Basis adjustments for liquidation payments to retiring and deceased partners.by Harris, Richard W.
A new revenue ruling by the IRS specifies the timing of basis adjustments available to partnerships under IRC Sec. 734(b) in connection with certain deferred liquidation payments to a retiring partner or a deceased partner's successor. The author provides the background on such basis adjustments and provides many examples to help understand this complex tax area.
The IRS ruled in Rev. Rul. 93-13, 1993-7 I.R.B. 12 (2/16/93), with respect to the special basis adjustment available to a partnership under IRC Sec. 734(b) in connection with certain deferred liquidation payments to a retiring partner or a deceased partner's successor. Such adjustment is to be made in accordance with the amount and timing of the recognition of gain or loss on such distributions by the recipient partner. Although this ruling clarifies the IRS's position on the issue, in many cases it will produce an unfair result at the partnership level. A more sensible and equitable approach would allow the IRC Sec. 734 basis adjustment at the time the partnership incurs a definite legal obligation for future liquidation payments that are fixed as to amount and timing.
Tax Treatment of Partnership Distributions
IRC Sec. 731(a) (1) generally provides that a partner receiving a distribution of cash or other property from a partnership, recognizes gain only to the extent that cash distributed exceeds the partner's basis in his or her partnership interest immediately before the distribution.
Example 1: Partners A, B, and C each have a basis in their partnership interest of $50,000. In 1993, the partners receive current distributions as follows:
A - Cash = $30,000, B - Fixed Assets = (FMV = $100,000, Basis = $60,000), C - Cash = $56,000.
Only Partner C recognizes a gain on the distribution ($6,000) since she received cash in excess of her partnership basis.
A distribution may result in a recognized loss to a partner only where the partner's interest in the partnership is being completely liquidated and he or she receives only cash, unrealized receivables as defined in IRC Sec. 751(c), (e.g. cash-basis accounts receivable), or inventory as defined in IRC Sec. 751(d)(2). Loss in recognized to the extent the partner's basis in the partnership exceeds the amount of cash and basis of such other assets received in liquidation of the interest.
Example 2: Partner A receives 1) Cash = $50,000, and 2) Inventory (FMV = $50,000, Basis = $30,000) in liquidation of his partnership interest which had a basis of $100,000. A's recognized loss is $20,000.
Except for 1) distributions involving a disproportionate distribution of IRC Sec. 751 "hot assets" and 2) payments considered as a distributive share of income or as a guaranteed payment under IRC Sec. 736(a), any gain or loss recognized by the partner is treated as having resulted from a sale or exchange of the partner's partnership interest (i.e., generally capital gain). IRC Sec. 736(a) payments generally include payments (determined with or without regard to the income of the partnership) which are paid for either 1) unrealized receivables, or 2) partnership goodwill where payments for goodwill are not called for in the partnership agreement. However, the Omnibus Budget Reconciliation Act of 1993 (OBRA '93) precludes IRC Sec. 736(a) treatment for liquidation payments where capital is a material income producing factor. Such payments must be treated as made in exchange for the partner's interest in partnership property under IRC Sec. 736(b). Finally, except for disproportionate distributions under IRC Sec. 751(b), no gain or loss is recognized by the partnership in connection with a distribution to a partner.
IRC Sec. 734 Basis Adjustments For Partnership Distributions
In certain circumstances, a distribution to a partner may result in a "special basis adjustment" to the remaining assets of the partnership. IRC Sec. 734(b) (1) provides generally that where a partnership has made a valid IRC Sec. 754 election, the basis of partnership property (remaining after the distribution) shall be increased by 1) the amount of any gain recognized to the distributee partner(s) on the distribution, and 2) the amount by which the partnership's basis in any property distributed exceeds the basis of such property to the distributee partner after the distribution. A partner takes a basis in distributed property equal to 1) in the case of a nonliquidating distribution, the partnership's basis in such property, not to exceed the recipient partner's predistribution basis in the partnership less any cash received in the same transaction; and 2) in the case of a distribution in liquidation of a partner's interest, the partner's predistribution basis in the partnership reduced by any cash received in the same transaction.
Thus, a positive IRC Sec. 734 basis adjustment will be made in cases where the partnership is distributing more cash and/or asset basis than the distributee partner's basis in his or her partnership interest prior to the distribution. In effect, a positive IRC Sec. 734 basis adjustment is the mechanism by which Subchapter K preserves partnership asset basis, which would otherwise be lost as a result of the distribution of assets (including cash) having a basis in excess of the distributee partner's basis in the partnership.
Example 3: Partners A and B each have a basis of $40,000 in their respective partnership interest. In 1993, Partner A receives a distribution of Cash = $45,000 and Partner B receives a distribution of Blackacre (FMV $80,000, Basis = 45,000). Partners A and B recognize gain of $5,000 and zero, respectively, and (assuming a IRC Sec. 754 election is in effect) the partnership applies a $5,000 IRC Sec. 734 basis adjustment to its remaining assets with respect to each of the distributions.
A partnership having an IRC Sec. 754 Election in effect is required to decrease the basis of remaining partnership property in the amount of 1) any loss recognized by the distributee partner under IRC Sec. 731(a) (2), or 2) the excess of a distributee partner's basis in any property distributed in liquidation of the partner's interest over the partnership's pre-distribution basis in such property.
Example 4: Partners A and B each have a basis of $70,000 in their respective partnership interests. In 1993, A and B receive respective liquidating distributions of Cash = $50,000 and Greenacre (FMV $90,000, Basis = $50,000); recognizing losses of $20,000 and zero, respectively. If the IRC Sec. 754 election is in effect, the partnership must make a $20,000 negative IRC Sec. 734 basis adjustment to the remaining partnership assets with respect to each of the distributions.
The positive or negative IRC Sec. 734 basis adjustment is made immediately after the distribution and is allocated among the remaining assets in accordance with IRC Sec. 755, which generally requires that any positive or negative IRC Sec. 734 basis adjustment be allocated in a manner that reduces the difference between the fair market value and adjusted basis of partnership assets. Thus, the special basis adjustment must be applied so as to reduce, and never to increase, the gain or loss inherent in the partnership's assets at the time the adjustment is made. Furthermore, the IRC Sec. 734 basis adjustment made must be allocated to property of the same class as that distributed. For this purpose, capital and IRC Sec. 1231 assets constitute one class and all other property is considered another class. Thus, if a capital or IRC Sec. 1231 asset is distributed, any resulting IRC Sec. 734 basis adjustment must be made only to the partnership's remaining capital and IRC Sec. 1231 assets. Where assets from both classes are distributed, any resulting IRC Sec. 734 basis adjustment is apportioned between the classes to the same extent as the distributed assets from each class that gave rise to the adjustment. Thereafter, the basis adjustment is allocated among the individual assets within each class in a manner that reduces the difference between FMV and the adjusted basis of the individual assets in the class.
Where one class of assets is distributed, but no property of that class is retained by the partnership (or the retained property of the same class has insufficient inherent gain or loss to fully absorb the IRC Sec. 734 basis adjustment), the amount of the unabsorbed basis adjustment is suspended until the partnership acquires property of the same class in the future. Presumably, the suspended basis adjustment will be applied when currently owned or subsequently acquired assets are determined to have a FMV/adjusted basis differential.
Example 5: In the event the partnership in the above example has retained no capital or IRC Sec. 1231 assets (or none having an inherent loss), the $40,000 negative IRC Sec. 734 basis adjustment is suspended until the partnership subsequently acquires an asset of that class (having or obtaining a negative differential between FMV and adjusted tax basis).
Finally, where the IRC Sec. 734 adjustment results in the context of 1) a distribution of cash in excess of the recipient partner's basis in the partnership (i.e., recognized gain to the partner), or 2) a loss recognized by the distributee partner, the adjustment is allocated entirely to capital gain or IRC Sec. 1231 assets.
Effect of IRC Sec. 734 Basis Adjustment on Depreciation
Where the liquidating distributions result in a positive IRC Sec. 734 basis adjustment to depreciable assets, the partnership's depreciation deductions will be higher in the future. Conversely, a negative IRC Sec. 734 basis adjustment will result in lower subsequent depreciation deductions.
In the case of positive adjustments to pre-ACRS depreciable property (i.e. placed in service prior to 1981), the adjustment amount is apparently treated as "used" property and depreciated over the remaining useful life of the underlying asset. Treas. Reg. 1.167(c)-1(a)(6) requires this treatment for depreciation attributable to IRC Sec. 743(b) basis adjustments. Presumably, a similar rule applies to property subject to IRC Sec. 734(b) basis adjustment. Thus, the additional basis in depreciable real estate would be depreciated in accordance with the straight-line method for commercial property, the 125% declining-balance method for residential rental property, and the 150% declining-balance method in the case of personal property.
The amount of positive IRC Sec. 734 basis adjustment to ACRS recovery property placed in service at the time of the IRC Sec. 734 basis adjustment. Any negative IRC Sec. 734 basis adjustment to ACRS property reduces future recovery deductions since the remaining basis (reduced by the negative basis adjustment) is recovered using an adjusted applicable ACRS percentage.
Tax Treatment of Distributions to Retiring or Deceased Partners
A retiring partner or the successor of a deceased partner may receive payment for the value of his or her partnership interest in either a lump-sum distribution or a series of distributions in the future. Except for amounts treated as a guaranteed payment or distributive share under IRC Sec. 736(a) and disproportionate distributions treated as a deemed sale or exchange under IRC Sec. 751(b), such payments will be treated under the normal distribution rules of IRC Sec. 731 as described above. Thus, where a partner's interest is to be retired in a series of distributions, the partner is treated as receiving a non-taxable return of basis until such time as the cash received exceeds the partner's basis. Accordingly, no gain is recognized until total cash distributions exceed the partner's basis in the partnership. Where such payments are made to the successor of a decedent partner, the stepped-up basis occurring at the death of the decedent partner often results in little or no gain recognized on the distribution.
Example 6: Partner A has a basis of $200,000 in her partnership interest. Her interest is to be retired in 5 equal annual installments of $60,000. All of the payments are qualified under IRC Sec. 736(b). She will recognize $100,000 gain as follows:
Where, as in the example above, the total of the IRC Sec. 736(b) payments is fixed in amount (i.e. not determined in accordance with the income of the partnership or contingent as to amount for any other reason), the retiring partner or deceased partner's successor in interest may elect to report the gain attributable to the distributions on a pro rata basis as the payments are received, rather than in accordance with the normal rules of IRC Sec. 731(a).
Example 7: Same facts as in the previous example, except Partner A makes the election to recognize gain on a pro rata basis as the payments are received. She would recognize $100,000 gain as follows:
A similar result occurs where the retiring or deceased partner is to receive a series of liquidating distributions and has a recognized loss on the transaction. The recipient is treated as receiving a return of basis in full as payments are received. Thus, loss is deferred until all payments have been received by the partner. Again, this treatment is subject to the recipient's election to treat the loss as occurring on a pro rata basis as the liquidation payments are received.
Effect of Partnership Liabilities
A retiring partner or decedent partner's successor receiving liquidation payments is normally treated as a continuing partner under Subchapter K until such time as his or her partnership interest has been completely liquidated. Thus, such partner's share of partnership liabilities, and basis derived from such liabilities, remains intact (so long as the partner retains a legal or economic risk regarding repayment of the liability) to offset the liquidating distributions and to postpone the recipient partner's gain. Where the share of liabilities of the retiring partner or deceased partner's successor is assumed by the partnership upon retirement or death, such that the partner is no longer legally or economically responsible for the debt, the partner will be deemed to have received an immediate distribution of cash under IRC Sec. 752(b). At full pay-out, the recipient partner will be considered to have received a deemed distribution of cash under IRC Sec. 752(b) as a result of (and in the same amount as) the reduction in his or her respective share of liabilities. Thus, the existence of partnership liabilities often enhances the deferral period for gain recognition in connection with deferred IRC Sec. 736(b) liquidation payments.
Example 8: Retiring Partner P, is to receive IRC Sec. 736(b) liquidation payments of $50,000 per year for 5 years in full payment for his partnership interest having a basis of $200,000, including $110,000 basis attributable to recourse debt. P's tax consequences are as follows:
Rev. Rul. 93-13
Until recently, it was unclear whether the IRC Sec. 734 basis adjustment resulting from deferred liquidation distributions to a retiring partner or a deceased partner's successor is to be made at the time of the transaction or as the payments were made. The issue is not addressed in either the Code or Regulations. However, the IRS's position has been resolved in Rev. Rul. 93-13, which states the IRC Sec. 734 basis adjustment "should correspond in both timing and amount with the recognition of gain or loss by the retiring partner (or deceased partner's successor in interest)".
Generally, a partnership entitled to a positive IRC Sec. 734 basis adjustment attributable to deferred liquidation payments would prefer to make the entire adjustment at the outset of the transaction. This is for two reasons: 1) to receive immediate benefit of the additional basis in connection with future depreciation and/or sale of partnership assets, and 2) to avoid the inconvenience of having to make the multiple basis adjustments and resulting calculations attributable to the deferred liquidation payments. The issue of fairness surrounding the timing of the IRC Sec. 734 adjustment is especially important where the retiring partner does not make the pro rata recognition election to recognize gain as the deferred payments are received. In such case, the partnership will not benefit from the IRC Sec. 734 adjustment until after the partner's basis has been fully recovered even though it will have, in many cases, made substantial liquidation payments prior to that time.
Example 9: Partner RP is to receive 10 consecutive annual cash payments of $100,000 in liquidation of her partnership interest having a basis of $800,000, The partnership has no liabilities and has an IRC Sec. 754 Election in effect. RP does not make the pro rata recognition election. Therefore, she will recognize no gain for the first eight years and will recognize a $100,000 gain in each of years 9 and 10. Under Rev. Rul. 93- 13, the partnership is entitled to the IRC Sec. 734 basis adjustment (in the total amount of $200,000) only in years 9 and 10.
This example illustrates the inequity of the rule announced in Rev. Rul. 93-13. The partnership has paid out $800,000 before it is entitled to any benefit from the IRC Sec. 734 adjustment for the purpose of depreciation or reduced gain on sale of assets.
Where the distributee partner makes the election to recognize gain pro rata over the term of the liquidation payments, the situation is somewhat better for the partnership. That is, the partnership will make the IRC Sec. 734 adjustment in the same amounts as the recipient partner's recognized gain on the transaction. While this gives added tax benefit to the partnership, it also poses a significant additional burden in making and tracking the annual IRC Sec. 734 adjustments. If the recipient partner in the above example makes the pro rata recognition election, (thus recognizing $20,000 gain each year as payments are received), the partnership will be entitled to make similar IRC Sec. 734 adjustments to its assets. Of course, the administrative burden of tracking multiple, successive IRC Sec. 734 adjustments is greatly increased when the required adjustments and sales of property during the payout term are considered.
A much simpler and seemingly more equitable approach would be to allow the partnership to make the IRC Sec. 734 adjustment at the beginning of the pay-out period at least where the payments are fixed as to amount and time of payment and represent a true legal liability to the partnership. Under this approach, the partnership is viewed as having purchased the assets (or more precisely, the partner's interest in the assets) for a deferred fixed payment obligation. Where the partnership has the legal obligation to make the liquidation distributions at certain times and in fixed amounts in the future, there is little justification for not allowing a full IRC Sec. 734 adjustment at the time such obligation is incurred. The partnership's situation is nearly identical, economically and legally, to a partnership having purchased assets from a third party for a deferred payment obligation.
The Loss Case
As indicated previously, a retiring partner or deceased partner's successor will recognize a loss where the total IRC Sec. 736(b) liquidation payments include only cash (and/or unrealized receivables or inventory) and are less than the partner's basis in the partnership interest. Where the recipient partner does not make the pro rata recognition election, the loss is recognized only after all cash payments have been received. Under Rev. Rul. 93-13, the negative IRC Sec. 734 basis adjustment would occur at the end of the process. This result has obvious benefit to the partnership by deferring the downward basis adjustment and allowing higher depreciation deductions and lower gains on asset sales during the payout period. However, it is questionable whether the application of this rule makes good tax sense where the amount and timing of the deferred liquidation payments are fixed. The deferral of such negative IRC Sec. 734 adjustments allows the partnership to take interim advantage of asset basis for which, after considering the terms of the liquidation payout, it has no cost. This results in the partnership obtaining false depreciation deductions and artificially low asset sale gains. Where the recipient partner makes the pro rata recognition election, the result is somewhat less favorable to the taxpayer (i.e. less deferral of downward basis adjustment), but does not necessarily make more tax sense.
Richard W. Harris, LLM, CPA, is an Assistant Professor for the graduate tax program at the Kogod College of Business Administration, The American University, Washington, D.C.
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