Study Outline For:
Partnership Taxation
Module: Overview of Subchapter K

 

Partner's Basis in a Partnership  - Selected Readings              [ Close This Page ]   
 

 

Please browse the following statutory provisions

Code Sections
Regulations
1.752-1
752
1.752-2

1.752-3

General Theory of Partnership Basis Rules

The purposes for determining a partner's basis in a partnership are threefold:

  1. 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 and 731),
  2. A 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 (732(b)), and
  3. A partner's basis is important because it is used to limit the deductibility of a partner's share of partnership losses. ( 704(d)).

"Outside" 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).

Example 1

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 course.

Basis Upon Acquisition
The basis of the partnership interest received by the contributing partner equals:
    1. The amount of any cash contribution;
    2. The adjusted basis of any property contributed; plus
    3. The amount, if any, of gain recognized under 721(b).

An 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.


Adjustments to Basis

As 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.

  1. Increases to Basis. The basis of a partnership interest is increased by:
    a. Additional contributions to the partnership or other forms of acquisition (e.g., purchases),
    b. 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).
  2. Decreases 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).
    c. 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)
    d. 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)

Alternative 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).


Additional Considerations

The items must be taken into account when a partner's basis in a partnership is being computed.

  • 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.
  • Tax-Exempt 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.
  • Timing 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. Reg. 1.704-1(d)(2).

    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).

    Normally, 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.
  • Dual 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. 1.704-1(b)(2)(iv)(b).

Study Questions Make your selection by clicking the appropriate response letter.

1.

Which of the following will NOT increase a partner's basis in their partnership interest?
An increase in the partner's share of liabilities.

A partner's share of tax-exempt income.

A partner's share of non-deductible items.
A parter's share of a long-term capital gain.

2.

Which of the following will increase a partner's basis in their partnership interest?
A distribution of $10,000 in cash.

A partner's share of tax-exempt income.

A partner's share of tax deferred gain.
A decrease in the partner's share of liabilities.

3.

Partnership ABC makes a charitable contribution of capital gain property (FMV of $30,000; Basis of $21,000) to a qualified charitable organization. Partner A, an individual, is a one-third partner with an outside basis of $5,000. Ignoring limitations, what is partner A's potential charitable deduction for the year?
 
$0.
 
$5,000

$7,000
 
$10,000

Liabilities under the Final Regulations

A partner's share of partnership liabilities affects the basis of the partnership interest in the following manner:

  • An 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 Sec. 752(a)

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


Liability Defined

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:

  1. Basis in property (including cash) owned by the obligor,
  2. A deduction that is taken into account in computing taxable income of the obligor, or
  3. 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).

Liabilities 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.


Tiered Partnerships

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.


Contributions 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).


General Validity of Debt Issues

In 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.

Invalid Debt

Examples

In Estate 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.

In 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. .


Valid Debt

Example

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.


Recourse versus Nonrecourse

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.

  1. 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.
  2. 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.

The 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. Sec. 1.752-1


Determining recourse liabilities

A 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:

  1. All partnership assets are worthless and disposed of in a taxable transaction for zero consideration.
  2. All partnership liabilities are due and payable in full.
  3. The partnership allocates all gains and losses with respect to the disposition according to the partner's capital accounts.
  4. The partners interests in the partnership are liquidated. Reg. Sec. 1.752-2(b)(1).

A 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, 1.752-2(b)(1).

Example 1

X and 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:

Partner
X
Y
Beginning basis
$10,000
$ 50,000
Loss on land
(30,000)
(30,000)
Loss on building
(40,000)
(40,000)
Ending deficit
(60,000)
$(20,000)

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.


Study Questions Make your selection by clicking the appropriate response letter.

1.

How do partnership liabilities affect a partner's basis in the partnership?
An increase in partnership liabilities has no effect on basis, it only affects a partner's capital account.

An increase in partnership liabilities reduces a partner's basis in the partnership interest.

A decrease in partnership liabilities reduces a partner's basis in the partnership interest.
A decrease in partnership liabilities increases a partner's basis in the partnership interest.

2.

Which of the following statements is not true concerning the determination of a partners basis with respect to liabilities incurred or assumed?
If a debt is recourse and nonrecourse, the debt will be treated as two liabilities.

If a debt is recourse and nonrecourse, it will be treated as nonrecourse.

On a nonrecourse liability, no partner will have to defray the cost out of his/her own funds.
A general partner is responsible for a recourse debt.

3.

Which of the following statements is true concerning the requirements of the atom bomb test (constructive liquidation) of Regulation 1.752-2?
 
All partnership liabilities are deemed due and payable.
 
All assets, except cash, are considered to be worthless.

Only the limited partner's interest in the partnership is deemed liquidated.
 
No partner is required to restore a negative capital account.

4.

Which of the following statements is not true concerning debts of the partnership?
 
A Nonrecourse debts are shared by limited and general partners.
 
B If a debt has recourse and nonrecourse characteristics, it is treated as two separate debts.

C Nonrecourse debts are shared by partners according to their loss sharing ratios.
 
D Recourse debts are allocated to the partner who bears the recourse burden.

Determining 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.

  1. Reimbursement plans
  2. Partner loans
  3. Related party loans
  4. Guarantees

In 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)


Reimbursement plans

A 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. Sec. 1.752-2(b)(5)


Partner Lender Rules

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. Sec. 1.752-2(c)

A partner will not be considered to have the economic risk of loss for a nonrecourse loan made by the partner if:

  1. the partner's interest in each item of partnership income, gain, loss, deduction or credit is 10 percent or less, and
  2. the loan constitutes qualified nonrecourse financing under the at risk rules of Section 465(b)(6). Reg. Sec. 1.752-2(d)

Related Party Loans

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.

 

Example 1

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.

Note: 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:

Partner
A
B
Beginning basis
$70,000
--
Loss on building
15,000
15,000
Ending deficit
$85,000
$15,000

If avoidance of the 752 rules is not a principal purpose of the arrangement, the liability would be shared equally between the partners


Query

Q: What facts might lead to a conclusion that a principal purpose of the arrangement is the avoidance of the economic risk of loss rules.

A: 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


Guarantees

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:

  1. Waiving rights to subrogation
  2. Agreeing to treat any payments to the lender as capital contribution
  3. Agreeing to indemnify any other partners that might be required to discharge a recourse obligation. Reg. Sec. 1.752-2(o Example (4)

Study Questions Make your selection by clicking the appropriate response letter.

1.

Which of the following considerations will not affect how a loan will be treated under the new Regulations?
The fact that a partner made the loan to the partnership.

The fact that a loan reimbursement plan exists in the debt instrument.

The fact that there is a guarantor of the loan.
The loan originates from a brother of a partner.

2.

A loan always will be treated as a recourse loan when...
A partner loans money to a partnership.

A loan reimbursement plan exists.

A right of subrogation exists with respect to the loan.
A loan is part of a "wrap around" arrangement.

3.

To ensure that a guarantor partner receives basis for a recourse note, the partner may want to do all but which of the following:
 
Waive rights of subrogation.
 
Agree to indemnify other partners who are required to discharge obligations.

Become a limited partner.
 
Agree to treat payments to the lender as a contribution to capital.

4.

Concerning partnership loans, observe the two following statements.

  • Statement 1 - Limited partner A made a personal loan to a partnership of $10,000.
  • Statement 2 - Limited partner A guarantees a loan to the bank of $25,000 (waiving no rights).

How much risk of loss is partner A bearing?

 
$0
 
$10,000

$25,000
 
$35,000

5.

X is the general partner and Y is the limited partner in the X partnership, sharing profits and losses 50/50. How are the partners' bases affected if Y guarantees a partnership recourse loan to a bank of $20,000 (assume no waivers exist)?
X gets a $20,000 increase in basis.
Y gets a $20,000 increase in basis.

X and Y each get a $10,000 increase in basis.
 
Neither X nor Y get a basis adjustment.

Nonrecourse Liabilities Defined
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).

Under the new Regulations, a partner's share of nonrecourse liabilities is equal to the sum of the following three separate elements. Reg. Sec. 1.752-3(a)

  1. A partner's share of minimum gain;
  2. Built-in gain that would be allocated to the partner under Section 704(c);
  3. A partners share of the residual nonrecourse liability after reducing the total liabilities by the amounts determined in 1, and 2. above.

Practical

Note

From a practical standpoint (and in most cases), items 1 and 2 will not occur unless one of the following events occur:

  • A partner is receiving a special allocation of property;
  • 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
  • A partnership is being re-valued for the entry of a new partner.

Otherwise, the nonrecourse debt will be allocated according to profit sharing ratios under item 3 above.


The Partner's Share of Minimum Gain

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)

When 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 partner.

Example 1

Partner 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.

Accordingly, 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).

Without 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.

Occasionally, 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).

Example 2

Fifteen 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.

Although 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.


The 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


The LLC and Nonrecourse Liabilities

Recall 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).

The 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.


Study Questions Make your selection by clicking the appropriate response letter.

1.

Which one of the following is not a component of a partners share of nonrecourse liabilities?
A partner's share of minimum gain.

A partner's share of built-in gain.

A partner's share of residual guaranteed debt.
A partners share of residual nonrecourse debt.

2.

For purposes of nonrecourse liabilities, a partnership's minimum gain can best be described as:
Assets in excess of liabilities.

Liabilities in excess of assets.

Nonrecourse debt in excess of assets.
Nonrecourse debt in excess of basis.

3.

For purposes of nonrecourse liabilities, a partner's share of built-in 704(c) gain can best be described as...
 
Fair market value in excess of basis of assets contributed to the partnership.
 
Fair market value of all assets held by the partnership in excess of basis.

A partners share of liabilities in excess of basis.
 
A partners share of liabilities in excess of assets.

4.

Partner X contributes property with a fair market value of $20,000, basis of $0 and subject to a nonrecourse liability of $6,000 in exchange for a 20 percent interest in the XYZ partnership. Calculate X's built-in Section 704(c) gain.

 
$0
 
$1,200

$6,000
 
$10,000

5.

Partner X contributes property with a fair market value of $30,000, basis of $0 and subject to a nonrecourse liability of $6,000 in exchange for a 20 percent interest in the XYZ partnership. Calculate X's basis in the partnership.
 
$0
 
$1,200

$6,000
 
$10,000

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