Application of Sec. 704(c) to Divisions

Editor: Annette B. Smith, CPA

Partners & Partnerships

Generally, if a partnership divides into two or more partnerships and the partnership either undergoes a formless division or takes a form other than an “assets-up” form, Treasury regulations treat the transaction as an “assets-over” form of division (Regs. Sec. 1.708-1(d)(3)(i)). Under the assets-over form, in which at least one of the resulting partnerships is a continuation of the original partnership, the original partnership is deemed to (1) contribute the assets and liabilities to one or more resulting partnerships in exchange for interests therein under Sec. 721 and (2) immediately distribute the interests in the resulting partnership to the original partnership’s partners under Sec. 731 (Regs. Sec. 1.708-1(d)(3)(i)(a)).

Sec. 721(a) provides generally that neither the partnership nor the partners recognize gain or loss on a contribution of property to a partnership in exchange for a partnership interest. Sec. 722 provides that the basis of an interest in a partnership acquired by a contribution of money or other property to the partnership equals the amount of money and the adjusted basis of the property to the contributing partner at the time of the contribution, increased by the amount of any gain recognized under Sec. 721(b) to the contributing partner at that time.

Generally, in the case of a partnership’s distribution to a partner, gain is not recognized except to the extent that any money distributed exceeds the adjusted tax basis of the partner’s interest in the partnership immediately before the distribution (Sec. 731(a)). Sec. 732 provides the rules regarding the basis of distributed partnership property in the hands of a partner. Generally, under Sec. 732(a), the basis of property (other than money) a partnership distributes to a partner, other than in liquidation of the partner’s interest, equals the partnership’s adjusted basis in the property immediately before the distribution.

Accordingly, in an assets-over division, the resulting partnership generally will hold the property with the same basis as the original partnership following the deemed contribution. On the deemed distribution to the original partnership’s partners, assuming that each partner receiving the deemed distribution has sufficient outside basis in its partnership interest, the distributee partners generally also will take a substituted basis in the distributed resulting partnership. Thus, there generally would be no inside/outside basis disparity in the resulting partnership, because the original partnership’s basis in the asset carries over to the new partnership and the partners take a substituted basis in the resulting partnership equal to the assets’ basis inside the partnership.

However, the general division rules and other provisions do not account for property with a disparity between the property’s fair market value (FMV) and adjusted tax basis (Sec. 704(c) property) in an assets-over division. Sec. 704(c) prevents partners from shifting built-in gain or loss through the use of a partnership by requiring partners to take into account the difference between the basis of the property to the partnership and its FMV at the time of contribution (Sec. 704(c)(1)(A)).

While the Code and regulations provide guidance regarding Sec. 704(c) property generally, there is no guidance addressing how Sec. 704(c) principles should apply when a partnership distributes an asset to multiple partners in a partnership division, including in an assets-over division.

The lack of guidance under Secs. 704, 708, and 732 and the regulations on this issue may leave open two alternative approaches. One approach would be to follow a strict reading of Sec. 732 and allocate the tax basis of the distributed resulting partnership interest strictly in accordance with the pro rata percentage the partner is receiving (the pro rata method). An alternative approach would be to trace and allocate the tax basis of property distributed in a partnership division taking Sec. 704(c) principles into account (the tracing method) (see Schmalz and Amoni, “Applying the Disparity Offset Method to Achieve Tax-Follows-Economics Results,” 115 J. Tax. 133 (September 2011); see also Lay, “Allocation of Basis and Code Sec. 704(c) Gain in Partnership Divisions,” 12 J. Passthrough Entities 5 (May–June 2009)).

The following example demonstrates the different approaches (and potential distortions):

Example: Partner A and Partner B form Partnership AB. Partner A contributes $100 cash, and Partner B contributes Blackacre with an FMV of $100 and tax basis of $50. Partner A and Partner B share in all partnership items equally. After formation, Partner A has an outside tax basis of $100 in its AB partnership interest, and Partner B has an outside tax basis of $50 in its AB partnership interest. After formation, AB purchases Whiteacre (FMV of $100 and tax basis of $100). Ten years later, AB undertakes a partnership division under the assets-over form. AB contributes Blackacre to a new partnership, CD, in exchange for a partnership interest in CD and then distributes the partnership interest in CD to both A and B. Under Secs. 721 and 722, AB’s new partnership interest in CD has an FMV of $100 and tax basis of $50.

Pro rata method: If AB distributes the CD partnership interest to A and B using the pro rata method, A and B each should receive a partnership interest in CD with an FMV of $50 and tax basis of $25. After the division, A will hold a partnership interest in AB with an FMV of $50 and tax basis of $75 and a partnership interest in CD with an FMV of $50 and tax basis of $25. B will hold a partnership interest in AB with an FMV of $50 and tax basis of $25 and a partnership interest in CD with an FMV of $50 and tax basis of $25. Although A contributed only cash and no built-in gain or loss property, it now holds a built-in loss in its AB partnership interest and a built-in gain in its CD partnership interest.

Tracing method: If the tracing method is applied, the entire tax basis of the CD partnership interest should be allocated to A when AB distributes the CD partnership interest to A and B, to preserve B’s contribution of Sec. 704(c) property. After the division, A will hold a partnership interest in AB with an FMV of $50 and tax basis of $50 and a partnership interest in CD with an FMV of $50 and tax basis of $50. B will hold a partnership interest in AB with an FMV of $50 and tax basis of $50 and a partnership interest in CD with an FMV of $50 and tax basis of $0. The tracing method follows the principles of Sec. 704(c), and the result is that the partners are in the same position as they were before the partnership division with respect to built-in gain or loss in their respective partnership interests.

As the example demonstrates, when a partnership distributes an asset to multiple distributee partners in a partnership division, the method used to allocate the asset’s basis can lead to very different results.

EditorNotes

Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@us.pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.