Allocation of basis among properties distributed by partnerships.

Partnership distributions are generally tax-free to the partners. In a nonliquidating distribution, the distributee partner's property basis is equal to the partnership's adjusted property basis immediately before the distribution, but cannot exceed the partner's adjusted basis in the partner's partnership interest (reduced by any money distributed in the same transaction). In a liquidating distribution, the total basis of all property distributed is equal to the distributee partner's adjusted basis in the partner's partnership interest immediately before the distribution (reduced by any money distributed in the same transaction). When multiple properties are distributed in a liquidating distribution or when the total carryover basis of the distributed properties exceeds the partner's basis in his partnership interest, an allocation provision is needed to assign a portion of the partner's basis in the partner's partnership interest to each distributed asset.

Prior to the Taxpayer Relief Act of 1997 (TRA `97), a partner's basis was allocated first to unrealized receivables and inventory items (as defined in Sec. 751) up to their bases in the partnership's hands (in proportion to the partnership's bases in these assets). Any excess was allocated among other properties in proportion to their adjusted bases to the partnership (former Sec. 732(c)).

Example 1--Unrealized Appreciation (Pre-TRA '97): A partner with a basis of $190,000 in his partnership interest receives a distribution from the partnership in liquidation of that interest consisting of investment property X, with a basis in the partnership's hands of $20,000 and a fair market value (FMV) of $80,000, and investment property 15, with a basis in the partnership's hands of $90,000 and an FMV of $100,000. Neither asset consists of inventory or unrealized receivables. The basis allocation would be made as follows:

                               X                    Y

Adjusted basis
in the partnership's
hands                        $ 20,000           $ 90,000

Ratio                         18.18%             81.82%

Partner's basis
in his partnership
interest                     $ 190,000          $ 190,000

Basis in distribu-
tee's hands                  $ 34,545           $ 155,455

Proceeds from
immediate sale
at FMV                       $ 80,000           $ 100,000

Gain/ (loss)                 $ 45,455          ($ 55,455)

Example 2--Unrealized Depreciation (Pre-TRA '97): A partner with a basis of $2,000 in his partnership interest receives a distribution from the partnership in liquidation of his interest consisting of property X, with a basis in the partnership's hands of $1,500 and an FMV of $1,500, and property Y, with a basis in the partnership's hands of $1,500 and an FMV of $500. Neither asset consists of inventory or unrealized receivables. The basis allocation would be made as follows:

                               X                    Y

Adjusted basis
in the partnership's
hands                        $ 1,500            $ 1,500

Ratio                          50%                50%

Partner's basis
in his partnership
interest                     $ 2,000            $ 2,000

Basis in distribu-
tee's hands                  $ 1,000            $ 1,000

Proceeds from
immediate sale
at FMV                       $ 1,500            $ 500

Gain/ (loss)                 $ 500             ($ 500)

Section 1061 of the TRA `97 changed the manner in which a partner's basis in its partnership interest is allocated among multiple properties distributed by the partnership to a partner in a liquidating distribution and in a nonliquidating distribution, when the partnership's basis in the distributed properties exceeds the distributee partner's basis in his partnership interest. The basis allocation now takes into account the relative unrealized appreciation or unrealized depreciation contained in the distributed assets, when there is a difference between a partner's outside basis for his partnership interest and his share of the inside basis of the partnership assets distributed to him. Prior to the TRA '97, the allocation provision failed to take into account the actual FMVs of the partnership's distributed assets; partners tried to get increased depreciation deductions or artificial losses. Following a liquidating distribution, a partner could have a basis in the distributed property (other than unrealized receivables and inventory) that exceeded the partnership's own basis in that property. This led to many basis-shifting transactions in which basis was artificially increased, giving rise to inflated depreciation deductions or artificially large losses. Under new Sec. 732(c), when multiple properties are distributed in a liquidating distribution or when the total carryover basis of the distributed properties exceeds the partner's basis in his partnership interest, the partner's basis in his partnership interest is allocated as follows:

* First, to any unrealized receivables and inventory items in an amount equal to the adjusted basis of each such property to the partnership. If the basis to be allocated is less than the sum of the adjusted bases of these properties in the partnership's hands, a basis decrease is applied. If the partner does not have enough available basis to cover the full amount of the partnership's basis in unrealized receivables and inventory, the shortfall in available basis must be allocated among the unrealized receivables and inventory. Under both the old law and new law, the partner's basis is first allocated to these items to the extent of the partnership's basis immediately prior to the distribution. In no circumstances can more basis be allocated to these assets than the amount of the partnership's basis immediately before the distribution.

* To the extent any basis is not allocated under the above rule, basis is allocated to other distributed properties by assigning to each property its adjusted basis in the partnership's hands and then increasing or decreasing the basis (to the extent any increase or decrease is required) for the adjusted bases of the other distributed properties to equal the remaining basis under the rules described below.

* Any basis increase required under the above rules is allocated (1) first to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation before such increase (but only to the extent of each property's unrealized appreciation) and (2) to the extent the required increase is not allocated under (1), in proportion to the properties' respective FMVs.

* Any basis decrease required under the above rules is allocated (1) first to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation before such decrease (but only to the extent of each property's unrealized depreciation) and (2) to the extent the required decrease is not allocated under (1), in proportion to the properties' respected bases (as adjusted under (1)).

Example 3--Unrealized Appreciation (TRA '97): The facts are the same as in Example 1. The basis allocation would now be made as follows:

                              X                   Y

First $110,000 of
distributee partner's
outside basis--equal
to partnership's
adjusted basis               $ 20,000           $ 90,000

Remaining $80,000
of distributee
partner's outside
basis--based on
relative unrealized
appreciation                 $ 68,571           $ 11,429

Basis in distribu-
tee's hands                  $ 88,571           $ 101,429

Proceeds from
immediate sale
at FMV                       $ 80,000           $ 100,000

Gain/(loss)                 ($8,571)           ($1,429)

Example 4--Unrealized Depreciation (TRA '97): The facts are the same as in

Example 2. The basis allocation would now be made as follows:

                                     X                 Y

First $3,000 of
distributee partner's
outside basis--equal
to partnership's
adjusted basis                    $ 1,500           $ 1,500

$1,000 shortfall of
distributee partner's
outside basis--
based on relative
unrealized
depreciation                          0             ($1,000)

Basis in distribu-
tee's hands                       $ 1,500            $ 500

Proceeds from
immediate sale
at FMV                            $ 1,500            $ 500

Gain/(loss)                             0                0

Commentators have noted that new Sec. 732(c) targets an abuse sometimes referred to as the "million dollar pencil." Because an apportionment based on the adjusted bases of the partnership's assets is somewhat arbitrary (as it neglects to consider the FMV of the distributed assets), results can be skewed. One example involves the liquidation of a partnership with a relatively small amount of tangible assets (e.g., a pencil) and a large amount of goodwill with zero basis. On the purchase of a partnership interest followed by a liquidation, former Sec. 732(c) would apportion the bulk of the purchase price to the pencil, which could either be recovered through depreciation or sold for a tax loss. New Sec. 732(c) eliminates this result.

The opportunity to create additional depreciation deductions or manipulate losses in the above fashion is now gone. In light of the TRA '97, partnerships contemplating liquidating distributions (or nonliquidating distributions in which the partnership's basis in the distributed properties exceeds the distributee partner's basis for his partnership interest) should address valuation concerns. Because basis allocations are driven by relative unrealized appreciation or unrealized depreciation contained in the distributed properties, accurate appraisals of those assets' FMVs are increasingly important. (For more examples, see McCoskey and Streer, "The TRA `97'S New Basis Allocation Rules for Property Distributions" The Tax Adviser, July 1998, p. 486.)