BASIS ADJUSTMENTS RELATING TO TRANSFER OF PARTNERSHIP INTERESTS/DISTRIBUTIONS

BASIS ADJUSTMENTS RELATING TO TRANSFER OF PARTNERSHIP INTERESTS/DISTRIBUTIONS I. Section 754. A. Introduction. Code 754 is an important, but optional provision which permits a partnership to file an election which will allow it to adjust the basis of partnership property in the event of certain distributions (in accordance with Section 734) or allow a partner to adjust the basis of his share of partnership assets in the event of a transfer of a partnership interest (in accordance with Section 743). Absent a 754 election, there is no authority to adjust the basis of partnership assets directly as a result of distributions and transfers. B. The Election. The election is made for the first year that it is desired on the return for that year. Once made, the election applies with respect to all distributions of property by the partnership, and to all transfers of interests in the partnership, during the taxable year with respect to which such election was filed and all subsequent taxable years. Although a 754 election may be revoked by the partnership, the revocation is subject to strict regulatory limits. II. Section 743. A. Transfers of Interests: The Section 743(b) Adjustment. IN THE CASE OF A TRANSFER OF A PARTNERSHIP INTEREST, THE 754 ELECTION GIVES RISE TO A 743(B) ADJUSTMENT IF THE OUTSIDE BASIS OF THE TRANSFEREE PARTNER IS MORE OR LESS THAN THE INSIDE BASIS OF THE PARTNERSHIP. This may result in a positive or negative 743(b) adjustment. Under 743(b), the effect of the inside basis adjustment is solely for the benefit (or detriment) of the transferee partner and not the partnership or the other partners. EXAMPLE #1 Assume that Partnership ABC has the following balance sheet. The partnership has a 754 election in effect when X agrees to buy A s interest for $100,000 cash. {09000.BKW / 00932053.DOC.1 } 1

Partnership ABC Tax Basis Book Value Cash $110,000 $110,000 Stock 160,000 190,000 Total Assets 270,000 300,000 A 90,000 100,000 B 90,000 100,000 C 90,000 100,000 Total Capital $270,000 $300,000 Since the 754 election is in effect, a 743(b) adjustment of $10,000 will be made. As provided in 755, the adjustment will result in a increase to the partnership s basis in the stock of $10,000, but only for the benefit of X. This adjustment is normally kept as a memo account for the benefit of X and not on the partnership's balance sheet. Note that the election/adjustment has no impact on X s capital account, which is "inherited" from A. Nor does the election impact B or C. The adjustment for X should be kept in a memo account for X and should not be reflected on the partnership s books. The balance sheet for the partnership remains the same. EXAMPLE #2 Assume that same facts as in Week 11, Example 1, except that 1 month after X s admission, the partnership sells the stock for $220,000. Since the partnership has $60,000 gain without regard to the 743(b) adjustment ($220,000 - $160,000), it will allocate $20,000 gain to each of the partners. As to X only, his $20,000 gain allocation will be reduced by the $10,000 743(b) adjustment to basis, so that X reports only $10,000 gain. EXAMPLE #3 Assume that same facts as Example 1, except that the partnership never made a 754 election. In this situation, no basis adjustment is permitted to reflect X s purchase of A s interest, and if the stock is subsequently sold for $220,000, X will be allocated and must report his full 1/3 share of the $60,000 gain, that is $20,000. The only time X will recover the additional $10,000 of "outside basis" will be on liquidation of the partnership. {09000.BKW / 00932053.DOC.1 } 2

III. Determination of Amount of Adjustments Under 743. A. General Rule. The 743 regs provide: A transferee s share of the adjusted basis of partnership property is equal to the sum of the transferee s interest as a partner in the partnership s previously taxed capital, plus the transferee s share of partnership liabilities. Generally, a transferee s interest as a partner in the partnership s previously taxed capital is equal to-- (i) The amount of cash that the transferee would receive on a liquidation of the partnership following the "Hypothetical Transaction," (to the extent attributable to the acquired partnership interest); increased by (ii) The amount of tax loss (including any remedial allocations under 1.704-3(d)), that would be allocated to the transferee from the Hypothetical Transaction (to the extent attributable to the acquired partnership interest); and decreased by (iii) The amount of tax gain (including any remedial allocations under 1.704-3(d)), that would be allocated to the transferee from the Hypothetical Transaction (to the extent attributable to the acquired partnership interest). B. Hypothetical Transaction Defined. The Hypothetical Transaction is defined as an imaginary disposition by the partnership of all of the partnership s assets, immediately after the transfer of the partnership interest, in a fully taxable transaction for cash equal to the fair market value of the assets. ( 1.743-1(d)(2)) EXAMPLE #4 A is a member of partnership PRS in which the partners have equal interests in capital and profits. The partnership has made an election under section 754, relating to the optional adjustment to the basis of partnership property. A sells its interest to T for $22,000. The balance sheet of the partnership at the date of sale shows the following: Assets Adjusted Basis Fair Market Value Cash $5,000 $5,000 Accounts Receivable 10,000 10,000 Inventory 20,000 21,000 Depreciable Assets 20,000 40,000 Total $55,000 $76,000 {09000.BKW / 00932053.DOC.1 } 3

Liabilities and Capital Adjusted Per Books Fair Market Value Liabilities $10,000 $10,000 Capital: A 15,000 22,000 B 15,000 22,000 C 15,000 22,000 Total $55,000 $76,000 The amount of the basis adjustment under section 743(b) is the difference between the basis of T s interest in the partnership and T s share of the adjusted basis to the partnership of the partnership s property. Under section 742, the basis of T s interest is $25,333 (the cash paid for A s interest, $22,000, plus $3,333, T s share of partnership liabilities). T s interest in the partnership s previously taxed capital is $15,000 ($22,000, the amount of cash T would receive if PRS liquidated immediately after the hypothetical transaction, decreased by $7,000, the amount of tax gain allocated to T from the hypothetical transaction). T s share of the adjusted basis to the partnership of the partnership s property is $18,333 ($15,000 share of previously taxed capital, plus $3,333 share of the partnership s liabilities). The amount of the basis adjustment under section 743(b) to partnership property therefore, is $7,000, the difference between $25,333 and $18,333. Professor Hint: This is a funny way of saying the adjustment is equal to the difference between the Book Value (restated as of the date of the transfer) of the selling partner's capital account and the tax basis capital account of the selling partner subject to 704c adjustments. In this example, $22,000 - $15,000 = $7,000. EXAMPLE #5 A, B, and C form partnership PRS, to which A contributes land (Asset 1) with a fair market value of $1,000 and an adjusted basis to A of $400, and B and C each contribute $1,000 cash. Each partner has $1,000 credited to it on the books of the partnership as its capital contribution. The partners share in profits equally. During the partnership s first taxable year, Asset 1 appreciates in value to $1,300. A sells its one-third interest in the partnership to T for $1,100, when an election under section 754 is in effect. The amount of tax gain that would be allocated to T from the hypothetical transaction is $700 ($600 section 704(c) built-in gain, plus one-third of the additional gain). Thus, T s interest in the partnership s previously taxed capital is $400 ($1,100, the amount of cash T would receive if PRS liquidated immediately after the hypothetical transaction, decreased by $700, T s share of gain from the hypothetical transaction). The amount of T s basis adjustment under section 743(b) to partnership property is $700 (the excess of {09000.BKW / 00932053.DOC.1 } 4

$1,100, T s cost basis for its interest, over $400, T s share of the adjusted basis to the partnership of partnership property). At the time of T s entry, the PRS balance sheet was: PRS Assets Adjusted Basis Fair Market Value Cash $2,000 $2,000 Land 400 1,300 Total $2,400 $3,300 Liabilities and Capital Adjusted Per Books Fair Market Value Liabilities $ -0- $ -0- Capital: A 400 1,100 B 1,000 1,100 C 1,000 1,100 Total $2,400 $3,300 If you simply assume T is a 1/3 partner upon entrance, then his underlying share of partnership basis would appear to be $2,400/3, or $800, resulting in a $300 743(b) adjustment, since T paid $1,100 for his interest. But, because of the way that the 704(b) requires 704( c) gains to be allocated arising from A s original contribution of property with $600 built in gain potential, T s immediate potential tax gain is $700 (the $600 704(b)/704( c) gain "acquired" from A, plus 1/3 of the $300 additional gain arising from the land s appreciation while held by the partnership. IV. Special Situations Under 743. A. What happens if a transferee s special basis adjustment property is distributed to the transferee? If a partnership distributes property to a transferee and the transferee has a basis adjustment for the property, the basis adjustment is taken into account for purposes of the property distribution basis rules of section 732. See 1.732-2(b). B. What happens if a transferee s special basis adjustment property is distributed to another partner? A transferee with a basis adjustment in property that is distributed to another partner reallocates the basis adjustment among the remaining items of partnership property under 1.755-1(c). {09000.BKW / 00932053.DOC.1 } 5

C. What happens if a transferee receives liquidating property distributions? If a transferee receives a distribution of property (whether or not the transferee has a basis adjustment in such property) in liquidation of its interest in the partnership, the adjusted basis to the partnership of the distributed property immediately before the distribution includes the transferee s basis adjustment for the property in which the transferee relinquished an interest (either because it remained in the partnership or was distributed to another partner). Any basis adjustment for property in which the transferee is deemed to relinquish its interest is reallocated among the properties distributed to the transferee under 1.755-1(c). V. Section 734. A. NO ADJUSTMENT RULE. DISTRIBUTIONS OF PARTNERSHIP PROPERTY TO PARTNERS, LIKE CORPORATE DISTRIBUTIONS OF PROPERTY TO SHAREHOLDERS, GENERALLY DO NOT AFFECT THE BASIS OF UNDISTRIBUTED PROPERTY. EXAMPLE #6 Assume the balance sheet of the equal ABC partnership is as follows: Assets Adjusted Basis Fair Market Value Cash $2,000 $2,000 Blackacre 1,000 4,000 Total Assets $3,000 $6,000 Capital A $1,000 $2,000 B 1,000 2,000 C 1,000 2,000 Total Capital $3,000 $6,000 Assume that A receives cash of $2,000 in complete liquidation of his interest, recognizing gain of $1,000. Under the general rule of 734(a), the basis of the partnership property is not adjusted to reflect the recognition of this gain by A, and on a subsequent sale of Blackacre for $4,000, an additional gain of $3,000 is realized and taxed to partners B and C, causing each to recognize taxable income of $1,500 instead of $1,000. This will result in an outside basis adjustment to B and C which will be reconciled on liquidation of the Partnership. {09000.BKW / 00932053.DOC.1 } 6

VI. Optional Adjustment Rule of 734(b) A. Election. If the partnership makes a valid 754 election it may adjust the basis of its assets to reflect gain or loss to a partner arising from partnership distributions. This is a partnership basis adjustment, not a partner basis adjustment. B. METHOD OF ADJUSTING BASIS. THE AMOUNT OF THE 734(B) ADJUSTMENT IS DETERMINED AS FOLLOWS: 1. IF AN AMOUNT OF MONEY IS DISTRIBUTED WHICH EXCEEDS THE DISTRIBUTEE'S PREDISTRIBUTION BASIS IN HIS PARTNERSHIP INTEREST, THE DISTRIBUTEE RECOGNIZES GAIN IN THE AMOUNT OF THE EXCESS UNDER 731(A)(1), AND THE PARTNERSHIP IS ENTITLED TO INCREASE THE BASIS OF ITS REMAINING ASSETS BY A LIKE AMOUNT UNDER 734(B)(1)(A). 2. IF A PARTNERSHIP INTEREST IS COMPLETELY LIQUIDATED SOLELY IN EXCHANGE FOR CASH, UNREALIZED RECEIVABLES ( 751(C))) AND INVENTORY ( 751(D)(2)), THE DISTRIBUTEE RECOGNIZES A LOSS UNDER 731(A)(2) IF THE PREDISTRIBUTION BASIS OF HIS PARTNERSHIP INTEREST EXCEEDS THE AMOUNT OF CASH AND THE PARTNERSHIP S ADJUSTED BASIS OF THE UNREALIZED RECEIVABLES AND INVENTORY DISTRIBUTED, THEN 734(B)(2)(A) REQUIRES THE PARTNERSHIP TO DECREASE THE BASIS OF ITS REMAINING ASSETS BY THE AMOUNT OF THE LOSS. 3. IF THE PARTNERSHIP'S BASIS IN ASSETS DISTRIBUTED TO A PARTNER EXCEEDS THE DISTRIBUTEE'S BASIS IN HIS INTEREST, THE DISTRIBUTEE'S AGGREGATE BASIS IN THE DISTRIBUTED ASSETS IS LIMITED TO HIS PREDISTRIBUTION BASIS IN HIS PARTNERSHIP INTEREST UNDER 732(A)(2) AND 732(B), THEN 734(B)(1)(B) ALLOWS THE PARTNERSHIP TO INCREASE THE BASIS OF ITS REMAINING ASSETS BY AN AMOUNT EQUAL TO THE EXCESS OF THE PARTNERSHIP'S ADJUSTED BASIS IN ITS ASSETS OVER THE DISTRIBUTEE'S ADJUSTED BASIS IN THEM. 4. IF A PARTNER'S INTEREST IS COMPLETELY LIQUIDATED AND THE AGGREGATE BASIS OF DISTRIBUTED ASSETS IN HIS HANDS IS GREATER THAN THE PARTNERSHIP'S PREDISTRIBUTION BASIS IN THE ASSETS, THEN THE PARTNERSHIP'S BASIS IN ITS REMAINING ASSETS IS DECREASED UNDER {09000.BKW / 00932053.DOC.1 } 7

734(B)(2)(B) BY THE EXCESS OF THE DISTRIBUTEE'S BASIS IN THE DISTRIBUTED ASSETS OVER THE PARTNERSHIP'S PREDISTRIBUTION BASIS IN THEM. EXAMPLE #7 Assume the same facts as in Week 11, Example 6. If a 754 election had been in effect with respect to the cash distribution to A in the example set forth above, the partnership's basis in asset X would have been increased under 734(b)(1)(A) by the $1,000 gain recognized by A. A subsequent sale of assets by X would have generated gain taxable to B and C of $1,000 each. C. Distributions of Property. The basis of property distributed in a current distribution is generally the same in the hands of the distributee as it was in the hands of the partners ( 732(a)(1)), and 734(b) has no impact on the basis of the remaining partnership assets in connection with such distributions except under 732(a)(2) which limits the basis of property received in a current distribution to the distributee s outside basis. Similarly, in the case of a liquidating distribution, the basis of distributed property may be increased or decreased under 732(b) to equate to the distributee s outside basis. TO THE EXTENT THE BASIS OF DISTRIBUTED ASSETS IS DECREASED UNDER EITHER OF THESE EXCEPTIONS TO THE GENERAL CARRYOVER BASIS RULE, THE BASIS OF REMAINING PARTNERSHIP ASSETS IS INCREASED UNDER 734(B)(1)(B); TO THE EXTENT THE BASIS OF THE DISTRIBUTED ASSETS IS INCREASED, THE BASIS OF THE RETAINED ASSETS IS DECREASED UNDER 734(B)(2)(B). EXAMPLE #8 Assume the balance sheet of partnership DEF is as follows: Assets Adjusted Basis Fair Market Value Cash $ 4,000 $ 4,000 Capital Asset X 11,000 11,000 Capital Asset Y 15,000 18,000 Total Assets $30,000 $33,000 Capital D $10,000 $11,000 E 10,000 11,000 F 10,000 11,000 Total Capital $30,000 $33,000 {09000.BKW / 00932053.DOC.1 } 8

If D receives asset X in complete liquidation of his partnership interest, his basis in X is $10,000 under 732(b), or $1,000 less than the partnership's basis. Consequently, if the partnership makes a 754 election, it is entitled to increase the basis of its remaining assets by $1,000 under 734(b)(1)(B). This increase is allocated to Capital Asset Y under 755, and the partnership's post-distribution balance sheet is as follows: Assets Adjusted Basis Fair Market Value Cash $ 4,000 $4,000 Capital Asset Y 16,000 18,000 Total Assets $20,000 $22,000 Capital E 10,000 11,000 F 10,000 11,000 Total Capital $20,000 $22,000 VII. Section 755. A. Introduction. IRC 755 provides for two different methods of allocation of basis adjustments depending on whether the transaction falls under 734 or 743. As mentioned above, 743 applies to transfers of partnership interest, whereas 734 applies to distributions from a partnership to a partner. B. Capital Assets vs. Ordinary Income Assets. To make the allocation under 755 and without regard to whether 743 or 734 is involved, a division first must be made on the partnership books between Capital Assets and 1231 Assets (collectively "Capital Gain Property") and any other partnership property ("Ordinary Income Property"). In the case of a transaction under IRC 743, the gain or loss on a sale of a partnership interest is then allocated proportionately between the classes based on the net gain or net loss within each class. In the case of a transaction under 734, the character of the property distributed is first identified as Capital Gain Property or Ordinary Income Property. The basis adjustment to the partnership assets occurring from the distribution is generally restricted to the same class of property (Capital or Ordinary) as was distributed by the partnership. C. Hypothetical Transaction. Under 755, the regulations use what is called a "Hypothetical Transaction." Pursuant to the regulations, the Hypothetical Transaction is the amount of income, gain, or loss (including remedial allocations under 1.704-3(d) that the {09000.BKW / 00932053.DOC.1 } 9

transferee partner would receive (to the extent attributable to the acquired partnership interest) if, immediately after the transfer of the partnership interest, all of the partnership s property were disposed of in a fully taxable transaction for cash in an amount equal to the fair market value of such property. By this the regulations mean that the amount of gain or loss for each class of Capital Gain Property or Ordinary Income Property based on an ASSUMED SALE by the partnership of all the properties for fair market value. To determine the amount of gain or loss allocable to each partner, the provisions of IRC 704 control. D. Section 743 - Allocation of Basis Adjustment Between Capital Gain Property and Ordinary Income Property. EXAMPLE #9 A and B form equal partnership AB. A contributes $50,000 in cash and Asset 1, a nondepreciable capital asset with a fair market value of $50,000 and an adjusted tax basis of $25,000. B contributes $100,000. AB uses the cash to purchase Assets 2, 3, and 4. After a year, A sells its interest in AB to T for $120,000. At the time of the transfer, A s share of the partnership s basis in partnership assets is $75,000. Therefore, T receives a $45,000 basis adjustment. Immediately after the transfer of the partnership interest to T, the adjusted basis and fair market value of AB s assets are as follows: Assets Adjusted Basis Fair Market Value Capital Gain Property: Asset 1 $25,000 75,000 Asset 2 100,000 117,500 Ordinary Income Property: Asset 3 40,000 45,000 Asset 4 10,000 2,500 Total $175,000 $240,000 If AB sold all of its assets in a fully taxable transaction at fair market value immediately after the transfer of the partnership interest, the total amount of capital gain that would be allocated to T is equal to $46,250 ($25,000 704(c) built-in gain from Asset 1, plus 50 percent of the $42,500 appreciation in Capital Gain Property). T would also be allocated a $1,250 ordinary loss from the sale of the Ordinary Income Property. The amount of the basis adjustment that is allocated to Ordinary Income Property is equal to ($1,250) (the amount of the loss allocated to T from the hypothetical sale of the Ordinary Income Property). {09000.BKW / 00932053.DOC.1 } 10

The amount of the basis adjustment that is allocated to Capital Gain Property is equal to $46,250. This is computed by taking the total basis adjustment of $45,000 increased by the $1,250 ordinary loss attributable to the hypothetical sale of the Ordinary Income Property. VIII. Section 743 - Specific Rules for the Allocations Within the Items Comprising each Class of Property. The regulations provide as follows: A. Allocation Within the Class. (1) Ordinary Income Property. The amount of the basis adjustment to each item of property within the class of Ordinary Income Property is equal to: (a) The amount of income, gain or loss (including any remedial allocations under 1.704-3(d)) that would be allocated to the transferee (to the extent attributable to the acquired partnership interest) from the hypothetical sale of the item; reduced by (b) The product of: (i) Any decrease to the amount of the basis adjustment to Ordinary Income Property required pursuant to the last sentence of Reg. 1.755-2(b)(i); multiplied by (ii) A fraction, the numerator of which is the fair market value of the item of property to the partnership and the denominator of which is the total fair market value of all of the partnership s items of Ordinary Income Property. (2) Capital Gain Property. The amount of the basis adjustment to each item of property within the class of Capital Gain Property is equal to: (a) The amount of income, gain, or loss (including any remedial allocations under 1.704-3(d)) that would be allocated to the transferee (to the extent attributable to the acquired partnership interest) from the hypothetical sale of the item: minus (b) The product of: (i) The total amount of gain or loss (including any remedial allocations under 1.704-3(d)) that would be allocated to the transferee {09000.BKW / 00932053.DOC.1 } 11

(to the extent attributable to the acquired partnership interest) from the hypothetical sale of all items of Capital Gain Property, minus the amount of the positive basis adjustment to all items of Capital Gain Property or plus the amount of the negative basis adjustment to Capital Gain Property; multiplied by (ii) A fraction, the numerator of which is the fair market value of the item of property to the partnership, and the denominator of which is the fair market value of all of the partnership s items of Capital Gain Property. EXAMPLE #10 (i) Assume the same facts as Example 9. Of the $45,000 basis adjustment, $46,250 was allocated to Capital Gain Property. The amount allocated to Ordinary Income Property was ($1,250). (ii) Asset 1 is a capital gain asset, and T would be allocated $37,500 from the sale of Asset 1 in the Hypothetical Transaction. Therefore, the amount of the adjustment to Asset 1 is $37,000. (iii) Asset 2 is a capital gain asset, and T would be allocated $8,750 from the sale of Asset 2 in the Hypothetical Transaction. Therefore, the amount of the adjustment to Asset 2 is $8,750. (iv) Asset 3 is Ordinary Income Property, and T would be allocated $2,500 from the sale of Asset 3 in the Hypothetical Transaction. Therefore, the amount of the adjustment to Asset 3 is $2,500. (v) Asset 4 is Ordinary Income Property, and T would be allocated ($3,750) from the sale of Asset 4 in the Hypothetical Transaction. Therefore, the amount of the adjustment to Asset 4 is ($3,750). EXAMPLE #11 (i) Assume the same facts as Example 10 of this section, except that A sold its interest in AB to T for $110,000 rather than $120,000. T, therefore, receives a basis adjustment under 743(b) of $35,000. Of the $35,000 basis adjustment, ($1,250) is allocated to Ordinary Income Property, and $36,250 is allocated to Capital Gain Property. (ii) Asset 3 is ordinary income property, and T would be allocated $2,500 from the sale of Asset 3 in the hypothetical transaction. Therefore, the amount of the adjustment to Asset 3 is $2,500. {09000.BKW / 00932053.DOC.1 } 12

(iii) Asset 4 is ordinary income property, and T would be allocated ($3,750) from the sale of Asset 4 in the Hypothetical Transaction. Therefore, the amount of the adjustment to Asset 4 is ($3,750). (iv) Asset 1 is a capital gain asset, and T would be allocated $37,500 from the sale of Asset 1 in the hypothetical transaction. Asset 2 is a capital gain asset, and T would be allocated $8,750 from the sale of Asset 2 in the Hypothetical Transaction. The total amount of gain that would be allocated to T from the sale of the capital gain assets in the Hypothetical Transaction if $46,250, which exceeds the amount of the basis adjustment allocated to Capital Gain Property by $10,000. The amount of the adjustment to Asset 1 is $33,604 ($37,500 minus $3,896 ($10,000 x $75,000/192,500)). IX. Allocations of Section 734(b) Adjustments to Partnership Assets: Section 755. A. The Allocation Rules. Three steps are involved in the allocation of 734(b) basis adjustments to specific partnership assets: STEP 1: THE PARTNERSHIP'S ASSETS ARE FIRST DIVIDED INTO TWO CLASSES UNDER 755(B) "CAPITAL GAIN ASSETS" (CAPITAL ASSETS AND 1231(B) PROPERTY) AND "ORDINARY INCOME ASSETS" (ALL OTHER PARTNERSHIP ASSETS). STEP 2: A DETERMINATION IS MADE AS TO THE CLASS OF ASSETS TO WHICH THE 734(B) ADJUSTMENT IS ALLOCATED. STEP 3: THE 734(B) ADJUSTMENT IS ALLOCATED TO SPECIFIC ASSETS IN THE APPROPRIATE CLASS. B. Determination of Class of Assets (Step 2). 1. If the 734(b) adjustment is the result of an increase (or decrease) in the basis of distributed assets of a certain class, the basis of retained partnership assets of the same class is decreased (or increased) by a like amount. 2. If the 734(b) adjustment is a consequence of the recognition of gain by the distributee upon receipt of a distribution of cash in excess of his basis in the partnership, or the recognition of loss upon the complete liquidation of his partnership interest solely in exchange for money, unrealized receivables and inventory, the adjustment is allocated entirely to capital gain assets of the partnership. {09000.BKW / 00932053.DOC.1 } 13

EXAMPLE #12 A, B, and C form equal partnership AB. A contributes $50,000 and Asset 1, Capital Gain Property with a fair market value of $50,000 and an adjusted tax basis of $25,000. B and C each contribute $100,000. AB uses the cash to purchase Assets 2, 3, 4, 5, and 6. Assets 4, 5, and 6 are the only assets held by the partnership which are subject to 751. The partnership has an election in effect under 754. After seven years, the adjusted basis and fair market value of AB s assets are as follows Assets Adjusted Basis Fair Market Value Capital Gain Property: Asset 1 $25,000 75,000 Asset 2 100,000 117,500 Asset 3 50,000 60,000 Ordinary Income Property: Asset 4 40,000 45,000 Asset 5 50,000 60,000 Asset 6 10,000 2,500 Total $275,000 $360,000 Allocation Between Classes. Assume that AB distributes Assets 3 and 5 to A in complete liquidation of A s interest in the partnership. A s basis in the partnership interest was $75,000. The partnership s basis in Assets 3 and 5 was $50,000 each. A s $75,000 basis in its partnership interest is allocated between Assets 3 and 5 under 732(b) and (c). A will, therefore, have a basis of $25,000 in Asset 3 (Capital Gain Property), and a basis of $50,000 in Asset 5 ( 751 property). The distribution results in a $25,000 increase in the basis of Capital Gain Property. There is no change in the basis of Ordinary Income Property. C. Allocations Under Step 3. The adjustment attributable to a class of partnership assets to specific assets in the class is allocated "in a manner which has the effect of reducing the difference between the fair market value of the adjusted basis of partnership properties." The adjustment is, therefore, allocated so as to reduce proportionately the difference between the fair market value and the adjusted basis of each asset in the class. If the adjustment increases the basis of assets in the class, any loss assets (those which have bases in excess of their market values) are excluded from the allocation. Conversely, if the adjustment decreases asset bases, gain assets (those with market values in excess of their bases) are excluded. {09000.BKW / 00932053.DOC.1 } 14

IN APPLYING THESE ALLOCATION RULES, THE BASIS OF AN ASSET CANNOT BE REDUCED BELOW ZERO. IF AN ADJUSTMENT IS ALLOCATED TO A CLASS IN WHICH THE PARTNERSHIP DOES NOT HAVE RETAINED PROPERTY, OR IF A NEGATIVE ADJUSTMENT IS NOT FULLY ABSORBED BY THE BASIS OF PROPERTY IN THE CLASS, THE ADJUSTMENT (OR THE PORTION REMAINING AFTER THE BASIS OF APPLICABLE PROPERTY IS REDUCED TO ZERO) IS APPLIED TO SUBSEQUENTLY ACQUIRED PROPERTY IN THE CLASS. or Loss. EXAMPLE #13 Assume the same facts as in Example 12. Allocation Within Class. The amount of the basis increase to Capital Gain Property is $25,000 and must be allocated among the remaining capital gain assets in proportion to the difference between the fair market value and basis of each. The fair market value of Asset 1 exceeds its basis by $50,000. The fair market value of Asset 2 exceeds its basis by $17,500. Therefore, the basis of Asset 1 will be increased by $18,519 ($25,000, multiplied by $50,000, divided by $67,500), and the basis of Asset 2 will be increased by $6,481 ($25,000 multiplied by $17,500 divided by $67,500). D. Application of Section 755(b) to Adjustments Caused by the Recognition of Gain 1. Gain. To the extent a 734(b) adjustment is a consequence of the recognition of gain by a distributee under 731(a) upon the receipt of cash in excess of his basis, Regulation 1.755-1(b)(1)(ii) requires the resultant basis increase to be allocated entirely to capital gain assets. 2. Loss. Section 1.755-1(b)(1)(ii) of the Regulations also allocates solely to capital gain assets any negative 734(b) adjustment resulting from the recognition of loss by the distributee under 731(a)(2). E. The Negative--Basis Prohibition and the Carryover of Unused Basis Adjustments. 1. Zero Limit. Section 755(b) provides that the allocation of any adjustment to like-kind property shall not cause the basis of property to be reduced below zero. 2. Carryover. Section 755(b) also provides that if full application of a basis adjustment with respect to a class of property is prevented by an absence of property in the class, the unused adjustment is applied to subsequently acquired property of a like kind. {09000.BKW / 00932053.DOC.1 } 15

X. Section 732(d). A. General Rule. If a partnership interest is acquired by sale or exchange or upon the death of a partner in a transaction which is not subject to 743(b), 732(d) provides two special rules which require that distributed assets are treated as having adjusted partnership bases equal to the bases they would have had if 743(b) had been applicable to the distributee's acquisition of his interest. The two special rules are as follows: 1. Elective. At the option of the distributee, with respect to any property distributions within two (2) years of the acquisition of the partnership interest. 2. Mandatory. a. The fair market value of all partnership property (other than money) exceeded 110 percent of its adjusted basis to the partnership, b. An allocation of basis under 732(c) upon a liquidation of his interest immediately after the transfer of the interest would have resulted in a shift of basis from property not subject to an allowance for depreciation, depletion, or amortization, to property subject to such an allowance, and c. A basis adjustment under 743(b) would change the basis to the transferee partner of the property actually distributed. EXAMPLE #14 Transferee partner, T, purchased a one-fourth interest in partnership AB for $17,000. At the time T purchased the partnership interest, the election under 754 was not in effect and the partnership inventory had a basis to the partnership of $14,000 and a fair market value of $16,000. T s purchase price reflected $500 of this difference. Thus, $4,000 of the $17,000 paid by T for the partnership interest was attributable to T s share of partnership inventory with a basis of $3,500. Within 2 years after T acquired the partnership interest, T retired from the partnership and received in liquidation of its entire partnership interest the following property: Assets Adjusted Basis to AB Fair Market Value Cash $1,500 $1,500 Inventory 3,500 4,000 Asset X 2,000 4,000 Asset Y 4,000 5,000 {09000.BKW / 00932053.DOC.1 } 16

The fair market value of the inventory received by T was one-fourth of the fair market value of all partnership inventory and was T s share of such property. It is immaterial whether the inventory T received was on hand when T acquired the interest. In accordance with T s election under 732(d), the amount of T s share of partnership basis that is attributable to partnership inventory is increased by $500 (one-fourth of the $2,000 difference between the fair market value of the property, $16,000, and its $14,000 basis to the partnership at the time T purchased its interest). This adjustment under 732(d) applies only for purposes of distributions to T, and not for purposes of partnership depreciation, depletion, or gain or loss on disposition. Thus, the amount to be allocated among the properties received by T in the liquidating distribution of $15,500 ($17,000, T s basis for the partnership interest, reduced by the amount of cash received, $1,500). This amount is allocated as follows: The basis of the inventory items received is $4,000 consisting of the $3,500 common partnership basis, plus the basis adjustment of $500 which T would have had under 743(b). The remaining basis of $11,500 ($15,500 minus $4,000) is allocated among the remaining property distributed to T by assigning to each property the adjusted basis to the partnership of such property and adjusting that basis by any required increase or decrease. Thus, the adjusted basis to T of Asset X is $5,111 ($2,000, the adjusted basis of Asset X to the partnership, plus $2,000, the amount of unrealized appreciation in Asset X, plus $1,111 ($4,000/$9,000 multiplied by $2,500)). Similarly, the adjusted basis of Asset Y to T is $6,389 ($4,000, the adjusted basis of Asset Y to the partnership, plus $1,000, the amount of unrealized appreciation in Asset Y, plus, $1,389 ($5,000/$9,000 multiplied by $2,500)). {09000.BKW / 00932053.DOC.1 } 17