Complications in Sec. 743(b) substituted basis transactions

Editor: Jeffrey N. Bilsky, CPA

Sec. 743(b) basis adjustments are often challenging to complete accurately due to their inherent complexity. For Sec. 743(b) adjustments in substituted basis transactions, this challenge is further amplified by a divergent set of rules for allocating the adjustment among the partnership assets, compared to taxable transactions. As if that were not enough, the rules in Regs. Sec. 1.755-1(b)(5) (the final regulations) have been further modified by Prop. Regs. Sec. 1.755-1(b)(5), REG-144468-05 (the 2014 proposed regulations). While proposed regulations often are not effective until finalized, in this case, the modification is effective for all transactions on or after Jan. 16, 2014. As a result, practitioners must be aware that certain parts of the current language in the final regulations have effectively been superseded by the 2014 proposed regulations. Additionally, in situations where the transferor has a preexisting Sec. 743(b) adjustment and engages in a substituted basis transfer of their partnership interest, extra care must be taken when establishing the Sec. 743(b) adjustment for the transferee partner.

Substituted basis Sec. 743(b) adjustments generally

The final regulations provide that substituted basis transactions include any partnership interest exchange where the transferee’s basis in the partnership interest received is determined in whole or in part by reference to the transferor’s basis (Regs. Sec. 1.755-1(b)(5)(i)). Additionally, for exchanges on or after June 9, 2003, the substituted basis rules also apply to Sec. 743(b) basis adjustments where the transferee’s basis in the partnership interest is determined by reference to other property held by the transferee (id.). Common substituted basis transactions to which these rules apply include Sec. 351 transfers of property to a corporation, Sec. 721(a) contributions of property to a partnership in exchange for a partnership interest, and Sec. 731(a) distributions of partnership interests.

For partnerships with a Sec. 754 basis adjustment election in effect, a Sec. 743(b) adjustment is generally booked among the assets of the partnership, even if the total adjustment amount is zero. However, this general rule does not hold in the case of substituted basis adjustments. Instead, the final regulations provide that if the total basis adjustment is zero, no basis adjustment is made to any partnership property. At first blush, it may seem that substituted basis adjustments should always result in a Sec. 743(b) adjustment of zero. This is because the total amount of a basis adjustment is determined by the difference between the transferee partner’s outside basis in the partnership interest (outside basis) and the transferee partner’s share of the adjusted basis of the partnership property (inside basis).

Consider two examples to illustrate why a transferee partner may have a zero versus a nonzero Sec. 743(b) basis adjustment in a substituted basis transaction.

Example 1: Partners A and B own partnership AB. Outside basis and inside basis are equal for both partners, and AB has a valid Sec. 754 election. Subsequently, but without any other changes in the equity ownership of AB, B makes a Sec. 721(a) contribution of their interest in AB to partnership BC. In this example, B is the transferor partner, and partnership BC is the transferee partner. BC’s basis in the partnership AB interest is wholly determined by reference to B’s basis in the interest. Since B’s outside basis in the AB partnership interest was equal to B’s inside basis in AB, the same applies to the AB interest in partnership BC’s hands. Since the total adjustment would be zero and this is a substituted basis transaction, there is no Sec. 743(b) adjustment under the final regulations.

Example 2: Partners A and B own partnership AB. Outside basis and inside basis are equal for both partners. Subsequently, when the assets of AB have appreciated, B sells their interest in AB to partner C. Partnership AB does not make a Sec. 754 election for this transfer. As a result, partner C has a greater outside basis in AB than their share of adjusted basis in AB’s property. C subsequently makes a Sec. 721(a) contribution of the AB partnership interest to partnership CD. Upon this transfer, partnership AB makes a Sec. 754 election. As a result, partnership AB will book a Sec. 743(b) adjustment, which will be allocated exclusively to partnership CD. The result here varies from Example 1 due to the existing disparity between outside basis and inside basis at the time of the exchange.

Final regulations’ mechanics 

After identifying the total Sec. 743(b) basis adjustment, the next step is determining how to allocate that adjustment among the partnership’s various properties.This is the area where the 2014 proposed regulations must be carefully analyzed in concert with the final regulations to ensure the correct result is reached. Under the final regulations, the following rule structure is provided:

1 . First, split the partnership properties into two classes (Regs. Sec. 1.755- 1(a)(1)): 

a. Capital gain property: This consists of capital assets and Sec. 1231(b) property. Note that unrealized receivables under Sec. 751(c) are treated as separate assets for this purpose and will fall into the ordinary income property category.

b. Ordinary income property: This consists of all property other than capital gain property.

2 . Second, determine if there is a net increase or net decrease to be allocated among the partnership properties in total. 

a. If there is a net increase, an allocation can only be made to either capital gain property or ordinary income property if the hypothetical sale of all property in that category would result in an allocation of gain to the transferee partner. If gain would be allocated from both property categories, the adjustment must be made proportionately between the categories based on the relative amounts of gain (Regs. Sec. 1.755-1(b)(5)(ii)).

b. If there is a net decrease, an allocation can only be made to either property category if the total amount of gain or loss that would be allocated to the transferee on the hypothetical sale of all property in that category would result in a net loss. If loss would be allocated from both property categories, the adjustment must be made proportionately between the categories based on the relative amounts of loss (id.).

2014 proposed regulations’ automatic modifications of the final regulations 

Step 2 above presents a few potential problems. A substituted basis adjustment amount is based only on the difference between the outside basis and the inside basis of the transferred partnership interest. If the outside basis is higher than the inside basis, there will be a step-up under Sec. 743(b), and if the inside basis exceeds the outside basis, there will be a step-down. The rule structure articulated above would allow a step-up to be assigned among assets only if there is unrealized appreciation. Similarly, if there is a stepdown, that rule structure allows it to be assigned only if there is unrealized depreciation in the assets. 

Since the step-up or step-down status of substituted basis adjustments is divorced from the unrealized appreciation or depreciation of the underlying assets, the existing rule structure can result in fact patterns where the adjustment cannot be assigned to either asset category (capital or ordinary). The final regulations do not provide an explicit carryover or reassignment rule for these fact patterns; theoretically, this results in the basis adjustment simply never being recorded. The only carryover rule in the final regulations is for situations where decreases to an asset category would exceed the remaining basis of assets in that category.

Recognizing these issues in the final regulations, the 2014 proposed regulations, which, as previously mentioned, are fully effective for transactions on or after Jan. 16, 2014, provide the following update to the second step under the rules:

2 . Second, determine if there is a net increase or a net decrease to be allocated among the partnership properties in total. 

a. If there is an increase, it must first be allocated between capital gain property and ordinary income property in proportion to, and to the extent of, the gross gain or gross income to the transferee from the hypothetical sale of property in each category. Any remaining increase is allocated in proportion to the fair market value (FMV) of the property in each category (Prop. Regs. Sec. 1.755-1(b)(5)(ii)(B)).

b. If there is a decrease, it must first be allocated between the two asset categories based on the gross loss to the transferee from the hypothetical sale of property in each category. After adjusting basis downward for each category based on those gross losses, any remaining decrease is allocated based on the relative remaining adjusted basis in each asset category (Prop.

Regs. Sec. 1.755-1(b)(5)(ii)(C)). Updated step 2a effectively ensures that step-ups are first assigned to appreciated properties in each asset category because it looks at gross gain and gross income items rather than net gain. If the increase is in excess of the transferee partner’s share of unrealized appreciation, the excess is assigned based on the relative FMV of property in each category. This guarantees that the basis step-up will not simply be lost, as could have conceivably happened under the final regulations. These updates also allow a step-up to occur based on the relative FMV even in situations where there are no appreciated assets within the partnership.

Updated step 2b functions similarly but in reverse, so step-downs are first assigned to depreciated properties in each category. If the basis step-down exceeds the transferee partner’s share of unrealized depreciation, the excess is assigned based on relative remaining adjusted basis in each category. This ensures that the full step-down will be assigned unless the transferee partner does not have a sufficient share of adjusted basis in one or both asset categories. In those cases, the 2014 proposed regulations do provide for a carryover of the excess step-down to be applied when the partnership acquires assets within the affected category in the future (Prop. Regs. Sec. 1.755-1(b)(5)(iii)(D)).

Substituted basis transactions where transferor already has a Sec. 743(b) adjustment 

Under Regs. Sec. 1.743-1(f), when a transferor has a Sec. 743(b) adjustment associated with their partnership interest, the transferee must still compute their Sec. 743(b) adjustment without reference to the transferor’s basis adjustment. In the context of a taxable transfer, this rule makes sense; the transferee has an outside basis that is completely disconnected from that of the transferor. However, in substituted basis transfers, the general treatment is a step-in-the-shoes approach where the transferee steps into the outside basis of the transferor. The substituted basis transfers are largely treated as merely a change in the tax owner without other tax consequences.The result with respect to the Sec. 743(b) adjustment is divergent here; the transferee must potentially reassign the adjustment among assets and restart depreciable and amortizable lives on basis adjustment assets. The following example illustrates the potential complexity here:

Example 3: Partners A and B own partnership AB. Outside basis and inside basis are equal for both partners. Subsequently, when the assets of AB have appreciated, B sells their interest in AB to partner C. Partnership AB makes a Sec. 754 election for this transfer. As a result, partner C has a positive Sec. 743(b) adjustment. C subsequently makes a Sec. 721(a) contribution of the AB partnership interest to partnership CD. As a result, partnership AB will book a new Sec. 743(b) adjustment, which will be allocated exclusively to partnership CD.

In the context of the above example, imagine that partner C’s entire basis adjustment had been in an amortizable asset and that it had been amortized for 14 years of a 15-year life. When the “new” basis adjustment is recorded for partnership CD, under Regs. Sec. 1.743-1(f), it must be computed anew and potentially assigned to different assets. Even if it were all assigned to intangibles, it would still need to start a new amortizable life since the asset is treated as placed in service on the date of the exchange (Regs. Sec. 1.743-1(j)(4)(i)(B)(1)).

Treasury appears to recognize that this result does not align with the step-in-theshoes spirit of substituted basis transfers generally. This is evidenced by Prop. Regs. Sec. 1.743-1(f)(2), which provides that the general rule of computing a transferee’s basis adjustment without reference to a transferor’s basis adjustment does not apply to substituted basis transactions. The proposed rule generally provides that a transferee would simply succeed to the existing basis adjustment of the transferor in substituted basis transactions. Additional guidance is included for situations where the transfer results in an increase or decrease in total basis as a result of the transfer, e.g., where the transferor capitalizes associated transaction costs. Unfortunately, unlike Prop. Regs. Sec. 1.755-1(b)(5), which is already in effect, this proposed regulation does not take effect until it is published as final in the Federal Register. As of this writing, this regulation has been proposed for just over 10 years, having been originally published in January 2014.

Closing thoughts

Practitioners often consider substituted basis transfers of partnership interests to be simple compared to taxable transfers. While that can be the case in simple fact patterns where outside basis and inside basis are equal, it is not true in every case. Example 2 above illustrated one possible scenario of many that can give rise to a nonzero adjustment in a substituted basis transaction. Prior allocation errors, part-sale/partgift transactions, and preexisting inside basis/outside basis discrepancies may all require more detailed analysis.

Even in more straightforward substituted basis transactions, if the transferor already has a Sec. 743(b) basis adjustment, a new basis adjustment must be computed under Regs. Sec. 1.743-1(f). While Prop. Regs. Sec. 1.743-1(f)(2) has a well-designed fix for that specific problem, it is not clear when that solution will become final. Given the inherent complexity in this area, practitioners should exercise as much care in substituted basis partnership interest transfers as they do in taxable ones.

Editor notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta. Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Bilsky at jbilsky@bdo.com.