American Jobs Creation Act and Partnership Basis Adjustments
Philip F. Strassler, Keith M. Blitzer, Benjamin Levy, and
Jean Paul Schwarz
2006 - The American Jobs Creation Act of 2004 (AJCA), which
was signed into law on October 22, 2004, made significant
changes to a variety of partnership provisions to prevent
partners from shifting losses to new or existing partners.
The AJCA focuses on three types of partnership transactions:
contributions of property to partnerships, transfers of
partnership interests, and distributions of partnership
property. These changes increase the administrative burden
on partnerships that must now track basis adjustments that
were previously elective.
of Properties with a Built-in Loss
of property are generally nontaxable to both the partner
and the partnership. The partnership takes a carryover basis
in the contributed property, and the contributing partner
increases its basis in the partnership interest by the tax
basis of the contributed property. Using this set of rules,
a partner and a partnership have been able to shift losses
from the partner contributing “built-in loss”
property to the other partners.
example, under the pre–October 22, 2004, rules, a
partner was able to contribute property to a partnership
with a basis of $10,000 but a fair market value (FMV) of
$5,000, and take a $10,000 basis in his partnership interest,
and the partnership’s basis in the contributed property
would be $10,000. If the partnership was to liquidate the
contributing partner’s interest with other property,
the partner would take a basis in the property distributed
to him equal to his basis in the partnership ($10,000),
and the partnership would then have property with a $10,000
basis and a $5,000 FMV. A subsequent sale of the contributed
property would result in a $5,000 loss to the partnership,
allocated to the partners other than the contributing (liquidated)
AJCA changed these rules to stop a partner from transferring
a built-in loss (tax basis exceeds FMV) on contributed property
to noncontributing partners. Under the AJCA, built-in loss
may only be taken into account by the contributing partner,
and the tax basis of the partnership in the contributed
property is limited to FMV at the time of contribution.
This is done on a property-by-property basis without any
de minimus exclusion. In the event that the contributing
party’s interest in the partnership is transferred
or redeemed, the partnership’s basis in the contributed
property will be based on the FMV of the property at the
time of contribution. The built-in-loss is eliminated for
the continuing noncontributing partners.
the same example under post–October 22, 2004, rules,
the basis to the partnership of the contributed property
will be $5,000, its FMV at the time of contribution, thereby
eliminating the transfer of the loss to the noncontributing
of Partnership Interest with a Substantial Built-in Loss
AJCA added a new tax provision targeted to prevent creating
or accelerating tax losses that take advantage of the partnership
basis adjustment rules.
to the AJCA, partnership tax adjustments, commonly known
as “Section 754 Basis Adjustments,” were elective,
because of the substantial administrative burdens that partnerships
must incur in making and accounting for these adjustments.
In addition, once a partnership made an IRC section 754
election, all future partnership transfers required the
appropriate adjustments to the tax basis of partnership
AJCA requires mandatory basis adjustments upon the transfer
of a partnership interest after October 22, 2004, by sale
or exchange or upon the death of a partner, if, at the time
of the transfer, the partnership’s tax basis in its
assets exceeds the FMV of its assets by more than $250,000
(substantial built-in loss). If the partnership is an “electing
investment partnership” or a “securitization
partnership,” then these basis adjustments do not
partnership” is defined as any partnership whose sole
business activity is to issue securities that provide for
a fixed principal amount and which is primarily serviced
by the cash flows of a discrete pool of receivables or other
financial assets. The exact definition of an “electing
investment partnership” is beyond the scope of this
article, but can be broadly understood as an electing partnership
that has never been engaged in a trade or business, that
holds substantially all of its assets for investment, substantially
all of whose contributed assets are money, and none of whose
contributed assets had an adjusted tax basis in excess of
FMV. The testing as to whether the partnership has a substantial
built-in loss is done on an aggregate basis, rather than
asset by asset.
the new basis adjustment rules apply for transfers, the
partnership is required to adjust the tax basis of all partnership
assets to FMV for the new partner’s interest and keep
a separate accounting of those adjustments. The objective
of these rules is to prevent the new partner from sharing
in the substantial built-in loss in the partnership assets
at the time of the transfer. The mandatory adjustments and
accounting are required for each transfer of a partnership
interest where a substantial built-in loss is present, a
significant record-keeping burden for the partnership.
AJCA also provides authority for the IRS to issue regulations
regarding a partnership’s acquisition of property
in an attempt to sidestep the rules regarding substantial
of Appreciated Property in Full Redemption of a Partner’s
that completely redeems a partnership interest computes
the gain or loss on the partnership interest by taking the
difference between the redemption proceeds and its tax basis
in the partnership. Loss is not recognized unless the partner
receives only money, unrealized receivables, or inventory
in the distribution. Gain is not recognized unless money
distributed exceeds the tax basis of the partnership interest.
Most hedge fund partnership agreements allow for the general
partner to make an in-kind distribution to redeem a partnership
interest. The property that the partner receives in the
redemption would have a tax basis equal to its tax basis
in the partnership (which does not include unrealized appreciation
or depreciation) before the redemption, reduced by any cash
received in the redemption. In essence, the partner is not
taxed on the unrealized gain. This gain is taxed when the
property is disposed of. The AJCA does not charge the tax
treatment to the redeeming partner as described above.
to the AJCA, a partnership’s unrealized appreciation
in the shares distributed in full redemption would not have
been taxed to the remaining partners, because this unrealized
gain would have been removed from the partnership. Accordingly,
unless the partnership had made an IRC section 754 election
to adjust the basis of partnership property, the remaining
partners would not have been taxed on that appreciation
until they left the partnership or the partnership liquidated.
There were significant tax benefits to both the redeeming
partners and the remaining partners if this appreciated
property distribution technique was employed.
AJCA requires the tax basis of the remaining assets of the
partnership to be reduced upon redemption of an interest
where a “substantial basis reduction” occurs.
A substantial basis reduction occurs when either the distributing
partner recognizes a loss in excess of $250,000 upon the
redemption, or the redeeming partner receives property in
whose hands the tax basis is more than $250,000 greater
than in the hands of the partnership at the time of the
distribution. In this case, the partnership will reduce
the tax basis of the remaining assets in the partnership
by the amount of the redeeming partner’s recognized
loss, or by the step-up in basis that the redeeming partner
receives in the distributed property.
may utilize the “gain stuffing” or “fill-up
provision” of its partnership agreement as an alternative
to distributing appreciated securities in kind to a retiring
partner. Using such a provision, the retiring partner would
be specially allocated capital gains of the partnership
so as to reduce the amount of gain realized by the partner
upon the complete redemption of their partnership interest.
Examples of how these rules work are as follows:
1. Partner X requests a distribution in complete
redemption of an interest in Hedge Fund, L.P., on December
31, 2004. Partner X’s book capital account and tax
basis in the partnership are $2 million. Hedge Fund, L.P.,
distributes ABC Securities to Partner X in full redemption
of his interest in the partnership. ABC Securities has a
FMV of $2 million but costs only $1.75 million. At the date
of redemption, Partner X has $250,000 of unrealized gain
in the securities distributed. Partner X sells the securities
for $2 million.
this example, Partner X recognizes no gain on the sale of
ABC Securities; the sales proceeds of the securities, $2
million, equal the tax basis of ABC Securities, $2 million.
Hedge Fund, L.P., does not trigger any gain on the distribution
of ABC Securities and is not required to make any adjustment
to the tax basis of the other securities it owns, because
the difference between X’s tax basis in the partnership
($2 million) and the basis of the securities distributed
is not in excess of $250,000. The remaining Hedge Fund,
L.P., partners receive a $250,000 gain deferral on the $250,000
of unrealized appreciation.
2. Consider the same facts as example 1, except
that Partner X’s tax basis in Hedge Fund, L.P., is
$500,000. Partner X has an unrealized gain of $1.5 million
on his investment in the partnership. Hedge Fund, L.P.,
distributes EFG Securities to Partner X in full redemption
of his interest in the partnership. EFG Securities is worth
$2 million, but has a tax basis of $750,000. At the time
of the redemption, Partner X has an unrealized gain of $1.25
million in the securities distributed. Partner X sells EFG
Securities for $2 million.
this example, Partner X recognizes a gain of $1.5 million:
the proceeds of $2 million, minus the tax basis of the securities
of $500,000. Hedge Fund, L.P., does not trigger a tax on
the redemption and is not required to reduce the basis of
other securities it owns. The difference between Partner
X’s tax basis in the partnership of $500,000 and the
basis of EFG Securities distributed of $750,000 at the time
of the distribution does not exceed $250,000. The remaining
partners of Hedge Fund, L.P., receive a deferral of $1,250,000.
3. Partner X has a tax basis of $2 million
in Hedge Fund, L.P., and a capital account of $1.7 million.
Hedge Fund, L.P., distributes $1.7 million in cash to Partner
X in complete redemption of his partnership interest. Partner
X has a taxable loss on the redemption of his partnership
interest. Because all of the unrealized depreciation remains
in Hedge Fund, L.P., it holds a substantial amount of high–tax
basis depreciated securities. Hedge Fund, L.P., must reduce
the basis of those securities by $300,000, because there
was a substantial basis reduction upon the redemption of
order to avoid the need to make basis adjustments if a retiring
partner would realize a loss of more than $250,000 upon
the redemption of his partnership interest, “loss
stuffing” or “fill down” partnership provisions
can be used. In this example, the retiring partner would
be specifically allocated tax losses of the partnership
to reduce the amount of loss realized by the partner upon
the redemption of his partnership interests.
AJCA changes prevent the duplication of losses related to
partnership contributions, transfers of interest, and distributions.
Shutting the door on basis shifts will result in higher
administrative costs in tracking the new complex basis rules
that were formerly elective and infrequently used.
F. Strassler, CPA, is a partner; Keith M.
Blitzer, CPA, is a partner; Benjamin Levy,
CPA, JD, is a manager; and Jean Paul Schwarz,
JD, LLM, is a manager, all at Marcum & Kliegman’s
hedge fund/investment partnership group, New York, N.Y. They
can be reached at 631-414-4000 or 212-981-3000, as well as
more information, see www.mkllp.com.
This article has been adapted from Marcum & Kliegman LP’s
“Private Investment Form.”