MauledAgain

The definition in section 753 of income in respect of a decedent refers only to section 736(a) payments. If section 736 is repealed, section 753, as presently structured, becomes meaningless. Section 753 does not define income in respect of a decedent, because there are other payments made in respect of a decedent partner that constitute income in respect of a decedent. Even if section 736 is not repealed, it makes no sense to characterize 736(a) payments as income in respect of a decedent. The portion of section 736(a) payments that would be characterized as income in respect of a decedent under the general income in respect of a decedent rules would remain so characterized. Any other portion of section 736(a) payments ought not be characterized as income in respect of a decedent. Thus, no matter what is done with respect to section 736, section 753 ought to be repealed.

If section 736 is the most criticized provision in subchapter K, the anti-abuse regulations might be the most criticized regulations under subchapter K. The criticism extends not only to the substance of the regulations but also to the authority of the Treasury to issue them. With the enactment of the section 7701(o) economic substance provision, the need for the anti-abuse regulations is even less than whatever it may have been at the outset. In just about every ruling and judicial decision in which the anti-abuse regulations were invoked as a reason for the conclusion, alternative grounds under other provisions also were set forth. Repeal of the anti-abuse regulations would be an improvement.

Section 708 provides that a partnership terminates for federal income tax purposes if “within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.” The consequences of a termination of a partnership by reason of sale of a partnership interest are for all intents and purposes negligible. Because of the seven-year time periods in sections 704(c)(1)(B) and 737, the regulations were amended to provide that the terminated partnership transfers its assets to a new partnership, which is an impossibility because the new partnership cannot have just the old partnership as a sole partner. The old partnership is then treated as transferring the interests in the new partnership to the new group of partners, another impossibility because the old partnership cannot have multiple interests in the new partnership. The new partnership ends up with the same assets, adjusted bases in its assets, and other attributes as were held by the old partnership. Considering that large partnerships that qualify for the special rules in sections 771 through 777 do not terminate on account of sales of interests, there is no need to terminate any partnership on account of sales of interests, and particularly no need to engage in a sequence of impossible transactions that amounts to nothing more than a charade that in effect keeps the terminated partnership, for all intents and purposes, in existence.

Section 736 is one of the most frequently criticized provisions in subchapter K. Proposals for its repeal have been in place for decades. It is difficult to get across to students the fact that section 736 does not provide for substantive outcomes but merely separates liquidating distribution payments into segments, each of which is subject to different provisions elsewhere in subchapter K. The regulations under section 736 provide rules to deal with liquidating distribution payments received over multiple years, but those situations ought to be subjected to the provisions applicable to installment sales.

Considering the extensive explanations provided by advocates of repealing section 736, there is no need to duplicate those efforts. Suffice it to say that section 736 is a maze of exceptions, exceptions to exceptions, and exceptions to exceptions to exceptions, is a trap for the unwary who do not realize there are opportunities to affect the outcomes by putting goodwill provisions into the partnership agreement, and adds layers of unnecessary complexity to the taxation of partnerships.

The provisions in section 724 that retain the character of gain or loss in unrealized receivables, inventory, and depreciated capital assets contributed to a partnership, and the provisions in section 735 that retain the character of gain or loss in unrealized receivables and inventory distributed by a partnership, apply not only to those items but also, under section 724(d)(3) and section 735(c)(2) to substituted basis property. In other words, if the partnership or partner exchanges the property and the adjusted basis in the replacement property reflects in whole or in part the adjusted basis in the exchanged property, sections 724 and 735(a) apply to the replacement property.

In contrast, if the partnership or partner transfers the property to another person under circumstances that cause the other person to obtain a transferred basis in the property, sections 724 and 735(a) do not apply. In other words, if a partner, for example, transfers distributed inventory by gift to a another person, the other person holds the property as an investment and subsequently disposes of the property within the five-year property, section 735(a)(2) does not apply. The other person’s gain would be capital gain, not ordinary income. For sections 724 and 735(a) to be fully effective, they need to apply not only to substituted basis property but also to transferees with transferred basis in the property.

Sections 724(a) and (b) and 735(a)(1) and (2) apply to retain the original character of not only the inherent gain or loss in property contributed to, or distributed from, a partnership, but also any gain or loss arising from changes in value after the contribution or distribution. In contrast, section 724(c) applies to retain the original character only of the inherent capital loss in a capital asset contributed to a partnership. That approach makes more sense in light of the purpose of these provisions, which is to prevent manipulation of the character of the inherent gain or loss. Gain or loss arising after the contribution or distribution does not exist at the time of the transaction and thus is not something in the hands of the partner or partnership to attempt to recharacterized. In other words, the reasoning behind the limitation in section 724(c) should apply to sections 724(a) and (b), 735(a)(1) and (2), and the proposed section 735(a)(3).

Section 735(a)(1) provides that unrealized receivables distributed by a partnership to a partner generate ordinary income when the partner sells them, even if held by the partner as an investment, no matter when the sale takes place. Section 735(a)(2) provides that inventory distributed by a partnership to a partner generates ordinary income when the partner sells it, even if held by the partner as an investment, if sold within five years of the distribution.

Section 724(a) provides that unrealized receivables contributed by a partner to a partnership generate ordinary income when the partnership sells them, even if held by the partnership as an investment, no matter when the sale takes place. Section 724(b) provides that inventory contributed by a partner to a partnership generates ordinary income when the partnership sells it, even if held by the partnership as an investment, if sold within five years of the distribution. Section 724(c) provides that a capital asset contributed by a partner to a partnership that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partnership sells it, even if held by the partnership as inventory, if sold within five years of the distribution.

It is easy to see the lack of symmetry. There is no section 724(c) equivalent in section 724(a). The reason probably is explained by the fact that section 724 was enacted decades after section 735 was enacted and nothing was done to bring section 735 up to date. There needs to be a section 724(a)(3), to provide that a capital asset distributed by a partnership to a partner that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partner sells it, even if held by the partner as inventory, if sold within five years of the distribution.

One of the most vexing aspects of subchapter K is the complexity of the optional and special basis adjustments under sections 732(d), 734(b), and 743(b). The complexity arises not only from the extensive computational requirements but also from the fact that the optional basis adjustments generally are just that, optional, though mandatory in certain instances. Accordingly, section 732(d) provides a special basis adjustment that stands in place of the section 743(b) optional basis adjustment, but not the section 734(b) optional basis adjustment, but only in certain situations and not in all situations to which the section 743(b) adjustment would apply.

The basis adjustments under sections 734(b) and 743(b) resolve problems that exist because of the manner in which subchapter K applies both entity and aggregate approaches to different provisions. Those problems affect all partnerships. Now that pencil and paper calculations have been replaced by computer software, there is no good reason to make those adjustments optional. If making them mandatory in certain situations is acceptable, making them mandatory across the board is no less justifiable. If the adjustments are mandatory, the need for section 732 disappears and it can be repealed.

Section 751 is a subchapter K provision designed to ensure that gain or loss attributable to ordinary income assets in a partnership is characterized as ordinary income or loss, whether the gain is triggered by a sale of a partnership interest or a distribution from the partnership. Under section 751(c), unrealized receivables and a long list of recapture items are classified as ordinary income items. Under section 751(d), partnership inventory items are classified as ordinary income items if the transaction is a sale of a partnership interest, but if the transaction is a distribution the inventory items are classified as ordinary income items only if they are substantially appreciated in value. Substantial appreciation exists if the value of the inventory items exceeds 120 percent of their adjusted basis.

Until 1997, inventory items were classified as ordinary income items, for purposes of both sale and distribution transactions, only if they were substantially appreciated. In 1997, the definition of ordinary income items was amended so that inventory items are treated as ordinary income items for sale transactions but are not treated as ordinary income items for distribution purposes unless they are substantially appreciated.

Finding a sensible reason for the change, and for the different treatment, is difficult if not impossible. I tell students that Congress has created a trap for the unwary. I also tell students that Congress has also created an examination question that indicates the extent to which students are paying attention, being precise, and recognizing the twists and turns of tax law. Making matters worse, unrealized receivables are treated as inventory items, the practical effect of which is that because they already are ordinary income items, they play a role in determining whether inventory is substantially appreciated. It works both ways. For example, inventory with an adjusted basis of $100 and a value of $105 is not substantially appreciated standing alone, but if the partnership also has unrealized receivables with an adjusted basis of zero and a value of $50, the inventory is substantially appreciated because the total adjusted basis is $100 and the total value is $155. As another example, inventory with an adjusted basis of $100 and a value of $130 is substantially appreciated standing alone, but if the partnership also has realized receivables with an adjusted basis and a value of $100, the inventory is not substantially appreciated because the total adjusted basis is $200 and the total value is $230.

This complexity is unwarranted and unnecessary. Inventory is an ordinary income asset, period. Whether or not it is substantially appreciated is irrelevant to its nature as an ordinary income asset. Congress should repeal the substantial appreciation test and treat all inventory as ordinary income assets for purposes of section 751, whether the transaction is a sale of a partnership interest or a distribution.

The extent to which guaranteed payments affect adjusted basis in a partnership interest is unclear. This is yet another question for which there is no authority found in the statute, regulations, administrative issuances, or judicial decisions.

A partner must include a guaranteed payment in gross income in the taxable year for which the partnership properly claims the deduction or makes the required increase in the basis of an asset. Thus, if the partnership uses the accrual method and the partner uses the cash method, the partner includes the guaranteed payment in gross income even if it has not been paid. A mechanism is required to prevent the partner from including the guaranteed payment in gross income when it is eventually paid. This mechanism is basis.

The question is whether the basis acquired by reason of including the guaranteed payment in gross income is a stand-alone basis in the guaranteed payment or is added to the partner’s adjusted basis in the partnership interest. Though one might expect something to be found in section 705 or even section 707(c), or the regulations interpreting those sections, there is no answer there or in revenue rulings, notices, or court opinions. There is dictum in one case suggesting that the partner increases adjusted basis in the partnership interest, but there are inferences in the regulations that the partner does not increase adjusted basis in the partnership interest, though the reasoning is quite attenuated.

An example illustrates why the question matters. Assume that at the beginning of year 5, A’s adjusted basis in the partnership interest is $100. During year 5, the partnership accrues a $400 guaranteed payment to A but does not pay it. After deducting the guaranteed payment, the partnership breaks even, so there are no partnership items to allocate among the partners. During year 6, the partnership again breaks even, but there is no guaranteed payment. During year 6, the partnership sells a capital asset in which its adjusted basis is $1,000. It sells the asset for $1,000, and distributes $200 to each partner, including A. During year 7, the partnership again breaks even, and again there is no guaranteed payment, but the partnership pays to A the $400 guaranteed payment accrued during year 5.

If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the results are as follows. The basis of A’s partnership interest at the end of year 5 is $500 ($100 plus $400). The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to $300 ($500 minus $200). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($400 minus $100).

If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in an item that could be called, for ease of reference, guaranteed payment receivable, the results are as follows. The basis of A’s partnership interest at the end of year 5 remains $100, and A also has a basis of $400 in the guaranteed payment receivable. The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($200 minus $100). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the guaranteed payment receivable to zero, but does not generate any gain.

The difference, therefore, essentially is one of timing. Either way, A must report ordinary income of $400 in year one, and gain of $100. If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the gain is reported in year 7. If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in a guaranteed payment receivable, the gain is reported in year 6. Put another way, the issue is whether the basis obtained from including the guaranteed payment in gross income can be used to offset distributions and not just payment of the guaranteed payment.

However the question is resolved, clarifying amendments to the Internal Revenue Code or the regulations are necessary. Even if the situation arises only for partners with zero or relatively low adjusted basis in their partnership interests, taxpayers deserve an answer.

Section 704(e)(2), which attempts to apply two assignment of income doctrines to partnerships, is difficult to read, challenging to explain, and questionable in its application. Section 704(e)(2) is designed to prevent a partner who provides services on behalf of a partnership from shifting the income generated by those services to other partners who received their partnership interests by gift or who are family members. It also is designed to prevent a partner who provides capital to a partnership from shifting the income generated by that capital to other partners who received their partnership interests by gift or who are family members.

There are better ways to accomplish what section 704(e)(2) is designed to accomplish. In addition, the principles of section 704(e)(2) ought to apply across the board, and not merely in the limited circumstances to which it applies. Unlike sections 704(c) and 737, which also deal with assignment of income concerns but do not have subchapter S equivalents, section 704(e)(2) has a subchapter S equivalent, so this aspect of assignment of income apparently is of greater concern to the Congress.

With section 704(b) having been amended and regulations issued under section 704(b) in the years after section 704(e)(2) was enacted, it makes more sense to incorporate the concerns of section 704(e)(2) in section 704(b). In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that needs to be taken into account. The repeal of section 704(e)(2), and its accompanying section 704(e)(3), needs to be done in tandem with the enactment of language in section 704(b) that states, “In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that must be taken into account.”

In determining whether a partnership exists, it is necessary to identify at least two partners. The question of whether a individual or entity is a partner is wrapped up in the question of whether a partnership exists. These questions are factual in nature. Though the “check the box” regulations provide some rules, ultimately the initial question is whether an entity exists that ultimately can be classified as a partnership. In light of these regulations and the questions that must be answered, one is left wondering why section 704(e)(1) continues to exist.

Section 704(e)(1) provides that “a person shall be recognized as a partner . . . if he owns a capital interest in a partnership in which capital is a material income-producing factor. . .” Section 704(e)(1) was enacted in response to the Supreme Court’s decision in Culbertson, which essentially tagged the question of whether a person is a partner as a factual question. To the extent section 704(e)(1) was intended to reduce the amount of factual analysis necessary to answer the question, it has failed. First, it only applies to certain partnerships, and is of no value for partnerships in which capital is not a material income-producing factor. Second, section 704(e)(1) takes one factual question, namely, does the person in question intend to be a partner, and turns it into two questions, namely, when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.

The process of determining whether a partnership exists should also determine who the partners are. This is true even if two persons are identified as partners and the status of a third person is in question. The reason is that the technical question is whether a partnership exists among all three persons, not whether the third person is a member of a partnership between the first two persons.

In any event, no matter how the issue of whether a person is a partner is resolved, section 704(e)(1) is of no help whatsoever. Its repeal not only would remove useless language from the Internal Revenue Code, it would eliminate the need to answer the two questions of when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.

One of the more complicated areas of Partnership Taxation is the treatment of contributed property. Sections 704(c) and 737 are challenging, not only in terms of language, but also in terms of application and computations. These provisions are necessary to the extent it is necessary to prevent gain or loss inherent in property contributed by one partner from being shifted to other partners. But how necessary is that goal? The answer can be found by looking at S corporations.

If an S corporation shareholder contributes appreciated or depreciated property to the S corporation, the gain or loss recognized by the corporation, which includes the gain or loss inherent in the property when contributed, is allocated among all the shareholders. Thus, the inherent gain or loss is shifted to other shareholders. Why is there no section 704(c) and section 737 equivalents in subchapter S? Apparently, preventing the shifting of the gain or loss isn’t as terribly important as one might have guessed. The practical explanation probably is that enacting section 704(c) and section 737 equivalents in subchapter S would make subchapter S “too complicated.” So why is it acceptable to have a “too complicated” subchapter K when it comes to contributed property?

Until and unless subchapter S is graced with section 704(c) and section 737 equivalents, subchapter K ought to be relieved of a computational and interpretational complexity that does not afflict subchapter S. Surely the shifting of income and loss either is good or bad, but whatever it is, it ought to be the same whether it is being done by partners or by subchapter S shareholders.

For students who think that tax law is nothing more than a set of rules that they need to memorize, I emphasize that there are numerous situations in which not only must the rules be applied to a variety of different factual situations but also situations in which the rules are not known and advice to clients must be based on a careful analysis using comparative application of other provisions. One such example in the subchapter K area is illustrated by the following question. Is a loss carryforward under section 704(d) available to a transferee of the partnership interest? Those unfamiliar with tax, and even those somewhat familiar with tax, are likely to conclude that the answer is in the Code, the regulations, an administrative issuance, or a court decision. But in this instance they would be in for a surprise. There is no authority providing an answer to that question.

When I taught Partnership Taxation, I did not try to provide the students with an answer to the question of whether a section 704(d) loss carryforward is available to the transferee of a partnership interest, though some students reacted negatively to the lack of a definite answer. Instead, I encouraged them to look at other provisions in the tax law that deal with the transfer of losses, an approach which also bothered some students who considered forays outside of subchapter K to be “irrelevant” to the course. I pointed out to them that there are provisions that prohibit or discourage the transfer of losses. I also pointed out to them that there are provisions that permit the transfer of losses. Finally, I directed them to examine the language of section 1366(d)(2)(A), which provides that the corresponding S corporation loss carryover is available “with respect to that shareholder,” referring to the shareholder who owned the stock when the loss pass-through was disallowed.

So why, I asked and continue to ask, does the language “with respect to that partner” not appear in section 704(d)? Should its absence be interpreted as an intent by Congress to permit the 704(d) loss carryforward to be available to the transferee? There are canons of statutory construction that would permit that conclusion. From a policy perspective, is there any reason to treat section 704(d) losses and section 1366(d) losses differently when it comes to the treatment of the transferee? I use this issue to demonstrate the difference between the issue of what the law should be and the issue of what the law is as demonstrated by the question of what one tells the client.

The answer to this one is easy. Section 704(d) and section 1366(d) loss carryforwards, in terms of availability to the transferee, must be treated in the same manner. Preferably, section 704(d) should be amended to include the language “with respect to that partner.”

The language of section 705, which provides for the computation of a partner’s adjusted basis in a partnership interest, is unwieldy and requires inefficient calculations. Section 705 provides that basis equals basis reflecting the contribution of money or property and basis reflecting purchase price, increased “by the sum of [the partner’s] distributive share for the taxable year and prior taxable years of” taxable income, tax-exempt income, and excess depletion, and decreased by distributions and “by the sum of [the partner’s] distributive share for the taxable year and prior taxable years” of losses and non-deductible expenditures not chargeable to capital account.

For example, consider X, who contributed $100 to a partnership at the beginning of year 1. X’s distributive share of the partnership’s taxable income for year 1 is $50, for year 2 is $60, for year 3 is $30, and for year 4 is $80. There are no other partnership items and no distributions. Following the statute, X’s adjusted basis at the end of year 1 is $150 ($100 plus $50). Following the statute, X’s adjusted basis at the end of year 2 is $210 ($100 plus $50 plus $60). Following the statute, X’s adjusted basis at the end of year 3 is $240 ($100 plus $50 plus $60 plus $30). Following the statute, X’s adjusted basis at the end of year 4 is $320 ($100 plus $50 plus $60 plus $30 plus $80). This example, of course, is too simple. Imagine what the computation looks like in the fifteenth or twentieth year, and imagine, as likely is the case, that there are items of tax-exempt income, losses, distributions, and non-deductible items not chargeable to capital account.

What happens in practice, of course, is that practitioners begin with adjusted basis as of the end of the previous year, and then add the items for the current year to compute adjusted basis as of the end of the current year. Thus, in the example, X’s adjusted basis at the end of year 3 would be computed by adding $30 to $210.

Is it possible to rewrite section 705 to reflect practical reality? Of course. The model already exists. Section 1367, which provides for the computation of a shareholder’s adjusted basis in S corporation stock, provides that basis “shall be increased for any period by the sum of [the various items] determined with respect to that shareholder for such period.” Section 1367 is a newer provision than section 705 and reflects advances in technical drafting that took place during the intervening years. There is no good reason not to clean up section 705 so that it parallels section 1367.