Partnership Tax

High corporate and individual tax rates incentivize the use of partnerships and LLCs.

Basic Principles
- Tax follows book.
- Partnerships cannot be used to shift income or losses among the partners.
- Partnerships cannot be used to change the character of income.
- Basis is how the taxpayer keeps score with the Government – it accounts for the amounts on which taxes have been
paid already. Capital Accounts are how partners keep score with each other.
o Basis can never go negative, but the capital accounts can.
o Capital Accounts are crucial for determining substantial economic effect.

Notes on Partnerships for Tax Purposes:

- Partners pay taxes. Partnerships are conduits through which income and loss flow to individual partners, who are
liable for income tax on their distributive shares of partnership income and loss.
- LLCs receive the same tax treatment as partnerships under Subchapter K, and they should be used to own real
estate because of (1) pass-through treatment, (2) limited liability, and (3) the ability to receive basis for debt.
o Partnerships vs. S Corporations
 Partnerships
 *Flexibility in allocating income and other items among partners – the partnership agreement
lists the partners’ distributive shares and any § 704(b) special allocations, which are respected
so long as there is SEE. If the agreement is silent or an allocation lacks SEE, distributive shares
are governed by PIP.
o So long as there is a “gain chargeback” provision, the value-equals-basis presumption
allows partnerships to allocate all depreciation deductions to the partner in the
highest tax bracket.
 **Partners may include liabilities in their basis amounts, allowing them to take greater losses.
§ 752. In this way, partnerships and LLCs can be used to maximize loss utilization and take
phantom losses by (i) borrowing up front and (ii) using accelerated depreciation on what is
acquired with those loaned funds.
 If the partnership is engaged in a trade or business, a general partner’s entire distributive share
of the partnership’s business income (not investment income) is subject to self-employment
taxes.
 S Corporations
 Income must be shared in proportion to share ownership.
 S Corps allow for planning to limit self-employment tax liability: Only the portion of a
shareholder employee’s wages [reasonable compensation] is subject to employment taxes.
 Shareholders cannot include liabilities in their basis amounts, limiting the losses they may take.
[Losses are locked into corps.]
 § 1361(b) – Small Business Corporation Requirement – 100 or fewer shareholders, none of
which are corporations or nonresident aliens; Only one class of stock is permitted.
 Insufficient Basis Issue – S Corps cannot do levered refinances, because they do not get basis
for liabilities. One partial fix is to add a pass-through (LLC) to allow for some basis: (1) drop
the property into a disregarded single-member LLC; (2) give the S Corporation a preferred
interest in the LLC and the S Corporation shareholders common interests. Then, when the LLC
borrows, some of the debt can be allocated to the shareholders instead of the S Corporation.
o Potential Uses of Partnerships
 Disguised Sales – Taxpayers can (i) transfer property to a partnership in exchange for a partnership
interest and (ii) later on, receive cash or other property from the partnership in a way that has the same
result as a sale.
 Receipt of Partnership Interest for Services: Receipt of the partnership interest is a guaranteed
payment, and the interest is valued as a percentage of the capital accounts. The partnership recognizes
no gain or loss, but it receives a deduction that is allocated equally to the original partners. [Original
partners reduce basis/capital accounts to allow service partner to enter.]
 Carried Interest: 2% Fee is a Guaranteed Payment; 20% Profits Interest is Distributive Share subject
to a 3-year holding period.
  Drop-Downs: Could drop an asset down into a partnership and sell the partnership interest.

Section 704(b) Special Allocations

If a special allocation has SEE, it is within the regulatory safe harbor. Otherwise, it must be consistent with PIP.
- Economic Effect – Governed by documents and the economic equivalence test.
Basic Test (for general partnerships) Alternative Test (for limited partners)
(1) Capital Account Requirement – must (1) Partnership Agreement must meet the
follow § 1.704-1(b)(2)(iv); capital account and liquidation
(2) Liquidation Requirement – Liquidating requirements;
distributions must be in accordance with the (2) Partnership Agreement must contain a
positive balances in the partners’ capital Qualified Income Offset (QIO)
accounts; Provision to bring capital accounts
(3) Deficit Makeup Requirement – After back positive; and
liquidation, partners with deficits in their (3) The allocation does not create (or
capital accounts must be unconditionally increase) a deficit in a partner’s capital
obligated to restore that deficit, either under account in excess of their obligation to
state law or per the agreement. restore a deficit.
*Note that there is an economic equivalence test that essentially uses a constructive liquidation.
- Substantiality – A transaction’s EE is substantial if there is a reas. possibility the allocation will substantially
affect the dollar amounts to be received by the partners from the partnership, independent of tax consequences.

Sale of Partnership Interest

(1) AR – AB = Section 741 gain/loss
(2) Subtract Section 751 Assets by (i) identifying them, (ii) hypothesizing a sale, and (iii) allocating proceeds
(3) Subtract (2) from (1) to calculate total capital gain/loss
(4) Apply Section 1(h) if the selling partner is an individual: 28% on collectibles and 25% on Section 1250 Gain
(5) Subtract (4) from (4) to determine capital loss taxable either at 0, 15, or 20%.
*Buyers who pay a premium for a partnership interest will want a Section 754 election to be in place so that disparities
can be eliminated via a Section 734(b) basis adjustment.

Section 754 Election

- § 754 – If a partnership files an election . . . the basis of partnership property shall be adjusted, under section 734 in
the case of a distribution of property and under section 743 in the case of a transfer of a partnership interest. Such
an election shall apply with respect to all distributions of property . . . and to all transfers of interests in the
partnership during the taxable year . . . such election was filed and all subsequent taxable years.

Distributions
- Current Distributions
(1) ROB = Original AB – Money Received (and reduction of liabilities)
(2) Allocate ROB first to Section 751 properties
(3) Allocate remaining ROB to other properties received (capital assets)
(4) Allocate any remaining ROB to the partner’s AB in their partnership interest.
- Liquidating Distributions
(1) ROB = Original AB – Money Received (and reduction of liabilities)
(2) Allocate ROB to Section 751 properties distributed to the partner
(3) Allocate ROB to other property (capital assets)

Concerns in Partnership Tax Planning

(1) SEE – Are the after-tax consequences to one partner diminished or enhanced irrespective of whether the
transaction occurred?
(2) Is the transaction abusive, whether it be a “mixing bowl” transaction or a disguised sale?
o Distribution to another within 2 years of contribution  Disguised Sale Risk
o Between 2 and 7 Years  Mixing Bowl Risk
(3) Whether the transaction falls within the general abuse category?

Chapter 1 – Choice of Entity: What is a Partnership for Tax Purposes

High corporate and individual tax rates incentivize the use of partnerships and LLCs.

Partnership Definition: § 761(a) – Includes a syndicate, group, pool, joint venture, or other unincorporated organization
through, or by means of which any business, financial operation, or venture is carried on and which is not within the
meaning of this Title, a corporation, trust, or estate.
- Comm’r v. Culbertson (1949) – Even without contributions from some members, there can still be a partnership.
The test is whether considering all the facts, the agreement, conduct of the parties in execution of its provisions,
their statements, testimony of individual persons, the relationship of the parties, their respective abilities, and
capital contributions, the actual control of income and the purposes for which it is used, and any other facts
throwing light on their true intent, the parties in good faith and acting with a business purpose intended to join
together in the present conduct of the enterprise.
- Estate of Winkler v. Comm’r (T.C. 1997) – Routine pooling of money by two parents and their children to
purchase lottery tickets was held to be a partnership. Generally, taxpayers bear a high burden of proof to show a
preexisting agreement for a sharing of lottery winnings. The Tax Court was willing to essentially reconstruct the
capital accounts as a balance sheet. Here, the court found that the burden was met, it did not find that the mother
had given a gift, which allowed for the tax liability to be spread throughout the family.

Partnership Agreements must be amended before the tax return is due; generally on March 15, to make special allocations.

Business Entity – Two features that distinguish an entity from mere co-ownership are business activity and the sharing
of profits. See § 301.7701-1(a)(2).
*Anti-abuse regulations also require a business purpose for each transaction involving a partnership.

Choosing Which Business Entity To Operate As For Tax Purposes (Check-the-Box Regs)
(1) Business Entity – Need (1) a Business Activity and (2) Sharing of Profits
(2) If ownership interests are publicly traded  C Corporation. (§ 7704)
(3) If organized as a corporation under local law  C Corporation, unless it makes S Corp election.
(4) All other business entities with 2+ members (including LLCs and partnerships)  Partnership, unless it
affirmatively elects to be taxed as a C Corp. (§ 301.7701-3)
(5) If the entity is an individual  Proprietorship
(6) If member is a corporation  Branch/Division of Corporation (§ 301.7701-2(a))
*Checking the box to go from one entity to another will have deemed consequences under Reg. 301.7701-3(g).
Note:
- Partnerships pass losses through to their partners who may be able to currently deduct them.
- QBI Deductions provide further reasons for entities to want to be taxed as partnerships.
o Prior to the TCJA, lower corporate and individual rates would have revealed a preference for the corporate
form.

Chapter 2 – Partnership Formation

The rules applicable to formation and dissolution of partnerships ensure nonrecognition of gain or loss when feasible.
Basic Scheme: Under Sections 721-23, taxes are deferred at formation by transferring basis, as with corporations.
- § 721 –Nonrecognition for Partnership and Partners: Neither the partners, nor the partnership, shall recognize
gain or loss upon transfers of property in exchange for a partnership interest.
o Property vs. Services / Promissory Notes
 “Property” has been broadly construed. See Stafford (letter of intent with insurance company for
financing was of value and held to be property under § 721); Frazell (geological maps created by
contributing partner).
 The exchange of services for a partnership interest is generally a taxable event. § 83(a).
 The two exceptions are for (1) services and (2) investment partnerships.
 Oden – Promissory note from partner to partnership is not property because it cannot give basis.
- § 722 – Outside Basis: Partners’ Outside Basis in their Partnership interest is equal to the basis of the property
contributed plus cash contributed.
o Outside Basis = Contributions (§ 722) – Distributions (§ 733) ± Liability Adjustments (§ 705)
- § 723 – Inside Basis: Partnership’s Inside Basis in contributed property is the contributor’s basis.
- Holdings Periods
o § 1223(2) – The partnership is entitled to take the partners’ holding periods to its own.
 Note: Cash and Inventory do not have holding periods
o § 1.1223-3(b) – If a partner transfers property (AB = 50; FMV = 75) and $25 to the partnership, the
partnership’s holding period is determined based upon the relative FMV of the property contributed. There
is no tacking period for cash.
 Under these facts, there is a tacked holding period for ¾ (75/100) of the interest, and the other ½ has a
new holding period.
 Tacked Holding Period = (Capital Assets + 1231 Assets) / Total FMV of Property Contributed
 Non-tacked HP = (Cash + Ordinary Assets) / Total FMV of Property Contributed

Built-In Gains: Generally, built-in gains at the time of contribution are allocated first to the contributing partner.
Built-In Losses: Generally, built-in losses are preserved solely for the contributing partner: (i) Partnership’s AB = FMV
on the date of contribution; and (ii) Contributing Partner is given a special basis adjustment equal to their basis in the
property minus the FMV on the date of the contribution.
Contribution of Depreciable Property: Contributed depreciable property is subject to recapture only upon a later
distribution by the partnership, the partnership’s recapture gain includes the depreciation taken by the contributing partner.
- §§ 1245(b)(3), 168(i)(7) – Partnership succeeds the partner’s method of cost recovery, which must be shared
between the partner and the partnership during the year of contribution.

Reg. § 1.704-3 Methods

- Traditional Method – Contributor is effectively taxed more than the non-contributor to account for the built-in
gain upon contribution.
o General Principles
(1) Calculate (i) book gains/losses and (ii) tax gains/losses;
(2) Allocate book gains/losses in accordance with the partnership agreement;
(3) Allocate tax items to noncontributing partners to match their book gains/losses, if possible;
(4) Allocate the balance of the tax items to the contributor.
o Ceiling Rule – If there is book loss, but tax gain, there is no tax loss to match the non-contributing partner’s
book loss. Thus, the ceiling rule prevents allocations of loss to noncontributing partners.
 Traditional Method with Curative Allocations – Partnership may eliminate the ceiling rule
distortion by allocating an item for tax (not book purposes) to balance the noncontributor’s tax and
capital accounts.
 Remedial Allocations – Alternatively, a notional allocation can be created to cure the disparity.

Characterization of Gains and Losses from Disposition of Contributed Property

- § 724(a) – Unrealized Receivables – Any gain or loss is always ordinary.
- § 724(b) – Inventory Items – Gain or loss recognized by the partnership on inventory items within 5 years of the
contribution is ordinary.
- § 724(c) – Capital Loss Property – Gain or loss recognized by the partnership on capital loss property within 5
years of the contribution is capital.
See § 1.1223-3(b) for holding period rules based on the relative FMV of the property contributed. There is no tacking for
the portion of interest received for cash. FN 21, p. 25.

Liabilities:
- § 752(a): Assumption of Liabilities by Partner  Deemed Contribution  Increase (Inside and Outside) Basis
- § 752(b): Partnership Assume Liability  Deemed Distribution  Decrease (Inside and Outside) Basis (§ 733)
o To the extent a cash distribution exceeds the partner’s outside basis, gain must be recognized (§ 731(a)(1)).
- Initial Outside Basis = Contribution + § 752(a) deemed contribution - § 752 deemed distirbution
- Recourse Liabilities: Generally, recourse liabilities are allocated to those who bear the “economic risk of loss”
associated with the liability by determining who would have the ultimate responsibility for the liability if all assets
become worthless and the liability became due. [Normally, this is in accordance with the partners’ allocations for
losses.]
- Nonrecourse Liabilities: Generally, nonrecourse liabilities are allocated in the manner in which profits are shared.

Accounts Receivable: § 721 – Treated as property, § 723 – Partnership gets a transferred basis, § 724 – income upon
collection is ordinary, and § 704(c) – that income is allocated to the contributing partner.
Accounts Payable: Accounts payable that are assigned to the partnership by a cash method taxpayer are not partnership
liabilities under § 752. Instead, under § 704(c)(3), when the partnership pays the accounts payable, the deductions must
be allocated to the contributing partner.
[Amounts from A/R are taxed when received, and amounts from A/P are deducted when paid.]

Organization and Syndication Expenses

- Organizational Expenses (§ 709(b)(2)) – Legal, Accounting, and Filing Fees incident to the creation of the
partnership.
o § 709(a) – Not deductible; chargeable to capital
- Syndication Expenses – Expenses incurred in connection with selling partnership interests – marketing, legal,
accounting, and brokerage fees.
o § 709(a) – Not deductible; chargeable to capital
- § 709(b) – Partnership may elect to currently deduct the lesser of (i) amount of organizational expenses, or (ii)
$5,000 reduced by the amount by which the organizational expenses exceed $50,000. Those organizational
expenses not currently deducted may be amortized over 180 months (15 years).
- The rules making syndication expenses nondeductible, nonamortizable capital expenditures are a reaction to the
widespread use of syndicated partnerships by the tax shelter industry.

Chapter 3 – Partnership Operations

*The partnership serves as an accounting entity to assist partners and the IRS in calculating the venture’s income and
deductions and the partners’ shares thereof.
**Partnerships must adopt a taxable year, choose an accounting method, and make certain elections as if it were the
taxpayer. They must also compute taxable income (under § 703(a)) and file an informational return (Form 1065). Each
partner will be provided a Form K-1 Statement informing them of their respective shares of income and deductions
incurred at the partnership level.

Partnership Taxable Years

- § 706(a) – Partners must include their distributive share of partnership income “for any taxable year of the
partnership ending within or with the taxable year of the partner.” [The key date is the last day of the partnership’s
taxable year.]
o Example: If a calendar year partner is in a partnership with a June 30 fiscal year, their 2020 income will
include their share of the partnership’s income and deductions for the period from July 1, 2019 to June 30,
2020.
- § 706(b) – If the partnership can establish a valid business purpose for choosing a specific tax year, the partnership
may use that taxable year. But without a business purpose, the partnership must adopt its “required taxable year,”
unless it makes a Section 444 election.
o Administrative convenience for the partnership or its accountant will not be a valid business purpose, but a
partnership’s “natural business year” would suffice.
- Required Taxable Year - § 706(b)(1)(B)
(i) First Tier: Majority Interest Taxable Year: If one or more partners with the same taxable year
own greater than a 50% interest in profits and capital, then the partnership must adopt that
taxable year.
(ii) Second Tier: If all the principal partners (those owning 5% or more of profits or capital) have
the same year, that year must be adopted.
(iii) Third Tier: Least Aggregate Deferral Method – Each partners’ taxable year must be tested.
[First, assuming X’s fiscal year is adopted, the following table shows those results. The process
must be repeated for Y and Z’s tax years as well.]
o How to Count the Dates: Count from the Partnership’s date to the partners’.
Partner Taxable Year Profits Interest Months of Interest X
Deferral Deferral
X 6/30 30% 0 0
Y 8/31 40% 2 .8
Z 12/31 30% 6 1.8
Aggregate 2.6
Deferral
o Alternate Least Aggregate Deferral Method Calculation illustrating all three tax years tested at once:
50% x 0 = 0 50% x 6 = 3 50% x 7 = 3.5
30% x 6 = 1.8 30% x 0 = 0 30% x 1 = .3
20% x5 = 1 20% x 11 = 2.2 20% x 0 = 0
2.8 5.2 3.8
 Choose the tax year with the least aggregate deferral.
 Count from the partnership’s date to the partners’.
- In general, the partnership must test the validity of its taxable year on the first day of each year. If the tests shows
the taxable year is invalid, it must be changed.
o § 706(b)(4)(B) – However, once the partnership is required to change its taxable year because of the
“majority interest taxable year” rule, the partnership will not be required to change its taxable year again for
a minimum of three years.
- Section 444 Election: If the year chosen does not result in more than three months of deferral, the partnership can
generally elect to adopt that taxable year even if it lacks a valid business purpose.
o The tradeoff is that the partnership must make a “required payment” each year to offset the benefits of the
deferral. See § 7519.
 IRS generally will not challenge if 25% is earned in the last 2 months.

Method of Accounting – The partnership’s choice of which method to use is limited by the identity of its partners.
- § 703 – Partnership chooses the method of accounting for its income.
 o § 701 – Partners pay taxes, not the partnership.
o § 702 – Variable items that must be separately stated for each partner.
- § 448 – Partnerships with C corporations as partners are prohibited from using the cash method of accounting if the
average annual gross receipts of the company for the prior three years exceeds $25 million.
o One exception is that C corporations that are personal service corporations are treated as individuals.
- If the partnership is a tax shelter under § 461(i)(3), then it must use the accrual method of accounting no matter its
size. § 448(a)(3).

Computing the Partnership’s Taxable Income

- § 701 – Only partners pay taxes on partnership income.
- § 703(a) – How to compute partnership’s taxable income:
o § 702(a) – Separately Stated Items – Each partners must account separately for their share of (i) items
listed in § 702(a)(1)-(7) and (ii) bottom line income or loss, without regard to the separately listed items.
[These are shown separately on the K-1.]
 Variable Items: STCG/STCL; LTCG/LTCL; § 1231 Exchanges of Property; Charitable Contributions;
Dividends; Taxes; AMT Items; and QBI Income
- § 702(b) – Character of income or loss will pass through to the partners.
- § 704(b) – Distributive share shall be determined in accordance with the partners’ interest in the partnership if (1)
the Partnership Agreement does not provide how to split the distributive share, or (2) if the allocation lacks
substantial economic effect.

Partnership Elections – Section 703(b) provides that elections are made at the partnership/entity level, with three
exceptions: (1) § 108(b)(5), (2) § 617, and (3) § 901.

Adjustments to Partners’ Outside Bases

Contributions (§ 722)
- Distributions (§ 733)
+ Distributive Share of Taxable and Tax-Exempt Income (§ 705(a)(1))
- Distributive Share of Partnership Losses and Expenditures (§ 705(a)(2))
= Partner’s Outside Basis

Partnership Audit Rules

Each partnership must designate someone [with a “substantial presence in the United States”] to represent the partnership
in tax matters. This person has the power to bind the partnership and its partners by their actions (§ 6223(b)). All
adjustments, taxes, interest, and penalties will be assessed and collected at the partnership level (§ 6221), but the
partnership may elect to have the partners take into account the adjustments that are necessary at the partnership level (§
6226). The partners have no say in the audit or subsequent proceedings and must accept its outcome.

Aggregate View: Taxpayers are the partners.

Entity View: The partnership’s role in audits is essentially absolute.

Analysis for Allocating Partnership Items

- Bottom Line: Gross Income; Expenses; and Sec. 1245 Recapture (Non-separately stated items)
o Reported as taxable income for the partners. Secs. 703; 705.
- Separately Stated Variable Items: Depreciation; Sec. 1231 Gain; STCG; Dividend; Sale of Land. Sec. 702.
- Non-Deductible for Partnership: Charitable contributions and tax-exempt interest
o These items pass through to the partners. Sec. 705.
*Sec. 705 states to add each of these items to basis.
**Distributions reduce adjusted basis. Mid-year distributions are treated as occurring on the last day.

Chapter 4 – Financial Accounting and Maintenance of Capital Accounts

Capital Accounts have to be reported on Form 1065 each tax year. They are how partners keep score with each other.
Tax must follow book. Thus, capital accounts are crucial for SEE and special allocations.
Capital accounts can go negative – this is necessary in constructive liquidations to determine the EROL.

Reg. § 1.704-1(b)(2)(iv) – The capital accounting regulations are the cornerstone of the rules governing special
allocations under § 704(b), allocations of liabilities under § 752, and allocations of pre-contribution gain or loss under §
704(c).
- Contributions  Increase Capital Accounts
- Income  Increase
- Losses  Decrease
- Distributions  Decrease
- Liabilities  No affect to capital accounts, although tax basis will be increased

Tax/Book Disparities – Due to Contributions, Revaluations, and Disproportionate Distributions, the partnership’s
inside/tax basis will be different from its book value. As such, separate books must be kept for book and tax purposes.
o Outside Basis = Tax Capital + Share of Liabilities
o Tax Capital Account = Outside Basis – Share Liabilities
- Contributions – § 704(c) handles book/tax disparities created upon the contribution of built-in gain property by
first allocating that gain to the contributor.
- Revaluations – Revaluations are permitted when a new or existing partner contributes money or property to a
partnership as consideration for an interest in the partnership, as well as when money/property is distributed to a
partner in liquidation of all or part of their interest. [Sale of partnership interest does not allow for a revaluation.]ta
o Revaluations of assets are for book, not tax purposes. Those inherent gains or losses must be allocated
among the pre-existing partners as if the partnership sold the assets for FMV.
o Regs. § 1.704(b)(2)(iv)(f)(1)-(5) – Permit Revaluations
o Reverse § 704(c) Transactions – When revaluations of assets are made for book, and not tax, purposes, the
allocation of corresponding tax gain or loss is governed by § 704(c) so that the built-in gain is allocated to
pre-existing partners.

Balance Sheet

Assets Liabilities

Capital Accounts Outside Bases

Tax Capital Book
A OB – share of liabilities FMV Contribution
B + Sec. 752(a)
C - Sec. 752(b)

General Capital Accounting Rules

*Depreciation reduces book and tax values of capital accounts and assets. However, appreciation in assets is not reflected.
**Paying down debt does not affect capital accounts. It only reduces liabilities and assets.
***When a liability encumbers a contributed property, the contributor books the FMV of the asset net of the liability.
****When a partnership borrows itself, that amount is not reflected in the capital account; only in the liabilities section.

Chapter 5 – Partnership Allocations: Substantial Economic Effect

While Sec. 704(a) provides that allocations are made in accordance with the Partnership Agreement, Sec. 704(b) clarifies
that such allocations are respected so long as they have substantial economic effect (“SEE”). If they lack SEE, then
allocations are made in accordance with the partner’s interest in the partnership. To have SEE, an allocation must (1)
have economic effect and (2) be substantial. Reg. Sec. 1.704-1(b)(2)(i). To have economic effect, the partner to whom an
allocation is made must receive such economic benefit or burden. Reg. Sec. 1.704-1(b)(2)(ii). A transaction’s EE is
substantial if there is a reas. possibility the allocation will substantially affect the dollar amounts to be received by the
partners from the partnership, independent of tax consequences. Reg. Sec. 1.701-1(b)(2)(iii). Pre-Tax Test: An
allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to
be received by the partners from the partnership, independent of tax consequences. After-Tax Test: However, allocations
are insubstantial if, at the time the allocation becomes part of the Agreement, (1) the after-tax economic consequences of
at least one partner, may in present value terms, be enhanced compared to such consequences if the allocation were not in
the Agreement, and (2) there is a strong likelihood that the after-tax consequences of no partner, will in present value
terms, be substantially diminished relative to if the allocation was not added in the Agreement. Allocations are
insubstantial if they are made among partners solely to reduce their total tax liability, such as to shift tax consequences.
Or if they are made over several tax years, as transitory allocations.

Section 704(a) – A partner’s distributive share of income, gain, loss, deduction, or credit shall, except as otherwise
provided . . . , be determined by the partnership agreement.
- However, limitations exist under Subchapter K so that taxpayers cannot circumvent tax avoidance and assignment
of income/loss rules. The allocations must be significant independent of tax savings.

Under the current § 704(b) regulations, if an allocation has SEE, it is within the safe harbor. Thus, allocations that lack
SEE may still be respected if they are consistent with the partner’s interest in the partnership.
- § 1.704-1(b)(3) – PIP – Establishes the default rules for allocations that fail to meet the SEE safe-harbor.
o PIP – Items will be reallocated to the partners who actually bear/enjoy the economic burden/benefit of that
item. The factors to consider are: (i) relative contributions, (ii) interests in economic profits and losses, (iii)
interests in cash flow and other non-liquidating distributions, and (iv) rights to distribution on liquidation.
o Current Determinations Rule [for allocations that fail the basic test due to noncompliance with the deficit
makeup rule] – The amount each partner would have received if the partnership were liquidated in the
current year are compared with what each partner would have received if the partnership were liquidated on
the last day of the prior year. [This rule only applies if the allocations were “substantial” under § 1.704-1(b)
(2)(iii).]
Economic Effect – If there is an economic benefit or burden that corresponds to an allocation, the partner to whom the
allocation is made must receive such economic benefit or burden.
*Allocations of the partnership’s tax items must conform to the partner’s economic arrangement.
**Economic effect is governed by the documents; however, even if the basic and alternative tests are met, there may still
be economic effect under the economic equivalence test.
Basic Test (for general partners) Alternative Test (for limited partners)
(1) Capital Account Requirement – must (1) Partnership Agreement must meet
follow § 1.704-1(b)(2)(iv); the capital account and
(2) Liquidation Requirement – liquidation requirements;
Liquidating distributions must be in (2) Partnership Agreement must
accordance with the positive balances contain a Qualified Income
in the partners’ capital accounts; Offset Provision; and
(3) Deficit Makeup Requirement – After (3) The allocation does not create
liquidation, partners with deficits in (or increase) a deficit in a
their capital accounts must be partner’s capital account in excess
unconditionally obligated to restore of their obligation to restore a
that deficit, either under state law or deficit.
per the agreement.
o Basic Test
 Capital Account Requirement
 Liquidation Requirement
 Deficit Makeup Requirement
o Alternate Test [for limited partnerships]
 Satisfies capital account and liquidation requirements
  Agreement contains a Qualified Income Offset (QIO Provision)
 QIO Provision – If a partners ends up with an unexpected deficit in their capital account in
excess in the amount they must restore, the partnership must allocate items of income and gain
to that partner to eliminate that excess as soon as possible. See p. 83. This brings the capital
accounts positive for limited partners when they have a capital account deficit.
o Adjustments are required if the partners’ reasonable expectations do not come true.
 Allocation does not create or increase a deficit in a partner’s capital account in excess of the partner’s
obligation to restore a deficit.
o Economic Equivalence Test [“dumb but lucky”] – If a partnership does not technically comply with the
basic test, but its practices would product the same result to the partners as if they had complied with all the
requirements of the basic test.
 Partnerships that comply with this test normally will not need to fall within the SEE safe harbor
because they will almost always be consistent with the PIP.
*If an allocation of all depreciation to one partner takes their capital account negative, there is not economic effect.

Substantiality – The special allocation must have some effect other than tax savings.
o Pre-Tax Test: There must be a reasonable possibility that the allocation will substantially affect the dollar
amounts received by partners independent of the tax consequences. [Only if the effect of an allocation is to
reduce taxes without substantially affecting the partners’ pre-tax distributive shares, the economic effect will
not be substantial.]
 Shifting Tax Consequences – SEE is lacking if the partners have allocated types of income or loss
among themselves within a given year solely to reduce their total tax liability. The EE is not
substantial if at the time the allocations become a part of the partnership agreement, there is a strong
likelihood that (1) the net effect on the capital accounts of the partners will not be significantly
different from what it would be in the absence of the allocations, and (2) the total tax liability of all
partners will be less than it would be in the absence of the allocation.
 Transitory Allocations – When a partnership makes an “original allocation” in one year, and then
cancels out the EE of that allocation in a later year with an “offsetting allocation.” If both an original
and offsetting allocation are provided, and at the time these allocation become part of the partnership
agreement, there is a strong likelihood that (1) the net effect of the original and offsetting allocations
on the partners’ capital accounts will not differ substantially from what it would have been in the
absence of these allocations and (2) the total tax liability of the partners will be reduced from what it
otherwise would have been, then the allocation is not substantial, and it must be reallocated in
accordance with PIP.
 Presumptions:
o 5-Year Rule – If when the original and offsetting allocations are made part of the
agreement there is a strong likelihood that the original allocation will not be largely
offset within 5 years after the original allocation is made, it shall be presumed that
the EE of the allocation is not transitory.
 If an allocation is made up in five years, it is not substantial.
o Value Equals Basis Rule – Partnership’s assets are subject to an irrebuttable
presumption that they have a value equal to their basis (or book value if different
from basis). [This presumption also applies to the after-tax exception.]
o After-Tax Exception – If the after-tax effect of an allocation is to enhance the economic consequences of
one or more partners without adversely affecting any other partner, the allocation will not be substantial.

See Examples in Reg. 1.704-1(b)(5).

Section 704(e) – Family Partnerships

See p. 71, FN 7.

Chapter 6 – Allocation of Nonrecourse Deductions

SEE rules only apply to recourse deductions. They cannot apply to nonrecourse liabilities, as only the lender has EROL.
Nonrecourse loans are often an issue for limited partnerships and LLCs, where limited partners and members do not bear
any risk of loss. For nonrecourse loans, allocations are made according to minimum gain. For recourse loans,
allocations are made according to who bears the risk of loss.

Tufts – The amount of the nonrecourse loan upon the sale is the amount realized. [Treat the amount of the nonrecourse
loan as the amount realized and use that in the § 1001 calculation.]

Regs. § 1.704-2(e) – Safe harbor for allocations of nonrecourse deductions:

(1) Agreement must satisfy either the Basic or Alternative Test for EE;
(2) Nonrecourse deductions must be allocated by the agreement in a manner “reasonably consistent” with allocations
of some other “significant” partnership item attributable to the property securing the debt;
(3) The agreement must contain a “minimum gain chargeback” provision; and
 Minimum Gain Chargeback Provision – The partners who received allocations of nonrecourse
deductions must report an offsetting amount of gain when the partnership disposes of the property.
 If there is a net decrease in PMG for a taxable year, each partner must be allocated an
amount of income or gain equal to their share of the decrease.
 Exceptions Where Minimum Gain Chargeback Provision Is Not Triggered (p. 115):
o Conversions and Refinancing
o Contributions of Capital
o Revaluations
o Waiver requested by the partnership. § 1.704-2(f)(4)
(4) All other material allocations and capital account adjustments must be respected under § 1.704-1(b).

Terms
- Partnership Minimum Gain (PMG) = (Loan – AB): – Tufts gain – minimum amount of gain that the partnership
would realize were it to make a taxable disposition of property secured by nonrecourse financing.
o Regs measure the amount of nonrecourse deductions for a given year indirectly by reference to increases in
PMG during the year.
 PMG will increase for (1) cost recovery deductions and (2) secondary financing.
 Increase in PMG will normally be equal to the sum of nonrecourse distributions and
nonrecourse deductions for that year.
 Decreases in partners’ shares of PMG may trigger a minimum gain chargeback.
- Nonrecourse Distribution – Proceeds of nonrecourse borrowing that are distributed to the partners.
- Nonrecourse Deductions (NRDs) – Deductions attributable to nonrecourse financing, for which no partner bears
the economic burden.
o NRD = Net Increases in PMG - nonrecourse distributions
- Partner’s Share of PMG – Each year’s increase in PMG is allocated among the partners in accordance with the
amounts of the NRDs allocated to each and the amount of nonrecourse distributions made to each.
o Partner’s Share of Total PMG = Excess of (1) sum of NRDs allocated and nonrecourse distributions received
over (2) the partner’s share of net decreases in PMG.

Spreadsheets Should Be Used As Follows:

Amount of Loan (Constant)
(FMV of the property is
irrelevant due to Tufts)
FMV = AB PMG
(reduces each year with (to be allocated with respect to
depreciation) annual changes) – PMG
increases as FMV=AB declines.
**Decreases in PMG trigger the
gain chargeback provision.

Chapter 7 – Contributions of Property: Section 704(c) and Section 704(c) Principles

Tax follows book. There are disparities between the two with contributions and revaluations, which is why book must be
allocated first, then tax.
- Section 704(c) Property: Property contributed with different tax and book values.
o § 704(c)(1)(A) – Income, gain, loss, and deductions with respect to contributed property by a partner shall be
shared among the partners so as to take account of the variation between basis and FMV at the time of
contribution.
o § 704(c)(1)(C) – Built-in losses shall be taken into account only in determining the amount of items allocated
to the contributing partner.

Reg. § 1.704-3 Methods

- Traditional Method (§ 1.704-3(b)) – Contributor is effectively taxed more than the non-contributor to account for
the built-in gain upon contribution.
(1) Calculate book gains/losses and tax gains/losses
(2) Allocate book gain/losses in accordance with the partnership agreement
(3) Allocate tax items to the noncontributing partners to match their book gains and losses, if
possible
(4) Allocate the balance of the tax items to the contributor
o Ceiling Rule [when tax cannot follow book]: If there is book loss, but tax gain, there is not tax loss to
match the noncontributing partner’s book loss. The Ceiling Rule prevents allocations of loss to the
noncontributing partners.
 The ceiling rule limits the amount of tax cost recovery that can be allocated to the noncontributing
partner. This means that some built-in gain will at least-temporarily be shifted to the non-contributor.
 However, the disparity (for the noncontributor) can be offset with special allocations to make
tax match book.
- Traditional Method with Curative Allocations (§ 1.704-3(c)) – Partnerships may elect to make reasonable
“curative allocations” to eliminate ceiling rule distortions by allocating an item for tax purposes in a way that
differs from the allocations of the corresponding book item. [Curative Allocations must be reasonable in amount
and of the same type as the item subject to the ceiling rule.]
o Curative allocations only affect tax allocations, not book allocations. [This should make everyone’s tax and
book accounts equal (see p. 135)].
- Remedial Allocations (§ 1.704-3(d)) – Ceiling rule distortions can also be cured by making fictitious/notional
offsetting tax allocations to precisely eliminate any book/tax disparities created by the ceiling rule.
o Essentially, a loss is created for one partner, while an equivalent allocation of income is given to the other.
[The non-contributor avoids the shift in income that would have otherwise been caused by the ceiling rule.
o An allocation if “reasonable” if it is equal to the amount of the disparity.

Built-In Loss Property – The partnership must allocate any tax item related to that loss to the contributor. For the
noncontributing partner, the partnership will be treated as having an initial tax basis in the property equal to its FMV on
the date of contribution.
- Built-in losses are not subject to the ceiling rule and cannot be shifted to other partners.
- Treatment of Section 704(c)(1)(C) Property:
(1) Partnership is treated as having an AB = to FMV on the date of contribution.
(2) The Contributing Partner is given a § 704(c)(1)(C) Special Basis Adjustment equal to the
contributor’s basis in the property minus FMV on the date of contribution.
 If the Section 704(c)(1)(C) property is sold, (1) the partnership determines its book and tax gain
or loss on the sale using its common inside basis and allocates the gain or loss among its
partners, and (2) the contributing partner reduces her share of that gain or loss by the § 704(c)
(1)(C) basis adjustment. See p. 133.
- This treatment ensures that there is no disparity in the contributor’s capital accounts.

Depreciable Property
- Built-In Gains – To ensure the contributor will be taxed on the built-in gain, their share of current income must be
increased.
o Traditional Method – Allocate the depreciation away from the contributor, so that the noncontributor
receives tax depreciation up to their book depreciation, and only if tax depreciation remains thereafter, it is
 allocated to the contributor. This results in taxing the contributor on more than their share of book income,
thus resolving the book/tax disparity over the life of the asset.
(1) Calculate book and tax depreciation;
(2) Allocate book depreciation according to the Agreement;
(3) Allocate tax depreciation to the noncontributors to match their book depreciation; and
(4) Allocate the balance of the tax depreciation to the contributor.
o Traditional Method with Curative Allocations – Allocate a higher portion of income for tax (not book)
purposes to the contributor. This will solve the issue of overtaxing the noncontributor. See p. 141.
o Remedial Allocation Method
(1) Calculate book and tax depreciation
o § 1.704-3(d)(2) – Special Rule for calculating Book Depreciation:
 Contributed Portion – Assume the contributor sold the property to the
partnership on the date of contribution for FMV. “Asset 1” = Tax Basis
of Partnership = FMV
 Partnership steps into the contributor’s shoes and would use the
straight-line method over the remaining years of the property’s
life.
 Purchased Portion – The value of the property in excess of its basis is
treated for book purposes as if the partnership had purchased the
property for this amount. “Asset 2” = Built in gain = AR – AB.
 The partnership can adopt any appropriate method of cost
recovery for property of that type.
 Once the cost recovery period for the contributed property has
lapsed, there will be no further tax depreciation to allocate. As
such, the remedial allocation method will permit the partnership
to make two offsetting remedial allocations each year. See p.
144. [By the end of the purchased portion period, the book/tax
disparity will be eliminated.]
(2) Allocate book depreciation
(3) Match the noncontributor’s book depreciation with a tax allocation
(4) Allocate the balance of the tax depreciation to the contributor
(5) [If the ceiling rule prevents the noncontributing partner from receiving a tax allocation equal
to its book allocation, the partnership makes an offsetting remedial allocation of the
appropriate character and amount to both the contributing and noncontributing partner.]
- Built-In Losses
(1) Partnership would take a common inside basis equal to the property’s FMV, and the partners would be
entitled to recover this inside basis over the remaining recovery period.
(2) The partnership would depreciate the contributing partner’s § 704(c)(1)(C) basis adjustment over the
remaining recovery period.
- Methods of Depreciation
o The choice of which allocation method may be made on a property-by-property basis, but the overall method
or combination of methods must be reasonable based on the facts and circumstances. § 1.704-3(a)(2).
 If the contributor is in a higher tax bracket than the noncontributor, the traditional method would result
in the most savings for the contributor.
 If the contributor was in a lower tax bracket, the traditional method with curative allocations would be
best.
- Anti-Abuse Rules: § 1.704-3(a)(10) – An allocation method is not reasonable if “the contribution of property . . .
and corresponding allocation of tax items with respect to the property are made with a view toward shifting the tax
consequences of built in gain or loss among partners in a manner that substantially reduces the present value of the
partners’ aggregate tax liability. See pp. 152-53.
- Revaluations – Affect book values, not tax values.
o Reverse § 704(c) Allocations
Chapter 8 – Partnership Liabilities
Partnerships and LLCs can be used to maximize loss utilization. Borrow up front and take depreciation on the loaned funds to
the extent possible, as taxpayers love phantom losses.

§ 1.752-1 Liabilities

Economic Risk of Loss

- Satisfaction Presumption: In determining if a partner has a payment obligation, it is assumed that all partners will
perform their obligations, regardless of their actual net worth. [This presumption will not apply if the facts and
circumstances indicate a plan to circumvent the obligations, regardless of their actual net worth.] § 1.752-2(b)(6)
- Sharing Recourse Liabilities: (“At Risk” Rules of § 1.752-2(b)) – Constructive Liquidation:
Step 1: Assume Liabilities become due immediately;
Step 2: Assume Assets become worthless
Step 3: Assume Assets are sold for no consideration; resulting in loss equal to the total FMV of the
assets;
Step 4: Allocate income, gains, losses, and deductions [amount of deemed loss (FMV of property)]
according to the partnership agreement to reduce their AB.
Step 5: Assume partnership liquidates and must follow the QIO provision, so that the partners must
restore the deficit in their capital accounts. These are the amounts that they are at risk – their respective
shares of the partnership liability, which will be added to their basis. (§ 752).

Sharing Nonrecourse Liabilities: § 1.752-3(a) – A partner’s share of a partnership’s nonrecourse liabilities is equal to the
sum of:
(1) PMG = Loan – AB;
(2) Their share of § 704(c) minimum gain (the amount of gain if the property were disposed of for no consideration
other than satisfaction of the liability); and
(3) Their share of excess nonrecourse liabilities
 Methods Governing Excess Nonrecourse Liabilities:
 Significant Item Method – Sharing based on profit shares, which will be respected so long as
it is reasonably consistent with allocations of other items that have SEE.
 Alternative Method – Partners may agree to share nonrecourse liabilities in the same ratios that
they share nonrecourse deductions.
 Additional Method – If the liability encumbers contributed property, the partners may allocate
the excess nonrecourse liability first to the contributor in an amount of any § 704(c) gain in
excess of the § 704(c) minimum gain that is allocated under § 1.752-3(a)(2).
*Side agreements to guarantee a nonrecourse debt will give the debtor full EROL. However, bottom-dollar guarantees are
ignored.
**Pledging stock to guarantee the loan will increase the partner’s adjusted basis by an amount equal to the stock’s FMV.

Other Provisions
- § 704(d) – Limitation of Losses to Extent of Basis
- § 465 – Deductions Limited to Amounts at Risk – Taxpayer is at risk for cash contributions, AB of contributed
property, and borrowed amounts that the TP is liable for.
- § 469 – Passive Activity Losses and Credits – disallows deductions for PALs. Excess PALs are carried forward.
o PALs can generally only offset PAI.
Chapter 9 – Transactions (Other than Sales) Between a Partnership and its Partners
*This is an important area. Transactions between a partnership and its partners is generally treated in one of three way:
 Sec. 704(b) Distributive Share with respect to Partnership’s Income
o Character of income flows through to the partner;
 Includes 20% profit shares of 2/20 carried interest structures.
 Partnership’s accounting method is followed;
 Not subject to Capitalization Rules (deductible for non-receiving partners)
 QBI deduction may apply.
 Sec. 707(c) Guaranteed Payments without respect to Partnership’s Income (i.e. “not less than”
allocations) [waterfalls]
 Ordinary income
 The receipt of a capital interest is treated as a guaranteed payment.
 Includes 2% fee in 2/20 carried interest structure
 Partnership’s accounting method is followed
 Sec. 263 Capitalization Rules may apply
 QBI deduction does not apply. [Keeps law firms from being eligible - diversify]
 Special Analysis for Guaranteed Payments
 Step 1: Separate ordinary income, STCG, and LTCG
 Step 2: Partner who receives a guaranteed payment recognizes ordinary income equal to the
guaranteed payment (Sec. 61; Reg. 1.707-1(c)). Partnership then deducts the guaranteed payment
from its ordinary income, while capital gains and losses pass-through under sec. 702(a)(1)-(2) as
distributive shares.
 If ordinary income remains, it is allocated as distributive share according to the
Partnership Agreement.
 If there is a deficit in ordinary income, each partner receives a distributive share of
ordinary loss.
 Planning: Consider replacing guaranteed payments with priority cash flow/income allocations or
preferred returns on capital.
 Sec. 707(a)(1) Payments to Partners in a non-Partner Capacity
 Ordinary income (services, loans, or rentals without capital account adjustment);
 If a payment to a partner is higher than market rate, it is likely a sec. 707(a) payment. If
it is at a market rate, it then appears that the partner is acting within their duty to
maximize partnership profits.
 S Corp Management Companies for maintenance can avoid ordinary income under sec.
707(a).
 Partner’s accounting method is followed;
 Sec. 263 Capitalization Rules may apply
 QBI deduction does not apply.

The practical analysis is to ask:

1. Is this a payment of distributive share out of taxable income? [Sec. 704 applies]
2. Is the payment is to a “stranger” who would normally be hired outside of the partnership? [Sec. 707(a) applies]
3. Is the payment made irrespective of the partnership’s income? [Sec. 707(c) applies]

Example: ABC LLC has three partners who share all items equally. A is entitled to a $10,000 payment for services that
he performs for the partnership, without regard to the income of the partnership. ABC only has $6,000 of income.
 The payment is made irrespective of income, so it is a guaranteed payment under section 707(c). A has $10,000
of ordinary income. ABC has a $10,000 deduction under sec. 162(a) (subject to sec. 263(a)), giving ABC a
$4,000 loss that is allocated to B and C under sec. 704(b) because they have the economic risk of loss. However,
this is not a special allocation; it is a debt of the partnership that B and C agreed to pay.

Instead, “A is entitled to one-third of ABC’s income, but not less than $10,000. ABC ultimately has $60,000 of income.
 Here, ABC’s distributive share is $20,000, which is more than the minimum guarantee, so all of the payment is
treated under sec. 704(a).
 To the extent a payment is not made under sec. 704(a), it is treated as sec. 707(c) income.
Capitalization
Because payments to brokers and contractors in construction contracts have to be capitalized if they are paid under sec.
707(a), one planning technique is to make them partners for a short time to get within sec. 704 and avoid having to
capitalize the payments to partners in such capacities.

Disguised Payments for Services

If a partner performs services for a partnership and there is a related allocation and distribution to that partner and (if
viewed together) would be properly characterized as a transaction between unrelated parties, then the allocation and
distribution will be recharacterized as a disguised payment for services under section 707(a)(2)(A). Whether a transfer
constitutes a disguised sale depends on the facts and circumstances. Contributions and distributions made within a 2-year
period are presumed to be a sale, while those occurring more than 2 years apart are presumed not to be a sale. See Reg.
1.707-3. Proposed regulations provide that the most important factor is significant entrepreneurial risk. [If there is
significant entrepreneurial risk under the facts and circumstances, then an allocation will retain its capital treatment and
not be recharacterized.] This is similar to the step transaction doctrine.
** When a recharacterization to a service transaction occurs, the payment must be capitalized when required, and the
partners’ shares of income and loss must be redetermined.

Carried Interest
PE and hedge funds often compensate managers receive annual compensation equal to (i) a percentage of the amount of
capital contributed (1-2%) and (ii) a percentage of the fund’s net profits (10-20%). The net profits interest (“carried
interest”) is treated as distributive share (and can receive pass-through capital gain treatment), while the fee is treated as a
guaranteed payment. Many arrangements allow for the manager to elect to waive the fee in exchange for a greater
percentage of profits, which, if successful, would convert ordinary income into capital gain treatment.

Receipt of Partnership Interest for Services

Section 721 does not provide nonrecognition treatment to an exchange of services for a partnership interest.
*Generally, whether a partnership interest received for services is taxable depends on the type of interest received: (i)
capital or (ii) profits.
 Profits Interests - Generally not taxable on receipt (considered too speculative). As such, grants of profits
interest do not alter the basis or capital accounts of any partner, and there are no consequences for the partnership.
o Diamond v. CIR (7th Cir. 1974) - The receipt of a profits interest taxable upon receipt if it has a
determinable market value. The receipt of a partnership interest for acquiring a mortgage loan to
purchase a building was an interest that could be valued when it was sold immediately after the
transaction. [Practically, there could not have ascertainable value without the sale.]
 This case opened the door for the IRS to start arguing profits interests were taxable on receipt
under the facts and circumstances.
 Practitioners should not include profits interests in income unless the interest has immediate
liquidation value.
 Campbell v. CIR (8th Cir. 1991) - The profits interest received in this case was too speculative
and was not included in current income.
 Rev. Proc. 93-27 - A receipt of a profits interest is generally a nonrecognition event unless (i) the
interest relates to a substantially certain and predictable income stream from partnership assets or
(ii) the recipient partner disposes of the interest within two years of receipt.
 Regulations
 If an interest vests at the time it is transferred, the service partner must include the FMV of the
interest income, minus any amount paid for the interest.
 If the interest has not vested, tax is deferred and the partner is not treated as a partner until it does
vest. However, service partners can make a section 83(b) election and immediately include the
non-vested interest and be treated as a partner from then on. Once included in income,
subsequent appreciation in the property is not treated as compensation for services. [Start-ups
and private equity ventures want to have a section 83(b) election in place prior to the funding.]
 Prop. Reg. 1.83-3 - Mere profits interests would always have zero value and this not
taxable upon receipt.
 Capital Interests - Taxable upon receipt (a business’s balance sheet provides its value).
 If both a profits and a capital interest are received, the tax treatment is pro rata.
*Proposed Regulations exist that would treat all receipts of partnership interests as current inclusions upon receipt as
ordinary income that is deductible by the partnership subject to sec. 263.

Chapter 10 – Sale of Partnership Interest (§ 1.751-1(a)(2))

*Sales begin by taking an entity approach, but the aggregate treatment ultimately swallows the entity approach.
- § 741 – Treat the sale of a partnership interest as the sale of capital except as otherwise provided in § 751.
- § 743(a) – Sale of partnership interest has no effect on the partnership’s inside basis.
- § 754 – The partnership may elect to make a SBA of partnership assets to take into account the amount the buyer
actually paid. The adjustment will be pursuant to § 743(b).
o If the partnership has a “substantial built in loss ($250,000), it must elect to make the SBA. §§ 743(a)(1), (d)
(1).
Note that buyers often use installment notes, which defers timing on some of the seller’s income. However, character
of gain is maintained from the time of sale.
**When a partnership interest is sold, it is effectively looked through as a sale of the partner’s percentage of the
partnership’s assets. One potential planning technique is to drop property into a partnership to get capital treatment upon
sale.
***In M&A deals, “hot asset” analyses are required.
Analysis:
Step 1: AR – AB = Section 741 Gain/Loss
 [§ 741 – Selling partner’s gain or loss from the sale or exchange of a partnership interest shall
be treated as a capital gain or loss, except as provided in § 751 (for unrealized receivables and
inventory).]
 Remember: Take into account the partnership’s liabilities when calculating the selling
partner’s AB and AR.
Step 2: Back out § 751 Assets from Gain/Loss by:
 Identifying them [inventory, accounts receivable, and sec. 1245 recapture],
o If the AR of 751 assets exceeds the seller’s AB, there is ordinary income and
offsetting capital losses.
 Hypothesizing a sale, and
 Allocating proceeds.
Step 3: Subtract Step 2 from Step 1 to calculate capital gain/loss [subtract the gain from hot assets]
Step 4: Apply § 1(h) if applicable (selling partner is an individual)
 Identifying them,
o 28% Tax on Collectibles
o 25% Tax on § 1250 Gain (real property subject to depreciation)
 Hypothesizing a sale, and
 Allocating proceeds.
Step 5: Step 3 minus Step 4 provides Normal Capital Gains/Losses (taxed at 0, 15, or 20%)

Section 754 Election; Section 743(b) Adjustment – Address the issue of double taxation caused when Buyer’s pay
premiums for a partnership interest. Partners with a § 754 election in effect may eliminate such disparities through a
basis adjustment under § 734(b).
o § 743(a) – Basis of partnership property will not be adjusted due to transfers in partnership interests, unless
(i) a Section 754 election (optional basis adjustment to basis of partnership property) has been made or (ii)
the partnership has a substantial built in loss immediately after such a transfer.
o § 743(b) – If a Section 754 election is in effect, the partnership shall:
 Increase AB of partnership property by excess of the Buyer’s tax basis over the Seller’s former AB of
the partnership interest.
 [Bought for a price higher than the seller’s AB]
 Decrease AB of partnership property by excess of the Seller’s former AB of the partnership interest
over the Buyer’s current tax basis.
 [Bought for a price below the seller’s AB]
o Allocating Special Basis Adjustments: First, allocate to Section 751 property; Second, allocate to other
property.
 o Note: The Section 743 basis adjustment will be equal to the difference in the buyer and seller’s tax bases in
the partnership interest.
Analysis
(1) Hypothesize sale of all partnership assets for FMV
(2) Buyer’s Share of Partnership’s Inside Basis (Previously Taxed Capital) = (amount of cash buyer receives) + (tax
loss allocated to partner from sale) – (amount of tax gain allocated upon sale)
(3) (Amount buyer paid for partnership interest) – PTC = Amount of Adjustment
(4) § 755(a)(1) Make allocations in a manner to reduce the difference between FMV and AB of partnership
properties, but these allocations must be made to properties of like character (§ 755(b)):
a. Separate Ordinary Income Property and Capital Gain Property

Book/Tax Disparity for Purchaser

When an outside third party purchases a partnership interest that has a book and tax disparity, the buyer inherits that
book/tax disparity. This is because the buyer will inherit the seller’s tax and capital accounts, but will have their own
outside cost basis. As such, outside basis is often higher than the inherited tax basis, which leads to the buyer being
double taxed when the partnership later sells some of its assets (once on the partnership’s sale, then again on the sale of
their interest).] A sec. 754 election would allow for the disparity to be eliminated through a basis adjustment under Sec.
743.
Section 754 Election: If a sec. 754 election is made (or if there is a substantial built in loss), then section 743 allows for a
special basis adjustment (equal to Buyer’s cost basis minus Seller’s tax capital account) to the basis of the partnership’s
assets to take into account the buyer’s outside basis in each of those assets.
Chapter 11 – Basic Distributions
Partners can withdraw previously taxed profits without further negative tax consequences. Liquidations can be either
current or liquidating. However, losses can only be recognized on liquidating distributions, not current distributions.
Otherwise, current liquidations would be too ripe for abuse.
**Given that property can come in and out of a partnership without gain or loss so long as there is sufficient basis,
Subchapter K opens the door for abuse, which the anti-abuse rules seek to shut.

§ 731 – Partners will recognize gain to the extent that the distribution exceeds their outside basis.

Current Distributions
§ 731(a) – Partners will receive no gain or loss upon distributions, except to the extent that the money they receive
(including liability reductions) exceeds their outside basis.
§ 732(a)(1) – The AB of property distributed to the partner will be the same as the partnership’s AB of the property.
§ 732(a)(2) – The AB of the property received will be zero if there is no ROB to allocate to transferred property.
§ 733 – The partner’s AB of their partnership interest is equal to their original AB minus they money received minus basis
of properties received; however, basis cannot fall below zero.
Analysis
Step 1: ROB = Original AB – Money Received (and reduction of liabilities)
o If money + liability relief > outside basis, the excess is taxable gain.
 ROB > Partnership’s basis in distributed property: Partner receiving distribution takes a
transferred basis in assets. § 732(a)(1)
 Partnership basis in distributed property > ROB: Partner’s outside basis becomes 0.
Step 2: Allocate ROB first to § 751 properties
Step 3: Allocate remaining ROB to Other Property received (capital assets)
Step 4: Allocate any remaining ROB as the partner’s AB in their partnership interest.

Liquidating Distributions [terminate partner’s interest]

*Losses can be taken on liquidating distributions.
Step 1: ROB = Original AB – Money Received (and reduction in liabilities)
o If money received + liability relief > outside basis, excess is taxable gain (§ 731).
Step 2: Allocate ROB to § 751 Properties Distributed to Partner
o If ROB > or = sum of bases of 751 property, the partner takes the partnership’s basis in the properties. [The
excess basis should be allocated to other capital gain property, but if there is no capital gain property, treated
as capital loss.
o If ROB < sum of 751 property, reduce the bases of the distributed property so that bases of distributed
property = partner’s ROB.
Step 3: Allocate ROB to “other property”
o Any remaining ROB is recognized as capital loss.
o If ROB > Partnership’s Pre-Distribution Basis in Other Property, adjustments must be made to the bases of
those properties so that the combined bases in other properties equal the partner’s remaining ROB.
 Increase (§ 732(c)(2)): If sum of other property < remaining ROB.
 [Only basis of capital gain, not 751 property, is increased.]
 Rules for Increase:
o Measure only unrealized appreciation
o Add unrealized depreciation
o Allocate basis increases according to pro rata share of appreciation in each property,
but only up to the property’s FMV
o Excess Remaining ROB is assigned to other properties in proportion to the individual
properties’ relative FMV
 Decrease (§ 732(c)(3)): If sum of other property > remaining ROB.
 Rules for Decrease:
o Measure “unrealized depreciation” for loss properties
o Add unrealized depreciation
 o Allocate basis reductions according to pro rata share of depreciation in value of each
property
o If more basis reductions are necessary, allocated proportionally according to adjusted
bases of properties.

*Partnerships do not recognize gain on distributions.

**The partnership’s AB in Section 751 property is the original inside basis minus the amount of basis deemed to have
been transferred plus the amount of basis in cash paid upon distribution.
***If a Section 754 election is not in place, the partnership’s total inside basis of its assets will be less than the remaining
partners’ outside bases in their partnership interests. With such an election, the partnership will be able to adjust its inside
basis by the gain recognized by the distributee partner so as not to lose basis. However, section 734 elections may not
always be optimal and planning may be needed to make a distribution.

Hot Asset Analysis

If Section 751 property’s FMV is greater than 120% of its basis, it is deemed a hot asset.
o Hot Assets: Post-Distribution Interest + Actual Distribution - Pre-Distribution Interest in Assets = Change in
Interest in Hot Assets
o Cold Assets: Post-Distribution Interest + Actual Distribution - Pre-Distribution Interest in Assets = Change
in Interest in Cold Assets
Three-Step Analysis
o Deem recipient to receive an amount of 751 property equal to the decline in Hot Assets. [The ratio of this
amount of the 751 asset divided by the FMV of that asset is multiplied by the partnership’s basis in the
inventory. That amount will then reduce the partner’s outside basis and the partnership’s basis in the
inventory.]
o Section 751(b) Exchange: The partner is deemed to have exchanged the hot asset for cash, and when
appreciated property is used to pay for something, that is a recognition event. [The amount of the asset
deemed to have been sold for the cash is taxed as ordinary income.]
o Non-Section 751(b) Distribution: A is deemed to have received cash in an amount equal to the cash actually
received minus the amount of the 751 asset that was deemed to have been sold for cash. [Subtract the
partner’s reduced AB (as a result of the hot asset) from this amount of deemed distribution in cash. This
provides the amount taxed as capital gain.]
Disguised Sales and Exchanges & “Mixing Bowl” Transactions
Because Subchapter K allows property to be contributed and distributed in and out of a partnership without
recognition of gain, it is ripe for abuse. A mixing bowl transaction occurs when a partner contributes one piece of
property to a partnership, mixes it into the capital accounts, and then receives an asset equal to the value contributed.
 Disguised Sales: Under sec. 707(a)(2)(B), a transaction is a taxable sale if: (1) there is a direct or indirect transfer
of money or other property by a partner to a partnership, (2) there is a related direct or indirect transfer of money
or other property by the partnership to such partner (or another partner), and (3) the transfers, when viewed
together, are properly characterized as a sale or exchange of property. Reg. 1.707-3(b)(2) provides a non-
exhaustive list of factors to determine whether a disguised sale has occurred.
o Reg. 1.707-3(b)(1) – More specifically, a contribution and related distribution will be characterized as a
sale only if, based on all of the facts and circumstances, (i) the partnership would not have transferred
money or property to the partner BUT FOR the transfer of the property by the partner to the partnership,
and (ii) in the case of transfers that are not simultaneous, the subsequent transfer is not dependent on the
entrepreneurial risks of the partnership’s operations.
o Two-Year Presumptions:
 Transfers that occur within 2 years of one another are presumed to be a sale.
 Transfers separated by more than 2 years are presumed not to constitute a sale.
o Exceptions
 Debt-Financed Distributions: Partners may receive from the partnership cash or other property
financed with debt on a tax-deferred basis up to the amount of the partner’s “allocable share”
(based on economic risk of loss) of the partnership’s debt. Reg. 1.707-5(b)(1). To alter one’s
EROL, they can use guarantees, assumptions, and indemnity agreements. See Tribune Media
(T.C. 2021).
 Mixing Bowl Transactions: Under sec. 704(c)(1)(B), if section 704(c) property is distributed to any
partner, other than the contributing partner, within 7 years of the original contribution, the contributing
partner must recognized gain or loss in the amount and character that would have been allocated to her
under sec. 704(c)(1)(A) had the property been sold to the distribute at its FMV on the date of the
distribution.
 Basis Rules
 For gains, both the contributing partner’s outside basis and the partnership’s basis in the sec.
704(c) property must be increased (immediately before the distribution) by any gain recognized
by the contributor. Reg. 1.704-4(e)(1) & (2).
 For losses, the contributor must reduce their sec. 704(c)(1)(C) basis adjustment by the loss
recognized; the partnership[‘s common basis in the property is not affected.
 Section 737 – If, within 7 years of a contribution, the contributing partner receives a distribution
of property, other than the property they contributed, sec. 737 may trigger gain (not loss) for
them. If so, gain must be recognized equal to the lesser of (i) the excess distribution (distribution
minus outside basis), or (ii) the partner’s pre-contribution gain.
 Sec, 707(a)(2)(B) also recognizes that there can be disguised sales of partnership interests who one
partner receives a distribution and another party purchases a partnership interest.

Anti-Abuse Regulations
Reg. 1.701-2 is a sweeping anti-abuse regulation that gives the Commissioner the authority to recast a transaction “even
though [it] may fall within the literal words of a particular statutory or regulatory provision.” It requires that the
partnership be bona fide and that each partnership transaction or series of related transactions have been entered: (1) into
for a substantial business purpose, (2) the form of the partnership should be respected after applying substance over form
principles, and (3) the tax consequences to the partnership and to each partner must accurately reflect the partners’
economic agreement and clearly reflect each partner’s income.
Ch. 14 – Retirement of a Partner
1. What are the assets? Retiring partner’s basis? FMV of the assets? Gain?
2. Determine whether section 736(b) or (a) applies.
3. Identify section 751 assets.
4. Impact on the partnership’s inside basis in the assets?
5. Is there a better alternative, such as borrowing in the form of debt?
o Pay with a note.
o Pay the partner with some of the partnership’s assets.
o Borrow and give the retiring partner excess financing.
o Consider acquiring life insurance policies on each partner, with the others named as the beneficiaries. The
death benefits could be made payable to others, which is tax friendly, because life insurance proceeds are not
taxed. The surviving partners could then use the proceeds to buy the decedent partner’s interest under a buy-
sell agreement. If the partnership pays the premiums, they are passed down as distributive share expenses.
However, this plan is unlikely to work if a partners is in bad health or above 75 (higher premiums).
6. How much longer will the partnership continue to exist?

Sec. 736(b) Distributions – To the extent liquidating payments to retiring partners are in exchange for the retiring
partner’s interest in partnership property, they will be treated under the normal distribution rules, including sec. 751(b).
*All payments to retiring partners of capital-intensive partnerships will be governed by sec. 736(b).
**Sec. 736(b) provides partners more flexible treatment than sec. 453 installment sales do. Continuing payments are
permitted.
- Deferred Liquidation Payments: Unlike installment sales, partners can recover their basis first (rather than pro
rata) under sec. 736(b). Similarly, retiring partners can generally defer portions of their sec. 752(b) distributions
until their receipt of the last payment.
o No interest will be imputed to distributions, as they are not sales or exchanges.
- Exception: Sec. 736(a) applies to amounts paid to a retiring general partner of a service partnership for: (i)
unrealized receivables, defined in sec. 751(c), or (ii) goodwill of the partnership (unless the partnership agreement
provides for a payment with respect to goodwill). Such amounts will either be treated as distributive share or
guaranteed payments.
o A portion of the payments made to retiring service partners for their interest in unrealized receivable and
goodwill will be treated under sec. 736(a). [If the partnership is a service partnership, where capital is not a
material income producing factor, sec. 736(b)(2) applies to treat they payments for goodwill as sec. 736(a)
payments, unless the partnership agreement provides for payment for the partner’s interest in the goodwill.]
– Because goodwill is difficult to value, it is best for the partnership to hire an appraiser.
 The payments for goodwill will allow for a deduction for the remaining partners.
 Alternatively, the Partnership Agreement could be amended to allow the retiring partner to be paid for
their share of the partnership’s goodwill. However, only the retiring partner would prefer this, as they
transform ordinary income into capital gains. The remaining partners would lose deductions from the
goodwill and the basis of the assets will not account for the distribution unless a sec. 754 election is in
effect.