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Current developments.


* Final regulations were issued to address basis adjustments under Secs. 734(b) and 743(b).

* The IRS issued proposed and temporary regulations on the assumption of contingent liabilities.

* Final regulations discuss basis issues for corporate partners.

This article reviews and analyzes recent rulings and decisions on partnerships. It covers developments on partnership formation, election out of Subchapter K, statute of limitations, basis, debt and income allocation, transactions between partners and partnerships and partnership continuation.

During the period of this update (Nov. 1, 2002-Oct. 31, 2003),Treasury issued numerous sets of proposed and final partnership regulations, including one set on noncompensatory options. In addition, the IRS plans to provide guidance on partnership compensatory options and convertible instruments in the future. There were also various causes and rulings on the formation and operations of a partnership and abusive tax situations.


To decide if a partnership exists, it must be determined if the partners intended to join together for the purpose of carrying on a trade or business and to share the profits and losses of that venture. However, a written partnership agreement is not required. Because a partnership can exist without a written partnership agreement, the question "Is the venture a partnership or not?" must be answered repeatedly.

This year, there were two such cases, with differing results. In Ballantyne, (1) two brothers owned a partnership that operated two separate businesses. The partnership did not maintain a separate set of records, but did file a return each year. By oral agreement, each brother operated one of the businesses and withdrew profits therefrom. However, for tax purposes, they agreed to report income and losses equally. When one of the partners died, the family contested the allocation of income. The Eighth Circuit ruled that, because the partnership did not have a written agreement, the facts and circumstances surrounding the operation would determine whether the oral agreement set the partners' distributive shares. The court ruled that the oral agreement of an equal partnership was valid, based on the way the prior tax returns had been filed.

In another case, (2) two parties conducted foreign trade shows. As in Ballantyne, there was no written partnership agreement; in addition, no separate books and records were kept and no partnership returns were filed. In addition, the parties did not have joint control of the venture's capital and profits and there was no evidence of a profit-sharing agreement. Based on these factors, the Tax Court ruled there was no partnership.

These two cases also point out the importance of a written partnership agreement. If partners want a venture to be respected as a partnership with an oral agreement, the venture must be operated as such, with separate books and records maintained and partnership tax returns filed.

In a different situation, (3) a taxpayer exchanged his interest in several lots with another individual for an interest in a parcel of land. The taxpayer contended that the two individuals were partners in a partnership that owned all of the land and that his receipt of the interest in the parcel was a nontaxable partnership distribution. However, no partnership returns were filed. The IRS argued that no partnership existed; thus, the transaction was a taxable exchange between two individual taxpayers. The Tax Court agreed with the IRS, because the partnership did not own the land.

Abusive Tax Situations

Straddle Transactions

Notice 2003-54 (4) extended the 2002 rulings that dealt with multi-step transactions designed to use a straddle, a tiered-partnership structure and a transitory partner to allow a taxpayer to claim a permanent noneconomic loss. In this situation, the transaction involved the use of a common trust fund that invested in economically offsetting gain and loss positions in foreign currencies and then allocated the gains to a tax-indifferent party and the losses to a taxable party. The notice alerted taxpayers and their advisers that the tax benefits purportedly generated by this transaction would not be allowed for Federal tax purposes and that this and similar transactions are now listed transactions under the tax shelter regulations. (5)

Tax Shelters

For the past few years, Treasury and the IRS have been concentrating on tax shelters. Accordingly, they issued final regulations in February 2003 modifying the rules on filing disclosure statements under Sec. 6011(a). In addition, Rev. Proc. 2003-24 (6) provided exceptions applicable to certain loss transactions, and Rev. Proc. 2003-25 (7) provided exceptions applicable to certain transactions with significant book-tax differences.

Taxation on Formation


The gift of a family limited partnership (FLP) interest qualifies for the gift tax annual exclusion and the value of the gifted interest may be reduced by using minority interest and marketability discounts. However, in certain cases, the IRS may challenge the use or amount of the discount. In McCord, (8) a family formed a FLP and the parents assigned interests in it to their children, to trusts for the children's benefit and to two charitable organizations. The children agreed to pay any transfer taxes that would result if one or both of the parents died within three years of the gift. The gift's value was determined after taking into consideration minority interest and marketability discounts. The value was also reduced for the possibility that the children would have to pay additional taxes on the gift. The IRS disagreed with the (1) amount of discount taken and (2) reduction in value for the possibility of future taxes. Both parties used experts to determine the discount. Based on that testimony, the Tax Court agreed in both instances with the IRS.

Partnership Formation

Sec. 721(a) provides that no gain or loss is recognized on the exchange of property for a partnership interest. In MAS One Limited Partnership, (9) a partner who had guaranteed a loan on the partnership's property abandoned its partnership interest. The next day the partnership sold the property and used the proceeds to pay down the loan. As part of the plan, the guarantor partner paid the loan balance.

The partnership treated the payment of the loan guarantee as a nontaxable contribution of capital, because the guarantee was made when the taxpayer was a partner. The IRS argued that the partnership either had income from operations or relief of debt income, because the payer was not a partner when the payment was made. The district court agreed with the IRS, because (1) the partnership failed to show the payment represented an amount the departing partner owed the partnership and (2) the departing partner did not seek a new interest in the partnership.

Sec. 721(a) does not apply if a partner receives a partnership interest in exchange for services. In such case, the partner will have income equal to the fair market value (FMV) of the interest received and the partnership will have either a deduction or a capital asset for the same amount. An exception applies if the partner only receives a profits interest. Based on Rev. Proc. 93-27, (10) as clarified by Rev. Proc. 2001-43, (11) there is no gain or loss for a service partner who receives only a nonvested profits interest.

In Letter Ruling 200329001, (12) key executives received partnership interests subject to vesting forfeiture in exchange for services. The IRS determined that the issuance of the partnership interests as compensation for ser vices would not be a taxable exchange, because it met the requirements of Rev. Procs. 93-27 and 2001-43.

Treasury issued proposed regulations on the tax treatment of noncompensatory options and convertible instruments issued by a partnership. (13) The proposed regulations provide for no gain or loss recognition to either the option holder or the partnership on the options' exercise. The proposed rules characterize the option holder as a partner if his or her rights are substantially similar to the rights of other partners. They also modify Regs. Sec. 1.704-1(b)(2)(iv) to provide that the FMV of outstanding options must be considered when capital accounts are revalued. These regulations apply only to noncompensatory options, but Treasury plans to provide guidance in the future on compensatory options.

Sec. 721(b) provides an exception for a partnership that would be classified as an investment company if it were incorporated. In Letter Ruling 200317011, (14) a husband and wife exchanged interests in property (including real estate, stocks and bonds), incident to a divorce. After the exchange, they contributed their respective property interests to a limited partnership. The IRS ruled that Sec. 721(b) did not apply; thus, the taxpayers would have no recognized gain or loss on the transfer to the partnership.

Electing Out of Subchapter K

In Letter Ruling 200323015, (15) a state trust that elected to he treated as a partnership for tax purposes had multiple classes of ownership and divided income in a manner that differed significantly from the partners' ownership percentages. The IRS ruled that the partnership could not elect out of Subchapter K, because each partner's income could not be adequately determined without the computation of partnership income.

Partnership Year-End Election

In 2002,Treasury issued final regulations (16) on adoptions, changes and retentions of annual accounting periods. The IRS also issued three revenue procedures on this subject. (17) Rev. Proc. 2002-38 (18) allowed partnerships to change their accounting period if their current year no longer qualified as a natural business year or an ownership year. This year, the IRS issued Rev. Proc. 2003-79, (19) which allows partners to elect to spread their share of income ratably over four years from the partnership's short-year tax return that resulted from a change in year-end.

Basis Issues

Treasury issued Sec. 705 final regulations (20) that provide guidance when (1) a corporation owns a direct or indirect interest in a partnership that owns the corporation's stock, (2) the partnership distributes money or other property to another partner who recognized gain or loss on the distribution during a year the partnership did not have a Sec. 754 election in effect and (3) the partnership subsequently sells or exchanges the stock. Regs. Sec. 1.705-2(b)(2) would allow all increase or decrease in the basis of the corporation's partnership interest by the full amount of any gain or loss resulting from the partnership's sale or exchange of the stock that the corporation would not recognize under Sec. 1032. The final regulations extend the rules to situations in which the partner recognized either a gain or loss on the distribution, to provide a more consistent approach and to better conform to the 2002 Sec. 705 regulations.


Sec. 752(a) provides that an increase in a partner's share of a partnership's liabilities is deemed a contribution of money that increases the partner's outside basis; Sec. 752(b) provides that a decrease in a partner's share of liabilities is treated as a cash distribution. In Rev. Rul. 2003-56, (21) the IRS issued guidance on how to adjust a partner's basis when a partnership enters into a qualified like-kind exchange in which property, subject to a liability is transferred in one tax year and property subject to a liability is received in a subsequent tax year. The question is, can the liabilities be netted under Sec. 752 and, when is the net change in a partner's share of liabilities taken into account? The IRS ruled that the liabilities should be netted under Sec. 752, and any net decrease in a partner's share of liabilities should be taken into account under Sec. 752(b) in the first tax year, while a net increase in a partner's share of liabilities should be taken into account under Sec. 752(a) in the second tax year.

Sec. 752 Regulations

Treasury also issued temporary and proposed regulations (22) dealing with adjustments to partner basis, loss deductibility and similar issues when partnerships assume certain fixed and contingent obligations in exchange for a partnership interest. These regulations extend the rules of Sec. 358(h) to partnerships. The liabilities described in these regulations will be treated as having a built-in loss (BIL), which is allocated to the contributing partner under Sec. 704(c) principles.

The Sec. 752 regulations separate liabilities into recourse and nonrecourse obligations and provide different allocation methods for the two types. (Recourse liabilities are generally unsecured obligations, while nonrecourse liabilities are secured debts.) Recourse liabilities are allocated to general partners, while nonrecourse liabilities are allocated to all partners. In Letter Ruling 200340024, (23) a partnership planned to issue unsecured debt obligations to refinance secured mortgage debt. None of the partners would have may liability for repayment of the unsecured debt; the partnership would allocate such debt to the property that secured the mortgage. The IRS held that the unsecured debt would be treated as nonrecourse liabilities under Sec. 752 and as qualified nonrecourse financing under Sec. 465.With this ruling, the partners' share of liabilities should not change, thus eliminating the possibility of gain to the limited partners.

Partnership Operations and Income Allocation

Sec. 702 specifies the items a partner must take into account separately; while Sec. 703 provides that any election affecting the computation of taxable income from a partnership shall be made by the partnership, in a letter ruling, (24) a partnership termination was determined to be an involuntary conversion under Sec. 1033. The statute of limitations on the partnership's gain on the termination was extended three years. Because a partnership is a flow-through entity, its election to defer any gain on the involuntary conversion will flow through to the partners. In this case, because one of the partners was part of a consolidated group, the extension applied to the consolidated corporate return as well.

Partnership Agreement Allocation

Under Sec. 704(a), the allocation of partnership items is based on the partnership agreement. The IRS issued proposed regulations on a partnership's obligation to pay withholding tax on effectively connected taxable income allocated to a foreign partner under Sec. 704. (25) The proposed regulations generally follow the approach taken in Rev. Proc. 89-31 (26) for computing, paying and reporting the withholding tax, but provide special rules for publicly traded partnerships.

There are several exceptions to Sec. 704(a)'s general allocation rule. Sec. 704(b) allows a partnership to make special allocations as long as the requirements for substantial economic effect are met. One of the requirements is the maintenance of capital accounts. Reds. Sec. 1.704M(b)(2)(iv) allows capital accounts to be revalued in certain instances. The IRS issued proposed regulations (27) that expand the circumstances in which a partnership can revalue capital accounts to include the grant of a partnership interest (other than a de minimis interest) for the provision of services. The IRS is also considering other situations in which capital accounts can be revalued. One proposal would allow revaluations whenever there is more than a de minimis change in the manner the partners share profits and losses.

State trust agreements: The IRS also ruled (28) in the case of a state trust that elected to be treated as a partnership. The owners wanted to transfer tax-exempt obligations to an entity that would have two classes of interest, with different rights to allocation of income and distributions. The Service determined that the partnership's tax-exempt income would have the same character in the partner's hands and that the trust agreement contained all the necessary provisions for the income allocation to have substantial economic effect. Treasury is planning further guidance on state trusts that elect to be treated as partnerships for tax purposes.

Built-in-gain from long-term contracts: Under Sec. 704(c), any built-in gain (BIG) or BIL attributed to the property before the contribution has to be allocated to the partner making the contribution; the BIG or BIL at the time of the contribution is the difference between the property's FMV and the partner's adjusted basis in the property.

Treasury issued proposed regulations (29) on contributed contracts accounted for under a long-term-contract method. Under the regulations, the contribution of such connects is described as a "step-in-the-shoes" transaction; thus, there is no gain or loss under Sec. 721(a) on the contribution. The income or loss from the long-term contract will be allocated to the contributing partner under Sec. 704(c). The BIG or BIL from the long-term contract is the income the partner would have had to recognize had the contract been disposed of immediately before the contribution, less any gain recognized on file contribution of the contract to the partnership.

The regulations also provide that long-term contracts are deemed unrealized receivables under Sec. 751(c). In addition, the distribution to a partner of a contract accounted for under a long-term contract method of accounting is a constructive completion transaction. In computing partnership income on the distribution, the contract's FMV is treated as the amount realized from the transaction.

Transaction Between Partners and Partnerships

Sec. 707(a) governs transactions between a partnership and the partners acting as other than in their capacity as partners, including sales, leases, loans and services. In Bitker, (30) a farming partnership used land owned by the partners individually. The partnership made the loan payments on the land. The partners argued that the loan payments were rent for the use of the land under Sec. 707(a).The IRS disagreed, arguing that the payments were distributions to the partners. The Tax Court agreed with the IRS, became the taxpayers did not prove that the payments were made for the use of the land or that the amount paid represented the land's fair rental value.

Sec. 707(a)(2)(B) prevents taxpayers from characterizing a sale of property as a contribution to a partnership followed (or preceded) by a distribution from the partnership, with the purpose being tax deferral or avoidance. A contribution and subsequent distribution is presumed to be a sale. However, Regs. Sec. 1.707-5(b)(1) provides a safe harbor that, if met, will treat the transaction as a contribution and distribution. In Letter Ruling 200341005, (31) taxpayers contributed stock to a partnership on two different dates. In exchange for each contribution, they received an interest in the partnership and cash. The IRS ruled that the contributions and subsequent cash distributions were not disguised sales under Sec. 707(a)(2)(B), because the cash distributed was less than the safe-harbor limit.

Partnership Continuation

Mergers and Divisions

Under Sec. 708(b)(2)(A), a partnership resulting from a merger of partnerships is deemed the continuation of any merging partnership whose members own more than 50% of the capital and profits interests. (32) For a division of a partnership into two or more partnerships, Sec. 708(b)(2)(B) provides that the resulting partnerships (other than a resulting partnership with members having a 50%-or-less interest in the capital and profits of the prior partnership) are deemed continuations of the prior partnership.

In Letter Ruling 200339031, (33) six partnerships merged into one limited liability company (LLC) that will be taxed as a partnership. The LLC is deemed to be the continuation of the partnership that contributed assets having the greatest FMV. As such, the depreciation methods and useful lives of property from that partnership would not change. The LLC would take a carryover basis in the properties contributed by the other partnerships, and to the extent the property contributed was placed in service before 1981, their depreciation methods and useful lives would not be affected by the merger.

See. 754 Election

When a partnership distributes property or a partner transfers his or her interest, the partnership can elect under Sec. 754 to adjust the basis of partnership property. A Sec. 754 election allows a step-up or -down in basis under either Sec. 734(b) or 743(b) to reflect the FMV at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The election must be filed by the due date of the return for the year the election is effective. Normally, the election is filed with the return. If a partnership inadvertently fails to file the election, it can ask for relief under Regs. Secs. 301.9100-1 and -3.

In a series of rulings, (34) the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership was eligible to make a Sec. 754 election, but inadvertently omitted the election when filing its return. The Service reasoned that the partnership in each case acted reasonably and in good faith and granted an extension to file the election under Regs. Sec. 301.9100-1 and -3, until 60 days after the ruling. The extension was granted even when the partnership relied on a tax professional to file its tax return and make the proper election. (35)

Sec. 755 provides a method to allocate the step-up or -down in basis under Sets. 734(b) and 743(b). Final Sec. 755 regulations (36) were issued this year to replace Temp. Regs. Sec. 1.755-2T. The final regulations differ from the proposed regulations issued in 2000, in several ways. First, the final regulations use the residual method to value only Sec. 197 intangibles, not all assets (as did the proposed regulations). Second, the residual method only applies to partnerships whose assets constitute a trade or business. Lastly, the final regulations adopt a single method to determine the basis adjustment under both Sets. 734(b) and 743(b), not just the latter.

Editor's note: Dr. Burton is a member of the AICPA Tax Division's Partnership Taxation Technical Resource Panel.

For more information about this article, contact Dr. Burton at

(1) Est. of Melvin W. Ballantyne, 341 F3d 802 (8th Cir. 2003).

(2) Comtek Expositions, TC Memo 2003-135.

(3) Walter L. Medlin, TC Memo 2003-224.

(4) Notice 2003-54. IRB 2003-33, 363.

(5) See Regs. Sec. 1.6011-4(b)(2).

(6) Rev. Proc. 2003-24, IRB 2003-11, 599.

(7) Rev. Proc. 2003-25, IRB 2003-11, 601.

(8) Charles T. McCord, 120 TC 358 (2003).

(9) MAS One Limited Partnership, SD OH, 7/10/03.

(10) Rev. Proc. 93-27, 1993-2 CB 343.

(11) Rev. Proc. 2001-43, 2001-2 CB 191.

(12) IRS Letter Ruling 200329001 (7/18/03).

(13) REG-103580-02 (1/22/03).

(14) IRS Letter Ruling 200317011 (4/25/03).

(15) IRS Letter Ruling 200323015 (6/6/03).

(16) TD 8996 (5/17/02).

(17) Rev. Procs. 2002-37, 11133 2002-22, 1030; 2002 38, IRB 2002-22, 1037; and 2002-39; IRB 2002-22, 1046.

(18) Rev. Proc. 2002-38, note 17 supra, clarifying and superseding Rev. Proc. 87-32, 1987-2 CB 396.

(19) Rev. Proc. 2003-79, IRB 2003-45. 10.

(20) TD 9049 (3/18/03).

(21) Rev. Rul. 2003-56, IRB 2003-23, 985.

(22) REG-106736-00 (6/24/03); TD 9062 (6/24/03).

(23) IRS Letter Ruling 200340024 (10/3/03).

(24) IRS Letter Ruling (CCA) 200315021 (4/11/03); for details, see Penick, Tax Clinic, "Prop. Regs. on Partnership Withholding on Foreign Partners," 35 The Tax Adviser 14 (January 2004).

(25) REG-108524-00 (9/3/03).

(26) Rev. Proc. 89-31, 1989-1 CB 895.

(27) REG-116914-03 (7/2/03).

(28) IRS Letter Ruling 200323015 (6/6/03).

(29) REG-128203-2 (8/6/03).

(30) Curtis R. Bilker, TC Memo 2003-209.

(31) IRS Letter Ruling 200341005 (10/10/03).

(32) For a discussion of the proposed regulations in this area, see Orbach and Heller, "Merger and Division Prop. Regs.," 31 The Tax Adviser 854 (December 2000).

(33) IRS Letter Ruling 200339031 (9/26/03).

(34) IRS Letter Rulings 200343022 (10/24/03), 200336006 (9/5/03), 200328014 (7/11/03) and 200318040 (5/2/03).

(35) See IRS Letter Rulings 200318059 (5/2/03) and 200316021 (4/18/03).

(36) TD 9059 (6/9/03).

Hughlene A. Burton, Ph.D., CPA

Associate Professor

University of North Carolina-Charlotte

Charlotte, NC
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Title Annotation:regarding the taxation of partnerships
Author:Burton, Hughlene A.
Publication:The Tax Adviser
Date:Feb 1, 2004
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