Disallowance of certain partnership loss transfers.

If a partner contributes property to a partnership, generally, neither the contributing partner nor the partnership recognizes any gain or loss at the time of the contribution. The partnership takes the property, at an adjusted basis equal to the contributing partner's adjusted basis in the property. The contributing partner increases its basis in its partnership interest by the contributed property's adjusted basis. In addition, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest, unless the partnership has elected under Sec. 754 to make basis adjustments.

New Law

Sec. 704(c)(1)(C)--contributions of BIL property: According to AJCA Section 833, a built-in-loss (BIL) may be taken into account only by a contributing partner, not by the other partners. In determining the amount of items allocated to partners other than the contributing partner, the basis of the contributed property is treated as the fair market value (FMV) at the time of contribution. Additionally, if the contributing partner's partnership interest is transferred or liquidated, the partnership's adjusted basis in the property is based on its FMV when contributed, and the BIL is eliminated.

Sec. 743(b)--mandatory application if aggregate BIL exceeds $250,000: Under AJCA Section 833, generally, the Sec. 743 basis adjustment rules are mandatory (rather than being elective, as under prior law), when an interest in a partnership that has a substantial BIL is transferred. For this purpose, "substantial" means that the partnership's adjusted basis in its property exceeds the property's FMV by more than $250,000.

Sec. 734(b)--mandatory application if Sex. 734(b) adjustment exceeds $250,000: AJCA Section 833 states that a basis adjustment under Sec. 734(b) is required for a distribution with a substantial basis reduction. This is a downward adjustment of more than $250,000 that would be made to the basis of partnership assets if a Sec. 754 election were in effect.

Example 1: Partner A contributes property X to partnership PRS when it has an FMV and an adjusted tax basis of $500,000. B and C each contribute $500,000. A later sells its PRS interest to D for $125,000, the then--FMV of A's interest. A recognizes a $375,000 loss on the sale. B's and C's cash was equally invested in properties Y and Z and the FMV of each of PRS's properties has declined by $375,000. Thus, PRS has a substantial BIL in its property at the time A sells its PRS interest to D; PRS must adjust the basis of its assets with respect to D just as if it has a Sec. 754 election in effect, generally adjusting the tax basis to the FMV with respect to D.

Example 2: The facts are the same as in Example 1, except that A's interest is liquidated for $125,000 when the basis of his partnership interest remains $500,000. A recognizes a $375,000 loss on such distribution. Because the loss recognized by A exceeds $250,000, there is a substantial basis reduction under new Sec. 734(d); thus, PRS has to reduce the basis of its assets in an amount equal to A's recognized loss.

Investment partnership exception to Sec. 743(b) rule: Under AJCA Section 833, an electing investment partnership is not treated as having a substantial BIL and, thus, is not required to make basis adjustments to partnership property when a partnership interest is transferred. A partner-level loss limit rule applies, rather than the partnership basis adjustments. Under this rule, the transferee partner's distributive share of losses from the sale or exchange of partnership property is not allowed, except to the extent that the partner's share of such losses (determined without regard to gains) exceeds the loss recognized by the transferor partner. Losses disallowed under this role do not decrease the transferee partner's basis in its partnership interest. On subsequent disposition of its partnership interest, the partner's gain is reduced (or loss is increased) because the basis of the partnership interest has not been reduced by such losses.

To qualify for this exception, an investment partnership must meet eight requirements, coupled with an irrevocable election. Included in these requirements are: (1) restrictions on each partner's ability to cause a redemption of such partner's interest; (2) a mandate that the partnership interests be issued within 24 months of the first capital contribution; and (3) a limit on the life of the partnership to no more than 15 years (20 years for partnerships in existence on June 4, 2004).

Securitization partnership exception to both Secs. 743(b) and 734(b) rules: AJCA Section 833 treats a securitization partnership as not having a substantial BIL or a substantial basis reduction; thus, such a partnership is not required to make basis adjustments to partnership property if a partnership interest is transferred or property is distributed to a partner. Partnership basis adjustments remain elective for these partnerships. Unlike an electing investment partnership, the partner-level loss limit rule does not apply to a securitization partnership.

Effective Date

These provisions apply to contributions, distributions and transfers after Oct. 22, 2004. For an electing investment partnership in existence on June 4, 2004, special grandfathering rules may apply.

Implications

RIC and hedge fund considerations: Both the Secs. 743 and 734 rules described above are significant to regulated investment companies that invest through partnerships (such as master-feeder structures) and receive loss allocations. Master funds and many other investment partnerships traditionally have not made Sec. 754 elections due to the complexities involved in administering the required basis adjustments, which can involve the tax basis of every asset held by the partnership. Some partnership agreements use special allocations instead, or fill-up provisions, in an attempt to provide similar benefits without the administrative burdens.

The investment partnership and securitization partnership exceptions discussed above should be considered, although most hedge funds and master funds will probably not qualify due to the restrictions on redemptions, the requirement to issue partnership interests within 24 months and the limit on the life of the partnership to 15 (or 20) years. On the other hand, it is likely that many private equity funds will be eligible to qualify as investment partnerships. The exception for securitization partnerships may apply, for example, to certain synthetic floating-rate municipal bond partnerships.

When these rules may potentially apply, investors and investment managers will need to be aware of the provisions to apply portfolio and partnership accounting systems accordingly. Further, the provisions could affect any partnership that distributes securities. Finally, managers of funds that allow lateral transfers of partnership interests (e.g., some private equity funds) will now need to obtain partners' tax basis information associated with their interests, to deal properly with the new rules.

Adjustments still optional in many circumstances: The provisions do not technically make Secs. 743(b) and 734(b) adjustments mandatory. They are mandatory only if the substantial BIL/substantial basis reduction threshold is satisfied. This might be an important development for partnerships that do not wish to make basis adjustments, even when such adjustments are positive. For example, investment funds traditionally have not made Sec. 754 elections due to the complexities involved in administering the required basis adjustments.

Observations for de minimis rules: The new provisions use different applicability thresholds. There is no minimum BIL necessary for the Sec. 704(c)(1)(C) role to apply. The new Sec. 743 substantial BIL looks to the aggregate BIL at the partnership level. Thus, even if the transferred interest were to involve only a de minimis BIL (or potentially, a built-in gain), the adjustment may be required if the partnership has an overall BIL in excess of $250,000. However, the AJCA provides for future regulations to prohibit stuffing of assets into a partnership, to alter the aggregate BIL.

The new Sec. 734 substantial basis reduction rule does not look at the aggregate partnership BIL, but, rather, at the specific Sec. 734(b) adjustment that arises from the distribution of cash or property to the partner, to determine if the $250,000 threshold is satisfied. Thus, the Secs. 734 and 743 rules could apply in different circumstances.

Securitization partnership and investment partnership exceptions extremely limited: The securitization partnership provision is quite generous, but likely applies only to a limited number of partnerships. The investment partnership provision is much less generous because, even though the partnership is not required to make the basis adjustment, the same aggregate loss limits are required at the partner level. Not only is the investment partnership exception generally limited to private equity, venture capital and other long-term investment partnerships (primarily due to the 24-month limit), but the exception is limited to the Sec. 743(b) provision.

Thus, even if a partnership were to elect such exception, it will continue to be subject to the mandatory Sec. 734(b) adjustment if, for example, cash were distributed to a partner in liquidation of its interests, resulting in a greater-than--$250,000 loss. However, the Sec. 734 rule may have limited applicability in venture capital funds, given that most partners do not leave prior to fund liquidation. An additional consideration for investment funds that use the aggregation method under the Sec. 704(c) regulations is how to integrate the partner-/ property-specific basis computations under Secs. 704(c)(1)(C), 743(b) and 743(e), with the mechanics of such aggregation rules, which are, by definition, not property specific.

Unanswered Questions

Open issues include the following:

* How will these rules apply to tiered partnerships? (Treasury has been granted regulatory authority to address tiered arrangements.)

* Is there a risk that Sec. 704(c)(1)(C) applies to "reverse" Sec. 704(c) amounts that arise from the revaluation of partnership assets under Sec. 704(b)?

* Will a technical termination trigger the application of Sec. 704(c) (1) (C)?

* Is excess basis on Sec. 704(c)(1)(C) property taken into account in determining whether a partnership has a substantial BIL or in determining the basis that property receives on distribution to a noncontributing partner?

* Are Sec. 743 adjustments taken into consideration in calculating a substantial BIL?

FROM STEVEN SCHNEIDER AND ROBERT CRNKOVICH, WASHINGTON, DC

Partnerships

The AJCA contains many provisions of special interest to partnerships. These new rules affect the calculation and allocation of partnership income and ownership interests for many businesses operating under subchapter K.