the authors' interpretation of the Proposed Regulations.

(96) Under section 351(b)(1), gain is recognized only to the extent of boot. If the partnership had contributed more than one asset to the corporation, the stock consideration and the boot would have to be allocated among the assets transferred in accordance with their relative fair market values. See Rev. Rul. 68-55, 1968-1 C.B. 140 (method of allocating boot received in a section 351 transfer); Joel Rabinovitz, Allocating Boot in Section 351 Exchanges, 24 T L. Rev. 337 (1969).

(97) I.R.C. [sections] 732(b); Prop. Reg. [sections] 1.743-1(g)(1)(i).

(98) I.R.C. [sections] 351(b)(1).

(99) Prop. Reg. [sections] 1.743-1(h)(2)(i).

(100) Prop. Reg. [sections] 1.743-1(g)(2)(iii).

(101) Prop. Reg. [sections] 1.743-1(b)(2)(i).

(102) This rule also applies to partnerships that terminate under section 708(b)(1)(B), regardless of whether the "new" partnership makes a section 754 election. Prop. Reg. [sections] 1.743-1(h)(1). A partnership terminates under section 708(b)(1)(B) if, during any 12-month period, 50 percent or more of the interests in the capital and profits of the partnership are sold or exchanged.

(103) Prop. Reg. [sections] 1.743-1(h)(1).

(104) Although the Proposed Regulations do not specifically incorporate the tiered partnership basis adjustment rules set forth in Rev. Rul. 87-115, 1987-2 C.B. 163, that revenue ruling should continue to apply. The ruling holds that a lower-tier partnership's assets may be adjusted under section 743(b) when an interest in the upper-tier partnership is transferred, but only if both partnerships make a section 754 election. The transferee's "outside basis" in the lower-tier partnership is deemed to be its share of the upper-tier partnership's basis in the lower-tier partnership (including any basis adjustments personal to the transferee). The transferee's inside basis in the lower-tier partnership's assets is deemed to be the upper-tier partnership's inside basis in those assets multiplied by the transferee's percentage interest in the upper-tier partnership. See also Rev. Rul. 92-15, 1992-1 C.B. 215 (similar rules apply to basis adjustments under section 734(b)).

(105) Prop. Reg. [sections] 1.743-1(k)(1).

(106) Prop. Reg. [sections] 1.743-1(k)(3).

(107) Prop. Reg. [sections] 1.743-1(k)(2)(i). A transferee of a decedent's interest must notify the partnership within one year of the death of the partner. Prop. Reg. [sections] 1.743-1(k)(2)(ii). The requirements are identical to those requirements that apply to an exchange of a partnership interest, except that the transferee must disclose the value of the partnership interest on the applicable valuation date as determined under section 1014.

(108) Prop. Reg. [sections] 1.743-1(k)(2)(i). These rules are similar to the requirements provided in section 6050K, dealing with section 751(a) sales or exchanges.

(109) Prop. Reg. [sections] 1.743-1(k)(4).

(110) Prop. Reg. [sections] 1.743-1(k)(5). A partner's share of income, deduction, or credits, etc. is generally reported on Schedule K-1 of Form 1065.

(111) Prop. Reg. [sections] 1.743-1(k)(5).

(112) This follows from the provisions of section 1016(a)(2) that basis is reduced by any depreciation or amortization deductions that are "allowed or allowable."

(113) Remarks of Paul F. Kugler, Assistant Chief Counsel (Passthroughs and Special Industries), at a March 12, 1998, Meeting of the Federal Bar Association, Washington, D.C.

(114) Preamble at 13.

(115) Prop. Reg. [sections] 1.6031(b)-(3)(ii).

(116) Treas. Reg. [sections] 1.708-1(b)(1)(iv) provides similar latitude to partners in partnerships that terminate on or after May 9, 1996, and before May 9, 1997 ("the transition period"). The new regulations generally apply to terminations of partnerships under section 708(b)(1)(B) that occur on or after May 9, 1997. In addition, the new regulations may be applied to section 708(b)(1)(B) terminations that occur during the transition period, provided that the partners and the partnership apply the regulations consistently. Thus, for terminations occurring during the transition period, partners may elect either set of regulations.

(*) Notes appear beginning on page 281.

ERIC B. SLOAN is a principal in the National Tax Office of Deloitte & Touche LLP in Washington, D.C. and an Adjunct Professor of Law at the Georgetown University Law Center. He specializes in the use of partnerships in mergers and acquisitions and corporate financing transactions. DEBORAH A. HARRINGTON, formerly an Assistant Branch Chief in the IRS's Office of Passthroughs and Special Industries, is a senior manager in the same office of Deloitte & Touche LLP. She specializes in the use of partnerships in real estate transactions. SCOT A. MCLEAN is a manager in the same office of Deloitte & Touche LLP.

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