A partnership that receives contributions of property must establish the basis, the holding period, and the character of the property in the hands of the partnership, and also determine available accounting and depreciation methods.
Determining the Basis of Contributed Property to the Partnership
Sec. 723 provides that a partnership’s basis in contributed property is generally the contributing partner’s adjusted tax basis in the property, plus any gain the partner recognizes under the investment company rules. In addition, if the contributing partner recognizes gain from the relief of liabilities, the partnership may be entitled to a basis step-up. The partnership also receives a higher basis if gain is recognized under the disguised-sale rules or under the Sec. 704(c) rules for contributed property later distributed to another partner. If contributed property has a built-in loss, the built-in loss is taken into account only in determining the amount of items allocated to the contributing partner. Except as provided in regulations, in determining the amount of items allocated to the other partners, the basis of the contributed property in the hands of the partnership is its fair market value (FMV) at the time of contribution (Sec. 704(c)(1)(C)).
Note: The IRS released a coordinated issue paper in March 2010 addressing the use of distressed assets to shift economic losses from a tax-indifferent party (usually a foreign taxpayer) to a U.S. taxpayer. These types of transactions involve the transfer of high-basis, low-value assets to a partnership. The coordinated issue paper states that the contribution of a worthless asset to a partnership does not give rise to any carryover basis; the partnership has no adjusted basis in any asset that was worthless at the time of contribution.
Determining Partner’s Holding Period in Partnership Interests Acquired From Property Contributions
Sec. 1223(2) provides that the partnership’s holding period for contributed assets includes the holding period of the assets in the hands of the contributing partner. This tacking-on concept applies whether or not the contributing partner recognizes any gain on the contribution because of a net reduction in liabilities. However, if the contribution is fully taxable because of the investment company rule of Sec. 721(b), the partnership’s holding period in the contributed securities begins on the contribution date. Similarly, if the contributing partner recognizes gain under the disguised-sale rules, the holding period of the property deemed purchased begins on the contribution date.
A partner’s holding period for a partnership interest received in exchange for a contribution of property depends on the character of the contributed property. If the contributed property is a capital asset or property used in a trade or business (within the meaning of Sec. 1231) immediately prior to the contribution, the partner’s holding period for the partnership interest includes the holding period of the contributed property (Sec. 1223(1)). If the partnership interest is received in exchange for money or other property, the partner’s holding period commences on the date the interest is acquired, i.e., the contribution date. The partnership’s holding period for the contributed property includes the contributor’s holding period (Sec. 1223(2)).
Example 1. Determining a partner’s holding period in a partnership interest and the partnership’s holding period in contributed property: On March 1, L, D, and M formed A Hardware, a general partnership, to conduct a small retail business. L contributed cash, D contributed equipment that she had owned for two years, and M contributed inventory she had acquired three months earlier. L is now considering selling her partnership interest to M for a profit, and the partnership is considering selling some of the equipment contributed by D. What is L’s holding period for her partnership interest? What is A Hardware’s holding period for the equipment contributed by D?
On March 1, A Hardware has a two-year holding period for the equipment contributed by D. Because this holding period exceeds any threshold relevant to a sale of the equipment, the practitioner can advise the partners that an immediate sale would pose no problems. Because their contributions consisted of cash and inventory, neither of which is a capital asset or Sec. 1231 property, L’s and M’s holding periods for their A Hardware interests begin March 1—the date of their contribution to the partnership. On that date, D has a two-year holding period in the interest she received in exchange for her contribution of Sec. 1231 property.
Applying the Divided Holding Period Rules
Regs. Sec. 1.1223-3 provides guidance relating to the allocation of a divided holding period with respect to a partnership interest. These rules generally provide that the holding period of a partnership interest will be divided if a partner acquires portions of an interest at different times, or if an interest is acquired in a single transaction that gives rise to different holding periods under Sec. 1223. The holding period for that portion of the partnership interest will be determined based on a fraction; the numerator is equal to the FMV of the portion of the partnership interest to which the holding period relates (determined immediately after the acquisition), while the denominator is the FMV of the entire partnership interest.
A divided holding period can create unexpected problems. For example, if a partner makes a cash contribution to a partnership in financial difficulty and the partnership is liquidated shortly thereafter, this regulation can cause the partner to recognize short-term capital gain. However, to circumvent these problems, the regulations provide that when determining the holding period of a partnership interest, if a partner makes one or more contributions of cash to the partnership and receives one or more distributions of cash from the partnership during the one-year period ending on the date of a sale, exchange, or gain-generating distribution, he or she may reduce the cash contributions made by the cash distributions received on a last-in, first-out basis, treating all cash distributions as if they were received immediately before the sale, exchange, or distribution (Regs. Sec. 1.1223-3(b)(2)).
This rule also applies in determining the holding period of a partnership interest where gain or loss is recognized on Sec. 731(a) distributions. This rule does not apply to deemed contributions and distributions resulting from increases and decreases in a partner’s share of partnership liabilities. Contributions of Sec. 751 hot assets within one year of a sale or exchange (but not a distribution) are also disregarded if the partner recognizes ordinary income or loss either as a result of the sale or as the result of a sale of the property by the partnership. However, if the partner does not have a long-term holding period in any portion of his or her partnership interest, this adjustment is not available.
Example 2. Sale of a partnership interest with divided holding period: B contributes $50,000 cash to O Management and Investments Partnership. She also contributes orchard equipment used in a trade or business that is held for more than one year. The equipment has a FMV of $100,000 and an adjusted basis of $40,000. The equipment has ordinary recapture potential of $20,000 (which is Sec. 1245 property). Six months after she acquired her partnership interest, B sells it to P for $175,000.
It is not completely clear how to determine B’s holding period in her partnership interest. There seem to be two filing positions because the regulation examples do not specifically address the contribution of recapture property. The first option is to consider the contributed equipment as a single asset. Under this option, the equipment would be entirely excluded from consideration in determining the holding period for the transferred interest, since it is a Sec. 751 asset contributed within one year of a qualifying disposition. Because the equipment is excluded, the entire $65,000 gain in excess of the depreciation recapture is considered short-term capital gain.
The second option is to treat the contributed recapture potential as a separate asset from the contributed equipment. This is consistent with the statement in Regs. Sec. 1.1223-3(e) that properties and potential gain treated as unrealized receivables under Sec. 751(c) are treated as separate assets that are not capital assets or Sec. 1231 property. Under this option, B has a divided holding period in her partnership interest: $70,000 of the original value of the interest is attributed to assets that are not capital gain or Sec. 1231 assets (the $50,000 cash plus the $20,000 of recapture). Because the sale occurs within one year of the contribution and the recapture is Sec. 751 property, the $85,000 gain on the sale would be allocated as shown in the exhibit (because the recapture is not included in the calculation assigning gain to the short-term or long-term category).
Note: A practitioner faced with applying the divided holding period rules to contributions of property subject to depreciation recapture should advise his or her client of the uncertainty in this area and the approach reflected by the practitioner in the client’s tax return.
Determining Accounting Methods
In many instances, an ongoing business will be contributed to a newly formed or existing partnership. This business may use accounting methods different from those the partnership wants to adopt. There is no “carryover” of accounting methods under the provisions of subchapter K. Therefore, a newly formed partnership (or an existing partnership to which an ongoing business is contributed) elects its own tax accounting methods. A partnership may not be able to use the cash method in certain situations.
Determining Depreciation Methods
The general rule under Sec. 721 is that no gain or loss is recognized on the transfer of property in exchange for an interest in a partnership. When depreciable property is contributed to a partnership, the partnership is treated as if it stepped into the shoes of the transferor partner. The partnership uses the depreciation method and remaining depreciable life used by the transferor. To the extent gain is recognized on the exchange and the basis of the property in the hands of the partnership exceeds the basis in the hands of the transferor, the partnership is treated as if it placed property with a value equal to the basis increase in service on the contribution date.
Determining Availability of Suspended Losses
Property contributed to a partnership may have related losses that were not deductible by the contributing partner because of statutory limitations. The losses could have been suspended because of the application of the at-risk rules or the passive activity rules. Any losses suspended by these provisions prior to the contribution of the related property/activity remain with the contributing partner and are not transferred to the partnership but are added to the transferor’s basis in the partnership interest (Prop. Regs. Sec. 1.465-67(b); Sec. 469(g)).
Contributing Property Subject to Investment Tax Credit Recapture
Investment tax credit recapture is not triggered because of a mere change in the form of conducting the trade or business in which the property is used, provided that the property is retained as investment credit property in the same trade or business, the transferor retains a “substantial interest” in the business, substantially all of the assets necessary to operate the trade or business are transferred to the same transferee to whom the investment credit property is transferred, and the transferee’s basis in the investment credit property is determined in whole or in part by reference to its basis in the hands of the transferor (Regs. Sec. 1.47-3(f)).
Where the transferor is a partnership, the partner must retain the substantial interest. A transfer of depreciable property held for the production of income also can qualify as one made in connection with a mere change in form. In Letter Ruling 200033030, the IRS held the contribution of several operating partnership interests, held by a limited partner, that were contributed to a holding limited partnership, was a change in form and did not trigger investment tax credit recapture.
A transferor is considered to have retained a substantial interest in the trade or business if, after the change in form, his or her interest in the trade or business is (Regs. Sec. 1.47-3(f)(2))—
- Substantial in relation to the total interest of all persons; or
- Equal to or greater than his or her interest prior to the change in form.
Planning tip: Credit recapture can be avoided if the investment credit property that is contributed to a partnership is simultaneously leased back to the contributing partner (Regs. Sec. 1.47-3(g)). This is the case even if the lease term is substantially less than the useful life of the investment credit property.
Credits that are part of the investment credit under Sec. 46 and subject to recapture are the:
- Rehabilitation credit (Sec. 47);
- Energy credit (Sec. 48);
- Qualifying advanced coal project credit (Sec. 48A);
- Qualifying gasification project credit (Sec. 48B);
- Qualifying advanced energy project credit (Sec. 48C); and
- Qualifying therapeutic discovery project credit (Sec. 48D).
This case study has been adapted from PPC’s Tax Planning Guide—Partnerships, 27th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian, Linda A. Markwood, Delia D. Groat, Cynthia Zatopek, and Diane L. Cason, published by Practitioners Publishing Co., Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.