New IRS form for partners receiving property distributions

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS released a draft form in summer 2024, with subsequent revisions and draft instructions, that partners will use, starting with tax years beginning in 2024, to report their tax basis in property distributed to them by partnerships. In addition to disclosing the partner’s basis in distributed property, the new Form 7217, Partner’s Report of Property Distributed by a Partnership, requires the partner to provide information about various factors, including the partnership’s predistribution basis in the property and its fair market value (FMV), that affect a partner’s basis computation. This item describes the rules that govern a partner’s basis in property distributed from a partnership and describes the required information disclosures on Form 7217.

Form 7217 does not impose new reporting obligations for partnerships that distribute property and does not really create additional computational work for partners that already properly computed their basis in distributed property. However, the form appears to be part of an ongoing trend by the IRS to facilitate partnership audits by requiring more detailed reporting from partnerships and partners.

Tax treatment of partnership distributions generally and basis computations under Sec. 732

Partnership distributions of money or property to partners are generally tax-free under Sec. 731(a), subject to a variety of exceptions. For instance, a partner is taxed on the amount by which any cash and marketable securities (as defined in Sec. 731(c)) received in the distribution exceed the partner’s predistribution basis in its partnership interest. Further, certain distributions that alter a partner’s interest in the partnership’s unrealized receivables (as defined in Sec. 751(c)) and substantially appreciated inventory items (as defined in Sec. 751(d)) result in tax under Sec. 751(b). Additionally, if a partner previously contributed cash or property to a partnership, related transfers of other property to that partner might be characterized as taxable sales under Sec. 707(a)(2)(B). However, in many instances in which a partnership distributes property to a partner, the parties expect that the distribution will not result in an immediate taxable event (see Venables, “Partnership Distributions: Rules and Exceptions,” 55-8 The Tax Adviser 26 (August 2024)).

Sec. 732 and its regulations provide the rules for how a partner that receives a distribution of property from a partnership computes their basis in the distributed property. For a nonliquidating distribution, the partner’s basis in the property is equal to the partnership’s predistribution basis in the property but may not exceed the partner’s predistribution basis in its partnership interest (reduced by any cash received in the same transaction). Where a partner takes a basis in distributed property that is less than its predistribution basis in the hands of the partnership, the partnership may be able to adjust the basis of its other assets under Sec. 734(b) if it has a Sec. 754 election in effect. A partner’s basis in property received in a liquidating distribution is equal to the partner’s predistribution basis in its partnership interest, which is, again, reduced by any cash distributed in the same transaction.

The Sec. 732 regulations also provide rules to allocate basis across multiple properties distributed as part of the same transaction. These rules aim to ensure that available basis is first allocated to any distributed unrealized receivables (as defined in Sec. 751(c)) and inventory items (as defined in Sec. 751(d)), so as to limit the amount of ordinary income recognized by the partner upon disposition of those assets to the amount that would have been recognized at the partnership level. In a second step, after accounting for the distributed ordinary-income property, basis is allocated to any other distributed property, up to the amount of the partnership’s predistribution basis in such property. If the partner does not have enough allocable basis to make the partner’s basis in the other property equal to the partnership’s predistribution basis, the regulations provide that the required decrease is first allocated to those properties with unrealized depreciation to the extent of such depreciation. Any remaining decrease is allocated based on the distributed properties’ relative adjusted bases.

If the partner has additional basis to allocate after the second step (which can occur in the case of a liquidating distribution), the regulations provide a methodology to allocate this remaining basis among the distributed properties (other than unrealized receivables and inventory items). The increase is allocated first to those properties with unrealized appreciation to the extent of that appreciation. Any remaining basis is allocated based on the relative FMVs of the distributed properties.

Partnership-level basis adjustments in distributed property also affect the Sec. 732 computation at the partner level. For instance, a partnership might have a Sec. 734(b) adjustment in its property as a result of a prior distribution. Or a distributee partner that previously purchased its interest might have a Sec. 743(b) adjustment in a distributed property or might receive a similar basis adjustment in distributed property as a result of a Sec. 732(d) election. Each of these basis adjustments is generally treated as part of the partnership’s basis in the distributed property for purposes of applying the Sec. 732 allocation rules described above.

The various basis computations required by Sec. 732 can be complex and are certainly much more involved than simply assuming the distributed property takes a carryover basis. A partnership that distributes property must provide information needed for the partner to compute its basis under Sec. 732 on its Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. (e.g., the partnership’s basis in the property and its FMV). For 2023 tax years, the IRS required partners receiving property distributions to report certain information about their partner-level Sec. 732 computations on a statement with their returns if their basis in distributed property differed from the partnership’s predistribution basis. Form 7217 standardizes that presentation.

New reporting on Form 7217

Starting for tax years beginning in 2024, the IRS requires a partner that receives a property distribution from a partnership to file Form 7217 with its annual tax return. A separate Form 7217 is required for each day during the year in which the partner received a property distribution (even if all distributions were part of the same transaction). Distributions of only money do not trigger a requirement to file Form 7217.

Part I of Form 7217 requires the partner to provide general information about the distribution (e.g., whether it was a liquidating distribution or resulted in gain recognition under Sec. 751(b) or Sec. 731(a)), as well as the partner’s and partnership’s aggregate basis in all distributed property. Part I requires the partner to specify its predistribution basis in its partnership interest, which partners were not previously required to report except when reporting a gain or loss resulting from a distribution or a sale of a partnership interest.

Part II requires the partner to identify the components of its Sec. 732 computation on a property-by-property basis. The partner must provide a description for each distributed property, which includes the relevant asset class code from the Table of Class Lives and Recovery Periods found in IRS Publication 946, How to Depreciate Property. The partner must also specify the partnership’s predistribution basis in that property, which is generally required to be reported to the partner on its Schedule K-1. The partner also indicates whether basis adjustments under Sec. 732(d), 732(f), 734(b), or 743(b) affected the partnership’s predistribution basis. Finally, the form provides spaces to disclose the property’s FMV and the partner’s final basis in the property after applying Sec. 732.

While the draft instructions to Form 7217 go on to describe how a partner applies Sec. 732 to determine the basis of distributed property, taxpayers are not required to show a detailed basis computation on Form 7217. However, the level of disclosure required on Form 7217 ought to allow the IRS to evaluate whether partners are applying the Sec. 732 rules correctly.

Form 7217 is not being released in connection with a significant change to the basis allocation rules under Sec. 732. Partners that have previously been properly applying the Sec. 732 rules may find that being required to “show their work” on Form 7217 represents a smaller, incremental compliance burden compared to partners that may not have been appropriately applying Sec. 732. However, Form 7217 follows other efforts by the IRS in recent years (e.g., tax basis capital reporting; Schedules K-2, Partners’ Distributive Share Items — International; and K-3, Partner’s Share of Income, Deductions, Credits, etc. — International) to gather more detailed information from partnerships and partners.

Information gathering on basis-shifting transactions?

The new requirement for more granular information on partner-level basis computations might also be explained by the IRS and Treasury’s recent efforts to tamp down so-called “basis shifting” transactions involving partnerships with related-party partners. In June 2024, the IRS and Treasury released a three-part guidance package (Notice 2024-54, proposed regulations REG-124593-23, and Rev. Rul. 2024-14). Notice 2024-54 announced two sets of forthcoming proposed regulations targeting taxpayers’ ability to use basis adjustments achieved through basis-shifting transactions. The proposed regulations identified certain basis-shifting transactions and substantially similar transactions as “transactions of interest” under Sec. 6011 and indicated the IRS’s intent to challenge the benefits claimed pursuant to certain basis-shifting transactions under generally applicable judicial doctrines. At the time this Tax Clinic item was drafted, the government had not issued guidance beyond the initial June 2024 package.

Two of the categories of basis-shifting transactions targeted in the June 2024 guidance package implicate the basis-allocation rules under Sec. 732 that will now be subject to additional disclosure on Form 7217. In one category of transaction, a partnership with related partners distributes high-basis property to a partner with a low basis in its partnership interest. This may allow the partnership to allocate a basis adjustment under Sec. 734(b) to its remaining properties equal to the excess of the partnership’s prior basis in the distributed property over the distributee partner’s basis in the property (which is limited to such partner’s basis in its partnership interest). Such distributions could be structured to shift basis off nondepreciable or long-lived distributed properties and onto retained properties with more favorable cost recovery rules or onto property anticipated to be sold in the near future.

In another category of targeted transactions, low-basis property is distributed to a partner with a relatively high basis in its partnership interest in complete liquidation of the interest. The distributee then asserts under Sec. 732 that it takes a stepped-up basis in the distributed property equal to its prior basis in its partnership interest. In this case, the distributed property may be subject to a favorable cost recovery method, or the distributee may anticipate selling the distributed property soon after receiving it.

Even prior to finalization of the various components of the June 2024 guidance package, Form 7217 might assist the IRS in identifying benefits claimed by partners as a result of the mechanical rules under Sec. 732, including basis-shifting transactions. For instance, if a partner claims a step-up in the basis of distributed property from a liquidating distribution, this step-up would be plainly reported on the face of Form 7217. Additionally, requiring the use of the asset class codes from the Table of Class Lives and Recovery Periods in Part II of Form 7217 may allow the IRS to more easily identify situations where a partner has stepped up the basis of property with a favorable recovery period or, alternatively, stepped down the basis of long-lived or nondepreciable property. As such, it appears that the IRS might use the information provided on Form 7217 to identify partnership distribution transactions for further scrutiny.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.