The Section 734(b) Basis Adjustment Needs Repair



The partnership tax provisions – Subchapter K of the Internal Revenue Code – work pretty well. And they have a difficult job to do because they must provide a reasonable mechanism for taxing arrangements between parties that can be far from off-the-rack. It should not be difficult to figure out how to tax two individuals who contribute equal amounts of cash to start a joint business in which each will own a one-half interest. But it quickly becomes problematic when one if the two partners wants a greater share of early receipts in exchange for a lower share of back-end gains. And if the amounts they contribute are unequal, they will have some arrangement to account for that difference which the taxing structure must digest. A partnership is the most flexible form of business organization, and the rules of Subchapter K capture that flexibility surprisingly well.

The basic paradigm upon which Subchapter K is best described as tax transparency; that is, that a partnership should be all but invisible to the taxing system. In particular, transactions between a partner and the partnership should be tax-free as much as possible, with the taxable events being dealings between the partnership (or the partners) and third-parties. Thus, most contributions and distributions are tax-free,[2] but transfers of partnership assets or interests to non-partners generally are taxable.[3]

A corollary of tax transparency is the general equality of aggregate inside and outside bases. “Inside basis” is the partnership‟s adjusted basis in its assets, while outside basis is a partner‟s adjusted basis in his partnership interest. Because aggregate inside basis and aggregate outside basis each represent the after-tax (and debt financed) investment

in partnership assets, they should equal one another.[4] They start equal by reason of the basis rules applicable to contributions of property (including the debt allocation rules of section 752),[5] and they will in general remain equal throughout the life of the partnership.[6] The examples presented throughout this Article do not consider the case of partnership indebtedness, although adding debt to the transaction should not change the analysis.

When they are not equal, astute taxpayers can exploit the difference.[7] Suppose, for example, that aggregate outside basis is higher than aggregate inside basis. A sale of all the partnership interests would transfer the partnership‟s assets just as would a direct asset sale, but by selling the higher-basis interests, aggregate gain is reduced. Equivalently, if inside basis were higher, the assets rather than the interests would be sold.

Nonetheless, there are transactions that can break the equality of aggregate inside and aggregate outside basis. An election is provided by section 754 which ensures, by adjusting inside basis, that this equality is in fact always maintained so long as the election is made soon enough. Indeed, the basis adjustments provided by the section 754 election are so well designed – and the equality been aggregate inside and aggregate outside basis so important – that commentators have called for making these basis adjustments mandatory rather than optional.[8]

When an election under section 754 is made, the electing partnership becomes subject to two basis adjustment provisions: (1) section 734(b), providing for certain inside basis adjustments upon the occurrence of specified triggering distributions of cash or property from the partnership; and (2) section 743(b), providing for certain inside basis adjustments upon the sale or exchange of a partnership interest. The regulations specifying the manner of making these adjustments have recently undergone major revisions, with the greatest attention focused on the section 743(b) adjustments. Now– and despite the lack of any real statutory support – an incoming partner will in effect take a share of inside basis in each of the partnership‟s assets equal to that partner‟s share of each asset‟s fair market value, an outcome so reasonable that one could only have wished the Congress rather than Treasury had seen fit to specify it.

But the regulations applicable to section 734(b) adjustments were not much changed,[9] and that is unfortunate. Because while the amount of the section 734(b) adjustment is computed properly,[10] the allocation of that adjustment is not right. Absent a correction, the statute as written offers significant tax reduction strategies.

Nonliquidating, Taxable Distributions of Cash – The Easy Case

Consider first the simplest case in which an inside basis adjustment under §734(b) is mandated because a distribution of cash causes income recognition to the distribute. For example, suppose that P and Q form the PQ partnership by contributing cash of $100 each. The partnership uses $60 of its cash to purchase nondepreciable Blackacre, and after Blackacre has increased in value to $340, cash of $120 is distributed to P in a nonliquidating distribution. After the distribution, the books of the partnership read (where “CA” stands for capital account and “OB” stands for outside basis):

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If the partnership has an election under §754 in effect, it is entitled to an inside basis increase of $20;[12] such an adjustment will equalize aggregate inside basis (now $80, $20 in the remaining cash and $60 in Blackacre) with aggregate outside basis (now $100, all in Q’s outside basis). This means that the partnership’s basis in Blackacre will increase from $60 to $80. But who should get the benefit of that adjustment?[13]

Prior to the distribution, Q‟s distributive share of the appreciation in the partnership‟s assets was $140 (half of the $280 increase in value), and after the transaction, that share remains the same. To be sure, presumably Q will be required to reduce his share in the venture to reflect a reduction in invested capital, but that should affect profits and losses only going forward: gains and losses accrued as of the date of distribution should remain unchanged.

The way to ensure that the distribution does not inappropriately affect the economics of the venture is to restate the partner‟s capitals accounts immediately prior to the distribution (called an asset “book-up”).[14] That is, because Blackacre is now worth $340, each partner‟s capital account should be increased by his share of the $280 increase from cost of $60 to current value of $340. Thus, the books of the partnership really should be:

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The books accurately show that P now has a one-third interest in the capital of the partnership[15] while Q‟s interest has grown to two-thirds. Presumably P and Q will agree to share future profit and loss in these new proportions. But that has no effect on the taxation of the accrued gain in Blackacre of $280; that accrued gain should be shared equally between the partners because it was a return on their investments when their investments were equal. And, perhaps more importantly, the accrued gain must be taxed equally to P and to Q because, by booking it into the partners‟ capital accounts equally, they are now bound to share the tax gain in the same manner as they shared the book gain under applicable Treasury regulations.[16]

Surprisingly, a restatement of the capital accounts is permitted but not required under current law,[17] presenting a variety of tax minimizing opportunities.[18] But to understand the importance of the restatement, consider what would happen if the capital accounts were not restated and then, after P‟s profit share had been reduced to one-third, Blackacre were sold for $340. The books of the partnership would become:[19]

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These totals show P with a capital account balance of only $73, which means that if the partnership were to liquidate immediately, P would be entitled to cash of $73 (and the remaining cash of $287 would go to Q).[20] When coupled with the prior cash distribution to P of $120, that means P‟s total return from the venture would be $193. Given that P

contributed cash of $100 and the partnership‟s only asset grew by $280 while P was a

50% owner, this means that the distribution will have reduced P‟s total return from $240

to $193. [21] That reduction makes no sense, and a capital account restatement avoids this

result.[22] Although current law does not require the restatement, most advisors recommend it,[23] and the regulations are clear that if a restatement is not made, the partnership will be closely scrutinized to determine if the failure to restatement capital accounts represents an inappropriate shifting of value between related parties.[24]

So let us return to the books of the partnership after the distribution and after the capital account restatement. We have:

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The partnership‟s only asset has appreciated from its cost of $60 to its current value of

$340. If the asset is now sold, there will be a tax gain of $280, allocable equally between

the partners.[25] Thus, each partner must include gain of $140 on his individual return,[26] and the books will become:

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If the partnership now liquidates, it will distribute cash of $120 to P and $240 to Q, giving them each a total return of $240. Since each partner invested $100, each should be taxed on $140, and for Q is exactly what happened: the only taxable event was the sale of Blackacre, and Q reported a gain of $140 as a result. Thus, the liquidation is tax-free to Q, as it should be.

But for P the analysis is more complex. The initial distribution of $120 was taxable to the extent of $20 because, at the time of the distribution, P‟s outside basis was only $100;[27 ]distributed cash is taxable to the extent that it cannot be absorbed by the distributee‟s outside basis. Thus, although the partnership had not yet earned any income, P was forced to report $20 of income on his individual return.

When the partnership subsequently sold Blackacre, P was allocated half of the tax gain from that sale, or $140. Thus, P will have included at this point a total of $160 from partnership activities, which is in fact $20 more than P‟s 50% share of the partnership‟s total income. However, when the partnership distributes cash of $120 to P in a liquidating distribution, P will be entitled to claim a loss of $20[28] at that time because P‟s final outside basis is not the $120 received but $140 as shown in the chart above.

Thus, each partner reports aggregate income of $140, as is proper. But while Q‟s income recognition occurs when Blackacre is sold by the partnership, P in fact recognizes excess income during the life of the partnership with an offsetting loss upon liquidation. This timing mismatch disadvantages P without helping Q in any way, and the optional basis under section 734(b) eliminates it. Or at least it should.

There is no doubt that the cash distribution triggers, if elected, the optional basis adjustment provided by section 734(b) equal to a positive $20.[29] But what is surprising – what is really unfathomable – is that this adjustment is made not for the benefit of P alone but rather is made to the common basis of the partnership‟s assets (here, Blackacre) for the benefit of both P and Q.

If the basis adjustment were allocable only to P – and the central point of this Article is that it should be so allocable – then the sale of Blackacre by the partnership would generate taxable income of $140 to Q but only $120 to P.[30] Thus, P‟s share of gain from Blackacre is reduced for the prior gain recognized by P on the earlier cash distribution.

This allocation of the basis adjustment ensures that there is no timing mismatch once Blackacre is sold, and so neither partner recognizes gain or loss on a liquidation of his partnership interest.

But under current law the basis adjustment reduces not P‟s gain alone but rather the over-all gain to the partnership.[31] Thus, the effect if the basis adjustment is to reduce the aggregate gain from $280 to $260 and so reduces each partner‟s share of that gain from $140 to $130. As a result, the books become:

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Now, when the partnership is liquidated, P has a loss of $10 on the distribution of $120 and Q has an equivalent gain on the distribution of $230. By allocating the basis adjustment to the partnership‟s common basis, we have permitted Q to defer recognition of income (reporting only $130 rather than $140 on the sale of Blackacre) while forcing P to overstate gross income ($20 from the cash distribution plus $130 from the sale of Blackacre) until each partner exits the partnership[.33]

This result is wrong for P, wrong for Q, and, as is always the case when some rule misallocates income, wrong for the treasury. Suppose P is a low bracket taxpayer (such as an exempt organization or an off-shore corporation) while Q is a high-bracket domestic taxpayer. Now, the early income recognition to P is irrelevant while the deferral to Q is a revenue leak. Of course, if the relative tax brackets are reversed, there is a revenue gain. But because the transaction is wholly within the partnership‟s control (if excess cash is not distributed to P prior to the sale of Blackacre, this issue never arises), the revenue gain will never occur.

It should not be surprising that the current common basis adjustment provided by section 734(b) fails in this example: the adjustment arises only because income is recognized by P on the cash distribution, and since it is P who recognizes that income, it should be P who enjoys the basis increase. The distribution had no effect on the economics of the venture nor on the tax position of the nondistributee partner, Q. Thus, changing the amount of gain that Q recognizes on the sale of Blackacre when sold by the partnership violates one of the most important rules of taxation: a taxpayer‟s tax results should be determined by that happens to him and not to others, a rule occasionally breached and always to bad effect.[34]

What is particularly surprising in this context is that Congress knows that optional basis adjustments can by made to affect a single partner and thus without any impact on partners who had no connection with the triggering event. Under section 743(b), the optional basis adjustment applicable to certain sales and exchanges of partnership interests, the adjustment is and always has been made only as to the transferee partner.[35]

That is the correct result, and it is hard to see how one could draft that provision without

similarly providing that an optional basis adjustment triggered by a distribution is made only with respect to the distributee.

There can be other circumstances in which a distribution triggers an optional basis adjustment under section 734(b), and upon close examination the current rule is as misguided in those cases as in the simple case discussed above. However, the analysis can become more complex, and in one circumstances there is another problem which must itself be fixed so as to avoid obscuring the proper application of the section 734(b) basis adjustment. Taking these problems in turn, we begin with the following.

Nonliquidating Distributions of Property – A Harder Case

Suppose P and Q each contribute $100 to the PQ partnership as equal partners. The partnership purchases two assets, Blackacre for $60 and Whiteacre for $140. When Blackacre increases in value to $300 and Whiteacre increases in value to $200, Whiteacre is distributed to P in a nonliquidating distribution. The distribution triggers a restatement of the capital accounts,[36] and so the books of the partnership become:[37]

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This distribution results in a $40 positive inside basis adjustment under section 734(b) if the partnership has an election under section 754 in effect.[38] Since no gain or loss was recognized by P on the distribution, the impact of the basis adjustment cannot be – as it was in the examples above – to offset P‟s gain on the distribution. Rather, the effect of

the basis adjustment is to ensure that P does not pick up more than P‟s share of the

partnership‟s taxable income. That is, because P is entitled to enjoy one-half of the

growth of the assets held by the partnership, P ultimately should bear no more than one-

half of the tax liability. The optional basis adjustment can have that effect, but more is needed.

Note that because of the distribution to P, P‟s share of the taxable gain from the sale of Blackacre and Whiteacre combined is much more than half of the aggregate increase in each (that is, more than one-half of the $240 gain from Blackacre plus one-half of the $60 gain from Whiteacre). To see this, note that if the partnership now sells Blackacre for its current fair market value of $300, the gain of $240 will be divided equally between P and Q, [39] leaving the books as:

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Assets Book Value Adjusted Basis Fair Market Value
Cash $ 300 $ 300 $ 300

These books show that if the partnership now liquidated, P would get cash of $50 and Q would get cash of $250. That is proper: P‟s cash, plus the $200 value of Blackacre distributed to P, gives P a full 50% return; Q‟s equal return is all in cash.

But if the partnership does not liquidate, the tax results have been skewed: each partner has so far included gain of $120 from the sale of Blackacre, and there is no appreciation remaining within the partnership. Q has enjoyed an economic increase of $150 (as shown by Q‟s capital account), yet Q has been taxed on only $120. And the sale of

Whiteacre will not produce any further income to Q because it is now owned by P. Q‟s

capital account was increased by half the gain in Whiteacre, but because Whiteacre was

distributed to P prior to sale, Q will never be taxed on that gain. Thus, Q has been undertaxed by $30.

One would think that if Q is undertaxed by $30, then P must be overtaxed on the same amount. But in fact it is much worse: P will recognize a gain of $100 on the sale of Whiteacre and is allocated gain of $120 on the sale of Blackacre by the partnership, bringing P‟s total recognized gain to $220, fully $70 more than it should be. To get P to where P should be requires two fixes; the basis adjustment under section 734(b) (on these facts, in an amount of $40) gets P only part of the way.

A Necessary Detour Through Section 704(c)(1)(A)[41]

There are in fact two separate problems with the taxation of this relatively simple example, and each obscures the other. To separate them, it is best to reconsider this problem but with a minor change: assume that Blackacre and Whiteacre were each bought for $100. Now, when Whiteacre is distributed to P in a nonliquidating distribution, the books of the partnership read:

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This distribution does not trigger an inside basis adjustment under section 734(b) because P‟s outside basis of $100 now can absorb the full inside basis of the distributed property. Thus, to the extent there is any skewing of tax results, it cannot be caused by a misapplication of the section 734(b) basis adjustment. But there is a skewing of tax results, and it was caused by the book-up of Whiteacre.

To properly account for the unrealized appreciation in distributed property, that property must be revalued immediately prior to the distribution and any unrealized book gain or loss must be put into the partners‟ capital accounts as they would share that gain or loss were it realized. This restatement of capital accounts causes a book/tax disparity for the partners because an adjustment is made to capital accounts but not to outside bases; outside bases are adjusted only when the gain or loss is recognized by the partnership.

There are two kinds of book/tax disparities: temporary and permanent[.42] The book-up of Whiteacre incidental to its distribution causes a permanent book/tax disparity; the book-up of undistributed Blackacre at the same time causes only a temporary book-tax disparity. Look first at the book-up of Blackacre: each partner‟s capital account is increased by $100 because Blackacre was purchased for $100 but is worth $300 at the time of the book-up. Thus, each partner‟s capital account is increased by $100 as a result of the book-up,[ 43] although the outside bases remain unchanged. As a result, the book-up of Blackacre creates a book tax disparity for each partner.

This combined $200 book/tax disparity is only temporary because it will be eliminated when the partnership sells Blackacre. Blackacre is now carried on the books of the partnership with a book value of $300 (after the book-up) but with a cost (tax) basis of

$100. Thus, when Blackacre is sold for $300, there will be no book gain but $200 of tax gain, and that tax gain will be includible by each partner to the extent of $100 and so will increase each partner‟s outside basis to restore parity with the capital accounts. Indeed, so long as Blackacre ultimately is sold for $300 or more, the book/tax disparity caused by the book-up will be eliminated.[44]

Not so for the book/tax disparity caused by the book-up of Whiteacre, though, because Whiteacre will never be sold by the partnership: it is distributed to P. This means that the entire taxable gain inherent in the property at the time of distribution ultimately will be includible to the distributee, P, even though for capital account purposes the gain was shared equally between P and Q. Thus, the restatement of Q‟s capital account caused by the book-up of Whiteacre causes a permanent book/tax disparity for Q, with Q‟s capital account greater than Q‟s outside basis by the amount of the book-up allocable to Q.

The analysis is slightly more complicated for P because there are two adjustments to P‟s capital account: P‟s capital account is increased for P‟s share of the unrealized gain in Whiteacre, and then P‟s capital account is reduced by the full current value of Whiteacre because Whiteacre was distributed to P. The net effect of these capital account adjustments is a reduction in P‟s capital account equal to the book value of the property prior to the book-up and a further reduction for Q’s share of the book-up. Since P‟s outside basis is reduced only the pre-distribution book value of Whiteacre,[45] that means the distribution leaves P‟s capital account below P‟s outside basis by the amount of the book-up to Q.

Note that the permanent book/tax disparity for P is the precise opposite of the permanent book/tax disparity for Q. That is not a coincidence; rather, it is the distinguishing factor of a permanent disparity as opposed to a temporary one.[46]

Permanent and offsetting book/tax disparities arise in many circumstances other than in

connection with distributions of property, and in all of those other settings current law offer ways of correcting the problem. It all goes back to contributed property and section

704(c)(1)(A), and while the drafters of the regulations promulgated under that section knew that the principles they were crafting could be useful in other contexts,[47] they apparently did not see the connection to distributed property.[48]

When property is contributed to a partnership in exchange for a partnership interest, the property is booked in to the contributing partner‟s capital account at current fair market value[49] even though the contributing partner takes a carryover outside basis[50] Thus, the contribution of appreciated or loss property must always create a book/tax disparity for the contributing partner, albeit a temporary one. For example, suppose P and Q form the PQ partnership, with P contributing cash of $100 and Q contributing property with value of $100 but adjusted basis of only $60. The books of the partnership will read:

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These books show a $40 book/tax disparity for P and an equivalent book/tax disparity in the property contributed by Q. When that property is sold by the partnership, both disparities will be eliminated. For example, suppose that the property is subsequently sold for $220, producing a book gain of $20 and a tax gain of $60. Assuming that P and Q are equal partners, the books will become:

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There is no longer a book/tax disparity for Q because the pre-contribution unrealized appreciation has been recognized for tax purposes. Any increase in value post- contribution (here, a $20 increase) plays no role because it increases both the capital accounts and the outside bases when recognized.

But if the property had turned around in value after contribution to the partnership, the temporary book/tax disparity would be converted (in whole or in part) into a permanent one. For example, suppose the partnership sold the property contributed by Q for only $90. In that case, there would be a book loss of $10 despite a tax gain of $30. Putting these numbers into the partners‟ capital accounts would leave:

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The $30 of taxable income recognized by Q on the sale reduced Q‟s book/tax disparity, as did the capital account loss unmatched by tax loss. But of the original $40 of book/tax disparity, only $35 has been eliminated, and the remaining $5 is now permanent because with the property sold, there is no book/tax disparity in the partnership‟s assets that can cure the remaining difference. That is why there is an equal and offsetting book/tax disparity for P: a permanent book/tax disparity is one not reflected in the assets of the partnership but rather reflects a mismatch among the partners.[51] Here, P has been overtaxed (P has suffered an economic loss of $5 but has received in deduction) while Q has been under-taxed (Q has enjoyed a net increase in the property of $35 but has been taxed on only $30).

As a conceptual matter, the proper answer is to allocate to contributing partner Q taxable gain equal to the entire pre-contribution gain of $40. Similarly, taxable loss equal to the post-contribution $10 diminution in value should be allocated between P and Q as they have agreed to share losses; that is, $5 to each partner. That is, each partner should be allocated for tax purposes what he was allocated for book purposes.[52]

Historically, the regulations have imposed a “ceiling” limitation on allocations under section 704(c)(1)(A) such that the partners cannot be allocated more taxable income or loss than is recognized by the partnership.[53] In the example above, when the property is sold for $90, the taxable gain recognized by the partnership equals $30. Accordingly, application of the ceiling limitation means that the partnership must allocate only that amount of tax gain and no more between the partners. In particular, they cannot allocate an extra $10 of gain to contributing partner Q. Further, because no tax loss is recognized by the partnership, no tax loss can be allocated to any partner.

Regulations promulgated under section 704(c) provide three alternatives[54] that can be used to respond to the problems caused by the ceiling limitation: (1) the traditional method;[55] (2) the traditional method with curative allocations;[56] and (3) the remedial allocation method[.57] The traditional method is the simplest: when the ceiling limitation is encountered, do nothing. Thus, in the example immediately above in which property is contributed to the partnership with a fair market value of $60 and then is sold for $90, the book/tax disparities for P and Q will remain until the partnership is liquidated.

The traditional method with curative allocations uses other tax income or deductions of the partnership to eliminate any book/tax disparity caused by the ceiling limitation. For example, suppose in the PQ example above that the partnership recognizes additional income of $10 in the year it disposes of the property contributed by Q. Consistent with the partnership agreement, allocation of this income should be $5 to P and $5 to Q, both for book purposes and for tax purposes. However, if this gain is allocated equally for book purposes but entirely to Q for tax purposes, this disparate book/tax allocation will just offset the book/tax disparity caused by the ceiling limitation; thus, it cures the book/tax disparity caused by the ceiling limitation. Putting this curative allocation into the partnership’s books produces:

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Just as unrelated partnership income can be used as the curative allocation, unrelated partnership loss can be used to the same effect. For example, suppose the partnership had an unrelated loss of $3,000 in the year that the partnership sold the property contributed by Q. If this loss is allocated equally between the partners for book purposes but entirely to P for tax purposes, the book/tax disparity is eliminated. Such a curative allocation of loss would leave the partnership books at:

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Indeed, any combination of unrelated income and loss totaling $10 can cure the book/tax disparity caused by application of the ceiling limitation, and the proposed regulations do not express a preference for income over loss or vice versa. Of course the proposed regulations do not authorize curative allocations in any amount greater than that needed to eliminate the book/tax disparities.[58]

The remedial allocation method in this context operates much like the traditional method with curative allocations except that unrelated income or loss is not used to cure; rather, the cures are manufactured out of whole cloth. Thus, in the example above, the remedial allocation method could be used to create an allocation of $10 of deduction to P and an offsetting allocation of $10 of income to Q. The touchstone of the remedial allocation method is that an allocation is made to the contributing partner (or partners) sufficient to cure any book/tax disparities caused by the ceiling limitation, and an offsetting allocation is made to the noncontributing partner. Thus, the books will read:

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The remedial allocation method eliminates the otherwise-permanent book/tax disparities in all cases and so ensures that neither partner is over or under-taxed. Because it works so well, one might reasonable ask why the remedial allocation method is not required of all partnerships. The answer is two-fold. First, in the context of depreciable property, it is considerably more complex that the other two methods[.59] Second, it arguable is inconsistent with the statute, a point not particularly relevant here but discussed further in the margin.[60]

Return again to the Blackacre/Whiteacre partnership in which each asset was purchased for $100 and then Whiteacre is distributed to P. At the time of the distribution, Blackacre is worth $300 and Whiteacre is worth $200. Assume that the partnership elects not to book-up undistributed Blackacre but that, as required by current regulations, Whiteacre is booked to current value immediately prior to the distribution. The books of the partnership become:

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The distribution has caused a permanent book/tax disparity for each partner: P‟s outside basis is $50 too high (representing some form of over-taxation) while Q‟s outside basis is $50 too low (meaning Q has been under-taxed). What has caused the problem is that the partners shared the book-up of Whiteacre but only P will be taxed on the gain when it is recognized; by distributing Whiteacre to P, all of the gain was shifted to P even though the book-up gave Q half of the economic benefit of that gain.

The analysis does not change in any fundamental way if the partnership had elected to book-up undistributed Blackacre as well as distributed Whiteacre. Had that been done, the books would have been:

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There is now a $150 book/tax disparity for Q, of which $100 is attributable to the book- up of Blackacre and so is only temporary. P‟s book/tax disparity is more obscure: there is a temporary $100 book/tax disparity (with the capital account high) attributable to Blackacre and a partially offsetting $50 book/tax disparity (capital account low) attributable to Whiteacre. If Blackacre is sold, the temporary disparities are eliminated, as shown below:

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As these final books show, P‟s outside basis is high (representing over-taxation) while

Q‟s outside basis is low (representing under-taxation), in each case a mismatch of $50.

Having seen that the distribution of appreciated property causes precisely the same problem as that caused by the ceiling limitation and addressed by the three section

704(c) recovery methods, it remains to be determined whether anything can or should be done to remedy the situation in the distribution context. Unfortunately, no current regulation addresses the issue in this context although the need for a fix is clear. Consider the following.

Exempt organization EO and taxable organization TO form the ET partnership as equal partners, each contributing cash of $100. The partnership purchases two capital assets, each for $100. Asset #1 increases in value to $200 while assets #2 increases in value to

$190. The partnership is ready to sell its assets and would like to minimize the tax liability of TO. How can that be done without causing one of the two partners to reduce their share of the economic profit?

The partnership should distribute asset #2 to EO in a nonliquidating distribution and then it should sell asset #1. This will produce the following books:

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These books show that if the partnership were to liquidate now, it would distribute $5 of its cash to EO and $195 of its cash to TO. That is right: EO has already received asset #2 in-kind, and that asset is worth $190. This value, when added to its $5 share of the available cash, represents its full 50% share of the partnership‟s $190 value prior to the distribution and sale. Of course, TO‟s equal share of that value is entirely in the cash.

But notice have the tax consequences have been skewed: each partner included taxable income of $50 when asset #1 was sold. But that is all the income that TO will include. Asset

#2 is now owned by EO, and when EO sells that asset, there will $90 of taxable income. But that income will be includible entirely to EO – that is, to the organization that pays no tax – even though the economic value of the appreciation in asset #2 was shared with TO.[61]

To be sure, if TO leaves the partnership in exchange for a cash distribution of $195 – or if it sells its partnership interest for that amount – it will pick up its rightful gain of $45 because its outside basis is only $150.[62] But that gain can be avoided simply by keeping the partnership in place. For example, the partnership might have been formed with a third party, an affiliate of TO, contributing a small amount to the partnership in

exchange for a small interest. This permits EO to exit in exchange for its cash share of $5 without terminating the partnership. Once EO exits, TO can treat the cash inside the venture as its own without recognizing the $45 it should have been forced to include from its share of the appreciation in asset #2. And if TO for some reason needs to terminate the partnership, it can exit by the simple expedient of using the cash to purchase some property – anything other than marketable securities will work[63] – and then distributing that property because distributions of property are generally tax-free.

This technique for shifting recognition of income from one partner to another by the simple expedient of distributing appreciated property should not be permitted, and the solution already is understood: the distribution of appreciated property creates equal and offsetting permanent book/tax disparities for each partner, and these disparities should be eliminated by resort to the section 704(c) recovery methods. Indeed, the right answer is mandated remedial allocations.

Forcing remedial allocations in this circumstance requires legislative action because there is no authority for taxing nondistributee partners absent a shift of ordinary income caused by the distribution.[64] But the legislative fix is not difficult, and it merely requires application of a well-understood solution to a well-understood problem arising in a fresh context. If such a proposal were enacted, the books of the partnership in this example would be as follows:

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Now, the book/tax disparities for each partner are gone, TO has not escaped any

taxation, EO‟s total share of the partnership‟s income equals $50 from the sale of asset #1, $90 when asset #2 is sold, and $45 of remedial deduction, for net income of $95, the same as TO.

Actually, though, this result is not quite right because EO has been given a remedial allocation of loss prior to disposition of the distributed property (that is, prior to its sale of asset #2). This accelerated loss could be used to a taxpayer‟s advantage simply by turning the example around: if asset #2 had been distributed to EO and a remedial allocation of loss had been given to TO, then there would have been an accelerated tax loss to TO without justification.

To ensure that the distribution does not work any inappropriate advantage to either party, the remedial allocation of income should be made to the nondistibutee in accordance with general section 704(c) principles but the offsetting remedial allocation of deduction should be converted into a positive basis adjustment in the distributed property. This ensures that there is no acceleration of deduction to the distributee partner; more generally, this basis adjustment ensures that the distributee is not taxed, upon disposition of the property, on the nondistributee partner‟s share of the unrealized appreciation in the distributed asset.

Thus, in the example above, TO‟s outside basis is increased for the remedial allocation of income while EO‟s outside basis is decreased for the $45 positive basis adjustment given to Asset #2 now held by EO. That positive basis adjustment will reduce EO‟s gain (or increase EO‟s loss) when it sells Whiteacre.

A Return to the Main Road

Which brings us back to the optional basis adjustment under section 734(b) when high- basis property is distributed in a nonliquidating distribution. Recall the earlier fact pattern that we were not then able to analyze: A and B each contribute $100 to the AB partnership as equal partners. The partnership purchases two assets, Blackacre for $60 and Whiteacre for $140. When Blackacre increases in value to $300 and Whiteacre increases in value to $200, Whiteacre is distributed to A in a nonliquidating distribution. The distribution triggers a restatement of the capital accounts, and so the books of the partnership become:

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Before determining the proper basis adjustment under section 734(b), let us first enter into the books of the partnership the remedial allocation of income to nondistributee Q as well as the downward outside basis adjustment to P corresponding to the remedial allocation of loss as described above. After those adjustments, the books become:

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The remedial allocation of loss to P has driven P‟s outside basis negative, and while there is not inherently wrong with such a result, it unquestionably is not an outcome consistent with the current workings of Subchapter K.[65] But let us put that wrinkle aside for the moment and take a close look at the books of the partnership as they now stand. Look first at the capital account and outside basis of Q. Q has book/tax disparity of

$120, and the entire amount of that disparity is caused by the book-up of Blackacre. Thus, Q‟s book/tax disparity is temporary and will be eliminated upon the disposition of Blackacre by the partnership. Indeed, if there was not such a book/tax disparity for Q, disposition of Blackacre would cause a permanent book/tax disparity for Q.

Turning now to P, there is a book/tax disparity of $80. But there should a book/tax disparity of $120 because that is the amount of P‟s tax gain that will be recognized without any corresponding book gain when the partnership sells Blackacre. As the books currently stand, disposition of Blackacre by the partnership will eliminate the temporary book/tax disparity for Q but will create a permanent $40 book/tax disparity for P, a disparity that is not offset by an equivalent disparity in the partnership‟s assets (that is, it is not a temporary book/tax disparity). This book/tax disparity can be eliminated in only one way, and that is by applying a positive $40 inside basis adjustment – an adjustment currently provided by section 734(b) – to the partnership‟s remaining asset in favor of P alone. Once again section 734(b) provides the proper adjustment but fails to allocate it in the proper way.

If the section 734(b) adjustment is made only in favor of P, then disposition of Blackacre by the partnership yields the following books:

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This produces a very nice result: there are no book/tax disparities anywhere in sight, and each partner has been taxed on precisely his share of the partnership‟s gains. And when P sells distributed Whiteacre, P will be taxed on only P‟s share of the gain because of the remedial allocation/basis adjustment proposed above.

But what should be done about that pesky negative outside basis caused by P‟s remedial allocation of loss (converted into asset basis)? The remedial asset basis given to P should be deferred until P‟s outside basis can absorb the corresponding negative basis adjustment.[66] When and if P‟s outside basis can absorb the downward adjustment, P should be given the appropriate upward basis adjustment in the distributed asset. If P no longer owns the distributed property (because it has been sold or exchanged[67]) then P should be entitled to claim an immediate loss in lieu of the basis adjustment. This loss offsets the remedial allocation of income includible by Q, and because gain or loss has already been recognized by P on the disposition of the distributed property, allowing P to claim such a loss does not pose an opportunity for inappropriate acceleration of loss

recognition.

Liquidating Distributions

The existing section 734(b) basis adjustment works well in the context of liquidating distributions, but that is because the continuing partners are, in effect, taking over the capital account of the exiting partner.[68] And they are entitled to the basis adjustment not in their own right but rather as transferees of the exiting partner. For example, suppose A, B and C form the ABC form the ABC partnership by contributing cash of $100 each. The partnership purchases Redacre for $120, and when it has increased in value to $270, A wants to exit the partnership. If cash of $150 is distributed to A (and Redacre is booked to fair market value immediately prior to the distribution), the books of the partnership will be:

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If the partnership has an election in effect for the year of distribution, it is entitled to an inside basis adjustment of $50 under section 734(b).[69] If A remains in the partnership, that adjustment should benefit only her: as described at the beginning of this Article, this basis adjustment just offsets the gain recognized by A on the distribution and a basis adjustment given only to A ensures she will not be taxed a second time when Redacre is sold. That is, absent the inside basis adjustment there is $150 of unrealized appreciation in Redacre, and A has already been taxed on her one-third share. The basis adjustment should not reduce the shares of B and C in the unrealized appreciation in Redacre because they have not yet been taxed on any part of those shares.

But suppose A leaves the partnership as a result of the distribution. The analysis does not change except in one way: what would have been A‟s share of the unrealized appreciation in Redacre has been shifted to B and C because of A‟s exit. And just as A should not be taxed on that share had she remained in the partnership, so B and C should not be taxed on it if she leaves. That is, they should enjoy the section 734(b) basis adjustment not to reduce their shares of the gain in Redacre but rather to eliminate A‟s

share of the gain, a share of the gain now assumed by B and C only because of the exit by A.

Consider the following modest variation on this transaction. Rather then receive a distribution of $150 in liquidation of his her partnership interest, A receives a distribution of only $135 and reduces her share of future profits and loss to 4%.[70] After the distribution and assuming an election under section 754 is in effect, the books of the partnership become:

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As the books now show, Redacre has enjoyed a $35 increase to its common adjusted basis in the hands of the partnership. Suppose the A now sells her 4% interest to individual D for its fair market value of $15. A will recognize a gain on the sale of $15, and D will take a cost basis in the partnership interest. But will there be an inside basis adjustment under section 743(b)?

Under section 743(b), D is entitled to benefit from an inside basis adjustment equal to the excess, if any, of the amount paid for the partnership interest (that is, $15), and D‟s share of the partnership‟s interest basis. D‟s share of the inside basis is defined by the regulations to equal D‟s share of “previously taxed capital,”[71] and that, under a complex formula also provided by the regulations, equals about $38.[72] This adjustment (for the benefit of D alone) ensures that if the partnership sells Redacre immediately after D

joins, D will have no taxable income or loss.

But note that the adjustments under sections 734(b) and 743(b) total about $73, which is far too much. Had C exited with a single liquidating distribution, C would have recognized a gain of $50 and there would have been an inside basis adjustment of the same amount. Had there been no distribution but simply a sale by A to D for cash of $150, again A would recognize income of $50 and there would be a basis adjustment of $50. But by dividing the transaction into a part-distribution, part-sale, we have managed to increase the aggregate inside basis adjustment by almost 50%, far more than A‟s recognition of income under the combined distribution/sale transaction.[73]

Some Final Thoughts

How did all this come to be? The section 734(b) basis adjustment has been in the Code since 1954; why has nothing been done to fix it in the last fifty years? One cannot know for sure, but two possibilities seem likely. First, the section 734(b) basis adjustment works fine in the context of liquidating distributions, albeit for what amounts to a coincidence. Still, it works, and because nonliquidating distributions present multiple problems[,74] the flaw in the section 734(b) adjustment is obscured in that context. Second, the section 734(b) predates by almost 40 years the understanding of an asset book-up, and without that concept, application of the section 734(b) adjustment makes no great sense however it is done. For example, reconsider the facts with which this Article began: P and Q form the PQ partnership by contributing cash of $100 each. The partnership uses $60 of its cash to purchase nondepreciable Blackacre, and after Blackacre has increased in value to $340, cash of $120 is distributed to P in a nonliquidating distribution. After the distribution, the books of the partnership read:

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We know that P‟s share of future partnership activities should decline from one-half to one third; absent a book-up, it is hard to see why that should fail to apply to the accrued gain in Blackacre as of the time of the distribution. Thus, if Blackacre is now sold by the partnership for $340 and the gain of $280 is allocated 93 to P and 187 to Q (that is one- third to P and two-thirds to Q), Q is over-taxed on $17. Allocating a $20 section 734(b) basis adjustment to the common basis of the property would reduce P‟s share of the gain to $86 and Q‟s share of the gain to 184, and that is close to right. But of course these numbers make hash of the partner‟s agreed-upon economic sharing, as shown in the following books:

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These books show Q owning $297 of the partnership‟s cash of $360. But prior to the distribution and sale, Q‟s share was only half of $480, or $240. By failing to book Blackacre to fair market value as a result of the distribution and change in relative partnership interests, we have reduced P‟s net share of the venture and increased Q‟s share.

Of course, when section 734(b) first entered the Code, there were no partnership capital accounts and there were no asset book-ups. Without those concepts, it is very hard to separate what should be an unchanged sharing of accrued but unrealized gains and losses as of the date of distribution from a new, reduced sharing by the distribute going forward. Indeed, until 1984 a partnership could elect to shift pre-contribution unrealized appreciation and loss in contributed property away from the contributing partner and to the other partners.[75] But that day is long gone. Indeed, the recent history of Subchapter K is the growing recognition that basis shifting and misallocation of built-in gain should not be permitted.[76] To that end, distributions of property subject to reverse 704(c) allocations should be subject to the 704(c) recovery methods at the time of the distribution, and section 734(b) should be modified so that its basis adjustments apply only to the distributee except when the distribution triggering the basis adjustment is made in liquidation of a partner‟s interest in the partnership.

[1] Professor of Law, Emory University. I would like to thank Professor William D. Andrews for his comments and insights. This article was published in 57 TAX LAWYER 343 (2004).

[2] See §§721 (nonrecognition of gain or loss on contributions), 731(a) (gain not recognized to distributee unless distributed cash exceeds outside basis; loss not recognized except on certain liquidating distributions), 731(b) (partnership not taxable on distribution). But see §751(b) (certain distributions recharacterized as taxable exchanges). In recent years, anti-abuse provisions seeking to eliminate the use of partnerships as tax-free mixing bowls have obscured the basic paradigm. See §§704(c)(1)(B), 707(a)(2)(B), and 737.

[3] See, e.g., §741. When a partner engages with the partnership in a nonpartner capacity, the transaction should be and is taxable. §§707(a), 707(a)(2)(B). Distributions that effect a shift of ordinary income assets among the partners can will also be treated as a taxable transaction to the extent of the rearrangement, §751(b), as can many distributions that might otherwise cause a shirt of pre-contribution unrealized appreciation in contributed assets, see §§704(c)(1)(B) and 737.

[4] William D. Andrews, Inside Basis Adjustments and Hot Asset Exchanges in Partnership Distributions, 47 TAX L. REV. 10 (1991).

[5] See §§722 (outside basis equals amount of cash contributed plus adjusted basis of property contributed), 723 (inside asset basis carries over from adjusted basis of property in hands of contributing partner).

[6] See §705 (adjusting outside basis for distributive share of income (including exempt income)deductions, and nondeductible, noncapitalizable expenditures).

[7] See, e.g., Stephen D. Rose & Robert E. Holo, Creative Partnership Exit Strategies, 49 USC MAJORTAX PLANNING INST. ¶1202 (1997).

[8] E.g., Andrews, supra note 4, at 23 (proposing §734(b) adjustment be made mandatory). Note that downward basis adjustments are now mandatory in many circumstances. See §§734(a), 734(d),743(a) and 743(d)-(e). The basis adjustments considered in this Article are all optional, upward adjustments.

[9] See, e.g., Terence F. Cuff, The proposed Regulations on Partnership Basis Adjustments, 57 NYU INST. FED. TAX. §10.05, at 10-33 (1999) (“The changes to the Section 734 regulations are modest”); Jill E. Darrow, Basis Adjustments Following the Sale of Partnership Interests and Property Distributions: The Proposed Regulations, 57 NYU FED. TAX. INST. §9.07[2][a], at 9-25 (1999) (“The Proposed Regulations concerning allocations of distribution-related adjustments clarify but (unlike the Proposed Regulations concerning transfers of partnership interests) do not make significant changes to the rules provided in the Current Regulations.”) (footnote omitted); Martin J. McMahon, Jr., Optional Partnership Inside Basis Adjustments, 52 Tax Law. 35, 78 (1998) (proposed regulations under section 734(b) are “less extensive” than these under section 743(b)).

[10] If a distribution triggers an optional basis adjustment under section 734(b) at a time when aggregate inside basis does not equal aggregate outside basis because a prior event triggering an under section 734(b) or section 743(b) occurred but was not made because an election under section 754 was not then in effect, it is hard to know what the right basis adjustment should be. Should it continue the prior disparity (the freeze approach) or attempt to eliminate it (the curative approach)? This Article takes no position on that thorny issue, although others have. See, e.g., Martin J. McMahon, Jr., supra note 9, at 67-68; Noël B. Cunningham, Needing Reform: Tending the Sick Rose, 47 TAX L. REV. 77, 80-81 (1991); ALAN GUNN, PARTNERSHIP INCOME TAXATION 185-86 (3d ed. 1999); LAURA E. CUNNINGHAM & NOËL B. CUNNINGHAM, THE LOGIC OF SUBCHAPTER K 178-80 (2d ed. 1999).

[11] P‟s outside basis is reduce only by $100 despite the distribution of $120 because P‟s outside basis cannot be reduced below $0. Section 733 (parenthetical).

[12] Section 734(b)(1)(A).

[13] It is worth observing that what permits Q to receive a so much cash and yet continue to have a positive interest in the partnership is the appreciation in Blackacre. Because that appreciation is as yet unrealized, P‟s share is not reflected in P‟s outside basis, and this lack of basis is what causes the gain recognition to P on the cash distribution. Thus, one way to look at the transaction is that the distribution has the effect of taxing P on some of the unrealized appreciation in Blackacre. From this perspective, the entire basis adjustment should be allocable to P. The text comes to the same result in a slightly different but consistent way.

[14] See Reg. §1.704-1(b)(2)(iv)(f)-(g); see generally Howard E. Abrams, Reverse Allocations: More Than Meets the Eye, 5 J. PASSTHROUGH ENTITIES 35 (September-October 2002); Stephen B. Land, Revaluations Revisited: Partnership Allocations and the Demise of the Ceiling Rule, 54 TAX LAW. 299 (2001); Lawrence Lokken, Partnership Allocations, 41 Tax L. Rev. 547, 569 (1986).

[15] The partnership now owns cash of $20 and Blackacre with a value of $340. The capital account of P is $120, representing a one-third share of that total value.

[16] Reg. §1.704-1(b)(4)(i).

[17] Reg. §1.704-1(b)(2)(iv)(f).

[18] See generally Abrams, supra note 14.

[19] There is a taxable gain on the sale of Blackacre of $280 (amount realized of $340 less adjusted basis of $60). One third of that gain is $93.33, rounded to $93.

[20] If allocations in the partnership agreement are to be respected, they must provide that liquidating distributions will at all times be made in proportion to final capital account balances. See Reg. §§1.704-1(b)(2)(ii)(b)(2)-(3) (general test for economic effect), -1(d)(ii)(d)(1) (alternate test for economic effect).

[21] Prior to the distribution, the partnership owned cash of $140 plus Blackacre worth $340, for a combined value of $480. P‟s one-half of that value was $240.

[22] See Lokken, supra note 14, at 576-82.

[23] E.g., 1 WILLIAM S. MCKEE, WILLIAM F. NELSON & ROBERT L. WHITMIRE, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS ¶10.02[2][c][ii], at 10-45 (3d ed. 1997); Stephen B. Land, Partnership Revaluations, 43 Tax Law. 33, 34-35 (1989); John P. Stones, Jr., Partnership Allocations of Built-In Gain or Loss, 45 Tax. L. Rev. 615, 632 (1990).

[24] Reg. §.1704-1(b)(2)(iv)(f) (flush language following (5)(iii)).

[25] The taxable gain now must be allocated equally between the two partners because they elected to allocate the book gain in that manner when Blackacre was revalued. Reg. §1.704-1(b)(4)(i). The revaluation book gain could have been allocated however the partners wanted, constrained only by the substantial economic effect requirement of section 704(b). Reg. §1.704-1(b)(2)(iv)(f)(2).

[26] Of this $140 gain, $120 is allocable under §704(c) principles because of the prior book-up, see Reg. §1.704-1(b)(4)(i), and the remaining $20 is allocable under §704(b) in accordance with the partners‟ agreed upon sharing of profits, which in this case is 50% each.

[27] Section 731(a)(1).

[28] Section 731(a)(2).

[29] Section 734(b)(1)(A).

[30] Cf. Reg. §1.743-1(j) (applying §743(b) basis adjustment to transferee by subtracting basis adjustment from distributive share).

[31] Compare §734(b) providing that “such increase or decrease shall constitute an adjustment to the basis of partnership property with respect to the transferee only.”

[32] The sale produces no book gain or loss but a tax gain of $260, computed as follows: amount realized equals $340, and adjusted basis equals initial cost of $60 plus the section 734(b) basis adjustment of $20, so the excess of amount realized over adjusted basis equals $340 less $80, or $260.

[33] See Cunningham & Cunningham, supra note 10, at 176.

[34] Perhaps the most famous violation in this rule is the taxation of a income interest. Under Irwin v. Gavit, 268 U.S. 161 (1925), a income beneficiary gets no basis on the devise of an income interest when the remainder is devised to someone else, so that the gross amount received by the income beneficiary is taxable, a result now codified in §102(b)(2). However, in Helvering v. Horst, 311 U.S. 112 (1940), the Court that the donee of an income interest recognizes no income on collection when the remaining interest in the property is retained by the donor. As a result, taxation of the income interest turns on what the donor elects to do with the remainder of the property, something of no significance to a donee of the income interest alone. This peculiar result may have been eliminated by enactment of §1286, at least in the context of income interests in bonds, but even that remains uncertain: the provision that addresses the tax consequences to the holder of the income interest (§1286(a)) applies only if the income interest is “purchase[d]” while the provision that applies to the holder of the corpus of the bond (§1286(b)) applies whenever the income interest is “dispose[d] of.”

[35] See note 31 supra. The section 734(b) adjustment should have much the same effect as that of the section 743(b) adjustment. A section 743(b) adjustment ensures that the purchaser of a partnership interest is not taxed on appreciation in partnership assets to the extent that appreciation was implicitly taxed to the outgoing, selling partner. The section 734(b) adjustment does not, at least in the context of a nonliquidating distribution, involve the transfer of an interest in the current value of the partnership, and so application of the section 734(b) adjustment avoids double taxation of unrealized appreciation in partnership assets to the extent that unrealized appreciation has tacitly been recognized on the distribution of cash in excess of outside basis or to the extent it will be taxed on the disposition of distributed property that taxes a lower basis in the hands of the distributee than it had in the hands of the partnership. In the context of a liquidating distribution of cash, the section 734(b) adjustment is essentially identical to the section 743(b) adjustment. See text at notes 68 to 73 infra.

[36] The book-up of Whiteacre immediately prior to the distribution is mandatory; the regulations require that all distributed property be booked to fair market value immediately prior to distribution. Reg. §1.704-1(b)(2)(iv)(e)(1). The book-up of undistributed Blackacre is optional but advised. See note 14 supra.

[37] P will take a basis in Whiteacre of $100, §732(a)(2), forcing a reduction in P‟s outside basis to $0, §733(2).

[38] Section 734(b)(1)(B).

[39] Since the unrealized appreciation was allocated equally between P Q when Blackacre was booked to fair market value, the associated taxable gain recognized by the partnership when Blackacre is sold must be allocated in the same proportions. Reg. §1.704-1(b)(4)(i).

[40] Because P has an outside basis of only $100 at the time of the distribution, P taxes a basis in the distributed asset of $100, §732(a)(2), and reduces outside basis by that $100, §733(2). Under §731(a), the tax consequences of a distribution are determined on the date of the distribution. While the regulations provide that a distribution which is a draw against distributive share is not taken into account until the close of the taxable year, Reg. §1.731-1(a)(1)(ii), there is nothing about the distributions in these examples that make them “draws.” For more on the timing of the taxation on partnership distributions, see RICHARD L. DOERNBERG & HOWARD E. ABRAMS, FEDERAL INCOME TAXATION OF CORPORATIONS AND PARTNERSHIPS 749-50 (3d ed. 2000).

[41] For a history of current section 704(c)(1)(A), see Steines, supra note 23.

[42] These terms are not (as best I know) commonly used, but they seem to capture the difference between book/tax disparities that can be eliminated by a disposition of partnership property and those that cannot be so eliminated.

[43] If the partners had agreed to share the gain from Blackacre differently, then the book-up would be different. For example, if the partners had agreed to allocate 60% of the gain from Blackacre to P and 40% to Q, then P‟s capital account would be increased by $120 as a result of the book-up (i.e., 60% of $200) while Q‟s capital account would be increased by $80% (40% of $200).

[44] To the extent that Blackacre is sold for less than $300, a portion of the book/tax disparity will become permanent because of the “ceiling rule” in Reg. §1.704-3(b)(1) which provides that ”the total income, gain, loss, or deduction allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss or deduction with respect to that property for the taxable year.” Such a permanent book/tax disparity can be avoided only by “curing” with skewed allocations of other taxable items or “remedying” with notional tax allocations. For more on the ceiling rule as well as curative and remedial allocations, see text at notes 53 thru 59 infra.

[45] Technically, P‟s outside basis was reduced by the partnership‟s adjusted basis in Whiteacre, and that is equal to the book value of Whiteacre only because there was no book/tax disparity already in Whiteacre prior to the distribution. Had such a disparity been in existence, then the analysis provided above would have to be applied twice, once as to the existing book/tax disparity and once, as described in the text, as to the book/tax disparity caused by the distribution itself. When a single piece of property has multiple layers of book/tax disparity, the analysis is unchanged but the computations become more complex. See Abrams, supra note 14, at

[44]-46.

[46] A “temporary” book/tax disparity as used in the text refers to a difference between a partner‟s capital account and that partner‟s outside basis (excluding the impact of debt on outside basis) caused either (1) by contributing property with unrealized gain or (2) by booking assets to fair market value upon the occurrence of some triggering event such as a distribution. So long as the book/tax disparity in the partner‟s T-account is matched by a book/tax disparity in some partnership asset, the partner‟s book/tax disparity potentially can be eliminated by disposition of the property (and possibly by depreciation of the property as well, see generally Howard E.

Abrams, Dealing with the Contribution of Property to a Partnership: Part 2, BUSINESS ENTITIES 18, 18-22 (January/February 2001)). But if there is no book/tax disparity in the partnership‟s assets (so that the partnership‟s aggregate inside basis equals the aggregate book value of its assets, again ignoring debt), then book/tax disparities in the partners‟ T-accounts must offset if aggregate inside basis is to equal aggregate outside basis and aggregate capital accounts are to equal aggregate book value of the partnership‟s assets.

[47] See Reg. §§1.704-3(a)(6), 1.704-1(v)(2)(iv)(f).

[48] The distribution of property is generally a tax-free event, see §731(a)(1), and so the regulations need to speak to property having a book/tax disparity that is disposed of in a tax-free manner. Unfortunately, the regulations assume that all tax-free disposition are exchanges in which the partnership receives replacement property with a substituted basis. Reg. §1.704-3(a)(8).

[49] Reg. §1.704-1(b)(2)(iv)(d)(1).

[50] Section 723.

[51] See note 46 supra.

[52] See Steines, supra note 23, at 641.

[53] See generally Reg. §1.704-3(b).

[54] See generally Joel Scharfstein, An Analysis of the Section 704(c) Regulations, 48 Tax Law. 71 (1994).

[55] See Reg. §1.704-3(b).

[56] See Reg. §1.704-3(c).

[57] See Reg. §1.704-3(d).

[58 ]Reg. §1.704-3(c)(3)(i); see also Reg. §1.704-3(c)(4) (ex. 1(iii)). Note also that “[a] partnership may limit its curative allocations to allocations of one or more particular tax items (e.g., only depreciation from a specific property or properties) even if the allocation of those available items does not offset fully the effect of the ceiling rule.” Reg. §1.704-3(c)(1).

[59] See Abrams, supra note 46, at 18-25; Land, supra note 14, at 56-64.

[60] Section 702 provides that each partner include his “share” of the partnership‟s tax items. Under the remedial allocation method, a partner may include a tax item even though there is no equivalent tax item at the partnership level. Thus, it is hard to conclude that the partner is including his “share” of anything. To be sure, the remedial allocation accomplishes what Congress seemed to have intended by enacting what is now section 704(c)(1)(A); the question is only whether the section 702 should have been amended to make that possible. The Treasury has recently become more aggressive in writing partnership regulations that accomplish congressional goals despite an absence of statutory support. For example, the optional basis adjustment in section 743(b) is supposed to be based in part on a transferee‟s “proportionate share of the adjusted basis of the partnership[„s] property”, see §§743(b)(1), 743(b)(2). Yet, while a partnership‟s adjusted basis in its property can never be negative, the regulations definition of a partnership‟s “share” of that adjusted basis can be. See DOERNBERG & ABRAMS, supra note 40, at 886.

[61] If an exempt organization invests in a debt-financed real estate real estate partnership, the exempt organization‟s share distributive share will be subject the tax on unrelated business income unless the partnership‟s allocations satisfy a complex set of requirements, see § 514(c)(9)(vi), intended to ensure that the partnership does not in effect transfer some of the benefit of the organization‟s tax exemption to other partners. Remarkably, booking appreciated assets to fair market value and then distributing them to the exempt organization does not run afoul of these requirements.

[62] For the taxation of a cash distribution, see §731(a)(1); for the taxation of a sale of a partnership interest, see §741.

[63] See §731(c).

[64] See note 60 supra.

[65]See for example the parenthetical in section 733.

[66] Compare the suspension of loss under §704(d) as provided by Reg. §1.704-1(d).

[67] If P has exchanged the distributed property in some tax-free way (such as in a like-kind exchange under section 1031), then the substitute-basis property received in that exchange should be given the basis increase.

[68] A cross-reference placeholder.

[69] Section 734(b)(1)(A).

[70] After the distribution, the partnership owns assets with aggregate value of $335, and A‟s share of that value is $15, and that share represents a bit more than 4%.

[71] See Reg. §1.743-1(d)(1).

[72] D‟s capital account equals $15 because it is carried over from A. Reg. §1.704-1(b)(2)(iv)(l). D‟s share of “previously taxed capital” is the amount she would receive if all the partnership assets were sold for cash and then the partnership were liquidated, which equals $15, less her share of taxable gain that would be recognized on the sale of its assets, which is one-third of $115, or about $38. Thus, D‟s share of the previously taxed capital equals about negative $23, and the basis adjustment under section 743(b) equals D‟s purchase price of $15 less

[73] A cross-reference placeholder.

[74] For example, a non-pro rata nonliquidating distribution is skin to a partial sale of a partnership interest by one partners to the others. Yet, all of the distributee‟s outside basis is available to shelter gain on the distribution while on a portion is available on the sale.

[75] What is now section 704(c)(1)(A) was first made a mandatory provision applicable to all contributed property by the Deficit Reduction Act of 1984, Pub. L. No. 98-369, §71, 98 Stat. 494, 589. That was only extended to revaluations of partnership property, and even then only on an optional basis, by regulations finalized late in 1985. See T.D. 8065, 50 F.R. 53423 (December 31, 1985) (adding Reg. §1.704-1(b)).

[76] In 1984 what is now section 704(c)(1)(A) became mandatory. See id. Then section 704(c)(1)(B) was added by the Revenue Reconciliation Act of 1989, Pub. L. No. 101-239, §7642,Stat., to ensure that section 704(c)(1)(A) could not be avoided by distributing contributed property to a noncontributing partner. Finally, section 737 was added to protect the integrity of section 704(c)(1)(A) by preventing a tax-free separation of contributed property from the contributing partner effected by distributing other property to the partner.