of Subchapter K
browse the following statutory provisions
Theory of Partnership Basis Rules
for determining a partner's basis in a partnership are threefold:
- A partner's basis is used to measure
the gain or loss from a sale or taxable exchange of a partner's interest in the
partnership or the liquidation of a partner's interest in the partnership (§§741
partner's basis is used in determining the basis of partnership property (other
than money) received in liquidation of the partner's interest in the partnership
A partner's basis is important because it is used to limit the deductibility of
a partner's share of partnership losses. ( §704(d)).
Versus "Inside" Basis -Why Is it Differenct?
Many times, a partner's basis for his
or her partnership interest ("outside" basis) does not equal the partnership's
basis for its assets ("inside" basis). This inequality may occur, for example,
as a result of the acquisition of a partnership interest through purchase or inheritance.
If a partnership interest is acquired from an existing partner, the purchasing
partner will take a cost basis in the partnership interest, which may be higher
or lower than the basis of the partnership interest in the hands of the selling
partner. As a result, the purchasing partner's basis in the partnership interest
will differ from his (or her) share of the basis of the partnership's assets.
To equalize the inside and outside bases, the partnership may elect to adjust
the basis of its assets. §743(b).
Partner P owns a
one-third interest in the PQR partnership that has assets with a FMV of
$30,000 and an inside basis of $24,000. Further assume that P has an outside basis
of $8,000 which is equal to his share of inside basis (1/3
of $24,000). If P sells his interest to S for its value $10,000, S will now have
an outside basis of $10,000 (what he paid for it) but his share of inside basis
will still remain at $8,000 (1/3 of $24,000).Note
that this disparity can be remedied with a §754 election discussed later in the
The basis of the partnership
interest received by the contributing partner equals:
The amount of any cash contribution;
The adjusted basis of any property contributed; plus
The amount, if any, of gain recognized under §721(b).
adjustment to the basis amount above may be required when property subject to
a liability is contributed to the partnership, or when the partnership assumes
a liability from any partner.
If a partnership interest is acquired other than as a result of a contribution
of property (e.g., by purchase of an existing partner's interest or acquisition
of a partnership interest from a decedent), the partner's basis is determined
under the general basis rules of §§1011, 1012, 1014, 1015, etc.
a result of the operations, the basis that a partner has in his or her partnership
interest will fluctuate throughout the term of the partner's ownership. The basis
of a partner's interest in the partnership will either increase or decrease by
the following: §705.
to Basis. The basis of
a partnership interest is increased by:
contributions to the partnership or other forms of acquisition (e.g., purchases),
The partner's share of partnership taxable income, tax-exempt income,
c. Depletion deductions
in excess of the basis of the property subject to depletion , and
d. An increase
in the partner's share of partnership liabilities (including partnership liabilities
assumed by the partner).
to Basis. A partner's
basis is decreased by:
a. Distributions of money or other property from the partnership.
b. The partner's share of partnership losses and nondeductible, noncapitalized
expenditures, including the partner's share of disallowed partnership losses if
such losses reduce the basis of partnership assets without a corresponding effect
on its income. Rev. Rul. 96-10, 1996-1 C.B. 138 and §705(a)(2).
Any reduction in a partner's allocable share of partnership liabilities. In Rev.
Rul. 94-4, 1994-1 C.B. 195, the IRS stated that a reduction in a partner's share
of partnership debt is treated as an advance of cash to the partner and is taken
into account at the end of the partnership year. This ruling formalized existing
IRS policy that the decrease in basis occurs on the last day of the year and not
on the mid-year date when the partner's share of debt declines. §752(b)
The partner's deduction for depletion with respect to certain oil and gas property
of the partnership (but not in excess of the partner's proportionate share of
adjusted basis of such property). §705(a)(3)
Rule for Basis Determination
Section 705(b) allows the Commissioner to prescribe rules by which the adjusted
basis of a partner's interest may be determined by reference to the share of the
adjusted basis of partnership property which would be distributable upon the termination
of the partnership. This alternative rule is available where it is not practical
to apply the §705(a) general rule or where it is reasonable to conclude that the
result will not vary substantially from that which would be obtained under the
general rule. In practice, the IRS will often accept a taxpayer's "good faith
effort" to compute basis under §705(b).
items must be taken into account when a partner's basis in a partnership is being
- No Negative
Basis: The basis of a partner's interest in a partnership cannot be reduced
below zero. This situation has a potential to occur when a partner receives a
distribution from the partnership or has a loss in excess of their outside basis.
§705(a)(2)&(3).Thus, instead of reducing basis below zero, a partner is fully
taxed on distributions of cash in excess of basis and then takes a zero basis
in any noncash property distributions.
Income: Tax-exempt income that increases basis should include only that income
which is permanently tax-exempt. Income that is tax-deferred rather than exempt
(such as a nonrecognized gain on a like-kind exchange) should not trigger a basis
increase. For example, in Rev. Rul. 96-10, 1996-1 C.B. 138, a sale of property
between two related partnerships for which a loss was disallowed under §707(b)(1)
was followed by the sale of the property to an unrelated party for which gain
was not recognized under §267(d). The IRS held that the partners decreased the
bases of their partnership interests for their shares of the partnership's disallowed
loss and increased the bases of their interests for their shares of the gain that
was not recognized.
of Basis Adjustments: In determining a partner's basis for purposes of the
limitation of §704(d), a partner's basis is first increased for his or her distributive
share of partnership income items under §705(a)(1), and decreased by distributions
and other items under §705(a)(2) except for losses. The partner's basis thus determined
serves as the limitation on the deduction of partnership losses. Treas.
Rev. Rul. 66-94, 1966-1 C.B. 166, illustrates the ordering rules for determining
a partner's basis for partnership loss purposes. Contributions to a partnership
and distributions from a partnership (including cash distributions) reduce a partner's
basis before partnership losses are taken into account. c. Losses suspended on
pro rata basis. If losses exceed the partner's basis, the deductible losses are
deemed to consist of a pro rata share of each type of loss (e.g., ordinary and
capital loss). Treas. Reg. §1.704-1(a)(2).
in computing the partner's basis for purposes of calculating gain on a cash distribution,
the partner's basis must be determined through the date of the distribution. However,
advances or draws against a partner's distributive share of partnership income
and reductions in a partner's share of partnership liabilities are treated as
made on the last day of the year. Treas. Reg. §1.731-1(a)(1)(ii)
and Rev. Rul. 94-4.
Charitable Contributions: A partner's share of partnership
charitable contributions is not subject to the basis limitation. See Treas. Reg.
§1.704-1(d)(2) and also, PLR 8753015. If a partnership makes a charitable contribution
of property, the partners' bases in their partnership interests are decreased
(but not below zero) by their shares of the partnership's basis in the contributed
property. Rev. Rul. 96-11, 1996-1 C.B. 140.
Interests: A partner holding both a general and limited interest in the same
partnership is treated as having a single (combined) basis for both interests.
Rev. Rul. 84-53, 1984-1 C.B. 159. (A similar rule applies to combine a partner's
multiple interests for capital accounting purposes. Treas. Reg.
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under the Final Regulations
A partner's share
of partnership liabilities affects the basis of the partnership interest in the
increase in partnership liabilities increases a partner's basis in the partnership.
- A decrease
in partnership liabilities decreases a partner's basis in the partnership. IRC
Before partners' can share in partnership liabilities for basis purposes a determination
must be made as to which of the partnership's obligations will be treated as liabilities
Although the final §752 regulations do not specifically define the term "liability,"
the definition of a liability in the previously issued temporary regulations probably
provides a good working definition of the term. For purposes of §752, under former
Temp. Treas. Reg. §1.752-1T(g), an obligation is considered a liability only to
the extent that incurring or holding the obligation gives rise to:
- Basis in property (including
cash) owned by the obligor,
A deduction that is taken into account in computing taxable income of the obligor,
- An expenditure
that is not deductible in computing the obligor's taxable income and is not properly
chargeable to capital. Treas. Reg. §1.752-1(g). See Treas.
Reg. §1.752-1T(k), Example (2).
of Cash Method Partnerships, Etc.
Accounts payable. For
partnership taxable years beginning prior to September 19, 1988, partnership liabilities
include the partnership's obligations for repayment of trade accounts, notes,
and accrued expenses even if those items are not recorded on the partnership's
books due to its use of the cash method of accounting. Rev. Rul. 60-345, 1960-2
C.B. 211. For partnership taxable years beginning after September 18, 1988, such
obligations will not be considered partnership liabilities of a cash basis partnership
for purposes of §752. Rev. Rul. 88-77, 1988-2 C.B. 128.
Contributions of accrued liabilities. Contributions made after March 31, 1984,
of accrued but unpaid liabilities (e.g., accounts payable) by a cash method partner
to a partnership will be treated similarly to §357(c) items in a corporate tax
context. Thus, those items should not be treated as liabilities for purposes of
§752. Staff of the Joint Committee on Taxation, General Explanation of the Revenue
Provisions of the Tax Reform Act of 1984 (P.L. 98-369), 215 (the "Staff Report").
Deferred income. Unrestricted progress payments received by a partnership
using the completed contract method of accounting represent deferred income rather
than a partnership liability. Rev. Rul. 73-301, 1973-2 C.B. 215. However, a partnership's
prepaid subscription income constitutes a partnership liability. TAM 9823002.
A limited partner's basis for his or her interest in a first tier limited partnership
includes that partner's share of the second tier partnership's liabilities which
are allocated to the first tier partnership. Rev. Rul. 77-309, 1977-2 C.B. 216.
to Capital Versus Loans
Loans to partners. A partner's receipt of money from a partnership under
an obligation by the partner to repay the funds constitutes a loan, and thus a
liability of the partnership, rather than a distribution. To the extent such obligation
is canceled, the obligor partner will be considered as having received a distribution
at the time of the cancellation. Treas. Reg. §1.731-1(c).
Loans by the general partner. Nonrecourse loans by the general partner
to either the limited partners or the partnership may constitute capital contributions
to the partnership by the general partner, rather than loans. Rev. Rul. 72-135,
1972-1 C.B. 200.
Convertible debt. A nonrecourse loan by an unrelated third party to a partnership,
secured by the partnership's property and convertible at the option of the lender
into an interest in the partnership's profits may be treated as a capital contribution
rather than as a loan. Rev. Rul. 72-350, 1972-2 C.B. 394.
Advances to the partnership by the partners considered equity. Advances
to a partnership by a partner have been held to be capital contributions (rather
than loans) where the loans were noninterest-bearing, unsecured, subordinated
debt. Hambuechen v. Commissioner, 43 T.C. 90 (1964).
Advances to the partnership by the partners considered loans. Advances to
a partnership by a partner were held to be loans (rather than capital contributions)
where repayments were made regularly, notes were given, the advances were not
subordinated, and the partnership's capitalization was not abnormal. Kingbay v.
Commissioner, 46 T.C. 147 (1966).
Validity of Debt Issues
certain circumstances the IRS has taken the position that a debt does not exist
for tax purposes. Critical factors in this determination are whether or not the
debt is nonrecourse and whether the value of the collateral can support the purported
debt. This determination is generally made when the debt is incurred.
to Franklin, 64 T.C. 752, (1975), aff'd, CA-9, the Tax Court determined that
nonrecourse debt used to purchase real estate in a sale-leaseback transaction
was not valid debt. The rent payments were constructed to cover the debt service
and the Court found the purchase price to be significantly inflated.
Rev. Rul. 78-79, 1978-1 C.B. 62, the Service held that a nonrecourse note
issued for the purchase of a patent was not valid debt. The note represented 99.75%
of the purchase price. The Service determined that the fair market value of the
patent was not shown to even approximate the amount of the nonrecourse note. Further,
the transaction seemed to be designed to generate amortizable basis in the patent.
In Manuel D.
Mayerson, 47 T.C. 340 (1966), the taxpayer acquired a building with a minor
down payment (approximately 3%), the balance due on a nonrecourse note which could
be paid off at any time but required interest only payments during its 99-year
term with a balloon payment at the end. The Court upheld the purchase because
the value of the property appeared to support it and was negotiated at arm's-length.
Because a liability has a direct influence on the amount of basis that a partner
is deemed to hold, a determination of what is a partner's share of liabilities
must be made. In making this determination, two considerations must be addressed.
- Is the liability
in question a recourse or nonrecourse liability? This is important because different
sets of sharing rules are used depending upon the type of liability.
How are both recourse and nonrecourse liabilities allocated among the partners?
This is important because assorted rules and profit sharing ratios may exist for
different items of partnership income and deductions.
basic approach used in addressing both of these issues reflects Congress' goal
in the Tax Reform Act of 1984 of ensuring that the partner who receives the basis
with respect to a partnership liability also bears the economic risk of loss for
the liability. Regulations effective for liabilities incurred or assumed on or
after January 30, 1989, have undertaken this directive and instituted the ultimate
responsibility test, which at times appears to resemble more closely a term of
art. The thrust of this test is to determine who bears the ultimate financial
responsibility for payment of a partnership liability. If it can be established
that a partner will have to satisfy a liability out of his/her own funds, it is
a recourse liability. If no partner will have to defray the cost of a liability
out of his/her own funds, or if the partnership fails to do so, then the liability
is said to be a nonrecourse liability. If a liability has nonrecourse and recourse
characteristics, the debt will be treated as two different liabilities. Reg.
recourse liability is any liability for which any partner (or person related to
a partner) bears the economic risk of loss for the liability. A partner's share
of recourse liabilities equals the portion, if any, of the economic risk of loss
for such liability that is borne by that partner (or persons related to such partner)
if the liability is not discharged by the partnership. To determine the risk of
loss, the Regulations adopt a hypothetical worst-case scenario called a "constructive
liquidation," which is often referred to as the "atom bomb test' (constructive
liquidation). Treas. Reg. §1.752-1(a)(1).
Under constructive liquidation, the following scenario is deemed to occur:
- All partnership assets
are worthless and disposed of in a taxable transaction for zero consideration.
- All partnership
liabilities are due and payable in full.
The partnership allocates all gains and losses with respect to the disposition
according to the partner's capital accounts.
The partners interests in the partnership are liquidated. Reg.
partner then would bear the economic risk of loss to the extent that, after constructive
liquidation, the partner would be obligated to pay a creditor or make a contribution
to the capital of the partnership. A partnership contribution obligation generally
occurs when a partner is required to restore a negative capital account balance
as a result of the constructive liquidation. Accordingly, the partner is generally
allowed to include that amount of his/her potential liability in the basis of
his/her partnership interest. This required contribution is taken into account
before the balance of the liabilities are pro rated. Reg. Sec,
Y are partners in the XY partnership, each sharing profits and losses 50 percent
and each obligated to restore any negative capital account balances. The only
asset of the partnership is land with a basis and fair market value of $60,000.
X has a basis in the partnership interest of $10,000 and Y's basis is $50,000.
If the partnership borrowed $80,000 on a recourse basis to purchase a building,
the debt would be allocated $60,000 to X and $20,000 to Y determined as follows:
on land|| |
Due to the atom
bomb test (constructive liquidation), the land and building are deemed worthless
and sold for $0, generating the respective losses. Partner X is obligated to contribute
$60,000 while partner Y only is obligated to contribute $20,000. Both are required
to restore their negative capital account balances. Thus, to that extent, the
liabilities are allocated accordingly.
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the Risk of Loss
In making the determination
of who bears economic risk of loss, the partnership agreement and a wide variety
of conventions used by lenders must be taken into consideration. The label of
a loan will not determine which partner bears the ultimate risk of loss. The loan
must be analyzed to determine who, in fact, bears the risk of loss. Typically,
loans may incorporate any one of the following practices into the instrument that
can change how the loan will be treated for tax purposes.
essence what each of these techniques does is go beyond the constructive liquidation
test and determines who ultimately will be liable for satisfying the liability
from his/her own funds. If a partner has any right to a reimbursement or if relief
exists under the debt instrument, to that extent, the partner does not bear the
risk of loss. These techniques will be discussed in more detail later.
See Reg. Sec. 1.752-2(b)(3)
partner will not bear the economic risk of loss to the extent that he/she (or
a related party) is entitled to receive a reimbursement. In this context, a reimbursement
is an obligation of another partner or the partnership that effectively relieves
that economic risk of loss to that partner. Potential reimbursement from an unrelated
third party (such as an insurance company) does not effect a partner's share of
recourse liability. Reg.
A loan from a partner is always viewed as a recourse loan. From an economic viewpoint,
a partner could never make a nonrecourse loan to a partnership because, by definition,
a nonrecourse loan is one in which no partner is personally liable. If the partnership
is unable to repay its loan, the partner has lost the personal assets that were
advanced. Therefore, the Regulations always treat the lending partner (whether
limited or general) as bearing the full risk of loss to the extent of the loan.
If a partner should sell assets to the partnership for a personal note that wraps
around a nonrecourse mortgage to an unrelated party, the wrapped note (unrelated
party) is treated separately. In this case the Regulations do not treat the partner
as having risk of loss on the nonrecourse mortgage to the unrelated party. Reg.
partner will not be considered to have the economic risk of loss for a nonrecourse
loan made by the partner if:
partner's interest in each item of partnership income, gain, loss, deduction or
credit is 10 percent or less, and
the loan constitutes qualified nonrecourse financing under the at risk rules of
Section 465(b)(6). Reg. Sec. 1.752-2(d)
A recourse liability must be allocated to a partner to the extent that a person
related to the partner bears the risk of loss. This rule can have the effect of
converting a nonrecourse liability into a recourse liability if a partner is related
to the lender. The Regulations define a related party by adopting (with substitutions)
the rules of Section 267(b) and 707(b)(1). The Regulations substitute an 80 percent
or more ownership test for the 50 percent test in those sections, and brothers
and sisters are not considered to be related persons. The attribution rules of
Section 267(c) also apply. Reg. Sec. 1.752-4(b)(2)
As a result of the related party rules, one should note the bottom line effect
on certain, limited partnerships. The impact may be to shift allocation of a liability
away from limited partners who would ordinarily share in the basis increase attributable
to an otherwise nonrecourse liability.
A and B are equal partners
in AB general partnership. AB borrows $100,000 from X Corp. on a nonrecourse basis
secured by the partnership's property. X Corp. is a C corporation owned 80% by
A and 20% by an individual unrelated to A or B. Even though debt is shared equally
between A and B, Treas. Reg. §1.752-2(c)(1) provides that a partner bears the
economic risk of loss for a liability if the partner (or a person related to such
partner) is the creditor with respect to such liability. Because A owns 80% of
X Corporation, A and X Corporation are related parties under Treas. Reg. §1.752-4(b)(i).
Since A is related to the creditor, under the partner-lender rule, A is treated
as bearing the economic risk of loss with respect to the loan by X Corporation
and will be allocated the entire $100,000 for purposes of §752.
If X Corporation was owned 70% by A and owned 30% by an individual unrelated to
A or B, it is not the 80% required by Treas. Reg. §1.752-4(b)(i) to be considered
related under §752. However, Treas. Reg. §1.752-4(b)(2)(iv) may require that a
portion of the loan be treated as if it were made by A. Under that rule, if the
partnership has a liability owed to or guaranteed by an entity, a partner in the
partnership owns 20% or more of such entity and a principal purpose of the arrangement
is to avoid the allocation of the liability to the partner who owns the interest
in the entity, then such partner will be treated as holding, the lending or guaranteeing
entity's interest as a creditor or guarantor to the extent of such partner's ownership
interest in such entity. Therefore, if A caused X to be used in order to avoid
the application of economic risk of loss rules, 70% of the loan would be treated
as if it were made by A to the partnership which would provide the following result:
|Loss on building||
If avoidance of the §752 rules is not
a principal purpose of the arrangement, the liability would be shared equally
between the partners
facts might lead to a conclusion that a principal purpose of the arrangement is
the avoidance of the economic risk of loss rules.
If B needed the basis from the
liability, A might lend or contribute the money to X so it could be lent to AB,
rather than contributing or lending the money directly to the partnership
If a partner guarantees
a partnership nonrecourse liability, it will be allocated to that partner as if
it were a recourse liability. This rule applies equally to general and limited
partners. If a partner has agreed to guarantee a partnership's recourse liability,
the risk of loss does not necessarily lie with the partner due to the rights of
subrogation . Under the theory of subrogation, the guarantor is entitled to stand
in the shoes of the lender after making the payment to the lender. Thus, the guarantor
may sue the partnership after making payment and recover the funds from all the
general partners. Accordingly, the general partners bear the risk of loss and
all share in the basis allocations. To ensure that a guarantor partner receives
the entire basis for any recourse loans that are guaranteed, the partner must
generally waive any recovery rights. Generally, this would include:
- Waiving rights to subrogation
- Agreeing to treat any
payments to the lender as capital contribution
Agreeing to indemnify any other partners that might be required to discharge a
recourse obligation. Reg. Sec. 1.752-2(o Example (4)
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|A nonrecourse liability
is defined as a partnership liability for which no single partner bears the economic
risk of loss. Thus, when a partnership borrows money on a nonrecourse basis, the
true risk of loss is born by the lender and not the partner/borrowers. As a result,
one might expect that none of the partners would be attributed a portion of basis
for these types of liabilities. However, if this were the case, taxpayers would
be precluded from deducting depreciation , for example, on assets that they purchased
using nonrecourse debt. Accordingly, the new Regulations adopted a technique that
is similar to the old Regulations (allowing an allocation), but with an expanded
approach to cover the order in which nonrecourse liabilities are allocated. Reg.
Sec. 1.752-1(a)(2). |
the new Regulations, a partner's share of nonrecourse liabilities is equal to
the sum of the following three separate elements. Reg. Sec.
A partner's share of minimum gain;
Built-in gain that would be allocated to the partner under Section 704(c);
A partners share of the residual nonrecourse liability after reducing the total
liabilities by the amounts determined in 1, and 2. above.
Partner's Share of Minimum Gain
a practical standpoint (and in most cases),
items 1 and 2 will not occur unless one of the following events
partner is receiving a special allocation of property;
contributed to a partnership (subject to a nonrecourse
debt) that has a book basis different from its tax basis or has a built-in
gain or loss; or
partnership is being re-valued for the entry of a new partner.
the nonrecourse debt will be allocated according to profit sharing ratios under
item 3 above.
Partnership minimum gain is the excess of each nonrecourse liability over the
book basis of the partnership asset
to which the liability is attributable. (Note:
In more cases that not, book and tax basis will be the same).
The purpose of this rule is to provide a partner with sufficient outside basis
to allow a depreciation or expense deduction attributable to the underlying asset
that was purchased with the nonrecourse liability. Therefore, a partner's share
of partnership minimum gain is equal to the amount of nonrecourse deductions allocated
to that partner during the year. The rules for determining minimum gain are exactly
the same as those to be discussed later when determining deductions attributable
to nonrecourse debt. Reg. Sec. 1.704-2(d)
The Built-in Gains Under Section 704(c)
property is contributed to a partnership that has a nonrecourse liability in excess
of its adjusted basis, the property has a built-in gain. Under the Regulations,
this excess is referred to as the Section 704(c) built-in gain. If not for these
Regulations, a partner would have to recognize gain on the contribution of property
that was encumbered by a nonrecourse debt that exceeded the adjusted basis of
the property. A gain would have occurred because the contributing partner's share
of the liability decreased by more than the partner's basis in the property. Under
the finalized Regulations, the allocation of liabilities by the amount of the
built-in gain is designed to prevent the recognition of gain to the contributing
X contributes property with a fair market value of $10,000, basis of $0 and subject
to a nonrecourse liability of $6,000 in exchange for a 20 percent interest in
the XYZ partnership. The built-in section 704(c) gain is $6,000; all of which
is credited to partner A.
partner A receives the entire $6,000 basis attributable to the debt. This basis,
however, is offset by the relief of the $6,000 liability on the transfer of the
property, so that partner A's outside basis remains at zero ($0 beginning basis
+ $6,000 share of liabilities - $6,000 relief = $0).
this rule, Partner X would only have received 20% of the $6,000 basis attributable
to the debt. Therefore, his basis would have been: $0 + $2,000 - $6,000 = <$4,000>.
Partner A would have had to recognize a $4,000 gain.
a situation may exist where a built-in gain arises that is neither technically
minimum gain nor section 704(c) built-in gain. When this happens, the built-in
gain is treated as a built-in section 704(c) gain. Such a case might occur when
a new partner joins an existing partnership and the books require a restatement
to current fair market value. Reg. Sec. 1.704-1(b)(2)(iv) @
and Reg. Sec.1.752-3(a)(2).
years ago A and B form a partnership with equal cash contributions of $50,000,
and buy a building for $100,000. During the current year C joins the ABC partnership
for a cash contribution (the building is now valued at $250,000 and still has
a basis of zero). At the same time that C joins the partnership, ABC borrows $250,000
on a nonrecourse basis secured by the building.
technically there is no minimum gain nor section 704(c) gain, for tax purposes
(not for GAAP), the books will
be revalued to FMV to reflect the value when C enters the partnership. Accordingly,
C's entrance will be treated as a section 704(c) gain, which will be attributable
to A and B. Thus, A and B will each be awarded $125,000 basis attributable to
the nonrecourse debt.
Residual Nonrecourse Liabilities
Once the nonrecourse liabilities have been allocated to the various partners for
their minimum gains and Section 704(c) built-in gains, any remaining nonrecourse
liability can be referred to as the residual nonrecourse
liability. As illustrated earlier,
except for rare situations, the vast majority of liability allocations will be
governed by this residual approach. Reg. 1.752-3(a)(3)
The general rule
for allocating residual nonrecourse liabilities is straight forward: nonrecourse
debt is allocated relative to the partner's interest in the partnership
profits. In other words, partnership
nonrecourse liabilities are allocated according to a partner's profit-sharing
ratios. The Regulations permit the partnership agreement to specifically state
the partners' profits interests solely for purposes of determining their share
of partnership nonrecourse liabilities. Furthermore, residual nonrecourse liabilities
may be allocated in a manner that is reasonably consistent to the manner in which
the deductions attributable to the liabilities may be deducted. This can lead
to some interesting (and complicated) debt allocations. Reg.
1.752-3(b) Example 2
LLC and Nonrecourse Liabilities
that for purposes of §752, a partnership liability is a nonrecourse liability
to the extent that no partner or person related to a partner bears the economic
risk of loss for that liability. Therefore, it becomes extremely important to
distinguish the treatment of liabilities in a limited liability company (LLC)
context from those in a partnership context. Treas. Reg. §1.752-1(a)(2).
members of LLCs are generally shielded from personal liability for the debts and
obligations of the entity. Thus, if an LLC is taxed as a partnership for federal
tax purposes, the liabilities of the LLC are generally classified as nonrecourse
liabilities for purpose of §752 since no member (or person related to a member)
bears economic risk of loss with respect to the indebtedness. However, to the
extent that a member guarantees an LLC's debt without right of subrogation, or
otherwise assumes personal liability, the member will bear economic risk of loss
for the debt and it will be treated as a recourse liability that is allocable
to the member under the partner-lender
rule. In addition, recourse debt that exists at the time of conversion of
partnership to an LLC under state law may be treated as recourse debt for §752
purposes following the conversion if state law provides for continuation of the
members' personal liability for the debt in the successor entity.
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