Some bad news for partnerships in TRA '97.

Lost amid all the hoopla surrounding the Taxpayer Relief Act of 1997 (TRA '97) is the fact that it does not just contain tax reductions. There are also provisions intended to close perceived loopholes, as well as other tax increases. Several of these loopholes and tax increases are in the area of partnership taxation. As has been widely noted, the TRA '97 also significantly adds to the complexity of the tax law. The already complicated area of partnership taxation did not escape the increase in "complexification."

One of the most complicated sections of the Code is Sec. 704. While many professionals struggle to understand the complexities of Sec. 704(b), Sec. 704(c) is sometimes lost in the shuffle. Sec. 704(c) describes built-in gain rules for partnerships and contributing partners. Built-in gain is defined as the fair market value (FMV) of appreciated property in excess of the contributing partners' bases. The built-in gain is recognized by the contributing partner if the property is distributed to another partner, as if the property had been sold for its FMV at the time of the distribution (Sec. 704(c)(1)(B)). The second way that built-in gain can be recognized is if the partnership distributes to the contributing partner property with an FMV in excess of the asset's basis in the partnership (Sec. 737).

While the TRA '97 does not further complicate this area, it does extend the time that the partnership built-in gain rules are effective, from five to seven years. The new time frame is effective for property contributed after June 8, 1997.

Previously, a partner was required under Sec. 751(a) to recognize as ordinary income amounts received in a sale or exchange of a partnership interest attributable to unrealized assets or substantially appreciated inventory. The TRA '97 eliminates the "substantially appreciated" exception for sales and exchanges after Aug. 5, 1997, unless there was a binding contract before June 8, 1997. The "substantially appreciated" requirement was designed as a de minimis exception, so that the complexities of Sec. 751 could be avoided if the inventory had only a small appreciation. However, it appears that Congress was concerned that striving for tax simplicity had allowed too much room for manipulation and potential avoidance.

By reference, the TRA '97 also expands Sec. 721(b), which provides an exception to the no gain or loss provisions of Sec. 721(a) when the partnership would be treated as an investment company within the meaning of Sec. 351(e)(1) if it were incorporated. The TRA '97 expands the Sec. 351(e) definition of which assets must be considered in determining whether a corporation would be an investment company to include: stocks and securities, money, financial instruments, foreign currency, interests in real estate investment trusts, regulated investment companies, common trust funds and publicly traded partnerships, certain interests in precious metals and entities that hold such items, and any other assets specified in regulations. The new rules are effective for transfers after June 8, 1997, unless there was a binding contract in place at that time.

New Sec. 706(c)(2) also mandates that, for partnership years beginning after 1997, a partnership's tax year will close with respect to a partner on the date of that partner's death. Previously, if a partner died during a partnership's tax year, the partner's entire allocable share of income, loss, etc., for the year would be taxed to the partner's estate or successor in interest. While this may seem like a fairly simple change, it will cause additional recordkeeping and reporting for partnerships. It is important to note that the TRA '97 does not provide that income can be prorated, but rather indicates that the tax year must be closed with respect to the deceased partner.

All in all, the partnership area gained little if any relief from the TRA '97, instead providing more revenue for Federal coffers while increasing complexity.

From Eileen W. Belkin, CPA, Gray, Gray & Gray, Boston, Mass.