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Partnership - Audit Technique Guide - Chapter 1 - Basic Principles (Rev. 3/2008)

LMSB-04-0208-007
Rev. 3/2008

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to either return to the Table of Contents or proceed to the next chapter.

Table of Contents  | Chapter 2

INTRODUCTION

The rules governing the federal taxation of partners and partnerships are intended to permit taxpayers to conduct joint business and investment activities through a flexible economic arrangement without incurring an entity-level tax.  In the landmark case of Commissioner v. Tower1, the Supreme Court stated that a partnership “is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.” 

Bona fide partnerships entail the joint contribution of capital or services for the purpose of carrying on a business or investment activity in which the partners share profits and losses.  Partnership taxation is primarily found in Subchapter K of the Internal Revenue Code of 1986.  Subchapter K was initially enacted as part of the Internal Revenue Code of 1954.

Unlike a C corporation, which is taxed as a separate entity, a partnership is not a taxpaying entity.  The partners report the partnership’s income, gain, loss, deductions, and credits on their own individual tax returns.

This chapter will cover basic concepts and definitions found in Subchapter K:

  • Overview
    • Contributions of property – General non-recognition rule
    • Inside Basis
    • Outside Basis
    • Capital Accounts
  • Aggregate and Entity Concepts
    • Taxable Year, Accounting Method, Elections
    • Partnership Operations
  • Liabilities
    • Definition
    • Partner’s Share of Recourse Liabilities
    • Partner’s Share of Nonrecourse Liabilities

OVERVIEW

Contributions of Property – General Non-Recognition Rule

The creation and operation of partnerships entails the contribution of money, property, or services by the partners to the partnership.  The contribution of services to a partnership in exchange for a partnership interest may be a taxable transaction (see Chapter 2).  The contribution of property to a partnership in exchange for a partnership interest generally receives tax favored treatment under IRC section 721. 

As a general rule, no gain or loss is recognized on the contribution of money or property to a partnership.  This is true whether the contributions take place upon formation or at a later date.  This general non-recognition rule provides partners a significant element of flexibility for property contributions.  In contrast, the contribution of property to a corporation is generally a recognition event unless the control requirements of IRC section 351 are satisfied.

When a partner contributes appreciated or depreciated property to a partnership, the property has an inherent built-in gain or built-in loss that accrued in the hands of the partner.  Property with built-in gain or built-in loss is referred to as “section 704(c) property”.  At the time of contribution, the section 704(c) property will have a tax basis that differs from its fair market value (FMV).  The property’s FMV at the time of contribution is referred to as its “book value”2.   Because of the IRC section 721 non-recognition rule, property with a built-in gain or built-in loss can be contributed to a partnership with no immediate tax consequence. 

Example 1-1

Dave and Donna form an equal partnership to operate an orchard.  Dave contributes $100,000.  Donna contributes land with a FMV of $50,000 and a tax basis of $10,000.  Donna also contributes equipment that has a FMV of $50,000 and a tax basis of $75,000.  Upon contributing the land and the equipment, Donna will not recognize any of the land’s $40,000 built-in gain or any of the equipment’s $25,000 built-in loss.

In the above example, the FMVs of the land and the equipment at the time of contribution are referred to as the “book value” or “book basis.”  In this example, the book bases of the two assets differ from their tax bases.  Note that Dave and Donna each contributed $100,000 of value to the partnership. 

Based on assignment of income principles, the built-in gain or loss inherent in contributed property will eventually be taxed to the contributor. 

Partnership Inside Basis

The partnership’s basis in its assets is known as “inside basis.”  In addition to contributions of property, the partnership may acquire property by means of purchase.  Generally, the partnership’s basis in contributed property is the same as the adjusted basis of the property in the hands of the contributing partner at the time of contribution3.  Similarly, the partnership has a holding period in the property which dates back to the contributor’s acquisition of the property4.

Example 1-2

Same facts as in Example 1-1.  The partnership’s tax basis in the contributed land will be $10,000.  The partnership’s tax basis in the contributed equipment will be $75,000.  The partnership’s holding period for the assets will be the same as Donna’s holding period.  The partnership’s aggregate basis in its assets totals $185,000 (cash, land, and equipment).  Therefore, the partnership’s inside basis is $185,000.


Partner’s Basis in the Partnership Interest – Outside Basis

A partnership interest is an item of property.  Like any other item of property, it has a basis for tax purposes.  A partner’s basis in his/her partnership interest is referred to as “outside basis.”  Upon formation of the partnership, a partner’s initial outside basis will generally equal the amount of money and the adjusted basis of property contributed.5   If the partner purchases his/her partnership interest, the outside basis will equal the purchase price.6   Additionally, a partnership interest may be acquired by means of an inheritance7  or a gift.8

Outside basis is made up of two components.  The first is the partner’s tax capital account and the second is the partner’s share of partnership liabilities.  Generally, the sum of the partners’ outside bases will equal the partnership’s inside basis in its assets.  This fundamental concept correlates to the balance sheet equation of Assets = Liabilities + Owners’ Equity.  In the partnership context, this can be thought of as
Assets = Liabilities + Partners’ Tax Capital Accounts.

Although inside basis generally equals total outside basis, some distributions of property from the partnership or transfers of partnership interests can disrupt this equality.  Through means of the IRC section 754 election, the partnership is able to make upward or downward adjustments to the basis of its assets in order to restore the normal equality in the balance sheet and thus recreate the equality between inside basis and total outside basis. 

Capital Accounts

Each partner’s equity in the partnership is reflected in a capital account.  It is important to distinguish between tax capital accounts, IRC section 704(b) book capital accounts, and book capital accounts which are based on generally accepted accounting principals (GAAP).  Below is a brief overview of capital accounts.  IRC section 704(b) book capital accounts are described in greater detail in Chapter 6.

Generally, book capital accounts reflect the FMV of assets at the time of contribution and distribution.  The book capital accounts thus accurately show the partners’ economic interests in the partnership and track their “business deal.”  In Example 1-1, Dave and Donna have contributed equally to the partnership.  Because Dave contributed cash to the partnership, his tax capital account and his book capital account are equal.  Donna’s capital accounts, however, reflect a book/tax disparity.

The partners’ book capital accounts can sometimes be increased or decreased with no tax consequences.  A revaluation of a capital account may be referred to as a “book-up” or “book-down.”  For example, the partners generally wish to restate their book capital accounts upon the admission of a new partner.  For business purposes, this permits them to document their ownership in the appreciation of partnership assets that accrued prior to the new partner’s admission.  For tax purposes, this would permit gain or loss inherent in the property at that point to be taxed to the partner to whom it is properly allocable, thus upholding the assignment of income doctrine.

Given the facts in Example 1-1, the partnership’s balance sheet upon formation is as follows:

Assets

Capital Accounts

 

Book

Tax

 

Book

Tax

Cash

100,000

100,000

 

 

 

Land  

 50,000

10,000

Dave

100,000

100,000

Equipment

50,000

75,000 

Donna

100,000

85,000

Totals

200,000 

185,000 

    

200,000

185,000

Upon formation, Dave has a basis in his partnership interest of $100,000, which is the amount of money he contributed to the partnership.  Donna has a basis in her partnership interest of $85,000, which is the adjusted basis of the property she contributed.  Dave and Donna’s economic arrangement – an equal partnership – is reflected in their book capital accounts, which both reflect the $100,000 of value they each contributed.

Note that in Example 1-1, the partnership has no liabilities.  IRC section 752(a) provides that a partner is treated as contributing money to the partnership to the extent his/her share of partnership liabilities increases or he/she assumes a partnership liability.9 Conversely, IRC section 752(b) provides that a partner is treated as receiving a distribution of money if his/her share of partnership liabilities decreases or if the partnership assumes any of his/her individual liabilities.10 Since a partnership may acquire assets by means of borrowed funds, IRC section 752 helps to create and preserve the equality between inside and outside basis.

Example 1-3

Dave and Donna, as equal general partners, determine that the partnership should borrow money in order to pay for the construction of a barn so that they can store Donna’s contributed equipment.  The barn will cost $60,000.  The partnership borrows the money from a bank and immediately has the barn constructed.  The balance sheet is as follows:

Assets 

Liabilities

 

Book

Tax

 

Book

Tax

Cash

100,000

100,000

Bank Loan      

60,000

60,000

Land

50,000

10,000

 

 

    

 

Capital Accounts 

Equipment

50,000 

75,000  

Dave

100,000

100,000

Barn

60,000 

60,000 

Donna

100,000

85,000

Totals

260,000

245,000 

 

260,000 

245,000

Since Dave and Donna are equal partners, IRC section 752(a) treats the $60,000 borrowing as if Dave and Donna had each contributed $30,000 to the partnership.  Dave’s basis in his partnership interest is now $130,000 (cash contributed of $100,000 plus $30,000 of debt share).  Donna’s basis in her partnership interest is $115,000 (land contributed of $10,000, equipment contributed of $75,000, plus debt share of $30,000).

The manner in which partners share the partnership’s liabilities is discussed later in this chapter.  Note in Example 1-4, that after the partnership borrowing, Dave and Donna’s aggregate bases in their partnership interests ($245,000) equals the partnership’s inside basis in its assets ($245,000).

Contributions of property followed close in time by a distribution of cash or other property may be part of a disguised sale transaction.  The classic example of a disguised sale is one in which appreciated property is contributed to a partnership, followed by a distribution of cash to the contributing partner.  Disguised sales are often complex and the examiner’s success in identifying such transactions will depend on careful factual development.  See Chapter 4 for more information on contributions that may be part of a disguised sale.

There is an exception to the general policy of non-recognition for contributions to a partnership that would be treated as an investment company.  See IRC section 721(b).

Subsequent Changes to Basis

As previously stated, a partnership interest is an item of property that has a tax basis. Following the initial calculation of basis upon acquisition of a partnership interest, the results of operating the partnership will increase or decrease a partner’s outside basis.

A basic concept of partnership taxation is that the partnership is not a separate taxpaying entity.  Each partner is required to report his/her distributive share of partnership income, gain, loss, deductions, and credits.  For example, an individual partner will include his/her “allocable share” of partnership income on his/her own tax return regardless of whether the partnership made an actual distribution of the money earned by the partnership.  Thus, it would be possible for a partner to include $1,000 of partnership income on his/her own tax return in Year One, but not receive a $1,000 distribution of cash until Year Two.

In order to be respected, allocations of income, gain, loss, deduction and credits must be done in accordance with the partners’ interests in the partnership or must have substantial economic effect.  Chapter 6 addresses partnership allocations.

Increases to Basis

IRC section 705(a)(1) provides that the basis of a partner’ partnership interest is increased by his/her distributable share of:

(A) Taxable income
(B) Tax exempt income
(C) Excess of the deductions for depletion over the basis of the property subject to depletion

Example 1-4

In Year One, Partner A receives an allocable share of $1,000 of partnership taxable income and $500 of partnership income that is exempt from tax.  The partnership makes no distributions.  Partner A’s capital account, and his basis in his partnership interest, is increased by $1,500.

In Year Two, the partnership distributes $1,500 to Partner A.  Partner A’s capital account and outside basis is decreased by $1,500.  Because of the previous basis increase, Partner A will not be subject to double taxation.

Example 1-5

Under IRC sections 611 and 613A, a taxpayer is permitted to deduct percentage depletion in excess of the adjusted basis of the depletable property.  Percentage depletion provides a tax benefit in that the depletion deduction does not reduce the basis of the asset.  A positive adjustment to the basis of the partnership interest puts the partner in the same position as if a direct interest were held in the depletable property.

Partner A owns an interest in an oil and gas partnership.  Partner A receives an allocable share of percentage depletion which reduces his basis in his partnership interest.  IRC section 705(a)(1)(C) increases his basis in his partnership interest by the same amount.  If Partner A’s basis was not increased, and he sold his partnership interest, he would realize more gain (or less loss) and thus the benefit of percentage depletion would be eliminated.  The IRC section 705(a)(1)(C) basis increase prevents this.

Decreases to Basis

IRC section 705(a)(2) provides that a partner’s partnership interest is decreased by distributions provided for in IRC section 733.  These distributions are:

(1) the amount of money distributed, and
(2) the partner’s amount of basis in property distributed.

Additionally, IRC section 705(a)(2) provides for the following decreases:

(A) Losses of the partnership;
(B) Nondeductible partnership expenditures which cannot be capitalized;
(C) Depletion.

Outside basis functions to ensure that over the partnership’s life, the partner does not withdraw more or less than his/her investment without a tax impact.  Both IRC sections 705(a)(2) and 733 indicate that basis cannot be reduced below zero.  A distribution of money to a partner in excess of his/her outside basis results in a gain under IRC section 731(a)(1).  In effect, the partner has received a distribution that “belongs” to another partner in the sense that the amount is reflected in another partner’s outside basis.

Example 1-6

Partnership ABC owns two assets, $3,000 of cash and stock with a FMV of $3,000 and a zero basis.  Each of the three partners has an outside basis of $1,000.  In complete liquidation of his partnership interest, Partner A receives a cash distribution of $2,000 in cash.  Partner A has economically received an appropriate amount in order to be cashed out of the total value of the partnership ($6,000).  For tax purposes, he has taken more than his share of the partnership’s cash.  The $2,000 cash distribution first reduces his basis by $1,000 under IRC section 705(a)(2) and IRC section 733, and then results in a $1,000 gain under IRC section 731(a)(1).

The IRC section 705(a)(2) stipulation that basis cannot be reduced below zero ties in with the limitation on a partner’s distributive share of loss under IRC section 704(d).  Under IRC section 704(d), a partner’s distributive share of loss is limited to his/her outside basis at the end of the partnership year in which the loss occurred.  The IRC section 704(d) limitation is discussed in Chapter 5.

The IRC section 705(a)(2)(B) reference to “expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account” bears further explanation.  Examples of this are:

  1. Charitable contribution deductions under IRC section 170;
  2. Losses, expenses, and interest disallowed between related parties under IRC section 267;
  3. Downward basis adjustments to the stock of a controlled foreign corporation (owned by the partnership) under IRC section 961(b);
  4. Premiums on life insurance contracts if not deductible under IRC section 264(a).

Example 1-7

The ABC Partnership has equal three partners.  The Partnership donates $60,000 to a qualified charitable organization.  The charitable donation is not deductible.  Each partner takes a $20,000 charitable contribution deduction into account in preparing his/her own tax return and each partner’s capital account (and his/her basis) is reduced by $20,000.  If partnership outside basis were not reduced by the nondeductible expenditure, a sale of the partnership interest would result a reduced gain (or increased loss) due to the higher basis.

It should be noted that losses and IRC section 705(a)(2)(B) expenditures can result in a negative balance in a partner’s capital account.  Assuming that the partner’s share of partnership liabilities is greater than his/her negative capital account, the partner will have a positive basis in his/her partnership interest.

AGGREGATE AND ENTITY CONCEPTS

A partnership can be viewed as a sum, or aggregate, of its individual partners.  Alternatively, a partnership can be viewed as having a tax personality separate and distinct from its individual partners, just as a C corporation has an identity separate from that of its shareholders.  Certain aspects of Subchapter K are governed by the "aggregate theory" which views the partnership as a collection of the partners.   In other instances, the entity theory governs and treats the partnership as a "taxpayer," even though it pays no tax.  For example, a partnership must adopt a taxable year and choose a method of accounting just as if it were a taxpayer.  Other aspects of the entity concept are briefly discussed below.

Elections

Elections come under the entity approach.   IRC section 703(b) lists three elections that will be made by each partner separately - all other elections must be made by the partnership.  The three elections that partners are to make individually are:

  1. Elections pertaining to exclusion of cancellation of debt income under IRC section 108;
  2. The IRC section 617 election to expense mining exploration expenditures;
  3. The election under IRC section 901 to deduct foreign taxes.

One of the most common partnership elections is the IRC section 754 election which permits the partnership to adjust the basis of its assets.

Profit Motive/Trade or Business

Profit motive is determined at the partnership level, and not at the level of the individual partners.  This means that questions concerning whether expenses are incurred in carrying on a trade or business within the meaning of IRC section 162(a) are addressed at the partnership level.

Character of Separately Stated Items

The entity theory governs the characterization of partnership income, gain, loss, deductions, and credits.  How the partner wishes to characterize these items has no relevance.

Although a partnership does not pay tax, the partnership computes taxable income and determines the character of the income, gain, loss, deductions and credits.  Items that could have a special significance to different taxpayers are separately stated under IRC section 702.  Treas. Reg. section 1.702-1(b) states that “the character in the hands of a partner of any item of income, gain, loss, deduction, or credit described in IRC section 702(a)(1) through (8) shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership.”  For example, capital gains and losses and charitable contributions are separately stated, since they could affect each partner differently, depending on the partner’s individual tax profile. 

Issue Identification

Determine if there was IRC section 704(c) property contributed to the partnership.  The book capital accounts and the tax capital accounts should reflect a different value for the contributed property.  The examiner may look to the outside basis computation, if it is more readily available, for the adjusted basis in the asset.  The examiner should verify the adjusted basis and the FMV of contributed property.

Review subsequent transactions to determine if the pre-contribution gain or loss should be recognized. It may be missing from a subsequent balance sheet or the Schedule M-2 may notate a distribution of property to a partner.  This could be a distribution of the IRC section 704(c) property to another partner or the distribution of other property to the contributing partner of the original IRC section 704(c) property.  There may be a disposition, a disguised sale, or a “mixing bowl” type of transaction that will all trigger gain recognition. Also, if the property was depreciable property, the separately stated depreciation deduction will not be present in subsequent Schedules K-1.

Review other types of contributions into the partnership.  Be aware that if Unrealized Receivables and Accounts Payable are contributed by a cash basis taxpayer to the accrual basis partnership, that when the partnership collects the receivables and pays the payables, the ordinary income and deduction are allocated to the contributing partner.  Accounts payable, under these circumstances, are not considered liabilities for purposes of IRC section 752.  Accounts payable contributed by an accrual basis taxpayer is considered a liability for purposes of IRC section 752.

Review the balance sheet for the type of assets held by the partnership.  If the partnership holds assets that are mostly stocks and securities, then gain may be recognized on the contributions.  Losses are not recognized.

Request the valuation method and appraisal for any property contributed to the partnership.  The valuation method used should be documented.  If a third party appraisal was not done, consider if there is a need to request the services of an IRS engineer to determine the FMV of the property at the time of contribution.

Request a copy of any promissory note contributed by a partner.

Examination Techniques

The examination techniques used should serve, in the end, to answer the following:

  • Does the Form 1065 balance sheet on Schedule L reconcile to the partnership books and records? Does it reflect FMV or adjusted basis?
  • Is the taxpayer maintaining book capital accounts according to the safe harbor rules under the substantial economic effect test in the 704 regulations? (See Chapter 6.)
  • Does it appear from a quick review of the Schedules K-1 that the partners have bases in their partnership interests?
  • Does it appear from the Schedule M-2 and Schedule K that there have been distributions of cash in excess of a partner’s basis?  If so, then gain must be recognized for the excess.
  • Does it appear from the Schedule M-2 and Schedule K that there was a property distribution?  If there was, then was there sufficient outside basis to reduce it by the full amount of the adjusted basis of the partnership asset?  If not and a substituted basis was used, then was the property later disposed of and the correct amount of gain reported on the partner’s return?  If there was a potential loss from the disposition, then was it disposed of to a related party?  If it was, then the loss rules under IRC section 267 apply and it must be deferred until the related party disposes of the property to an unrelated party.

Documents to Request

  1. Partnership agreement and all amendments.
  2. Partnership books and records (that is, working trial balance, depreciation schedules, income statements, balance sheets, general ledger, etc.).
  3. Prior and subsequent year partnership tax returns.
  4. Current year financial statements.
  5. Partnership book capital account calculations.
  6. Partner basis calculations (if the quick test reveals lack of basis).
  7. Copies of all loan documents including, but not limited to, promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees, and/or loan indemnification agreements.
  8. Calculations of adjusted basis in property contributed.
  9. Proof of ownership by the partnership in property contributed.

Interview Questions

  1. Is the balance sheet on the Form 1065 reflected at FMV or at adjusted basis?
  2. Does the partnership maintain book capital account workpapers?
  3. Does the Schedule M-2 reflect the book capital accounts?
  4. Were the assets reflected on the balance sheet on the Form 1065 contributed by the partners or purchased by the partnership?

ISSUE:  PARTNERSHIP LIABILITIES

A partner’s outside basis is made up of his/her tax capital account and his/her share of the partnership’s liabilities.  Therefore, determining a partner’s debt share is a critical component in determining the partner’s adjusted basis in his/her partnership interest.  The evaluation of certain tax shelters has focused on either the purported presence or the purported absence of a partnership liability.  Moreover, issues concerning liabilities are frequently encountered in disguised sale situations.

An increase in a partner’s share of partnership liabilities is considered to be a contribution of money by the partner to the partnership.  Conversely, a decrease in a partner’s share of partnership liabilities is considered to be a distribution of money to the partner by the partnership.  This deemed distribution of money may result in the recognition of gain under IRC section 731(a) or IRC section 751 if the amount of the distribution exceeds the partner’s adjusted basis in his/her partnership interest. 

When a partner contributes property subject to a liability to a partnership, two transactions are deemed to occur:  1) the partner is treated as having received a cash distribution equal to the entire liability assumed by the partnership11 and 2) the partner is treated as having made a cash contribution equal to his/her share of the partnership’s liabilities12.  These events are treated as having occurred simultaneously, resulting in a net deemed distribution or a net deemed contribution of money.  In the case of recourse debt, careful tax planning can ensure that a partner contributing debt-encumbered property will not realize an IRC section 731 gain.  In the case of nonrecourse debt, the rules operate to ensure that the contributing partner has sufficient basis to prevent an IRC section 731 gain.

A threshold question is whether a partnership liability actually exists.  The section 752 regulations were amended in 2005 to provide a definition for the term “liability”.  For transactions entered into after June 24, 2003, Treas. Reg. section 1.752-1(a)(4)(i) states that an obligation is a liability for purposes of IRC section 752 only if, when, and to the extent that incurring the obligation ---

(A) creates or increases the basis of any of the obligor’s assets (including cash)
(B) Gives rise to an immediate deduction to the obligor; or
(C) Gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital.

This definition is consistent with Revenue Ruling 88-77 which addressed the definition of partnership liabilities in the context of a cash basis partnership.  Additionally, in Revenue Ruling 95-26, a short sale of securities creates a partnership liability because it creates an obligation on the seller’s part to return the borrowed securities, and the cash received results in a basis increase to partnership assets. 

Treas. Reg. section 1.752-1(a)(4)(ii) defines the term “obligation” in the following manner:

An obligation is any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code.  Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps.

Rules for a new category of obligations, called “Reg. 1.752-7 liabilities” were issued in 2005.  The purpose of these regulations is to prevent taxpayers from duplicating or accelerating losses.  Only the partner from whom the partnership acquired the liability may claim a deduction to the extent of any built-in loss associated with the liability.  Reg. 1.752-7 liabilities are generally IRC section 704(c) property.  Treas. Reg. section 1.752-7 applies to partnership assumptions of Treas. Reg. 1.752-7 liabilities after June 23, 2003.

A debt that is created for the sole purpose of generating tax savings is not genuine and must be disregarded for tax purposes.  A business motive for incurring a partnership liability must exist.  Similarly, a bona fide debt cannot be ignored.
 
IRC section 752 is structured to keep a close correlation between inside and outside basis.  If deductions are funded by partnership debt, then IRC section 752 increases the outside basis to allow the partners the benefit of the deduction.  To this end, there is coordination between the rules which govern how partnership liabilities are shared and the rules governing partnership allocations under IRC section 704(b). 13

Nature of the Liability

In determining the partner’s share of the partnership debt, it is critical to identify the nature of the debt.

A recourse debt is one in which the creditor can pursue the partners.  If the partnership is not profitable and does not make payments on the loan, then the creditor can look to the partners to repay the debt.  Treas. Reg. section 1.752-1(a)(1) states that a partnership liability is treated as a recourse liability to the extent that any partner or related person bears the economic risk of loss for the liability.

 A nonrecourse debt is one in which the property is the only security for the loan, and therefore the creditor cannot pursue the partners individually.  In this case, the creditor expects to be repaid from the partnership’s profits.  Treas. Reg. section 1.752-1(a)(2) states that a partnership liability is treated as nonrecourse to the extent that no partner or related person bears the economic risk of loss.

Partner’s Share of Recourse Liabilities

A partner’s share of a recourse partnership liability equals the portion of that liability for which the partner or related person bears the economic risk of loss.  A “related person” means a person having a relationship to a partner that is described in Treas. Reg. section 1.752-4(b).  This regulation, in turn, refers to IRC section 267(b) and IRC section 707(b)(1).  It is important to bear in mind that a partner may be able to include partnership liabilities in his/her basis when a person considered to be related to that partner actually bears the economic risk of loss.

The concept of economic risk of loss is crucial in determining the proper sharing of partnership recourse debt.  Economic risk of loss is evaluated based on the extent to which a partner would be obligated to make a payment under a hypothetical liquidation of the partnership.  This constructive liquidation is described in Treas. Reg. section 1.752-2(b)(1).  The goal is to determine to what extent each partner would either have to contribute to the partnership or pay a creditor with no right to reimbursement. 

Under the constructive liquidation, the following is deemed to occur simultaneously:

  1. All partnership liabilities become payable in full;
  2. All of the partnership’s assets, including cash, have a value of zero;
  3. The partnership disposes of all of its property for no consideration other than the relief of liabilities;
  4. All items of income, gain, loss, or deduction are allocated among the partners;
  5. The partnership liquidates.

Because the partnership’s assets are assumed to have a zero value, the hypothetical sale of the assets results in a loss.  Allocation of the loss to the partners’ capital accounts results in deficit capital account balances.  The relative amount in each partner’s deficit capital account balance evidences each partner’s obligation to make a payment.

The following example illustrates the steps of the constructive liquidation:  A general partner (G) and a limited partner (L) form a partnership.  G contributes $10 and L contributes $90.  The partnership purchases a building by using the contributed funds of $100 and obtaining a recourse debt of $900.  The balance sheet is as follows:

Assets

Liabilities

Building

1,000

Recourse Note

900

 

 

Capital – G         

10

 

 

Capital -  L      

90

Totals

1,000

 

1,000

Under the hypothetical liquidation scenario, the building suddenly becomes worthless, but the liability is not discharged.  Since there is no relief of liability, the building is assumed to be sold for no consideration.  As a result of the hypothetical sale, there is a loss of $1,000 (zero amount realized less $1,000 basis).  The loss would be allocated to the two partners as follows:

    

G

L

Initial Capital

10

90

Loss

(910)

( 90)

Ending Capital

( 900)

0

Under the rules governing partnership allocations, L can only be allocated $90 of the loss since, as a limited partner, he has no obligation to restore a negative capital account.  The relative impact of the loss allocation on the capital accounts reveals that G would have to contribute $900 to the partnership in order for the partnership to pay the creditor.  Since G has the economic risk of loss, he is entitled to claim the entire debt in his basis. G’s outside basis in the partnership would therefore be $910 ($900 debt share plus $10 of contributed capital).  L’s outside basis is $90, the amount of money he contributed.

The above situation is very straightforward – it is obvious that the general partner and not the limited partner would be liable for repayment.  Oftentimes guarantees and other types of agreements can complicate the determination of which partner truly bears the economic risk of loss.  The regulations point out that the determination is based on facts and circumstances and cites guarantees, indemnifications, and reimbursement agreements as factors that may come into play.  For example, a guarantee could convert a nonrecourse liability into a recourse liability. 

The constructive liquidation scenario assumes that all partners and related persons who have payment obligations actually do so irrespective of their actual net worth.  Given that assumption, it is important to identify the obligor of last resort.  If, for example, a limited partner executes a guarantee that is conditioned on the lender first exhausting its remedies against the partnership, the limited partner would not achieve economic risk of loss status and would therefore not be able to include the guaranteed debt in his basis.  In the constructive liquidation scenario, it is assumed that the general partner will ultimately provide the funds to the partnership or reimburse the limited partner.

An exception to the presumption that partners will satisfy their payment obligations is found in an anti-abuse rule14 which states that an obligation of a partner to make a payment is not recognized if the facts and circumstances evidence a plan to circumvent or avoid the obligation.  This anti-abuse rule has been invoked in disguised sale situations in which one partner (the contributor/seller) wishes to increase his/her share of the partnership’s liabilities and therefore increase outside basis in order to avoid an IRC section 731 gain upon an ostensible distribution of cash which is in fact the proceeds of a sale.

Example 1-8

A subsidiary of Seller Corporation (subsidiary partner) and Buyer Corporation form a partnership.  The subsidiary is thinly capitalized.  The subsidiary contributes a low basis high value asset to the partnership.  The partnership borrows money from a third party financial institution, and the subsidiary partner guarantees this debt.  The partnership immediately distributes the borrowed funds to subsidiary partner.  If the facts and circumstances indicate that subsidiary partner will circumvent or avoid the obligation, the guarantee can be disregarded.

Assumption of Liabilities

As previously stated, an increase in a partner’s share of partnership liabilities is considered to be a contribution of money to the partnership that increases the partner’s outside basis.  Additionally, a partner who assumes a partnership’s liability is treated as having contributed money to the partnership.  Certain conditions must be met before a person can be considered to have assumed a partnership liability:

  1. The partner must be personally liable for the debt;
  2. The person to whom the liability is owed must know of the assumption and is able to directly enforce the obligation;
  3. The partner alone must bear the economic risk of loss, i.e., there is no right to reimbursement from another party.

Partner’s Share of Nonrecourse Liabilities

As previously stated, a nonrecourse debt is one in which the lender can only look to the property securing the debt, and not to the partners, for repayment.  In a pure nonrecourse situation, the lender can foreclose on the property but cannot take collection action against the partners.  Therefore, a partnership liability is nonrecourse to the extent that no partner or related person bears the economic risk of loss.  However, a partner can make a nonrecourse loan to his/her own partnership.  In this case, if no other partner has any personal liability on the note, then the partner making the loan would include that amount in his/her basis since he/she alone has the economic risk of loss.  Nonrecourse financing is commonly found in real estate or oil and gas partnerships.

It is important to bear in mind that when a partnership borrows on a nonrecourse basis in order to purchase or construct an asset, the partnership is entitled to basis immediately.  This immediate entitlement to basis is premised on the assumption that the taxpayer will bear the economic burden of having borrowed.  If the partner has no obligation to contribute money to the partnership to repay the debt, it is assumed that repayment will come from partnership profits.  Under former Treas. Reg. section 1.752-1(e), the original rule was that the partners’ share of nonrecourse debt was based purely on profit sharing ratios.

Although the central focus continues to be on the partners’ interests in partnership profits, other considerations also affect the way in which nonrecourse liabilities are shared.  Treas. Reg. section 1.752-315, Revenue Ruling 92-97, and Revenue Ruling 95-41 adopt a somewhat complex formula.  Each partner’s share of nonrecourse debt is the sum of three different categories of debt allocations.  Each of the categories has its own computational rules.  Before getting into the vocabulary that defines each of the three categories, or tiers, of debt, it should be emphasized that the purpose of this framework is to coordinate the rules for sharing liabilities with the rules under IRC section 704(b) that govern partnership allocations.  Such coordination ensures that the partners will have sufficient outside basis so that they may obtain nonrecourse deductions (depreciation, depletion, amortization) being generated by the property purchased with nonrecourse debt. 

The three tiers consist of:

  1. Partner’s share of IRC section 704(b) partnership minimum gain;
  2. Partner’s share of IRC section 704 (c) minimum gain;
  3. Partner’s share of excess non-recourse debt.

Partner’s Share of IRC Section 704(b) Minimum Gain

IRC section 704(b) minimum gain is created as the partnership claims deductions, typically depreciation, that decrease the property’s book basis below the balance of the nonrecourse debt encumbering the property.  Minimum gain is the amount of gain that the partnership would recognize if it disposed of property encumbered by a nonrecourse liability for no consideration other than full satisfaction of the liability.  Generally, this amount is the difference between the amount of the nonrecourse liability and the property’s adjusted book basis.

Example 1-9

A partnership purchases depreciable property for $1 million which is completely financed with nonrecourse debt.  If the partnership takes a $200,000 depreciation deduction, the basis of the property is now $800,000.  The amount by which the debt exceeds the basis ($1M less $800,000) is the amount of the minimum gain.  Note the amount of the minimum gain, $200,000 equals the amount of the nonrecourse deductions.

The concept of minimum gain came out of a 1983 court case, Commissioner v. Tufts16 .  In that case, a nonrecourse lender foreclosed on an apartment building whose FMV had fallen below the amount of the outstanding debt.  When a borrower surrenders property to a lender in exchange for debt relief, the transaction is treated as a sale or exchange.  The petitioner in Tufts argued that the amount realized was the FMV of the property.  The court determined that the amount realized by the borrower included the full amount of the nonrecourse debt.

If the book basis of the property is less than the outstanding amount of the nonrecourse debt, there is a potential taxable gain on the disposition of the property regardless of its FMV.  This potential gain is referred to as minimum gain.  A partner’s share of the partnership’s IRC section 704(b) minimum gain is generally the sum of his/her allocated nonrecourse deductions plus distributions financed by nonrecourse borrowing. 

Thus, the framework is that a partner who receives a nonrecourse deduction is provided with enough basis under the first tier of the nonrecourse debt sharing rules to reap the benefits of the deduction without being restricted by IRC section 704(d).  Minimum gain and the minimum gain chargeback are discussed in Chapter 6.

Partner’s Share of IRC Section 704(c) Minimum Gain

The second tier in the nonrecourse debt allocation framework focuses on IRC section 704(c) minimum gain.  IRC Section 704(c) minimum gain is the difference between the amount of nonrecourse debt encumbering the property and the property’s tax basis.  This tier is important in ensuring that a contributing partner whose property is encumbered with a nonrecourse liability that is greater than its tax basis will not incur an IRC section 731 gain. 

Partner’s Share of Excess Non-Recourse Debt

The third tier, excess nonrecourse liabilities, is the amount of liabilities not included in the first two tiers.  Excess nonrecourse liabilities are allocated in accordance with the partner’s share of partnership profits.

Example 1-10

Tim and Beverly form an equal partnership.  Tim contributes a building with a FMV of $200,000.  It has a tax basis of $100,000 and is subject to a nonrecourse debt of $150,000.  Beverly contributes $50,000 cash.

Tim’s basis in his partnership interest is computed as follows:

Property’s Adjusted Basis

100,000

IRC Section 752(b) Reduction of Liability

(150,000)

Tier One                               

0

Tier Two

50,000

Tier Three

50,000

Tim’s Basis

50,000

Beverly’s basis in her partnership interest is computed as follows: 

Cash contributed

50,000

Tier One

0

Tier Two

0

Tier Three

50,000

Beverly’s Basis

100,000

In the above example, the partnership has no Tier One debt to allocate.  This is because the partnership just formed and no depreciation (a nonrecourse deduction) has been allocated to the partners to create minimum gain.  Tim is allocated $50,000 of Tier Two debt, the difference between the amount of the liability encumbering the property he contributed ($150,000) and the property’s tax basis ($100,000).  This prevents Tim from incurring an IRC section 731 gain upon the contribution.  The remaining debt of $100,000 is the amount of the excess nonrecourse liabilities which is split equally between the partners in accordance with their equal interests in the profits of the partnership.

Issue Identification

Determine if there was IRC section 704(c) property contributed to the partnership.  The book capital accounts and the tax capital accounts should reflect a different value for the contributed property.  The examiner may look to the outside basis computation, if it is more readily available, for the adjusted basis in the asset.  The examiner should verify the adjusted basis and the FMV of contributed property.

Review subsequent transactions to determine if the pre-contribution gain or loss should be recognized. It may be missing from a subsequent balance sheet or the Schedule M-2 may notate a distribution of property to a partner.  This could be a distribution of the IRC section 704(c) property to another partner or the distribution of other property to the contributing partner of the original IRC section 704(c) property.  There may be a disposition, a disguised sale, or a “mixing bowl” type of transaction that will all trigger gain recognition.  Also, if the property was depreciable property, the separately stated depreciation deduction will not be present in subsequent Schedules K-1.

Review other types of contributions into the partnership.  Be aware that if Unrealized Receivables and Accounts Payable are contributed by a cash basis taxpayer to the accrual basis partnership, that when the partnership collects the receivables and pays the payables, the ordinary income and deduction are allocated to the contributing partner.  Accounts payable, under these circumstances, are not considered liabilities for purposes of IRC section 752.  Accounts payable contributed by an accrual basis taxpayer is considered a liability for purposes of IRC section 752.

Review the balance sheet for the type of assets held by the partnership.  If the partnership holds assets that are mostly stocks and securities, then gain may be recognized on the contributions.  Losses are not recognized.

Request the valuation method and appraisal for any property contributed to the partnership.  The valuation method used should be documented.  If a third party appraisal was not done, consider if there is a need to request the services of an IRS engineer to determine the FMV of the property at the time of contribution.

Request a copy of any promissory note contributed by a partner.

Examination Techniques - Liabilities

The examination techniques used should serve, in the end, to answer the following:

  • Are liabilities properly allocated to the partner's basis according to the economic risk of loss concept?
  • Are recourse liabilities for general partners being properly allocated to the proper partner? Are direct loans being allocated properly?  No special allocation should be made to the partner loaning the money.  The general partner making a direct recourse loan can still seek reimbursement from the other general partners.
  • Are guarantees of recourse loans by either a limited or a general partner being allocated under normal recourse rules?  No special allocation should be made for these guarantees unless the guarantor waives all rights of subrogation and then all of the liability may be allocated to that partner.  There should be a side agreement substantiating this.
  • Was there a relief of liabilities over the adjusted basis in the partnership interest? If so, then this is a deemed cash distribution (IRC section 752(b)) and gain will be recognized (IRC section 731(a)).
  • If there is any disagreement as to whether a loan is recourse or non-recourse, obtain written advice from local Counsel.

Issue Identification

Review the balance sheet and partner's Schedule K-1 for non-recourse liabilities.  They should be reflected on the designated line on the balance sheet and Schedule K-1.  However, accounts payable may be non-recourse liabilities, as well as other long-term or short-term notes.  Find out what type of liabilities are reflected on the balance sheet for purposes of the proper basis allocation and for at-risk purposes.  Accounts payable increase outside basis under the non-recourse allocation rules and will probably fluctuate from year to year.  See Chapter 5 for the at-risk limitations.

If there was a contribution of property encumbered by a “contingent liability”, the examiner should research the regulations under 1.752-7.

Request a copy of the partnership agreement to determine profit and loss sharing ratios. The agreement will also determine if a limited partner must contribute additional cash over and above its initial contribution.

Analyze all recourse and non-recourse loan documents to determine who is at-risk of loss if the partnership defaults on these loans.

Analyze all recourse loans for guarantees by either a general or limited partner.  The guarantees are disregarded unless the partner waives the right of subrogation.  In most cases the general partners are still ultimately responsible to reimburse any partner that made payments on a recourse loan.

Analyze all non-recourse loans for guarantees.  All of the liability will be allocated to the partner guaranteeing the loan unless there is a side agreement entitling the partner to reimbursement.

Analyze all direct loan documents by a partner to the partnership.  Determine if these represent arms length liabilities to the partnership or capital contributions because loans that should be classified as capital contributions may be classified as loans in order to give other partners outside basis to deduct losses that they may not be entitled to.  Also, if the loan is recourse in a general partnership, then the partner will be entitled to reimbursement from the other general partners.  General partners are jointly and severally liable for partnership loans so normal allocation of recourse loans will be used versus all of the loan being allocated to that partner.  If the loan is a non-recourse liability, then all of the liability will be all allocated to the lending partner.  This is true because the partner will not be entitled to any reimbursement unless there is a side agreement allowing reimbursement from another party.

Request any side agreements with creditors to determine if any of the partners are entitled to reimbursement, if they assume a loan for the partnership.  Request any indemnification agreements or other side agreements between partners that entitle the partners to reimbursement by another partner.  The liability will be allocated to the partner that will ultimately be at-risk of loss to pay the debt.

Request a computation of how the recourse and non-recourse liabilities were allocated to the various partners.

Documents to Request

  1. Partnership agreement and all amendments.
  2. Prior and subsequent year partnership returns.
  3. Copies of all loan documents including, but not limited to, promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees, and/or loan indemnification agreements.
  4. Side agreements between a partner and a creditor for assumptions.
  5. Indemnification or side agreements between partners for reimbursement.
  6. Security agreements.
  7. Outside basis calculations.
  8. Computations of recourse and non-recourse allocations.

Interview Questions

  1. What does each liability on the balance sheet represent? Are they recourse or non-recourse debt?
  2. Are there debt instruments? If so, request copies.
  3. Are there any guaranteed loans? Which ones?
  4. Are there any indemnification agreements or side agreements between the partners and another partner or person related to the partner?
  5. Are there any assumptions of debt by any of the partners? If so, is there a side agreement with the creditor?
  6. Are there any direct loans from a partner to the partnership? Are they recourse or non-recourse?

Supporting Law

TAM 200436011 (Sharing of Excess Nonrecourse Debt)

Crane vs. Commissioner, 331 U.S. 1, 67 S. Ct. 10147 (1947)

Commissioner v. Tufts, 461 US 300 (1983)

Revenue Ruling 88-77, 1988-2 C.B. 128– This ruling provides guidance on what is considered a partnership liability.

Revenue Ruling 92-97, 1992-2 C.B. 124 – This ruling provides guidance on the allocation of partnership cancellation of indebtedness income.

Revenue Ruling 95-41, 1995-1 C.B. 132 – This ruling provides guidance on the effect of IRC section 704(c) on the allocation of non-recourse liabilities under Treas. Reg. section 1.752-3(a).


  1.   Commissioner v. Tower, 327 US 280 (1946)
  2.   Chapter 3 addresses IRC section 704(c) property.
  3.   IRC section 723
  4.   IRC section 1223(2), Treas. Reg. section 1.723-1
  5.   IRC section 722
  6.   IRC section 1012
  7.   IRC section 1014
  8.   IRC section 1015
  9.   Treas. Reg. section 1.752-1(b)
  10.   Treas. Reg. section 1.752-1(c)
  11.   Treas. Reg. section 1.752-1(c)
  12.   Treas. Reg. section 1.752-1(b)
  13.   See Chapter 6
  14.   Treas. Reg. section 1.752-2(j)
  15.   Effective October 31, 2000
  16.   461 U.S. 300 (1983)

Table of Contents  | Chapter 2

Page Last Reviewed or Updated: 29-Nov-2013