Chapter 5
ADVANCED DISTRIBUTION RULES
LEARNING OBJECTIVES
After completing this chapter, you should be able to do the following:
• Calculate the basis of each property received by a partner or member receiving multiple properties in a non-liquidating distribution from a partnership or LLC.
• Calculate the basis of each property received by a partner receiving multiple properties in a liquidating distribution from a partnership or LLC.
• Recognize which properties will receive a step-up or step-down in basis when multiple properties are received from a partnership or LLC.
• Assess basis increases or decreases among multiple properties for federal income tax purposes.
Non-Liquidating Distributions Generally
NON-CASH DISTRIBUTIONS
The Code lays out a relatively straightforward framework for analyzing the tax consequences of proportionate non-liquidating distributions. This framework begins with the general rule of Section 731(a)(1), which states that neither the partner nor the partnership recognizes gain on receipt of property other than cash in a non-liquidating distribution.1 Partners must realize that relief of liabilities is treated as a distribution of cash, but aside from this caveat, it is relatively easy to structure a distribution to ensure tax-free treatment to both the partner and the partnership.
Any gain realized by the partner on the receipt of a non-cash, non-liquidating distribution is deferred until the partner disposes of the property received. Under Section 732(a)(1), partners generally take a carryover basis in property received from the partnership in a non-liquidating distribution (in other words, any distribution which does not completely terminate the partner's interest in the partnership). That is, the partnership's basis in the property becomes the partner's basis. The partner's basis in his or her partnership interest (in other words, the partner's outside basis) is then reduced, pursuant to Section 733, by an amount equal to the basis assigned to the property received from the partnership.
Example 5-1
John Smith has a tax basis of $20,000 in his interest in the PH Partnership. In December, John receives a tract of land, valued at $25,000, and having a tax basis to the partnership of $17,000. Neither Smith nor PH Partnership recognizes any gain on the distribution under Section 731(a)(1). Smith takes a $17,000 basis in the land, and reduces his basis in his partnership interest from $20,000 to $3,000.
There is one exception to the carryover basis rule. Where the partnership's tax basis in distributed property exceeds the partner's tax basis in his or her partnership interest, Section 732(a)(2) provides that the partner's basis in the distributed property is limited to her outside basis in the partnership interest. This is a corollary to the requirement that the partner reduce his or her tax basis in the partnership interest by the basis taken in the distributed property. Since the basis in the partnership interest cannot be less than zero, the basis in the distributed property cannot exceed the distributee's pre-distribution basis in the partnership interest.
KNOWLEDGE CHECK
1. Jamie is a partner in Lion Partners. Her basis in her partnership interest is $50,000. In a non- liquidating distribution, Jamie received a distribution of property 1 which had a tax basis of $54,000 and a fair market value of $62,000. The distribution was not a disproportionate distribution, and the provisions of Sections 704(c) and 707 do not apply. How much gain must Jamie recognize on receipt of the non-liquidating distribution?
a. $0.
b. $62,000.
c. $12,000.
d. $4,000.
Example 5-2
Assume the same facts as in example 5.1. John Smith has a tax basis of $20,000 in his interest in the PH Partnership. In December, John receives a non-liquidating distribution consisting of a tract of land valued at $25,000. Assume, however, that the partnership's tax basis in the land was $27,000 rather than $17,000. As before, neither Smith nor PH Partnership recognizes any gain on the distribution under Section 731(a)(1). Smith takes a $20,000 basis in the land, and reduces his basis in his partnership interest (outside basis) from $20,000 to zero.
KNOWLEDGE CHECK
2. Lynn is a partner in QLL Partners. Her basis in her partnership interest is $23,000 and her share of the fair market value of the partnership's assets is $124,000. In a non-liquidating distribution, Lynn received a distribution of property 1 which had a tax basis of $30,000 and a fair market value of $62,000. The distribution was not a disproportionate distribution, and the provisions of Sections 704(c) and 707 do not apply. What will be Lynn's tax basis in property 1 received from the partnership?
a. $23,000.
b. $30,000.
c. $62,000.
d. $39,000.
CASH DISTRIBUTIONS
Most cash distributions received by a partner from a partnership are also nontaxable to the partner. Where a partner receives a distribution of cash from the partnership, the partner will recognize gain only to the extent the amount of cash received exceeds his or her tax basis in the partnership interest. This is a corollary to the general rule that basis in the partnership interest is reduced by the basis allocated by the distributee partner to the property received in the distribution. As with a non-cash distribution, the basis of the partnership interest cannot be reduced below zero. Unlike a property distribution, however, the tax basis of cash received cannot be reduced below its face value. Thus, the partner must recognize income if cash is received in excess of the basis of the partnership interest.
Example 5-3
Sharon's tax basis in her 25 percent interest in Deep Ellum Partners is $15,000. Assume that she receives a non-liquidating distribution from Deep Ellum of $20,000 cash. The first $15,000 of this distribution will be nontaxable, and will reduce her tax basis in her partnership interest to zero. Because her basis cannot be reduced below zero, however, the remaining $5,000 received as part of the distribution will be taxable to her as a capital gain.
Note that a reduction in a partner's share of partnership liabilities is treated as a cash distribution from the partnership to the partner. This can present a trap for the unwary, turning an otherwise nontaxable distribution into a taxable one. For example, where a cash distribution reduces a partner's interest in the partnership and thus in partnership liabilities, the total amount of the distribution will include both the cash received and the reduction in the partner's share of partnership debt. If the sum of these two figures exceeds the partner's basis in his or her partnership interest, then gain must be recognized to the extent of the excess.
Example 5-4
Assume the same facts as in example 5-3. Sharon's tax basis in her interest in Deep Ellum Partners is $15,000. She receives a $20,000 cash distribution from the partnership. Assume that this distribution reduces her interest in partnership capital, profits, losses, and liabilities from 25 percent to 15 percent. Further assume that the partnership has total liabilities of $100,000. Thus, the distribution reduces her share of partnership liabilities from $25,000 (25 percent) to $15,000 (15 percent). Since this reduction in her share of partnership debt is treated as a distribution of cash to her from the partnership, her total cash distribution is now $30,000, rather than $20,000. Accordingly, she must now recognize a capital gain of $15,000 (rather than $5,000 as in the previous example). Her tax basis in her partnership interest is reduced to zero.
RECEIPT OF CASH AND PROPERTY
Where a partner receives a distribution consisting of both cash and other property, he or she accounts for the cash portion of the distribution first, and then the property portion. The result of this ordering rule is that the basis of the partnership interest is first reduced by the cash received. If insufficient basis is left to absorb the property distribution, the partner takes a stepped down basis in the property as described previously.
Example 5-5
Ed is a 20 percent partner in Horton Partners. His tax basis in his partnership interest is $28,000. He received a non-liquidating distribution consisting of $8,000 cash and property with a fair value of $45,000 and a tax basis of $25,000. Ed will recognize no gain on receipt of the distribution. The cash reduces his tax basis in the partnership interest to $20,000 ($28,000 pre-distribution basis less $8,000 cash distribution). He then accounts for the property distribution. His remaining basis in the partnership interest is less than the partnership's basis in the distributed property. Thus, he takes a $20,000 tax basis in the property received, and his basis in his partnership interest is reduced to zero.
Note that if the partnership had distributed the property to Ed first, and then distributed the cash in a separate transaction, he would have taken a $25,000 tax basis in the property, reducing his tax basis in the partnership interest to $3,000. He would then have recognized $5,000 on receipt of the subsequent distribution of the cash ($8,000 cash received less $3,000 tax basis in the partnership interest). It is important for both the partner and the partnership to recognize the importance of planning partnership distributions.
KNOWLEDGE CHECK
3. Perry is a partner in PLT Partners. His basis in his partnership interest is $23,000. In a non-liquidating distribution, Perry received a distribution of $15,000 cash and property 1 (tax basis of $30,000 and of $62,000). The distribution was not a disproportionate distribution, and the provisions of Sections 704(c) and 707 do not apply. Whatwill be Perry's tax basis in property 1 received from the partnership?
a. $23,000.
b. $30,000.
c. $62,000.
d. $8,000.
Finally, recall that a reduction in a partner's share of partnership liabilities is treated as a cash distribution under Section 752(b). Thus, where a partnership property distribution reduces the partner's interest in partnership liabilities, determining the tax consequences of the distribution requires the partner to account for the reduction in liabilities in addition to the receipt of property from the partnership. As in example 5-4, the deemed cash distribution arising from the reduction in the partner's share of debt is accounted for before accounting for the property distribution.
Example 5-6
Norma was a 25 percent partner in Peoria Partners until December when she received a property distribution in partial redemption of her interest in the partnership. Prior to receipt of the distribution, Norma's tax basis in her partnership interest was $50,000, consisting of her $20,000 capital investment in the partnership and her $30,000 share (25 percent) of partnership debt. (Assume the partnership's outstanding liabilities total $120,000.)
She received a distribution of property with a tax basis of $36,000 and a fair market value of $75,000. The property was not encumbered by debt. Assume that in connection with the distribution, Norma's interest in partnership capital, profits, and liabilities was reduced to 10 percent. Thus, in addition to the property, Norma must account for the reduction in her share of partnership liabilities from $30,000 (25 percent of $120,000) to $12,000 (10 percent of $120,000). As discussed previously, this reduction is treated as a cash distribution from the partnership to Norma, and must be accounted for before determining Norma's basis in the property.
The deemed cash distribution of $18,000 ($30,000 – $12,000) will reduce Norma's tax basis in her partnership interest to $32,000 ($50,000 original tax basis less $18,000 deemed cash distribution). Rather than taking a carryover basis in the property received from the partnership (which would be $36,000), her basis in the property will be limited to her remaining basis in the partnership interest ($32,000). Her basis in her partnership interest will be reduced to zero.
KNOWLEDGE CHECK
4. Until last month, Carlos was a partner in CLR Partners. His basis in his partnership interest was $23,000—consisting of the $15,000 balance in his capital account and his $8,000 share of partnership liabilities. In a liquidating distribution, Carlos received a distribution of property 1 (tax basis of $30,000 and fair market value of $62,000). The distribution was not a disproportionate distribution, and the provisions of Sections 704(c) and 707 do not apply. Whatwill be Carlos' tax basis in property 1 received from the partnership?
a. $15,000.
b. $23,000.
c. $62,000.
d. $30,000.
Thus, to recap the basic distribution rules, partners generally do not recognize gain or loss on receipt of a distribution from a partnership or LLC. Instead, any gain realized on the distribution is deferred and built into the tax basis of the property(ies) received in the distribution. As a result, understanding the rules determining the partner's tax basis in distributed property is very important. Although these rules are relatively straightforward, they become more complex when multiple properties are included in a single distribution.
Distribution of Multiple Properties
Allocation of basis among multiple assets follows a basic set of ordering rules. Basis is first allocated to cash, then to ordinary income assets, and then to other assets. This hierarchy of ordering rules ensures that capital gain realized on the distribution is not converted to ordinary income when distributed properties are subsequently sold. For example, if a partner receives a distribution consisting of both ordinary income property and capital gain property, he or she is allocated a carryover basis in the ordinary income property (equal to the partnership's basis in such property) before basis is allocated to the capital gain property. As a result, any increase or decrease to the basis of any of the properties received in the distribution is allocated to the capital gain assets first. If the partner still needs to reduce basis in distributed property to avoid recognition of income, the basis of ordinary income property received in the distribution will be reduced only after the basis of capital gain property (or Section 1231 property) has been reduced to zero.
Example 5-7
Jill is a partner in Oak Motte Partners. Her tax basis in her partnership interest is $24,000. She received a non-liquidating distribution consisting of $5,000 cash, inventory with a tax basis of $10,000 and a fair market value of $20,000, and capital gain property with a tax basis of $13,000 and a fair market value of $36,000. She recognizes no gain on the sale and determines her tax basis in the cash and properties received as follows:
| Pre-distribution tax basis in partnership interest | $ 24,000 |
| Less: cash received | (5,000) |
| Less: carryover basis in inventory received | (10,000) |
| Remaining basis in partnership interest | $ 9,000 |
Jill's tax basis in the capital gain property will be equal to the lesser of her $9,000 remaining basis in the partnership interest or the carryover basis of the property ($13,000). Thus, her tax basis in the capital gain property will be limited to $9,000. Note that the result of these ordering rules is that the entire step-down in the basis of the distributed assets in Jill's hands is allocated to the capital gain property.
A different problem arises when the distributee-partner receives multiple assets in the same class, and the aggregate basis of these assets must be increased or decreased under Section 732. The question then becomes how to allocate the basis adjustment among the assets received.
Example 5-8
J is a one-third partner in the JDR Partnership. Her basis in her partnership interest is $20,000. In December, J received a distribution from the partnership consisting of the following assets:
| Tax Basis | FMV | |
| Cash | $ 5,000 |
$ 5,000 |
| Inventory | 8,000 |
12,000 |
| Capital asset 1 | 12,000 |
22,000 |
| Capital asset 2 | 10,000 |
11,000 |
$ 35,000 |
$ 50,000 |
J cannot take a carryover basis in all these assets because her outside basis in her partnership interest, $20,000, is less than the aggregate carryover basis of the assets received, $35,000. Thus, the question becomes how to allocate the $20,000 aggregate basis she will take in these assets to the individual assets received. Under Section 732, J must first reduce her basis in the partnership by the $5,000 cash portion of the distribution. She will then allocate $8,000 to the inventory. The remaining $7,000 must be allocated between capital assets 1 and 2.
In situations like the one illustrated in example 5-8, the process by which a reduction in basis is allocated among multiple assets is a function of both the tax basis (to the partnership) and the fair market value of the affected properties. A series of steps must be followed in allocating a basis reduction among multiple assets received in a non-liquidating distribution.
DECREASE IN BASIS OF UNREALIZED RECEIVABLES AND/OR INVENTORY
Under the ordering rules, outside basis is first allocated to cash distributed. Outside basis is then allocated to unrealized receivables and inventory to the extent of the partnership's basis in these assets.2 If there is insufficient outside basis to cover the unrealized receivables and inventory, the shortage is allocated first to assets having unrealized depreciation, resulting in a decreased basis for these assets. If the reduction in basis is smaller than the total amount of unrealized depreciation inherent in the distributed assets, the available reduction is allocated to the properties in proportion to their respective amounts of unrealized depreciation.
Example 5-9
Q is a one-third partner in the QLR Partnership. Her outside basis in her partnership interest is $20,000. Q receives a distribution consisting of cash, unrealized receivables and inventory as follows. Assume that the distribution does not change Q's interest in partnership ordinary income assets.
| Tax Basis | FMV | Difference | |
| Cash | $ 2,000 |
$ 2,000 |
$ — |
| Accounts Receivable | 12,000 |
10,000 |
(2,000) |
| Inventory | 10,000 |
4,000 |
(6,000) |
$ 24,000 |
$ 16,000 |
$ (8,000) |
Q cannot take a carryover basis in the assets received from the partnership, because the aggregate basis of these assets ($24,000) exceeds her basis in her partnership interest ($20,000). Her aggregate basis in the distributed assets is limited to $20,000.
Again, she first reduces her outside basis by the $2,000 cash portion of the distribution.
She then allocates the remaining $18,000 basis between the receivables and inventory. Since these assets had an aggregate basis to the partnership of $22,000, the task is to divide the remaining ($4,000) reduction in basis between them. This amount is allocated in accordance with the relative amounts of excess of basis over fair market value inherent in the two assets.
Thus, 2/8 of the excess (1,000) will be allocated to the receivables and 6/8 (3,000) to the inventory. Q will thus take an $11,000 basis ($12,000 – $1,000) in the receivables, and a $7,000 basis ($10,000 – $3,000) in the inventory.
When the reduction in basis exceeds the aggregate unrealized depreciation inherent in the distributed properties, the reduction is first allocated to those properties with unrealized depreciation, until their basis equals their respective fair market value. The remainder is then allocated among all remaining properties in proportion to their remaining basis (as adjusted in the preceding sentence). If there are no properties with unrealized depreciation, the basis reductions will be allocated based on the properties' separate basis.
Example 5-10
R is a one-half partner in the RW Partnership. His basis in his partnership interest is $14,000. He receives a distribution of cash, unrealized receivables and inventory as follows. The distribution does not alter his interest in partnership “hot” assets.
| Tax Basis | FMV | Difference | |
| Cash | $ 2,000 |
$ 2,000 |
$ — |
| Accounts Receivable | 10,000 |
8,000 |
(2,000) |
| Inventory | 10,000 |
5,000 |
(5,000) |
$ 22,000 |
$ 15,000 |
$ (7,000) |
R's basis in the distributed property, in the aggregate, is limited to his outside basis in his partnership interest of $14,000. This basis is first reduced by the $2,000 cash distribution received. The remaining $12,000 is allocated to the unrealized receivables and inventory, requiring a total reduction in basis of $8,000. This $8,000 reduction, in turn, is first allocated between the two assets in accordance with the unrealized depreciation inherent in each: $2,000 to the receivables and $5,000 to the inventory. The remaining $1,000 reduction in basis is then allocated between the two assets in proportion to their remaining basis. Thus, 8/13 of this reduction ($615) is allocated to the receivables, and 5/13 ($385) is allocated to the inventory. R's total basis in the receivables will be $7,385 ($10,000 – $2,000 – $615). His total basis in the inventory will be $4,615 ($10,000 – $5,000 – $385).
DECREASE IN BASIS OF OTHER ASSETS
Where the partner's outside basis in the partnership interest exceeds the amount of cash and the basis of inventory and receivables received, but is insufficient to cover the aggregate tax basis of all assets received, the necessary reduction is allocated to capital assets. If multiple capital assets are received, the allocation process follows the same process described previously. First, the reduction is allocated to those properties which have unrealized depreciation, to the extent thereof. If the reduction is less than the total unrealized depreciation, it is allocated among those properties with unrealized depreciation in proportion to the relative amounts thereof. If the reduction exceeds the aggregate amount of unrealized depreciation inherent in the distributed properties, the remainder is allocated in proportion to the properties' remaining basis.
It is important to note, however, that the ordering provisions described previously continue to apply. That is, basis is first allocated to cash, then to unrealized receivables and inventory to the extent of their basis to the partnership, and finally, to other assets. If the partner's outside basis exceeds the amount of cash and the basis of ordinary income assets received, any reduction in basis required under Section 732(a)(2) will be applied solely to the remaining other assets, even if the ordinary assets contain unrealized depreciation. This requirement is necessary to preserve the character of the partner's share of partnership unrealized loss inherent in the distributed ordinary income assets.
Example 5-11
Elise is a partner in KidSmart Partners. Her basis in her partnership interest is $35,000. She receives a distribution of cash, inventory, and capital assets as follows. The distribution does not alter her interest in partnership “hot” assets.
| Tax Basis | FMV | Difference | |
| Cash | $ 2,000 |
$ 2,000 |
$ — |
| Inventory | 20,000 |
12,000 |
(8,000) |
| Capital asset 1 | 15,000 |
20,000 |
5,000 |
| Capital asset 2 | 10,000 |
5,000 |
(5,000) |
$ 47,000 |
$ 39,000 |
$ (8,000) |
Although the aggregate basis of the cash and property received by Elise is $47,000, her basis in those assets is limited to $35,000 under Section 732(a)(2). Thus, in the aggregate, a reduction in basis of ($12,000) must be allocated to the assets received. Under Section 732, her $35,000 outside basis must first be reduced by the $2,000 cash portion of the distribution. Next, she allocates $20,000 of her remaining basis to the inventory, notwithstanding the fact that it has declined in value to $12,000. Her remaining basis of $13,000 must then be allocated between capital assets 1 and 2, requiring a total basis reduction in these assets of ($12,000). The first ($5,000) of this basis reduction is applied to capital asset 2, reflecting the unrealized depreciation inherent in that asset. No reduction is applied to capital asset 1 at this point because it has no unrealized depreciation. The remaining ($7,000) of the required reduction, however, is allocated between both assets, in proportion to their remaining basis. (The total basis of the two assets is now $15,000 + $5,000 = $20,000). Thus, 15/20 of this ($7,000) reduction ($5,250) will be applied to capital asset 1. The remaining 5/20 ($1,750) will be applied to capital asset 2. Elise's final basis in the assets received would be as follows:
| Cash | $ 2,000 |
| Inventory | 20,000 |
| Capital asset 1 ($15,000 -$5,250) | 9,750 |
| Capital asset 2 ($10,000 -$5,000 – $1,750) | 3,250 |
$ 35,000 |
KNOWLEDGE CHECK
5. Amy is a partner in Xiowa Partners. Her basis in her partnership interest is $69,000. In a non-liquidating distribution, Amy received three properties. Property 1 was worth $40,000 and had a tax basis of $30,000. Property 2, valued at $15,000, had a tax basis of $23,000. Property 3 was worth $35,000 and had a tax basis of $22,000. The distribution was not a disproportionate distribution and the provisions of Sections 704(c) and 707 do not apply. How much gain must Amy recognize on receipt of the non-liquidating distribution?
a. $0.
b. $70,000.
c. $31,000.
d. $21,000.
6. In the previous question, what would be Amy's aggregate basis in the three properties received from Xiowa Partners?
a. $69,000.
b. $75,000.
c. $90,000.
d. $88,000.
7. In the previous question, what will be Amy's tax basis in property 2 received from Xiowa Partners?
a. $15,000.
b. $17,000.
c. $23,000.
d. $22,000.
8. Keith is a partner in Cellar Dweller Partners. His tax basis in his partnership interest is $42,000. He receives two tracts of land in a non-liquidating distribution from the partnership. The first tract has a tax basis of $30,000 and a fair value of $50,000. The second tract is worth $30,000, with a tax basis of $20,000. The distribution is not disproportionate and does not trigger the provisions of either Section 704(c) or Section 707. What portion of the resulting $8,000 step-down in basis will be allocated to the second tract?
a. $4,000.
b. $3,200.
c. $3,000.
d. $0.
LIQUIDATING DISTRIBUTIONS
Different rules apply when a partner receives property other than cash in a liquidating distribution. In this case, assuming no gain or loss is recognized on the liquidation, the partner's basis in properties received, in the aggregate, is equal to his or her outside basis in the partnership interest, regardless of the partnership's basis in the distributed properties.3 Thus, in contrast to a non-liquidating distribution, in which any necessary adjustment to the basis of properties received from the partnership will only be negative,4 the basis of properties received in a liquidating distribution may be either increased or decreased.
Example 5-12
Rebecca's outside basis in her partnership interest is $25,000. In complete liquidation of that interest, she receives property with an aggregate fair market value of $50,000, and an aggregate basis to the partnership of $17,000. Under Section 732(b), Rebecca's aggregate basis in the assets received will be $25,000, notwithstanding the fact that the aggregate basis of these properties to the partnership was only $17,000. (Had the partnership's basis in the distributed properties been $37,000, Rebecca would still take an aggregate basis of $25,000.)
The rationale for the substitute basis requirement of Section 7 32(b) is that the partner's remaining outside basis in the partnership interest must be zero after the distribution, since the partnership interest no longer exists. Thus, the entire pre-distribution outside basis must be assigned to the property or properties received in the liquidating distribution.
The procedure for allocating any necessary increase or decrease in basis among the assets received in a liquidating distribution is similar to that described previously. Indeed, where the application of Section 732(b) requires a reduction in the basis of assets received in the liquidating distribution, the process is identical to that described previously. See examples 5-10, 5-11, and 5-12. Where an increase, rather than a decrease, in basis is required, the process mirrors that described previously.
KNOWLEDGE CHECK
9. R is a one-third partner in the RW Partnership. His basis in his partnership interest is $14,000. He receives a liquidating distribution consisting of cash, inventory, and capital assets as follows. The distribution does not alter his interest in partnership “hot” assets and does not trigger the provisions of Sections 704(c) or 707.
| Tax Basis | FMV | |
| Cash | $ 2,000 |
$ 2,000 |
| Inventory | 10,000 |
25,000 |
| Capital asset | 10,000 |
13,000 |
$ 22,000 |
$ 40,000 |
What basis will R take in the capital asset?
a. $0.
b. $2,000.
c. $10,000.
d. $13,000.
10. Z is a 20 percent partner in the EZ Partnership. His basis in his partnership interest is $30,000. He receives a liquidating distribution consisting of cash and capital assets as indicated in the following table. The distribution does not alter his interest in partnership “hot” assets and does not trigger the provisions of Sections 704(c) or 707.
| Tax Basis | FMV | |
| Cash | $ 2,000 |
$ 2,000 |
| Capital asset | 18,000 |
13,000 |
$ 20,000 |
$ 15,000 |
What is Z's deductible loss on receipt of the liquidating distribution?
a. ($15,000).
b. ($5,000).
c. $0.
d. ($10,000).
11. Jamie was a partner in New Deal Partnership until December 31, when she received a liquidating distribution of cash, unrealized receivables, and inventory as indicated in the following table. The distribution did not alter her interest in partnership “hot” assets.
| Tax Basis | FMV | |
| Cash | $ 5,000 |
$ 5,000 |
| Receivables | 20,000 |
25,000 |
| Inventory | 18,000 |
20,000 |
Jamie's basis in her partnership interest prior to the distribution was $45,000. What basis willjamie take in the accounts receivable?
a. $0.
b. $20,000.
c. $25,000.
d. $22,000.
ALLOCATING AN INCREASE IN BASIS AMONG MULTIPLE PROPERTIES: ORDINARY VERSUS “OTHER” ASSETS
Again, in a case where the basis of distributed property must be increased, the ordering rules require that outside basis first be reduced by the cash portion of the distribution.5 Any remainder is then applied to unrealized receivables or inventory to the extent of the partnership's basis in those assets, with any remainder beyond that being allocated to other assets. Under Section 732(c), the partner cannot take a basis in unrealized receivables or inventory greater than the partnership's basis in those assets. If the partner receives no assets other than cash, unrealized receivables and/or inventory, any excess of his or her outside basis in the partnership interest over the partnership's basis in these as sets is charged as a loss.
Example 5-13
Lynn was a partner in Pheasant Ridge Partnership until December 31, when she received a liquidating distribution of cash, unrealized receivables and inventory as indicated in the following table. The distribution did not alter her interest in partnership “hot” assets.
| Tax Basis | FMV | |
| Cash | $ 2,000 |
$ 2,000 |
| Receivables | 10,000 |
18,000 |
| Inventory | 15,000 |
20,000 |
$ 27,000 |
$ 40,000 |
Prior to the liquidation, Lynn's basis in her partnership interest was $30,000. Under the general rule of Section 732(b), Lynn would take a substitute basis of $30,000 in the distributed properties. However, pursuant to Section 732(c), she cannot take a basis in the receivables or inventory greater than the partnership's basis in those assets. Thus, under Section 731(a)(2), she is required to recognize a loss (capital in nature) of ($3,000), the amount by which her basis in her partnership interest exceeds the amount of cash and basis of the receivables and inventory which constituted the sole assets received in the liquidating distribution.
Note that if the partner receives any property other than cash, receivables or inventory, he or she cannot recognize a loss under Section 731(a)(2). Instead, pursuant to Section 732(b), the basis of such other property is increased to reflect the partner's remaining outside basis in the partnership interest after the allocation to cash and ordinary income assets. Thus, in example 5-13, had Lynn received any other asset(s), she would have taken a $3,000 basis in that asset(s) and no loss would have been recognized. Essentially, this prevents the avoidance of the recognition of ordinary income on a later sale by increasing the basis of distributed ordinary income assets.
ALLOCATING AN INCREASE IN BASIS AMONG MULTIPLE “OTHER” ASSETS
As noted previously, any basis increase required under Section 732(b) is allocated solely to capital assets. Allocation of this increase among multiple assets requires consideration of both the basis and fair market value of the affected assets.
The rules governing the allocation of basis increases among multiple capital assets mirror those governing the allocation of basis decreases. First, the basis increase is allocated to those assets which have unrealized appreciation to the extent of such unrealized appreciation. If the basis increase is less than the aggregate amount of unrealized appreciation inherent in the distributed assets, the increase is allocated among all appreciated assets in proportion to the amount of appreciation inherent therein
Example 5-14
Jordan was a partner in the CB partnership until his interest was liquidated. In liquidation of his entire interest, Jordan received a distribution of cash, unrealized receivables, and capital and Section 1231 assets as follows. The distribution did not alter his interest in partnership “hot” assets. Moreover, assume that capital is a material income-producing factor in the partnership.
| Tax Basis | FMV | Difference | |
| Cash | $ 2,000 |
$ 2,000 |
$ — |
| Section 179 property (original cost $18,000; fully expensed under Section 179) | − |
18,000 |
18,000 |
| Capital asset 1 | 9,000 |
11,000 |
2,000 |
| Capital asset 2 | 16,000 |
19,000 |
3,000 |
$ 27,000 |
$ 50,000 |
$ 23,000 |
Jordan's basis in his partnership interest prior to the liquidating distribution was $30,000. Under Section 732(b), this becomes his aggregate basis in the assets received from the partnership. First, his outside basis is reduced by the $2,000 in cash received. Next, he allocates 0 basis to the Section 179 property, since that is the basis of such property to the partnership. Thus, the remaining $28,000 of basis must be allocated to capital assets 1 and 2. This amount exceeds by $3,000 the basis of these assets to the partnership. This excess must be allocated between the two capital assets.
Under the allocation rules, the first $5,000 of basis increases will be allocated in accordance with the unrealized appreciation inherent in each asset ($2,000 in capital asset 1 and $3,000 in capital asset 2). Since the total increase to be allocated is less than the total amount of unrealized appreciation inherent in the assets, the increase must be allocated pro rata in accordance with the relative amounts of unrealized appreciation inherent in each asset. Thus, 2/5 of the ($3,000) increase ($1,200) is allocated to capital asset 1 and 3/5 ($1,800) to capital asset 2. Jordan's basis in capital asset 1 will be thus $10,200 ($9,000 + $1,200). His basis in capital asset 2 will be $17,800 ($16,000 + $1,800).
Where the basis increase to be allocated to capital assets exceeds the aggregate unrealized appreciation inherent in those assets, the increase is first allocated to those assets with unrealized appreciation to the extent thereof. Remaining basis is then allocated among all capital assets received in proportion to their respective fair market values (which now equal their basis). This rule is the mirror image of that applied to allocate a basis reduction that exceeds the aggregate amount of unrealized depreciation inherent in affected assets.
Example 5-15
Myra received a liquidating distribution from her partnership consisting of cash, inventory and Section 1231 and capital assets as follows. Capital is a material income-producing factor for the partnership. The distribution did not alter her interest in partnership “hot” assets.
| Tax Basis | FMV | Difference | |
| Cash | $ 2,000 |
$ 2,000 |
$ — |
| Inventory | 10,000 |
20,000 |
10,000 |
| Capital asset 1 | 15,000 |
19,000 |
4,000 |
| Capital asset 2 | 10,000 |
16,000 |
6,000 |
$ 37,000 |
$ 57,000 |
$ 20,000 |
Myra's outside basis in her partnership interest prior to the liquidation was $50,000. This will be her aggregate basis in the assets received pursuant to Section 732(b). The first $2,000 of this basis is allocated to the cash received. The next $10,000 is applied to inventory. The remaining $38,000 is applied to capital assets 1 and 2, requiring an increase in their basis of $13,000.
The first $10,000 of this $13,000 increase is applied to eliminate the unrealized appreciation inherent in these two assets: $4,000 of the increase is applied to capital asset 1 and $6,000 to capital asset 2. These adjustments increase the basis of these assets to $19,000 and $16,000, respectively. The remaining $3,000 increase in basis is then apportioned between the two assets in accordance with their relative fair market values. Thus, 19/35 of this amount ($1,629) is allocated to capital asset 1, and 16/35 ($1,371) to capital asset 2. Myra's total basis in these assets ($20,629 and $17,371, respectively) thus exceeds their values, even though Myra also received inventory as part of the distribution, which still contains unrealized (built-in) appreciation.
KNOWLEDGE CHECK
12. Vicki is a 20 percent partner in the Arnold-Sutton Partnership. In September, when her basis in her partnership interest was $60,000, she received a liquidating distribution consisting of the following assets:
| Tax Basis | FMV | |
| Cash | $ 3,000 |
$ 3,000 |
| Capital asset 1 | $ 24,000 |
$ 24,000 |
| Capital asset 2 | $ 24,000 |
$ 48,000 |
| Totals | $ 51,000 |
$ 75,000 |
What basis will Vicki take in capital asset 1 received from the partnership?
a. $33,000.
b. $28,500.
c. $24,000.
d. $27,000.
13. In the previous question, what basis will Vicki take in capital asset 2?
a. $24,000.
b. $33,000.
c. $48,000.
d. $28,500.
Summary
When a partner receives a distribution of property, his or her basis in the asset(s) received depends on the nature of the distribution. For nonliquidating distributions, the partner generally takes a carryover basis in the asset(s) received, limited to his or her basis in the partnership interest. As a result of this limitation, partners often take a lower basis in distributed partnership property than the partnership had in that property. In such cases, allocation of the basis decrease is computed by reference to both the basis and fair market values of the properties involved. Thus, these rules place significant importance on accurate appraisal of the values of distributed assets, and may therefore inject additional uncertainty into the measurement of subsequent gains and losses (or depreciation deductions) in some situations.
In contrast, where a partner receives a distribution of property from the partnership in liquidation of his or her interest therein, the aggregate basis of the distributed properties will be equal to the basis of the partnership interest just prior to receipt of the distribution. In such cases, the partner may take an increased or decreased basis in the distributed property. Again, allocation of the increase or decrease in basis among multiple properties is a function of both the basis and the fair market values of the properties received. Thus, practitioners should carefully consider potential partnership distributions for planning opportunities.