Precontribution gain on a partnership's technical termination.

Facts: Moon and Peterson formed the Good Morning Partnership (GMP) on Jan. 1,1996. They are equal partners. Moon contributed a building with a $520,000 fair market value (FMV) and a $390,000 adjusted tax basis, and Peterson contributed $520,000 cash. GMP purchased several parcels of land with $360,000 of the contributed cash. The building was depreciated by the partnership based on a 39-year life, using the straight-line method. GMP has made Sec. 704(c) allocations for precontribution gain on the building using the traditional method. * During each year of partnership operations, operating income equaled expenses net of depreciation. Therefore, the loss recognized by GMP each year equaled its depreciation expense. * On Dec. 31, 1998, Moon sold his interest to Lee for $540,000, triggering a technical termination. Lee and Peterson agree to continue the business, calling it Good Day Partnership (GDP). GMP's balance sheet on the termination date was as follows:

Good Morning Partnership

           Adjusted basis          FMV

Cash             $160,000      $160,000
Building          360,000       520,000
Land              360,000       400,000
Total            $880,000    $1,080,000

           Adjusted basis       FMV
Capital:
Moon             $380,000      $540,000
Peterson          500,000       540,000
Total            $880,000    $1,080,000

Issue: Under the technical termination regulations, what are the effects on the precontribution gain?

Analysis

The sale of Moon's interest to Lee triggers a technical termination. Under Regs. Secs. 1.708-1(b)(1)(iv) and 1.761-1(e), a technical termination no longer results in a deemed distribution of the partnership's assets. Instead, the partnership is treated as transferring its assets and liabilities to a new partnership in return for interests in that partnership. The interests in the "new" partnership are then deemed distributed to the partners who either continue the partnership or dissolve it and wind up its affairs. Thus, for example, a technical termination no longer has the potential for triggering gain to the partners if their share of the partnership's cash exceeds the basis of their partnership interests.

The new regulations simplify the interaction of the technical termination rules with the following Code provisions:

1. Sec. 704(c)(1)(A)--that requires a property's built-in gain or loss (the difference between its basis and FMV at the time it is contributed to a partnership) to be allocated to the contributing partner through depreciation, depletion, etc., adjustments and, to the extent necessary, through a special gain or loss allocation when the partnership sells the property.

2. Sec. 704(c)(1)(B)--that applies the rules in item 1 to property that, instead of being sold by the partnership, is distributed to another partner within five to seven years of when it was originally contributed to the partnership.

3. Sec. 737--that provides if property is distributed to a partner who contributed other property to the partnership within the previous five to seven years, the partner must recognize gain equal to the lesser of (a) the gain the partner would have recognized under item 2 (the partner's net precontribution gain) if all the property the partner contributed within the last five to seven years was distributed to another partner or (b) the distributed property's value over the partner's adjusted basis in the partnership.

The new regulations provide that a technical termination does not restart the five- to seven-year period under Secs. 704(c)(1)(B) and 737. They also provide that the new partnership "steps into the shoes" of the old one with respect to property distribution and the Secs. 704(c) and 737 rules.

Under the new regulations, the assets of GMP are transferred to GDP and receive a carryover basis. Any remaining precontribution gain is now allocable to Lee.

Under the prior regulations, when a deemed contribution occurred after a technical termination, Sec. 704(c) was applied to allocate gain, loss, income and deduction for any property that increased or decreased in value after it was acquired (whether by contribution or purchase) before the termination. In conjunction with the revised amendments to the Sec. 708 rules, Kegs. Sec. 1.704-4(c)(3) amends the Sec. 704(c)(1)(B) rules to provide that there is no Sec. 704(c)(1)(B) gain or loss recognized when a technical termination occurs; there is no deemed distribution of the "old" partnership's assets. However, the continuing partners' precontribution gains or losses carry over as if nothing happened to their interests in the "new" partnership when the Sec. 704(c)(1)(B) rules apply.

As a result, Lee will be allocated Moon's remaining $120,000 of the Sec. 704(c) built-in gain. Even though the land that was purchased by GMP has increased in value by $40,000, there will not be an additional Sec. 704(c) gain related to that increase since, under the new regulations, the assets are not "contributed" to the new partnership (as noted previously).

Note: It is advisable for GMP to make a Sec. 754 election on its final tax return so that Lee will not suffer any detriment arising from the difference between the $380,000 inside basis and the $540,000 outside basis of the partnership interest.

Conclusion

The IRS felt it had to coordinate more closely the effects of a technical termination with Secs. 704(c) and 737. Accompanying the change to Sec. 708 were corresponding changes to the regulations under Secs. 704(c) and 737. In this case, Regs. Sec. 1.704-(4)(a)(4)(ii) provides that a new five- to seven-year holding period does not begin. In this situation, the five-year rule applicable to a distribution of property to a partner under Sec. 704(c) has only two more years to run, rather than a new five-year period. The same holds true for the five- to seven-year rule applicable to a distribution of property covered under Sec. 737 (Regs. Sec. 1.737-2(a)). Lee steps into Moon's shoes with respect to the remaining $120,000 built-in gain related to the contributed building. Finally, no new Sec. 704(c) built-in gain is created at the time of the technical termination on the appreciation that occurred after contribution of the building and purchase of the land.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 12th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, TX, 1998.

Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Washington, DC