The American Jobs Creation Act and Partnership Basis Adjustments

By Philip F. Strassler, Keith M. Blitzer, Benjamin Levy, and Jean Paul Schwarz

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Contribution of Properties with a Built-in Loss

Contributions 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.

For 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) partner.

The 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.

In 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 partners.

Transfer of Partnership Interest with a Substantial Built-in Loss

The AJCA added a new tax provision targeted to prevent creating or accelerating tax losses that take advantage of the partnership basis adjustment rules.

Prior 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 assets.

The 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 apply.

A “securitization 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.

If 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.

The 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 built-in losses.

Distribution of Appreciated Property in Full Redemption of a Partner’s Interest

A partner 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.

Prior 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.

The 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.

Planning Strategies

A partnership 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:

Example 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.

In 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.

Example 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.

In 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.

Example 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 Partner X.

In 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.

The 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.