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Current developments.


* The AJCA requires a negative basis adjustment when there is a transfer of a partnership interest.

* The IRS issued final regulations on revaluations of capital accounts and contributions of long-term contracts and proposed regulations on gain deferral on a sale of QSB stock, debt of disregarded entities and special allocations of foreign tax expenditures.

* Many rulings were issued on TEFRA audits, foreign partnerships, See. 704(e), partnership conversions and other areas.

This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, subchapter K elections, statutes of limitations, basis, debt and income allocations, transactions between partners and partnerships and partnership continuation.


During the period of this update (Nov. 1, 2003-Oct. 31, 2004), the American Jobs Creation Act of 2004 (AJCA) was enacted, which made several changes to subchapter K. In addition, numerous proposed and final partnership regulations were issued, concerning liability allocations, capital account revaluations and the status of tax-exempt-bond partnerships. Various rulings addressed partnership operations and abusive tax situations.


Signed by President Bush on Oct. 22, 2004, the AJCA contained several provisions that affect partnerships. Most of these apply to basis adjustments allowed on transfers of partnership interests. For example, according to AJCA Section 834, a partnership cannot step down the basis of stock of a partner (or a related person) when applying Sec. 755 basis allocation rules to a liquidating distribution under Sec. 734. The amount that cannot be allocated to the stock will (1) be allocated to other partnership assets or (2) create gain to the partnership if the step-down exceeds the tax basis of the other assets. With this law change, it becomes even more important for the partnership to be aware of any relationships its partners might have with companies whose stock the partnership owns.

In the past, basis adjustments made under either Sec. 734 or 743 were elective. However, when there is a substantial basis reduction, AJCA Section 833(c) requires an adjustment under Sec. 734(b). A substantial basis reduction is deemed to be a downward adjustment of more than $250,000 that would have been made to the basis of partnership assets if a Sec. 754 election were in effect. Likewise, a basis adjustment under Sec. 743 is required for transfers of partnership interests when there is a substantial built-in-loss (BIL). A substantial BIL exists when the partnership's adjusted basis in its property exceeds the property's fair market value (FMV) by more than $250,000. However, if negative adjustments have to be made, the partnership is not deemed to have made a Sec. 754 election for subsequent transfers.

The AJCA does not require electing investment partnerships to make these basis adjustments. Rather, it imposes special loss-disallowance rules at the partner level. It also does not require securitization partnerships to account for BILs in this way.

Under AJCA Section 833(a), only the contributing partner can recognize BILs under Sec. 704(c). To determine the amount allocated to a noncontributing partner, the Sec. 704(c) property's basis is its FMV at contribution. Thus, any remaining BIL is eliminated if the contributing partner disposes of his or her interest. Consequently, a subsequent purchaser of a contributing partner's interest may not benefit from this loss.

The new law also clarifies that the "stock for debt" exception in Sec. 108 does not exist for partnerships. Thus, when a partnership interest is exchanged for debt, the partnership must recognize cancellation of debt income and allocate it to its historical partners.

Partnership Issues

Entity vs. Aggregate Theory

An issue that often arises in the taxation of partners and partnerships is whether to use the entity theory or the aggregate theory. The entity theory treats the partnership as a separate and distinct entity from its owners; the aggregate theory treats it as an aggregate of its owners. Both of these theories are used in various sections of subchapter K.

This year, Treasury used the entity theory in proposed regulations on gain deferral on a partnership's sale of qualified small business stock (QSB). (1) Sec. 1045 allows noncorporate taxpayers to elect to defer gain on the sale of QSB stock by purchasing other QSB stock within 60 days. The proposed regulations provide that this deferral applies to partners if the partnership buys replacement QSB stock or a partner buys replacement QSB stock directly. A partner who sells an interest in a partnership that owns QSB stock is not eligible for the deferral. Likewise, the purchase of a partnership interest is not the purchase of QSB stock, even if the partnership owns such stock; Sec. 1045 does not take a look-through approach to the sale or acquisition of partnership interests.

Partnership Interests

Another issue is the classification of a partnership interest. For example, in Draper, (2) the taxpayer could not deduct a loss on his investment in a limited partnership as a worthless securities loss under Sec. 165(g). The court ruled that a partnership interest does not qualify as a security, even though a partnership interest is classified as a capital asset under Sec. 1221. This decision illustrates one way the Code treats partnerships differently from corporations.

TEFRA Issues

In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) was enacted to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. A question that continues to arise is whether an item is a partnership item. This dilemma arose in Wiener, (3) in which the taxpayer was a partner in a partnership with deductions disallowed under audit. The partnership took the issue to court. While the case was pending, the partner settled with the IRS on the disputed issues. After accepting the settlement, the IRS assessed additional tax and interest on the partner.

The partner sued for a refund and argued that the statute of limitations (SOL) prevented the additional assessment, as the year to which the partnership item related was closed. This argument was based on the assumption that the SOL issue was a nonpartnership item and, thus, TEFRA did not apply. The Fifth Circuit disagreed; it ruled that the SOL was a partnership item that had to be litigated at the partnership level, because the change to income arose from a partnership item. As a result, the IRS could assess additional tax and interest.

In a similar situation, (4) the issue was whether the IRS could initiate a TEFRA partnership audit for a year in which the SOL had expired for all of the partners. The question arose because the partners claimed losses attributable to the closed year in subsequent open years. The Service planned to assess tax against the partners in the open years for a disallowed loss on a partnership item that arose in the closed year. Because the SOL for assessing tax on the disallowed loss was open, the SOL for assessing tax on the closed-year partnership items was open as well. Thus, the IRS could initiate a TEFRA audit for the closed year. This ruling is very unfavorable, as it may open up closed tax years to audit.

Foreign Partnerships

A growing area is the use of partnerships instead of corporations in international operations. As the number of foreign partnerships that operate in the U.S. increases, so will the number of rulings. This year, there were two rulings on foreign partners in a foreign partnership that had a fixed base in the U.S. In Rev. Rul. 2004-3, (5) the IRS ruled that a foreign partner who is a U.S. nonresident alien would be subject to U.S. tax on his or her share of income from the partnership attributable to domestic operations, even though he or she never performed services in the U.S. This parallels the holding of Letter Ruling 200420012. (6)

Tax Shelters

For the past few years, Treasury and the IRS have been concentrating on tax shelters. To that end, they have developed a list of transactions deemed to be potential tax shelters. Last year, the IRS identified another partnership transaction (7) as a listed transaction. A domestic corporation and a foreign person (FP) form a partnership; FP is a common foreign parent. The partnership then contributes a substantial portion of its assets to a second domestic corporation related to the domestic corporate partner, in exchange for preferred stock. Under the partnership agreement, FP receives a substantial guaranteed payment for the use of capital and a disproportionately small share of partnership income and deductions. Conversely, the domestic corporate partner is allocated a disproportionately large share of partnership income and deductions.

This type of special allocation could allow the domestic partner to take substantial losses on its U.S. tax return. The Service intends to challenge this type of transaction on various grounds, including the fact that the special allocations lack substantial economic effect under Sec. 704(b).


One of the advantages of setting up a family limited partnership (FLP) is to reduce the assets in a taxpayer's estate. In addition, estate tax value of the partnership interest may be reduced by using minority interest and marketability discounts. In certain cases, the IRS may challenge the use or amount of the discount. In Est. of Lea K. Hillgren, (8) the decedent set up a FLP. She allegedly contributed seven properties in exchange for her partnership interest, but did not deed or transfer title to the partnership. Instead, under the partnership agreement, the property would remain in the limited partner's name for the partnership's benefit.

The IRS argued that the (1) property was not owned by the partnership, because title had never been transferred; (2) partnership should be disregarded for estate purposes; and (3) full value of the properties should be included in her estate under Sec. 2036(a). The estate countered that the FLP was a valid partnership and created as a premarital, asset-protection device.

The Tax Court agreed with the Service and ruled that the properties should be included in the estate at their FMV on the decedent's date of death. This ruling points out the importance of having a true transfer of assets to a FLP--the title to all property contributed should be legally transferred.

Partnership Formation

Sec. 721(a) provides that no gain or loss is recognized on the exchange of property for a partnership interest. However, Sec. 721(b) provides an exception for a partnership that would be classified as an investment company if it were incorporated. In Letter Ruling 200420020, (9) Sec. 721(b) did not apply when a corporation entered into a multi-step transaction with the purpose of spinning off a subsidiary. The first step was to form a limited partnership in which all the parent's shareholders contributed their stock in exchange for partnership interests. After the transaction, the only asset the partnership owned was the parent stock. The IRS determined that the partnership would not be considered an investment company if the entity were incorporated.

Electing Out of Subchapter K

Partnership rules require that income not be included in a partner's income until the last day of the partnership's tax year. Unfortunately, an annual inclusion can be incompatible with money market and certain bond funds; thus, many tax-exempt-bond partnerships try to elect out of subchapter K. However, these partnerships do not meet Sec. 761(a)'s requirements. To solve these problems, the IRS issued Rev. Proc. 2003-84, (10) allowing tax-exempt-bond partnerships an election to enable partners to take exempt income into account on a monthly basis. This procedure applies to any partnership that derives at least 95% of its income from exempt interest or exempt-interest dividends paid by a regulated investment company and whose expenses are allocable to producing, collecting, managing or protecting the exempt income or the assets that generate such income.

In conjunction with the procedure, Treasury issued final and temporary regulations (11) to provide an exception to the Sec. 6031(a) requirements, so that exempt-bond partnerships do not have to file annual partnership returns or issue Schedules K-1.


Under Sec. 752(a), 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.

Disregarded Entities

The IRS issued Sec. 752 proposed regulations (12) for taking into account certain obligations of a disregarded entity. The proposed rules also clarify when a partner bears the economic risk of loss for a partnership liability based on a disregarded entity's obligation. Because the owner of a disregarded entity may have limited liability, only the entity assets may be available to satisfy the entity's debts. Thus, Treasury determined that a partner should be treated as bearing the economic risk of loss for a partnership liability only to the extent of the net value of the disregarded entity's assets.


The Sec. 752 regulations separate liabilities into recourse and nonrecourse obligations and provide different allocation methods for each. Recourse liabilities are allocated to general partners, while nonrecourse liabilities are allocated to all partners. Generally, recourse liabilities are unsecured debts, while nonrecourse liabilities are secured.

In IPO II, (13) the IRS determined and the Tax Court agreed, that a two-member limited liability company's (LLC's) loan was recourse and that the entire debt should be allocated to the member who guaranteed the loan. That decision is based on an exception in Regs. Sec. 1.752-4(b)(2)(iii), which states that persons owning interests directly or indirectly in the same partnership are not treated as related persons in determining the economic risk of loss borne by each for the partnership's liabilities. The other member was an S corporation wholly owned by the guarantor and, thus, could not be a related party.

Letter Ruling 200436011 (14) addressed the appropriate allocation of nonrecourse debt. A partnership agreement made a special allocation of net income to one partner and a corresponding allocation of nonrecourse debt. The partners argued that the debt allocation was consistent with the special allocation of income prescribed by Regs. Sec. 1.752-3(a)(3). The Service disagreed and noted that the clause in the regulations that allows debt to be allocated in the same manner as "a significant item of partnership income or gain which has substantial economic effect" refers to a significant class of income or gain, such as gain from the sale of property or exempt income, not to a special allocation of net income. Thus, the proposed allocation of nonrecourse liabilities was inappropriate, because it did not truly reflect the overall economic relationship between the partners.

Partnership Operations and Income Allocations

Sec. 702 specifies the items a partner must take into account separately; Sec. 703 provides that any election affecting the computation of taxable income from a partnership must be made by the partnership.

In a series of rulings, (15) an LLC owned a facility that produced solid synthetic fuel from coal, eligible for a tax credit under Sec. 29(a). The Service determined that the LLC could take the credit and pass it through to its members based on their respective interests.

One way taxpayers try to convert ordinary income into capital gain is by contributing property to a partnership. Numerous Code sections try to prevent this situation. However, there are times when a taxpayer can successfully change the character of gain by using a partnership.

In Phelan, (16) the taxpayer, a real estate developer, acquired real property intended for residential development. He later transferred the property to a partnership. The partnership's only purpose was to hold the property for appreciation and sale.

The Tax Court ruled that the gain on the land sale by the partnership was capital gain, even though the partners were real estate developers and it would have been ordinary income had the partners sold the land individually. The court used the entity theory, instead of the aggregate theory, to determine the correct outcome.

Under Sec. 704(a), partnership items are allocated based on the partnership agreement; however, there are several exceptions to this general rule. Sec. 704(b) allows a partnership to make special allocations as long as they have substantial economic effect. One of the requirements is the maintenance of capital accounts. Regs. Sec. 1.704-1(b)(2)(iv) allows capital accounts to be revalued in certain instances. Final regulations (17) 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 final regulations made no changes to the proposed regulations (18) issued last year.

Foreign Tax Expenditures

Sec. 704(b) regulations provide that the allocation of certain items, including tax credits, cannot have substantial economic effect. This past year, temporary and proposed regulations (19) clarified the application of Sec. 704(b) to creditable foreign tax expenditures. The temporary regulations provide that allocations of these expenditures cannot have substantial economic effect and must be allocated in accordance with the partnership interests. However, a safe harbor provides that if foreign taxes are allocated in the same proportion as the income to which they relate, the allocation will be deemed to be in accordance with the partners' partnership interests. Thus, for foreign taxes to be specially allocated, the foreign income to which the taxes relate must be specially allocated in the same proportion.

Long-Term Contracts

Under Sec. 704(c), any built-in gain (BIG) or BIL attributed to property before 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.

Final regulations relate to contributed contracts accounted for under a long-term-contract method. (20) Under these rules, a contribution of such contracts is 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 the contribution of the contract to the partnership.

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

Installment Obligations

Proposed regulations (21) were issued on the treatment of installment obligations acquired via a contract under Secs. 704(c) and 737. The proposed regulations amend Kegs. Sec. 1.704-3(a)(8) to clarify that if a partnership disposes of Sec. 704(c) property in an installment sale, the installment obligation is treated as Sec. 704(c) property. In addition, if a partner contributes a contract to the partnership that is Sec. 704(c) property, any property the partnership acquires pursuant to that contract is also Sec. 704(c) property- if less than all the BIG or BIL is recognized.

See. 704(c) Rulings

The IRS issued several rulings this year on Sec. 704(c). In Rev. Rul. 2004-43, (22) it addressed whether Sec. 704(c)(1)(B) would apply to Sec. 704(c) gain or loss created in an assets-over partnership merger. The result was that Sec. 704(c)(1)(B) applied to newly created Sec. 704(c) gain or loss on property contributed by the transferor partner. However, it did not apply to any reverse Sec. 704(c) gain or loss created from a revaluation of property in the continuing partnership. Likewise, for Sec. 737(b) purposes, net pre-contribution gain will include the newly created Sec. 704(c) gain or loss from the property contributed by the transferor partnership, but not the reverse Sec. 704(c) gain or loss created by the revaluation of assets in the continuing partnership.

In a second ruling, (23) the Service determined that if a partnership revalues amortizable Sec. 197 intangibles, the Sec. 197 anti-churning rules do not apply and the partnership can make reverse Sec. 704(c) allocations to take into account the BIG or BIL from the revaluation. This allocation can be made regardless of the allocation method used under Sec. 704(c). However, if the Sec. 197 intangible was not amortizable, the partnership could make the allocations only if it used the remedial method.

A third ruling (24) dealt with the method of aggregating gains and losses from qualified financial assets when making reverse Sec. 704(c) allocations. In this instance, the partnership adopted the partial netting approach. This method preserves the tax attributes of each item of gain or loss realized by the partnership. The Service determined that the method for making the reverse Sec. 704(c) allocations was reasonable, provided that the contribution or revaluation of property and its corresponding allocation were not made to shift the tax consequences of the BIG or BIL among the partners in a manner that substantially reduced the aggregate tax liability.

Partnership Continuation

The two events that terminate a partnership for tax purposes under Sec. 708(b) are (1) no part of the business or venture continues to be carried on by any partner or (2) within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. In Rev. Rul. 2004-59, (25) the IRS ruled on the conversion of an unincorporated state law entity taxed as a partnership for Federal tax purposes into a state law corporation. The conversion was completed under a state law formless conversion statute that does not require an actual transfer of the entity's assets or interests. The Service determined the partnership (1) was deemed to have contributed all of its assets and liabilities to the corporation for its stock and (2) then terminated under Sec. 708, by making a liquidating distribution of the stock to its partners.

In another situation, (26) a general partnership converted into a LLC. After conversion, each partner owned the same percentage interest as before. The IRS determined that, assuming the LLC was classified as a partnership for Federal tax purposes and there was no change in the partners' respective shares of liabilities, neither the partnership nor the partners would recognize gain or loss on the conversion and the partnership would not be deemed terminated under Sec. 704(b)(1)(B).

An interesting situation arose in Harbor Cove Marina Partners Partnership. (27) Because of constant dissension between two of the partners, the managing partner dissolved the partnership, by distributing the marina property to itself and cash to the other partners. One of the other partners filed suit, claiming that the managing partner's actions violated the partnership agreement, which required, in the case of a liquidation, the marina to be sold publicly to the highest bidder and the cash distributed. The Tax Court ruled that the partnership did not terminate under Sec. 708 in the year the property was distributed to the partners because, depending on the results of the partner's lawsuit, significant amounts of income, gain, loss or deduction could occur in subsequent years.

Sec. 754 Elections

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 step-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 and normally is filed with the return. If a partnership inadvertently fails to file the election, it can ask for relief under Kegs. Sec. 301.9100-1 and -3.

In a series of rulings this past year, (28) the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership was eligible to make such an 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. Each partnership had 60 days after the ruling to file the election. The extension was granted even when the partnership relied on a tax professional to file its return. (29)

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

(1) REG-15062-03 (7/15/04).

(2) John D. Draper, Ct. Fed. Cls., 10/5/04.

(3) Morris A. Weiner, 5th Cir., 10/25/04.

(4) Chief Counsel Advice (CCA) 200414045 (4/2/04).

(5) Rev. Rul. 2004-3, IRB 2004-7, 486.

(6) IRS Letter Ruling 200420012 (5/14/04).

(7) See Notice 2004-31, IRB 2004-17, 830.

(8) Estate of Lea K. Hillgren, TC Memo 2004-46.

(9) IRS Letter Ruling 200420020 (5/14/04).

(10) Rev. Proc. 2003-84, IRB 2003-48.

(11) TD 9094 (11/10/03).

(12) REG-128767-04 (8/12/04).

(13) IPO II, 122 TC 295 (2004).

(14) IRS Letter Ruling 200436011 (9/3/04).

(15) See, e.g., IRS Letter Rulings 200443031 (10/22/04); 200431009 (7/30/04); 200426014 (6/25/04) and 200413004 (3/26/04).

(16) Timothy J. Phelan, TC Memo 2004-206.

(17) TD 9126 (5/6/04).

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

(19) TD 9121 and REG-139792-02 (both dated 4/21/04).

(20) TD 9137 (7/16/04).

(21) REG-160330-02 (11/24/03).

(22) Rev. Rul. 2004-43, IRB 2004-18, 842.

(23) Rev. Rul. 2004-49, IRB 2004-21, 939.

(24) IRS Letter Ruling 200438029 (9/17/04).

(25) Rev. Rul. 2004-59, IRB 2004-24, 1050.

(26) IRS Letter Ruling 200414013 (4/2/04).

(27) Harbor Cove Marina Partners Partnership, 123 TC 64 (2004).

(28) IRS Letter Rulings 200439019 (9/24/04); 200431011 (7/30/04); 200425035 (2/25/04); and 200420008 (1/27/04).

(29) IRS Letter Rulings 200440022 (10/1/04) and 200443026 (10/22/04).

Hughlene A. Burton, Ph.D., CPA

Associate Professor

University of North Carolina-Charlotte

Charlotte, NC
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Title Annotation:provisions on partnership taxation
Author:Burton, Hughlene A.
Publication:The Tax Adviser
Date:Feb 1, 2005
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