Given the current economy and the resulting decline in the value of investment partnership portfolios, tax practitioners must be familiar with the mandatory basis adjustments under Secs. 743 and 734 and the alternative rules for electing investment partnerships (EIPs).
Historically, in an appreciating asset environment, a partnership would make a Sec. 754 election upon the taxable transfer of an interest in the partnership or death of a partner. That election would allow the partnership to increase the basis of its assets for the benefit of the transferee partner under Sec. 743, reflecting the excess of the transferee’s basis in the acquired partnership interest over his or her share of the partnership’s basis in its assets. Where asset values are decreasing, a partnership would not make a Sec. 754 election where the transferee’s basis was less than his or her share of the partnership’s inside basis because, by doing so, the partnership would be required to make a negative basis adjustment.
Similarly, a partnership would tend to make a Sec. 754 election upon making a distribution to a partner that would cause a positive basis adjustment to the partnership’s assets under Sec. 734(b) but would not make the election if the resulting adjustment would be negative.
Secs. 734(b) and 743(b) were originally made elective because Congress recognized that computing and tracking the resulting basis adjustments could be a significant administrative burden. However, that electivity also provided planning opportunities that Congress came to consider abusive. In October 2004, Congress significantly reduced the perceived abuse potential by enacting the American Jobs Creation Act of 2004, P.L. 108-357. The act amended Secs. 743 and 734 to require negative basis adjustments in certain cases even in the absence of a Sec. 754 election. Negative Sec. 743 adjustments are now mandatory where there is a “substantial built-in loss” in the partnership immediately after the transfer, and negative Sec. 734(b) basis adjustments are mandatory where there is a “substantial basis reduction.”
Substantial Built-in Loss Under Sec. 743(d)
Under Sec. 743(d), a substantial builtin loss exists when the adjusted basis of partnership property exceeds its fair market value by more than $250,000.
Example 1: Three partners, A, B, and C, each contribute $1 million to Partnership ABC. ABC does not make a Sec. 754 election. ABC purchases land for $3 million, which subsequently declines in value to $2.4 million. A sells its interest to D for $800,000, recognizing a loss of $200,000. If no Sec. 743(b) adjustment were required, the partnership’s basis in the land would remain $3 million. Upon a sale of the land, B, C, and D would each be allocated a loss of $200,000. However, D has had no corresponding economic loss because his interest in the partnership is still worth its $800,000 cost. In the absence of a Sec. 754 election, D would effectively be able to duplicate the loss recognized by A.
In this situation, because the basis of the land is more than $250,000 higher than its market value at the time of the sale, a substantial built-in loss exists, and a Sec. 743(b) adjustment is mandatory. ABC must reduce the basis of the land by $200,000, the excess of D’s share of the land’s basis, $1 million, over his basis in his partnership interest, $800,000. Upon sale of the land for $2.4 million, B and C each recognize a loss of $200,000, but D’s loss is offset and eliminated by the Sec. 743(b) adjustment.
Substantial Basis Reduction Under Sec. 734(d)
Under Sec. 734(d), a substantial basis reduction occurs where a negative basis adjustment greater than $250,000 would be required if a Sec. 754 election were in effect. The negative basis adjustment required under Sec. 734(b) equals the sum of:
- The loss recognized to the distributee partner on a liquidating distribution consisting solely of money and hot assets under Sec. 731(a)(2); and
- The difference between distributed property’s basis in the hands of the distributee (as determined under Sec. 732) over the partnership’s adjusted basis in the distributed property immediately before the distribution.
Example 2: Assume that partners A, B, and C each contribute $1.5 million to equal Partnership ABC, which purchases land for $3 million and retains cash of $1.5 million. ABC does not make a Sec. 754 election. The land depreciates in value to $2.4 million, and ABC distributes $1.3 million to A in liquidation of her interest (1/3 of $1.5 million cash plus 1/3 of the $2.4 million value of the land). A’s outside basis was $1.5 million, so she recognizes a $200,000 loss on the distribution under Sec. 731(a)(2). The negative basis adjustment that would be required under Sec. 734(b) if a Sec. 754 election were in effect is $200,000, which is less than $250,000. Therefore, there is no substantial basis reduction and no mandatory basis adjustment under Sec. 734(d).
Example 3: Assume the same facts as in Example 2, except that ABC purchases two parcels of land, parcel 1 for $3.6 million and parcel 2 for $900,000. Parcel 1 declines in value to $1.2 million and parcel 2 declines to $600,000. Assume that ABC redeems A’s interest by distributing parcel 2. The basis of parcel 2 in the hands of ABC immediately before the transfer was $900,000. However, under Sec. 732, A takes a basis in the land equal to her basis in her partnership interest immediately before the distribution, or $1.5 million. If a Sec. 754 election were in effect, ABC would be required under Sec. 734(b) to reduce the basis of parcel 1 by the difference, or $600,000. Because the basis reduction exceeds $250,000, there is a substantial basis reduction and the adjustment is required under Sec. 734(d).
Required Disclosure of Sec. 743(b) and 734(b) Adjustments
Partnerships are required to disclose that they have made a Sec. 743(b) or 734(b) adjustment on Form 1065, U.S. Return of Partnership Income, Schedule B, line 12c. In addition, the regulations and Form 1065 instructions require the partnership to attach a statement to the return showing the computation and allocation of the basis adjustment. The statement must include the transferee partner’s name, employer identification number or Social Security number, and the adjustment computation and must identify the adjusted properties.
Sec. 743(e) Exception for EIPs
Certain types of partnerships avoid making Sec. 754 elections even where an adjustment would be favorable because of the inordinate complexity of tracking basis adjustments. Venture capital and private investment funds may find this particularly difficult due to the common use of tiered or fund-of-fund partnership structures, the volatility and turnover of investment portfolios, and fluctuating asset values.
Recognizing these difficulties, Congress carved out an exception to the mandatory adjustment rules under Sec. 743(d) (but not Sec. 734) for electing investment partnerships (EIPs). The principal benefit of the exception is to reduce the administrative burdens associated with tracking Sec. 743(b) adjustments. Instead of allocating and tracking Sec. 743(b) basis adjustment to each of the partnership’s assets relative to the transferee partner, the transferee’s distributive share of the partnership’s losses is then disallowed until it exceeds the loss recognized by the transferor. The transferee does not reduce the basis in his partnership interest by the disallowed losses.
What Partnerships Qualify as EIPs?
To qualify as an EIP, partnerships must meet the following requirements:
- The partnership must elect EIP treatment;
- The partnership must meet the definition of an investment company under Section 3(a)(1)(A) of the Investment Company Act of 1940 but for an exemption under paragraph (1) or (7) of Section 3(c) of the act;
- The partnership must never have engaged in a trade or business;
- Substantially all the partnership’s assets must be held for investment;
- At least 95% of all contributions to the partnership must be in cash;
- The partnership must not have received any contribution of assets with unrealized losses;
- The partnership must issue all its interests by private offering within 24 months of the initial capital contribution;
- There must be substantive restrictions on each partner’s ability to cause a redemption of his or her interest; and
- The partnership must have a term limit of 15 years or less (Sec. 753(c)(6)).
In addition, partnerships cannot elect EIP status if they already have a Sec. 754 election in effect (Notice 2005-32).
Unfortunately, these requirements significantly limit the applicability of the election. Many investment partnerships do not meet the 15-year test, and while venture capital and private equity funds often meet the redemption restriction test, most hedge funds and funds trading marketable securities do not. Amending a partnership agreement to satisfy the tests for EIP status may be difficult due to legal, structural, and economic issues.
How the EIP Election Is Made
Notice 2005-32 supplies the procedural and reporting requirements for an electing EIP and its partners. An EIP must attach a statement to an original or amended partnership return for the tax year in which the election is effective. The statement must:
- Set forth the name, address, and tax identification number of the electing partnership;
- Contain a representation that the partnership is eligible to make the election; and
- Contain a declaration that the partnership elects EIP treatment.
For the election to be valid, the partnership must file its return not later than six months after its original due date, excluding extensions.
Notice 2005-32 also imposes reporting requirements on the transferor and the EIP. If a partnership interest in an EIP is transferred in a sale or exchange or upon the death of a partner, the transferor must notify the transferee and the EIP in writing. The transferor partner must provide the notice within 30 days after the date on which the partner receives Schedule K-1 from the EIP for the year of the transfer and must include various specified items in the notice aimed at giving the transferee enough information to be able to compute the amount of its disallowed loss. The transferee and the EIP must retain the transferor’s notice as long as the contents may become material in tax administration.
In addition, an EIP must separately state on Schedules K and K-1 all allocations of losses to its partners and include a standardized annual disclosure statement (see Notice 2005-32, §5(C)) indicating that the partnership is an EIP and informing the partners of the effects of that status.
The current economic downturn has significantly increased the number of partnerships subject to mandatory basis adjustments under Secs. 743(b) and 734(b). Tax practitioners with partnership clients must be familiar with the mandatory basis adjustment rules, the mechanics of computing and allocating basis adjustments, and the definitions of “substantial built-in loss” and “substantial basis reduction” under Secs. 743(d) and 734(d). Practitioners advising investment funds should also understand the benefits and requirements of making an EIP election.
Lorin Luchs is a partner in National Tax Services of BDO Seidman, LLP in Bethesda, MD.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.
For additional information about these items, contact Mr. Luchs at (301) 634-0250 or firstname.lastname@example.org.