Partnership Inequalities: The Consequences of Book/Tax Disparities

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1 Partnership Inequalities: The Consequences of Book/Tax Disparities Howard E. Abrams 1 William K. Jacobs Visiting Professor Harvard Law School Outside of the partnership context, a taxpayer s after-tax investment in an asset (both equity and debt investments) is called the taxpayer s adjusted basis in the asset. In the partnership context, the aftertax investment of the partners (both equity and debt) can be divided among the partnership s assets (called inside basis) or among the partners (called outside basis). Because both aggregate inside basis and aggregate outside basis represent the aggregate after-tax investment in the partnership s assets, they should always be equal to one another. Section 705 ensures that activities of the partnership that change aggregate inside basis will change aggregate outside basis, but there is no universal rule that works the other way. Further, some distributions will affect outside and inside basis differently because Congress has insisted that negative outside basis not be allowed. 2 However, these problems can be eliminated by a partnership willing to make an election under section 754. Because such an election is not mandatory (more accurately, because the basis adjustments triggered by a section 754 election are not mandatory; a mandatory election is an oxymoron 3 ), the equality between aggregate inside and outside bases can be broken. And when that occurs, economically identical transactions can be taxed differently. For example, the sale by a partnership of all of its assets is equivalent to a sale by the partners of each of their partnership interests, but if aggregate inside basis does not equal aggregate outside basis, these two functionally equivalent transactions will yield different results. Congress has recognized the importance of the equality between aggregate inside and outside bases, not only in creating an election that can preserve the equality but also in mandating inside basis adjustments equivalent to those triggered by a section 754 election when the adjustment is negative 1 Copyright 2013 by Howard E. Abrams. 2 For example, a distribution of cash of $100 to a partner having an outside basis of $85 will trigger gain recognition to the partner of $15, 731(a)(1), and the partner s outside basis will decline to $0, 733(2). If the partner s capital account also equaled $85 immediately prior to the distribution (so there was no book/tax disparity prior to the distribution), then the distribution will reduce the partner s capital account to negative $15. If Congress did not reject the concept of negative outside basis, then presumably the distribution would have been tax-free and outside basis would have become negative $15, the same as the capital account adjustments. While such an approach may seem foreign, it has been adopted in the context of affiliated corporations filing a consolidated return, with an excess loss account standing in for negative outside basis. See generally Reg And yet see Reg (d) (example 8 and 9) (presumably making an elective election under 754 mandatory). 1

2 and exceeds a statutory minimum amount. 4 Such partially mandatory basis adjustments do not fully solve all problems caused by the possible inequality of aggregate inside and outside bases, but it goes far in that direction and, in any event, whatever problems remain have been accepted by Congress as small enough in magnitude to favor ease of administration over accuracy of taxation. The concept of a partner s capital account does not appear anywhere in the Code although it is the backbone of section 704(b) s requirement of substantial economic effect 5 as well as of the various regulations that incorporate this requirement. 6 A partner s capital account reflects the partner s share of the book value of the partnership and so is a better measure than outside basis of each partner s interest in the venture. However, because not all unrealized gain and loss is reflected in capital account balances and because such balances do not include disproportionate sharing ratios, if any, applicable to such unrealized gain and loss as well as to other future items of income and deduction, even capital accounts represent at best a crude measure of the value of interests in the venture. What is the relationship between a partner s outside basis and capital account balance? Because of section 752, outside basis includes a partner s share of the partnership s indebtedness while capital accounts do not have any similar component. 7 In addition, under section 704(c), any variation between the value and the adjusted basis of contributed property is included in the contributed partner s capital account but is not included in the contributed partner s outside basis until the property is disposed of in a taxable transaction or the adjusted basis of the property otherwise affects a taxable event. 8 Further, the rules applicable to contributed property have been extended to revalued partnership property (whether contributed to the partnership by a partner or not) via the requirement of substantial economic effect under section 704(b). 9 Because capital account balances (after adjustment for unrealized gain and loss) determine the amount each partner will receive upon liquidation of the venture, 10 the capital account balances always should reflect the economic relationships among the partners. And if a partner s outside basis differs from that partner s capital account (allowing for the effect of debt on outside basis as well as forward and reverse 704(c) layers on capital accounts), taxation of the partners during the life of the venture will not correspond to their non-tax relationships, a violation of the premise underlying the requirement of economic effect. Consider the following. X and Y form the XY partnership (or limited liability company taxable as a partnership), with X contributing property with adjusted basis of $60 and fair market value of $100 while Y contributes cash of $100. The opening books of the venture will read: 4 See 734(a) (mandatory basis adjustment if there is a substantial basis reduction ), 743(b) (mandatory basis adjustment if there is a substantial built-in loss ). 5 See, e.g., Reg (b)(2)(ii)(b)(1). 6 E.g., Reg (a)(2), (f) (example 2). 7 See Reg (b)(2)(iv)(c). 8 Compare Reg (b)(2)(iv)(d)(1) with Reg (b)(2)(iv)(f). 10 Reg (b)(2)(ii)(b)(2)-(3) (general test for economic effect), (b)(2)(ii)(d)(1) (alternate test for economic effect), 2

3 X Y $100 $ 60 $100 $100 Cash $100 $100 Property X s capital account exceeds X s outside basis by $40, but that book tax disparity corresponds to an equivalent book tax disparity in the partnership s assets. It is a temporary disparity in the sense that it will be eliminated by selling the contributed property. For example, if that property is sold for $110 at some point in the future, and assuming the partners agree to divide profits equally to the extent permitted by section 704, the books will become: X Y $100 $ 60 $100 $100 Formation (c) gain (b) gain $105 $105 $105 $105 Total Cash $210 $210 As these final numbers show, the book/tax disparity for X has been eliminated as has the book tax disparity in the partnership s asset: elimination of the latter eliminated the former en passant. But reconsider this example, assuming that the partnership sells the property contributed by X for $90 rather than for $110. Now, we get the following: X Y $100 $ 60 $100 $100 Formation (c) gain ( 5) 0 ( 5) 0 704(b) loss $ 95 $ 90 $ 95 $100 Total Cash $190 $190 The partnership owns $190 in cash, and each partner s share of that cash is $95 as shown by the capital account balances. For each partner, this represents an economic loss. Looking first at partner Y, this economic loss was not coupled with a deduction of $5 because the partnership has not recognized any taxable loss and so no loss or deduction could be allocated to Y because of the ceiling limitation and so Y suffers from negative deferral. X, on the other hand, contributed property with a built-in gain of $40 yet X has reported only $30 of taxable income following the sale of the contributed asset, and this $30 can be thought of as the $40 built-in gain less $5 as X s share of the economic, post-contribution loss 3

4 and less $5 of positive deferral. That is, the $5 book/tax disparity for each partner represents positive deferral for X and negative deferral for Y. The positive or negative deferral can be terminated by a taxable disposition of the partnership interest by either partner. For example, if Y sells her partnership interest for $95, she will recognize a $5 loss on the sale corresponding to the economic loss suffered by the decline in value of the asset contributed by X. 11 But if X continues to hold his partnership interest, his positive deferral of $5 continues. As a result and regardless of the relative marginal tax rates of the partners the offsetting book/tax disparities of the partners can be converted into a single, positive deferral opportunity by having the partner suffering the burden of negative deferral (here, that is Y) exit the venture in a taxable manner. 12 Permanent book/tax disparities are addressed under current regulations by the 704(c) recovery methods: the traditional method, the traditional method with curative allocations, and the remedial allocation method. The traditional method simply leaves the book/tax disparities as they are and so does not solve the problem 13 while the other two methods can, in general, correct the book/tax disparity for each problem. In particular, use of the remedial allocation method will force partner Y to recognize income of $5 and to permit X to deduct the same amount. But correction of the problem is, in general, optional. In particular, current regulations provide that no partnership can be forced to adopt the remedial allocation method even though it is the only 704(c) recovery method guaranteed to eliminate the book/tax disparities in all cases. 14 The reasoning behind this peculiar willingness to permit partnerships to eschew needed remedial allocations presumably is the concern that such allocations violate the basic premise underlying Subchapter K that allocation rules cannot create tax items not recognized by the entity. What follows are three fact patterns in which the government has been insufficiently sensitive to the deferral potential of book/tax disparities. After each example, I discuss whether the problem can be traced to the Code or to the regulations, and I ask whether potential abuses can be mitigated only by Congress, by administrative guidance, or by the courts. Situation 1 X and Y each contribute $100 to the XY general partnership. The partnership purchases a nondepreciable asset for $10, and it increases in value to $50. At that point, the asset is distributed to X 11 See Cf. Reg (d) (example 8(ii)) (recognizing that negative deferral can be avoided by exiting the venture, allowing positive deferral to continue to the detriment of the Treasury). 13 Book/tax disparities other than those caused by the ceiling limitation are eliminated by the usual rules promulgated under section 704(c)(1)(A) whether by disposition of the property that has a book/tax disparity or through the rules that burn off a book/tax disparity through the special 704(c) depreciation rules. As a result, it is only a permanent disparity caused by the ceiling limitation that the traditional method leaves uncorrected. See Reg (b)(2) (example 1(ii)). 14 Reg (d)(5)(ii). 4

5 in a nonliquidating distribution described in section 731, leaving the partnership with cash of $190. The books of the venture become: X Y $100 $100 $100 $100 Formation Revaluation ( 50) ( 10) 0 0 Distribution $ 70 $ 90 $120 $100 Cash $190 $190 The partnership owns only cash, and aggregate inside basis of $190 equals aggregate book value of the assets, also $190. Similarly, aggregate outside basis of $190 equals asset capital accounts. But comparing each partner s capital account and outside basis, we see that that is a $20 disparity for each partner, with X having a capital account deficit and Y having a capital account surplus. Because the partnership owns only cash, these book/tax disparities are not attributable to any book/tax disparities in the partnership s assets. Accordingly, they should be seen as a failure of Subchapter K to tax the partners properly. What has caused the problem can be seen from examination of Y s capital account. When the property was revalued immediately prior to distribution, the unrealized book appreciation was allocated in part to Y. The increase to Y s capital account, without an equivalent increase to Y s outside basis, causes a book/tax disparity. Usually, a partnership book-up in one year will be followed by a disposition and equivalent taxable gain in a subsequent year, and the subsequent taxable income eliminates the book/tax disparity caused by the revaluation. But because the revalued property is immediately distributed to X, the corrective allocation of dispositional taxable gain cannot occur. And so there is a permanent book/tax disparity for Y. And there is an offsetting book/tax disparity for X because while X s capital account was increased by half of the revaluation gain, it was reduced by the full amount (as well as by the pre-valuation book value of the property, but that does not cause a book/tax disparity). Thus, there is a book/tax disparity for X equal to the revaluation book gain allocated to Y, and because that is the same amount that creates the book/tax disparity for Y, there always will be equal (though opposite sign) book/tax disparities for the two partners when appreciated property is distributed. Note that remedial allocations will cure this problem because it is conceptually identical to a ceiling limitation problem. One wonders why the 704(c) recovery methods cannot be applied on these facts. The answer presumably is that when the 704(c) principles were extended to reverse 704(c) layers under section 704(b), no one saw the equivalence of a disposition (covered by section 704(c) principles) and distributions (not covered by section 704(c) principles). There seems no reason why 704(c) principles could not be extended to this situation by administrative guidance. 5

6 Situation 2 X and Y each contribute $100 to the XY general partnership. The partnership purchases a nondepreciable asset for $10, and it increases in value to $50. At that point, $110 in cash is distributed to X in a distribution described in section 731. The partnership makes an election under section 754 for the year of the distribution, and the partnership elects to revalue its assets and restate capital accounts pursuant to regulation section (b)(2)(f). The books of the venture become: X Y $100 $100 $100 $100 Formation Revaluation ( 110) ( 100) 0 0 Distribution $ 10 $ 0 $120 $100 Cash $ 80 $ 80 Property $10 Increase Under 743(b) If the partnership had not made the election under section 754, aggregate outside basis would not equal aggregate inside basis. But because the election was made, these two quantities are equal. However, the principle underlying section 704(c) is now violated: when the partnership s asset was revalued, the partners agreed to divide the $40 of unrealized appreciation equally. But because of the adjustment under section 754, sale of that property for its current value of $50 will generate a taxable gain of only $30. If that gain is allocated among the partners as they have split the unrealized appreciation (that is, equally), then each partner will recognize a taxable gain of only $15 when the property is sold, yielding: X Y $ 10 $ 0 $120 $ $ 10 $ 15 $120 $115 Cash $130 $130 Aggregate inside basis equals aggregate outside basis, and aggregate capital accounts equal aggregate outside bases. But each partner has a book/tax disparity despite there being no book/tax disparity in any partnership asset. While this could addressed by remedial allocations, in fact there was a more direct way to handle the problem. Prior to making the inside basis adjustment under section 743(b), there was $40 of unrealized appreciation in the partnership s property. The inside basis adjustment in effect converts $10 of that taxable gain into tax-exempt gain, gain that will be exempted for taxation when the property is sold because it was already taxed to X on the distribution of $110 in cash. The inside basis adjustment arises from the distribution not because anything has happened to Y (Y does not recognize any income by reason of the distribution) but only because the distribution triggered income recognition 6

7 to X. Accordingly, the inside basis adjustment should affect X only, and so the books of the partnership should become: X Y $100 $100 $100 $100 Formation Revaluation ( 110) ( 100) 0 0 Distribution Taxable income from sale $ 10 $ 20 $120 $120 Cash $130 $130 Can this result be achieved under the current statute? I think it can: section 734 does not specify how the inside basis adjustment should be allocated nor does section 755 speak to the issue. And the regulations also do not speak to the issue (the two examples in the regulations speak only to liquidating distributions). To be sure, the statute provides in section 743(b) that the inside basis adjustment provided by that section shall constitute an adjustment to the basis of partnership property with respect to the transferee only and section 734(b) has no similar language (substituting distributee for transferee ), but the absence of a parallel construction hardly seems to compel reaching a wrong result. Accordingly, this problem presumably could be resolved either by administrative guidance or by judicial recognition that an ambiguous statute does not mandate a wrong result. Representative David Camp of Michigan, Chairman of the House Committee on Ways and Means, 15 in March of this year submitted a Working Draft on Small Business Tax Reform (hereinafter the Camp Proposal). 16 The Camp Proposal offers a number of technical changes to Subchapter K that would, in the words of the proposal, establish[] additional limits on the use of partnerships as tax avoidance structures without interfering with the legitimate business operations of partnerships, clarif[y] confusing areas of partnership law, and correct[] a technical flaw with partnership rules to align them with S corporation rules. 17 One of those changes would rework the inside basis adjustments now in section 734 and 743, with the principle change to section 734 reading: In the case of any distribution to a partner, the partnership shall adjust the basis of partnership property such that each remaining partner s net liquidation amount immediately after such distribution is equal to such partner s net liquidation amount immediately before such distribution See 16 See 17 The Camp Proposal offers two distinct proposals, with Option 1 including those provisions identified in the text as well as multiple changes to the rules of Subchapter S. Option 2 of the Camp Proposal offers a more radical realignment of Subchapters K and S, replacing both of those subchapters with a single set of provisions applicable to all pass-thru entities with rules that much more closely follow Subchapter S than Subchapter K. 18 Ways and Means Discussion Draft 243(a) (March 12, 2013) (the Camp Proposal ). 7

8 The proposal further defines net liquidation amount to include both the gain or loss that would be recognized by the partnership if it sold all of its assets for fair market value as well as the gain or loss that would be recognized by the distributee partner if it sold all of the distributed assets immediately after the distribution for their fair market value. The point of the proposal is clear: distributions should not be used as a way to rearrange the partners share of gain and loss in partnership assets. Presumably this provision, while disappointingly lacking in detail, would continue the current determination of the amount of the section 734(b) adjustment in this case but would, as proposed above, allocate all of the adjustment to the distributee partner. Despite the broad language in the Camp Proposal s change to section 734(b), it cannot solve the problem identified in situation 1 because the distribution in situation 1 does not inappropriately change the partnership s inside basis in its assets (in the specific example used in situation 1, the partnership owns nothing but cash after the distribution so no inside basis adjustment is appropriate or even possible). By changing the partnership s inside basis, it can cure a book/tax disparity of a single partner, but it cannot speak to the problem of equal but offsetting book/tax disparities for two partners because changing the amount of income recognized by the partnership cannot solve both problems. Situation 3 The PQ partnership owns a single asset with book value of $0, inside basis of $0, and fair market value of $1,000. Each partner has capital account and outside basis of $0, and the partners have agreed to divide gain from the partnership s asset 60% to P and 40% to Q. The partnership borrows $200 on a nonrecourse basis from a third-party lender, Q guarantees repayment of the debt, and the loan proceeds are distributed to Q. The partnership elects to revalue its asset and restate capital accounts by reason of the disproportionate cash distribution. At this point, the books of the venture become: Table 3-1a P Q $ 0 $ 0 $ 0 $ 0 Starting Values Revaluation Borrowing 0 0 ( 200) ( 200) Distribution $600 $ 0 $200 $ 0 Debt Property $1,000 $ 0 ($200) [1] Q now sells one half of her partnership interest for its fair market value of $100 (and the Buyer, B, does not assume any part of the partnership s debt). The partnership makes an election under section 754 for the year, and in a subsequent year, [2] the partnership sells its asset for $1,000 and [3] repays the debt of $200. The books then read: 8

9 Table 3-1b P Q B CA OB $600 $ 0 $200 $ 0 $--- $ ( 100) [1] [2] ( 200) 0 0 [3] $600 $600 $100 $ 0 $100 $100 Cash $800 $800 As can be seen from Q s T-account, something has gone wrong. Prior to the sale by Q of half her interest in the venture, there was $1,000 of unrealized (tax) appreciation in the partnership s asset, of which 60% was allocable to P and 40% to Q. When Q sold half her partnership interest to B for $100, Q recognized a gain of $100. When the property was sold, Q recognized an additional gain of $200. When the debt was repaid (resulting in a deemed distribution of $200 to Q under section 752(b)), Q did not include any additional income. Thus, Q reported a total of $100 + $200 + $0 = $300 from the series of transaction, and that is $100 less than Q s 40% share of the gain that should have been allocable to Q. Of course, if B would have picked up $100 of gain anywhere on the transaction, there would be no missing income. But the election under section 754 ensures that B s $200 share of dispositional gain is fully eliminated by the inside basis adjustment under 743(b), so in fact $100 of gain from the property simply disappears. To be sure, it will reappear if Q sells her partnership interest or receives cash in a liquidating distribution, but that may not happen for a very long time, if ever. What went wrong? There are two possible answers. First, when Q sold half of her partnership interest for $100, she recognized a taxable gain of only $100 (amount realized of $100 less allocable share of $0 outside basis). But if the partnership s asset has a value of $1,000 and an inside basis of $0, there is appreciation of $1,000 inside the partnership. Of that amount, Q s share (prior to the sale) was 40%, or $400. So one would think that selling half of that 40% would trigger recognition of half of Q s share of the gain, or $200. But under current law, Q recognizes a gain of only $ Second, when Q sold half of her interest in the venture, a portion of Q s 704(c) gain moved to B and a portion stayed by Q. 20 If one-half of the $200 built-in gain moves from Q to B on the sale, then only $200 of the gain remains with Q. Because whatever portion of the built-in gain moves to B will then be 19 The tax consequences of the partial sale of a leveraged partnership interest are addressed in Rev. Rul , C.B In that Ruling, the Service concludes that proper adjustment must be made to the selling partner s outside basis to account for unshifted liabilities. In the example in the text, Q s outside basis is zero so no adjustment is possible. 20 Current regulations provide that upon the transfer of a part of an outstanding partnership interest, [t]he share of built-in gain or loss proportionate to the interest transferred must be allocated to the transferee partner. Reg (a)(7). 9

10 eliminated by the section 743(b) inside basis adjustment, the sale eliminates more gain than Q recognized on the sale. 21 Consider first the possibility that Q recognized an insufficient amount of gain on the sale to B. Since gain is computed as the excess, if any, of amount realized over adjusted basis, Q s gain can exceed $100 on the sale only if Q s amount realized exceeds the cash received of $100 or Q s adjusted basis on the sale is less than zero. Because there is no statutory basis for treating a partner as having a negative outside basis, 22 the gain can be increased only by finding an additional amount realized. To understand why the computation of gain from the partial sale of a partnership interest is complicated, consider the following facts: X and Y each own half of the XY partnership. XY owns Blackacre with inside basis of $400, fair market value of $500, and subject to a debt of $380. Each partner has an outside basis $200 (including one-half of the partnership s debt). Y sells one-half of her interest (that is, one-quarter of the partnership) to Z for its fair market value of $ If none of the debt shifts to Z as a result of the sale and we simply compute Y s gain or loss from the sale in the usual way, then Y s amount realized equals $30 and Y s adjusted basis in the interest sold equals $100, 24 so Y realizes a loss of $70 on the sale. But this cannot be right: the partnership owns a single asset, and that asset has appreciated rather than declined in value. Similarly, Y is selling a portion of her partnership interest, and her partnership interest has appreciated in value. It simply cannot be the case that Y recognizes a loss on the sale of a portion of her appreciated partnership interest. 25 In Revenue Rule 84-53, 26 the Service addressed this problem, concluding that liabilities allocable to the selling partner under section 752 must be removed from the selling partner s outside basis for computing gain or loss from the sale to the extent the liabilities do not shift to the buyer. So, for example, in the fact pattern discussed above, Y s outside basis for computing gain or loss on the sale is treated as $100 less $95, or $5. As a result, Y recognizes a gain of $25 on the sale (amount realized of $30 less adjusted basis of $5). Because the partnership s asset has unrealized appreciation of $100, and because Y is selling a 25% interest in the venture, recognition of $25 is appropriate. On the facts described in Tables 3-1a and 3-1b, the rule discussed above from Revenue Ruling cannot be applied because Q s outside basis is insufficient to absorb reduction by the unshifted liabilities. Revenue Ruling also considered this possibility and provides that when the selling partner s outside basis is too low to absorb complete elimination of the unshifted debt, gain and loss is 21 See generally Howard E. Abrams, Now You See It; Now You Don't: Exiting a Partnership and Making Gain Disappear, 22 Cf. 733 (distribution reduces distribuee partner s outside but not below zero ). 23 Since the partnership owns an asset with value of $500 encumbered by a debt of $380, the partnership s equity equals $120, and one-quarter of $120 equals $ Y s total outside basis equals $200, so the portion of Y s outside basis allocable to the portion sold equals onehalf of $200, or $100. See Reg (b). 25 See RICHARD L. DOERNBERG, HOWARD E. ABRAMS & DON A. LETHERMAN, FEDERAL INCOME TAXATION OF CORPORATIONS AND PARTNERSHIPS (4th ed. 2009) C.B

11 computed by reducing basis only by a portion of the unshifted debt. This rule, quoted in the margin, 27 ensures that the selling partner s outside basis for computing gain or loss from the partial sale of a partnership interest cannot become negative. One consequence of this rule is that when the selling partner has a zero basis immediately prior to the sale, there is no adjustment for any unshifted debt. Reducing outside basis for unshifted debt is a peculiar response to the problem addressed by Revenue Ruling 84-53: usually, debt is added to amount realized rather than subtracted from adjusted basis. 28 Because no analysis for the rules announced in Revenue Ruling were provided, we cannot know for certain why the government adopted a rule so contrary to the usual rule for accounting for liabilities in the sale or exchange of property. If a taxpayer owns encumbered property and transfers that property subject to the debt, the taxpayer s amount realized equals not only any cash and the value of any property actually received by the seller but also the debt encumbering the property 29 even if the selling taxpayer remains liable on the debt. 30 If we treat Q s share of the partnership s indebtedness as equivalent to an encumbrance on Q s partnership interest, then Q s amount realized should be increased by one-half of the debt (because Q is selling only one-half of her partnership interest), resulting in an amount realized of $200 and gain of $200 on the sale. Note that section 752(d) expressly provides that a partner s share of the partnership s liabilities are treated as part of the amount realized on the sale or exchange of a partnership interest, and there is no obvious reason why this provision should not apply to the sale or exchange of a part of a partnership interest. Put another way, the Service s decision to adjust the selling partner s outside basis to account for partnership liabilities seems misplaced. 31 And yet this approach, too, is not without its difficulties. If we assume, contrary to Revenue Ruling 84-53, that Q s amount realized equals the unshifted liabilities (that is, one half Q s liabilities because none of the liabilities shift under the rules of section 752(b) and Q is selling half of her partnership interest), then the books become: 27 [I]f the partner's share of all partnership liabilities exceeds the adjusted basis of such partner's entire interest (including basis attributable to liabilities), the adjusted basis of the transferred portion of the interest equals an amount that bears the same relation to the partner's adjusted basis in the entire interest as the partner's share of liabilities that is considered discharged on the disposition of the transferred portion of the interest bears to the partner's share of all partnership liabilities. Rev. Rul , C.B See Tufts v. Commissioner, 461 U.S. 300 (1983); Reg (a)(1). 29 Id. 30 See Reg (a)(4)(ii); McNulty v. Commissioner, T.C. Memo Note also that treating a portion of the selling partner s share of liabilities as contributing to the selling partner s amount realized should have no impact on the allocation of debt under section 752, just as the liability subtract rule articulated by Revenue Ruling has no impact on allocation of debt under section

12 Table 3-1c P Q B CA OB $ 0 $ 0 $ 0 $ 0 $--- $--- [1] [2] [3] 0 0 ( 200) ( 200) [4] $600 $ 0 $200 $ 0 $--- $ ( 100) [5] [6] ( 200) 0 0 [7] $600 $600 $100 $ 0 $100 $100 Cash $800 $800 Row [1] shows the opening books of the venture. Row [2] shoes the revaluation of the partnership s assets and restatement of the partners capital accounts. Row [3] shows the partnership borrowing, with all of the debt assumed to be allocable to Q. And Row [4] shows the distribution of cash to Q. Row [5] shows the sale by Q of half of Q s partnership interest without any debt shift under section 752. However, we assume that one-half of Q s share of the partnership s debt is added to the cash paid by B, so that Q s amount realized on the sale equals $100 + $100, or $200. This yields a taxable gain of $200, because Q s outside basis equals $0 immediately prior to the sale, and one-half of that amount (that is, one half of $0, or $0) is allocable to the portion of the partnership interest sold by Q. Row [6] shows that the sale of the property by the partnership generates taxable income of $1,000, allocable $600 to P, $200 to Q, and $200 to B (fully offset by Q s inside basis adjustment under section 743(b)). And Row [7] shows that repayment of the debt by the partnership reduces Q s outside basis to $0. Q has been properly taxed so far ($200 on the partial sale of Q s partnership interest and $200 on disposition by the partnership of its asset), but Q s outside basis equals only $100. As a result, a sale by Q of her partnership interest (or a liquidating distribution of cash) will trigger further gain recognition of $100, and there is no reason why Q should recognize further income from disposition of her interest in the venture. Much of the analysis described above seems right: (1) when Q sells half of her partnership interest, Q recognizes half of her share of the unrealized appreciation in the partnership s asset; (2) when the asset is sold, Q recognizes the remainder of her share of the appreciation in the partnership s asset; and (3) B s inside basis adjustment under section 743(b) equals the amount paid by B for the partnership interest acquired by B, thereby equating B s inside and outside basis. However, one thing plainly is wrong: Q s outside basis ends at $0 when it should equal $100. What went wrong? If (as proposed) a proportionate part of Q s share of the liabilities is treated as contributing to the amount realized, then we cannot use that portion of the liability again to reduce Q s basis or trigger 12

13 income to Q when the liability disappears. That is, to the extent a portion of the liabilities are treated as contributing to Q s amount realized, that portion should not be subject to section 752(b) when they are repaid to the lender. This rule surely makes sense (liabilities should be counted once but only once) and finds limited support in the regulations. 32 Reconsider the example above, changing the pre-sale borrowing and distribution from $200 to $300. The books become: Table 3-2a P Q $ 0 $ 0 $ 0 $ 0 Starting Values Revaluation Borrowing 0 0 ( 300) ( 300) Distribution $600 $ 0 $100 $ 0 Debt Property $1,000 $ 100 ($300) [1] If Q then sells one half of her partnership interest for its fair market value of $50 (and assuming the Buyer, B, does not assume any part of the partnership s debt but, as discussed above, Q s amount realized on the sale includes both the $50 actually received as well as one-half of Q s share of the liabilities, for a total of $200), and in a subsequent year, [2] the partnership sells its asset for $1,000 and [3] repays the debt of $300. The books will read: 32 Reg (3) provides: In the case of a liability incurred by reason of the acquisition of the property, this section [adding release of a debt to amount realized] does not apply to the extent that such liability was not taken into account in determining the transferor s basis for the property. While the liabilities fully contributed to Q s outside basis under section 752(a), by including a portion of the liabilities in amount realized on the disposition by Q of a part of Q s partnership interest, that portion of the liabilities were in effect removed from Q s outside basis. 13

14 Table 3-2b P Q B CA OB $600 $ 0 $100 $ 0 $--- $ ( 50) [1] [2] ( 300) * 0 0 [3] $600 $600 $ 50 $ 0 $ 50 $ 50 Cash $700 $700 * The deemed distribution of $300 only reduces Q s outside basis by $200 and triggers gain to Q of $100, 731(a)(1). Q picked up income of $200 on the sale to Q as well as $200 on the sale by the partnership of its property. But when the debt is repaid, Q receives a deemed distribution of $300 with an outside basis of only $200, forcing recognition of an additional $100, and that is $100 of gain more than Q should recognize. As discussed above, if the portion of the liability that was added to Q s amount realized is excluded from section 752(b) when the liability is repaid, then the liability repayment is tax-free to Q and Q s outside basis ends at $50. Is this the right answer? It is. Q reported $200 of taxable income from the sale to B and another $200 distributive share of gain when the partnership s asset was sold, for total income recognition of $400. On the distribution of loan proceeds, Q received cash of $300 and then received another $50 on the sale to Q. Since Q s cash flow ($350) is less than Q s income recognition ($400), there is no policy reason why repayment of debt by the partnership generally a tax-free taxation should trigger income recognition to Q. Taking $150 of the liabilities out of section 752(b) eliminate the extra gain recognition and ensures Q s ending outside basis equals her ending capital account balance. Reconsider this transaction but assume that the partnership does not distribute the loan proceeds to Q. Then, the analysis becomes: Table 3-3 P Q B CA OB $ 0 $ 0 $ 0 $ 0 $--- $ ( 150) ( 300) 0 0 $600 $600 $200 $ 50 $200 $200 Cash $1000 $1000 On the sale by Q of half her partnership interest, Q receives $200 in cash. Assuming we treat the unshifted portion of the debt as contributing to the amount realized, the amount realized equals $350, 14

15 and because the applicable portion of Q s outside basis equals $150, there is gain recognition of $200. Then when the partnership sells its asset, Q s distributive share of the gain equals an additional $200. Finally, when the debt is repaid, Q recognizes no gain under section 752(b) but reduces her outside basis down from $350 to $50. Thus, the total gain recognized by Q is $400, precisely Q s share of the appreciation in the partnership s asset. But Q s outside basis equals only $50, which means that if Q should sell her interest for current value of $200 (or, equivalently, received a liquidating distribution of $200 in cash), Q will recognize an additional $150 of gain, a gain that cannot be justified on any basis. But, as before, if we exclude from section 752(b) the portion of the liability that contributed to Q s amount realized, outside basis ends as it should equal to Q s capital account. To summarize, when a partner sells a portion of her partnership interest, a proportionate part of the selling partner s liability share should be added to the seller s amount realized even if no part of the debt shifts to the buyer. And when the debt is repaid, the portion of the debt that contributed to the seller s amount realized should not be captured by section 752(b). Can a court reach this result without a change to the section 741 and 752 regulations? Perhaps not: putting some of the debt into amount realized seems the right result under general tax principles and there is no regulation that says the opposite. But that result makes little sense without an offsetting change to the operation of section 752(b), and there is no easy way to find such a rule in the existing regulations. To be sure, there is no obvious authority for the basis subtraction rule adopted in Revenue Ruling 84-53, and so the replacement of that Ruling by one adopting the approach proposed above might well be accepted. Will the Service be willing to rethink Revenue Ruling 84-53? Unlikely. If not, there remains another alternative. Recall that by following the rule articulated in Revenue Ruling 84-53, the partial sale of a partnership interest by a partner having a low outside basis allows some gain to disappear. 33 But if that approach is accepted, the missing gain can be restored by increasing the portion of Q s built-in gain that remains with Q rather than shifts to B. How much of Q s built-in gain should be shifted to B? Current regulations provide that, upon the sale of a portion of a partnership interest, [t]he share of built-in gain or loss proportionate to the interest transferred must be allocated to the transferee partner. 34 As a result, half of Q s built-in gain is transferred to B when Q sells half of her partnership interest. But such a rule is hopelessly naïve: any portion of Q s built-in gain that shifts to B will be eliminated from recognition by an inside basis adjustment under section 743(b). 35 As I have argued elsewhere, only built-in gain recognized by Q on the sale should be eliminated from subsequent entity-level recognition by transfer to B. 36 So, for example, if under Revenue Ruling Q recognizes only $50 of gain on the sale to B, then only $50 of Q s built-in gain should be transferred from Q to B. To be sure, this rule does not ensure that selling half of a partnership interest will trigger half of the selling partner s share of appreciation in the partnership s asset, but it at least ensures that whatever gain is not picked up then will be includible to Q when the partnership s appreciated assets are sold. Can this result be reached under current law (assuming the basis subtraction rule of Revenue Ruling continues)? Because of the proportionate to the interest transferred language quoted above, it 33 See Tables 3-1a and 3-1b above and the discussion following Table 3-1b. 34 Reg (a)(7). 35 Howard E. Abrams, Partnership Book-Ups, 127 TAX NOTES 435, 440 (April 26, 2010). 36 Id. 15

16 may be hard to get to that result. But one way to read this language is focus on the selling partner s share of the partnership s equity undiminished by the selling partner s share, if any, of the venture s liabilities. Returning to Tables 3-1a and 3-1b, Q recognizes a gain of $50 on the sale to B, and Q s share of the value of the partnership s assets (undiminished by the liabilities) equals $400. As a result, the portion of the built-in gain that should shift to B equals 50/400, or one-eighth. Of course, one-eighth of $400 is $50, precisely the gain recognized on the sale to B. A strained reading of [t]he share of built-in gain or loss proportionate to the interest transferred must be allocated to the transferee partner? Sure. But it reaches the right result if the government is unwilling to rethink Revenue Ruling