Nonliquidating distributions: Ways to determine basis

By Timothy Steitz, CPA, J.D., LL.M., Washington, D.C.

Editor: Christine M. Turgeon, CPA

A partnership that distributes a partial interest in partnership property must apportion the tax basis in the property between the portion transferred and the portion retained. The Sec. 61 regulations generally require that basis be "equitably apportioned" but do not provide a working definition. One way to apportion a property's basis in a nonliquidating distribution is to use fair market value (FMV), but this can result in distortion under certain circumstances. This item considers to what extent taxpayers may be able to apportion basis instead under Sec. 704(c) principles.

The following example illustrates the basis apportionment issue that can arise in a nonliquidating distribution.

Example: Partner A contributes $100 to Partnership AB, which uses the cash to purchase 100 shares of corporate stock ($1 per share). Partner B is a general partner with a 20% profits interest. In year 1, the corporate stock appreciates in value to $200, creating $100 of economic gain, of which $80 is allocable to Partner A and $20 is allocable to Partner B. Partnership AB then distributes $20 worth of corporate stock (i.e., 10 shares) to Partner B in a nonliquidating distribution with respect to its profits interest.

Alternative approaches

In this example, there may be alternative methods to determine the basis of the distributed shares in the hands of the partnership for Sec. 732 purposes. This item examines two alternative approaches:

  1. Apportion basis relative to the stock's FMV; or
  2. Apportion basis by applying the principles of Sec. 704(c).

Under an FMV approach (and assuming Partner B has sufficient outside basis to avoid a step-down under Sec. 732(b)), the distributed stock would have a tax basis of $10 (i.e., $1 dollar per share), leaving $90 of basis in the stock remaining in the partnership. Alternatively, if Sec. 704(c) principles were taken into account, the distributed stock basis would be zero, to account for Partner A's $100 capital contribution being used to purchase the stock being distributed to Partner B. This Sec. 704(c) approach maintains the $80 of built-in gain allocable to Partner A (further demonstrated below) and leaves $100 of basis in the stock remaining in the partnership.

Now assume further that the partnership immediately sells the remaining stock for its residual value of $180, satisfies all debt, and distributes the cash in liquidation to its partners.

Under an FMV approach, the resulting gain from the sale of the stock is $90 ($180 amount realized over $90 tax basis). The entire $90 gain is allocable to Partner A because Partner B's profits interest was previously satisfied, resulting in $10 more of gain allocable to Partner A than Partner A was economically entitled to (i.e., $80). Immediately thereafter, Partner A's basis in its partnership interest is $190. Upon distribution of the $180 cash proceeds to Partner A in liquidation, Partner A recognizes a $10 capital loss ($180 of cash over its basis of $190), recouping the excess gain that it was initially allocated. Partner B is not entitled to a liquidating distribution and generally recognizes no gain or loss upon the termination of its interest. However, to the extent Partner B's outside tax basis was supported by debt, Partner B may recognize gain upon repayment of the debt under Secs. 752 and 731.

Under a Sec. 704(c) approach, the resulting gain from the sale of the stock is $80 ($180 amount realized over $100 tax basis). The entire $80 of gain is allocable to Partner A because Partner B's profits interest was previously satisfied. Immediately thereafter, Partner A's basis in its interest is $180, which is reduced to zero upon the receipt of the $180 cash in liquidation. No further gain or loss is recognized by either Partner A or Partner B.

The practical effect of the FMV basis approach under these facts is to shift basis from Partner A (i.e., the economic buyer of the stock basis) to Partner B. Partner A is initially required to recognize excess gain, which can only be offset by the later recognition of a corresponding loss in its partnership interest. Under the Sec. 704(c) approach, however, the basis purchased by Partner A remains with Partner A; as a result, upon sale of the stock, Partner A recognizes gain equal to its economic share of the gain (i.e., $80) with no offsetting loss trapped in the partner's interest.

Review of authority

Sec. 732 and its regulations do not address basis allocations on distributions of partial interests in property. The FMV approach described above is derived from Regs. Sec. 1.61-6(a), which provides that the basis of the entire property must be "equitably apportioned" among the divided parts (i.e., sold portions) of the property in order to calculate gain on the sale of a partial interest in property. Although equitable apportionment is not defined, the regulation's two examples use relative FMV to apportion basis among divisible properties.

Notwithstanding Regs. Sec. 1.61-6, the IRS has applied the equitable apportionment standard without regard to FMV. For example, in Rev. Rul. 84-53, the IRS examined the sale of a partial partnership interest. In Situations 1 through 3 of the ruling, the IRS applied an FMV approach where the partner's basis in its interest exceeded its share of liabilities (i.e., positive tax capital). In Situation 4, however, where the partner had negative tax capital, the IRS calculated gain on the sale of a partial partnership interest by allocating basis as a function of the liabilities relieved. The IRS's approach in Situation 4 reflects the apparent flexibility of the equitable apportionment standard, indicating that in cases where FMV apportionment leads to an inequitable result, another metric could be viewed as appropriate.

Because the regulations address transactions in which gain is realized, it is unclear how Regs. Sec. 1.61-6(a) may apply in the context of a property distribution in which gain is not recognized. It is also unclear to what extent Sec. 704(c) principles could be used as a mechanism to maintain equity in basis apportionment under Regs. Sec. 1.61-6(a), which is silent on this issue (as it only applies equitable apportionment in the context of FMV).

Potential availability of Sec. 704(c) principles

Additional guidance on whether Sec. 704(c) principles can be used as a measure of "equitable apportionment" is found in Sec. 704(c) itself and in the way other provisions of the Code and regulations apply Sec. 704(c) for basis allocation purposes. Sec. 704(c) specifically allocates income, gain, loss, and deduction — but not tax basis. However, Sec. 704(c) principles have been applied for purposes of allocating basis among distributed properties.

The 1954 legislative history of Sec. 704(c) describes an approach that allocates the tax basis of contributed property between the contributing and noncontributing partners "for purposes of computing depreciation, depletion, and gain or loss upon sale but not in the case of distributions" (S. Rep't No. 83-1622, 83d Cong., 2d Sess., p. 93 (June 18, 1954)). This carveout for distributions was not meaningfully addressed in subsequent versions of Sec. 704(c), particularly when Sec. 704(c) became mandatory in 1984. Further, regulations under other provisions of the 1954 Code take Sec. 704(c) principles into account. For example, former Regs. Sec. 1.751-1(a)(2) (T.D. 6175) required that Sec. 704(c) principles be taken into account when determining a partner's share of inside tax basis in a hypothetical distribution of property.

Regs. Secs. 1.704-3(a)(8) and 1.743-1(d) look to Sec. 704(c) principles when determining a partner's inside basis of partnership property in specific circumstances (e.g., partnership contributions of stock in a Sec. 351 exchange, and the allocation of Sec. 743(b) adjustments), but not in the context of a distribution of a partial interest in property.

Finally, the preamble to the final and temporary and proposed regulations under Sec. 337(d) and Sec. 732(f) highlights the uncertainty of applying Sec. 704(c) in the context of a distribution of corporate stock. In an effort to preclude basis shifting, Treasury and the IRS requested comments on whether additional guidance should be given "under section 732 providing that on a distribution of a partial interest in partnership property, the basis of the distributed property in the hands of the distributee partner is determined by taking the principles of section 704(c) into account" (T.D. 9722). It is unclear whether Treasury and the IRS view such guidance as necessary to apply Sec. 704(c) principles in a Sec. 732 context or whether it would be viewed as clarifying current law. Regardless, it appears that Treasury and the IRS would view the application of Sec. 704(c) principles as a potentially viable method of preventing basis shifting in the context of a property distribution.


The broad requirement that basis be equitably apportioned could be viewed as allowing flexibility in determining basis when FMV does not provide an equitable result. With respect to nontaxable distributions of partial interests in partnership property, Sec. 732 is silent on the issue, but there are several examples in the Code, regulations, and legislative history that take Sec. 704(c) principles into account in determining basis. As reflected in the example above, a Sec. 704(c) approach could result in an arguably more correct economic outcome without creating disparity, shifting basis, or trapping losses that otherwise would occur under an FMV approach. However, it is unclear whether a Sec. 704(c) approach would conform to the requirements of Sec. 732 and Regs. Sec. 1.61-6(a).


Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Ms. Turgeon at 973-202-6615 or

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

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