The alternative to changing or eliminating a partner’s interest by sale is a distribution to the partner that either reduces the partner’s interest or com- pletely liquidates the partner. New partners may be brought in with a con- tribution to the partnership. As discussed in Part V, however, substitution of partners by liquidation and contribution has to be distinguished from a sale by the outgoing partner to the incoming partner.
A. Statutory Provisions Applicable to Distributions
Section 731(a)(1) sets out the basic distribution rule that a partner rec- ognizes no gain on the distribution of money or property by a partnership except to the extent that a distribution of money exceeds the adjusted basis of the partner’s interest in the partnership.
Section 731(a)(2) allows recognition of loss on a complete liquidation of a partner’s interest in the distributing partnership where the partner receives only money or unrealized receivables or inventory with a basis transferred from the partnership that is less than the adjusted basis of the partner’s inter- est in the partnership.
Section 752(b) treats a reduction in a partner’s share of partnership liabili- ties as a distribution of cash, which has the potential under section 731(a)(1) to require recognition of gain to the extent a reduction in liabilities exceeds the distributee partner’s basis in the partnership interest. On the other side, a reduction in the distributee partner’s share of liabilities can result in an increase in the share of partnership liabilities of other partners, which is
treated as a contribution of cash and which thereby increases the other part- ners’ bases in their partnership interests.169
Section 751(b), a horribly complex provision, adopts an aggregate approach to distributions by providing that to the extent that a current or liquidating distribution changes partners’ interests in unrealized receivables and sub- stantially appreciated inventory, the distribution will be treated as a sale or exchange of the unrealized receivables and substantially appreciated inventory between the distributee and the partnership.170 This treatment may require
recognition of gain or loss on one or both sides of the transaction.
Section 736 provides that payments to a retiring partner in a service part- nership are to be considered as a distribution of partnership income or a guaranteed payment, resulting in both ordinary income to the retiring part- ners and a reduction in income to the continuing partners.171 Otherwise,
payments for a partner’s interest in partnership property are treated as a dis- tribution to the partner subject to both sections 731(a) and 751(b).172
Section 732(a) provides that in a current distribution, a distribution that does not liquidate the partner’s interest, the partnership basis in distributed property transfers to the distributee partner. However, the transferred basis of distributed property is limited to the distributee partner’s basis in the part- ner’s partnership interest.173
Section 733 reduces the distributee partner’s basis in the partner’s partner- ship interest by the amount of money distributed plus the amount of basis that is transferred to distributed property under section 732. The partner’s basis in the partnership interest is not reduced below zero.174
Section 732(b) applies an exchanged basis rule to property distributed in complete liquidation of a partner’s interest. The distributee partner’s basis in the partnership interest, reduced by the amount of any money distributed, is exchanged to become the basis of distributed property. Section 732(c) con- tains rules for allocating the exchanged basis among different assets.
Section 734 provides in general that the basis of partnership assets is not adjusted as a result of a distribution. However, if the partnership has a section 754 election in effect, section 734(b) provides that the basis of partnership
169 I.R.C. §§ 752(a), 722.
170 Unlike section 751(a), which applies to any inventory, section 751(b) only applies to
inventory that is substantially appreciated, meaning, under section 751(b)(3), that the total fair market value of all the inventory items of the partnership exceeds 120% of the aggregate adjusted basis for such property in the partnership. Inventory for this purpose generally includes any property that would produce ordinary income if sold. I.R.C. § 751(d).
171 I.R.C. § 736(a). Section 736(b)(2) provides that payments for unrealized receivables and
partnership goodwill (except to the extent the partnership agreement provides for payment for goodwill) are treated as section 736(b) payments. However, section 736(b)(3) limits the application of this rule to general partners in partnerships where capital is not a material income-producing factor.
172 I.R.C. § 736(b). 173 I.R.C. § 732(a). 174 I.R.C. § 733.
assets is adjusted to reflect gain or loss recognized by a partner on a distribu- tion and for changes in the bases of distributed assets in the hands of the partner.175 These adjustments are allocated among the bases of partnership
assets under the rules of sections 734(c) and 755. In addition, section 734(d) requires a reduction in the basis of partnership assets in the event that section 734(b) would cause a decrease in the basis of partnership assets in excess of $250,000 in connection with a recognized loss by the distributee partner or an increase in the basis of distributed partnership assets.
Section 704(c)(1)(B) requires a partner who contributed appreciated or depreciated property to a partnership to recognize gain or loss in the case of a direct or indirect distribution of the contributed property to another partner within seven years of the date of the original contribution.
Section 737, as a back-up to section 704(c)(1)(B), requires in the case of a distribution of property to a partner who contributed property with built- in gain that the distributee recognize gain in the amount of the lesser of the fair market value of the distribution over the partner’s basis in the part- nership interest or in the amount of precontribution gain built in to the contributed property.
B. Current Distributions: Basic Rules
Distributions to a partner who continues in the partnership, known as current distributions, are treated differently in important aspects than distri- butions that liquidate the partner’s interest. Current and liquidating distribu- tions must, therefore, be considered separately. The rule of section 731 treats the partnership as an entity that distributes entity level income and capital to partners. However, similar to sales of an interest,176 where a distribution
changes a partner’s interest in unrealized receivables and substantially appreci- ated inventory, the partner is treated as having an interest in each such asset and treating the distribution as a taxable exchange.177
Section 731(a), the basic distribution provision, provides that no gain or loss is recognized on a distribution of money or other property from a part- nership to a partner, except to the extent that any money distributed exceeds that partner’s basis in the partnership interest. The impact of distributions during the year is computed at the end of the partnership’s taxable year so that the effect of other partnership events during the year will enter into the computation of basis for purposes of determining section 731(a) gains, including gains resulting from reductions in liabilities.178 Thus, advances or
drawings against a partner’s distributive share of income are treated as made
175 I.R.C. § 751(a). 176 I.R.C. § 751(a).
177 I.R.C. § 751(b); see infra note 230. 178 I.R.C. § 731(a).
on the last day of the partnership year for the purposes of section 731 and for determining a partner’s basis under section 705.179
A reduction in a partner’s share of partnership liabilities is treated as a dis- tribution of cash to the partner with the possibility of gain recognition under section 731(a) if the reduction in liabilities exceeds the partner’s basis in the partnership interest.180 A partner’s share of liabilities is determined under the
rules of Regulation sections 1.752-2 (recourse liabilities) and 1.752-3 (non- recourse liabilities). In general, a partner’s share of recourse liabilities is based on the ultimate responsibility of the partner for partnership debt after the lender’s recourse to all other potential sources of repayment is exhausted.181
Nonrecourse liabilities are allocated to partners in the amount of the partner’s share of partnership profit or income recognized by a partnership and used to satisfy the nonrecourse liability.182
In a current distribution, the partnership basis in distributed property is transferred to the distributee partner, but the basis of distributed property is limited to the distributee partner’s basis in the partnership interest after being reduced by cash distributions.183 If the distributee partner’s basis in the
partnership interest is less than the combined bases of distributed partner- ship assets, section 732(c)(1) requires an allocation of basis first to unreal- ized receivables and inventory to the extent of the partnership’s basis in those assets, then to other distributed assets. This allocation prevents a change in the basis of these ordinary income assets that would cause a shift of the ordinary income. However, if the distributee partner’s outside basis in the partnership interest is less than the partnership basis in distributed unrealized receivables and inventory items, the partner’s transferred basis is allocated among the unrealized receivables and inventory first in proportion to unrealized depre- ciation in such assets are then in proportion to the adjusted basis of the unre-
179 Reg. § 1.731-1(a)(1)(ii). Under section 705, basis is increased for a partner’s share of
income items and decreased by the partner’s share of loss and deduction items plus the amount of basis assigned to distributions under section 733. A partner with both general and limited partnership interests is treated as having a unitary basis in the partnership interests. Rev Rul. 84-53, 1984-1 C.B. 159. For a discussion of ordering rules where pass-through losses and distributions during a year exceed the partner’s basis, see Rev. Rul. 66-94, 1966-1 C.B. 166.
180 I.R.C. § 752(b). Changes in a partner’s share of liabilities can result from a payment
of the liabilities, a transfer or distribution of encumbered property, an abandonment of encumbered property, or the admission of a new partner. Also, a distribution of encumbered property to one partner can result in a reduction of liabilities treated as a cash distribution to other partners.
181 Reg. § 1.752-2.
182 Reg. § 1.752-3. A nonrecourse debt is a partnership liability for which no partner has
personal liability. Reg. § 1.752-1(a)(2). Technically a partner’s share of nonrecourse debt is the sum of the partner’s share of partnership minimum gain with respect to the liability, a partner’s share of any section 704(c) gain that would be allocated to the partner on sale of the encumbered asset for the amount of the nonrecourse debt, plus the partner’s proportionate share of partnership profits. Reg. § 1.752-3(a).
alized receivables and inventory.184 Likewise, any reductions to basis allocable
among the distributed assets other than unrealized receivables and inventory are allocated first to reduce unrealized depreciation and then in proportion to the adjusted bases of distributed assets.185 The distributee partner’s basis in
the partnership interest is reduced—but not below zero—by the amount of money distributed plus any basis that is allocated to distributed property.186
Property distributions require an adjustment to partnership capital accounts to reflect book gain or loss that would be realized if the distributed property were sold by the partnership for fair market value at the time of the distribution with an allocation of the gain or loss among the partners followed by a reduction in the capital account of the distributee partner by the fair market value of the distributed property.187 In addition, the regula-
tions permit a “book-up” of all capital accounts at the time of a distribution of property to reflect the current value of all partnership assets.188 Gains and
losses reflected in the book-up are allocated among the partners in accord with the partners’ interests in each item. This adjustment to capital accounts in the event of a distribution permits the partnership to restate its capital accounts and each partner’s interest in capital to reflect changed values in the partnership and is an opportunity for the partners to update their interests. Although this elective book-up creates complexities in terms of allocating the difference between book items and tax items to the partners whose interests are affected by the book-up,189 revising book values to reflect the partners’
interests after a disproportionate distribution will reflect the contemporary state of the partnership and assist in the resolution of partner interests in the event of a dispute.
C. Distributions of Contributed Property
Section 704(c)(1)(A) requires that gains and losses with respect to property contributed by a partner be allocated among the partners in order to reflect the difference between the fair market value and basis of the contributed property. Because the contributing partner’s basis in contributed property is transferred to the partnership,190 the rule of section 704(c)(1)(A) is necessary
to ensure that a contributing partner does not escape the tax consequence of precontribution built-in gains or losses, or that such gains and losses are not
184 I.R.C. §§ 732(c)(1)(A)(ii), (c)(3). 185 I.R.C. §§ 732(c)(1)(A)(ii), (c)(3). 186 I.R.C. § 733.
187 Reg. § 1.704-1(b)(2)(iv)(e)(1). Although book gains and losses are recognized by the
partnership for capital account purposes, except to the extent that section 751(b) applies, distributions do not create tax gain or loss at the partnership level.
188 Reg. § 1.704-1(b)(2)(iv)(f)(5)(ii). 189 See Reg. §§ 1.704-1(b)(2)(iv)(f)(3), (g). 190 I.R.C. § 723.
shifted to other partners.191 The allocation provision of section 704(c)(1)(A)
will not work, however, if the contributed property is distributed to a partner other than the contributor or if the contributing partner leaves the partner- ship before the gain or loss with respect to contributed property is recognized by the partnership. Sections 704(c)(1)(B) and 737 operate as a backup to the allocation requirement of section 704(c)(1)(A) by providing special rules with respect to the distribution within seven years of property contributed to a partnership with built-in gain or loss at the time of contribution.
Section 704(c)(1)(B) captures a contributor’s precontribution gain or loss if the contributed property is distributed to another partner. Under this pro- vision, a partner contributing appreciated or depreciated property will rec- ognize gain or loss on a distribution of the contributed property to another partner within seven years of the contribution in an amount equal to the gain or loss allocable to the contributing partner under section 704(c)(1)(A) as if the property had been sold for fair market value at the time of distribution.192
The character of the gain or loss is determined as if the partnership had sold the property to the distributee.193 The contributing partner’s basis in the part-
nership interest and the partnership’s basis in the contributed property are adjusted to reflect the recognition of gain or loss.194
Section 737 captures precontribution gain if the contributing partner receives a distribution of other partnership property within seven years of a contribution of appreciated property. In effect, the contributing partner is treated as undertaking an exchange of the contributed property for the distributed property, a mixing bowl transaction. Section 737 requires that a partner recognize gain on the distribution of property other than the contrib- uted property to the extent of the lesser of the fair market value of distrib- uted property over the partner’s adjusted basis in the partnership interest or the amount of gain the partner would have recognized under section 704(c)
191 Section 704(c)(1)(C) also specifically addresses contributions of built-in loss property,
property where the transferred basis to the partnership exceeds fair market value. Such built-in loss is to be taken into account only by the contributing partner, and further, with respect to determining allocations to other partners, the basis of the contributed property shall not be greater than its fair market value. For a discussion of the computational difficulties created by this latter provision see Simmons, supra note 2, at 662 et. seq.
192 For example, if partner A contributes property to the ABC partnership with a value of
$100 and a basis of $75, on distribution of the property to B when it is worth $110, A will be required to recognize gain of $25. The amount of gain or loss charged to the contributing partner is determined under the method adopted by the partnership under Regulation section 1.704-3 for allocating section 704(c) gains and losses.
193 I.R.C. § 704(c)(1)(B)(ii).
194 I.R.C. § 704(c)(1)(B)(iii). Thus, in the example supra note 192, the basis of the distributed
(1)(B) on a distribution of contributed property to another partner.195 The
character of the partner’s recognized gain relates back to the character of the partner’s precontribution gain. Also, like section 704(c)(1)(B), section 737(c) provides that the distributee partner’s basis in the partnership interest and the partnership’s basis in contributed property is adjusted to reflect gain recog- nized by the distributee partner.
D. Liquidation Distributions
Liquidation distributions196 must be treated differently because the liqui-
dated partner no longer has a basis in the partnership interest into which partnership unrealized gains and losses may be continued. The liquidated partner’s partnership basis is generally transformed into the basis of distrib- uted assets, which receive an exchanged basis equal to the basis of the liqui- dated partner’s partnership interest.197 Also, while under section 731(a)(1)
gain is recognized on any distribution of cash in excess of the partner’s basis, loss may be recognized on a liquidation distribution that consists only of cash in an amount less than the partner’s basis in the partnership interest, or on a liquidation distribution that includes only unrealized receivables and inven- tory—in addition to cash—that carry over a basis less than the partner’s basis in the partnership interest that is liquidated.198
1. Section 736(a) Payments for Unrealized Receivables and Goodwill
Except as provided under the exception of section 736(a), the operative general rule of section 736(b) treats distributions in complete liquidation of a partner’s interest as section 731(a) distributions.199 However, in the case of
a service partnership, meaning a partnership in which capital is not a mate- rial income-producing factor, the analysis begins with section 736(a). Section 736(a) treats payments for a retiring partner’s interest in unrealized receivables and goodwill as a distributive share of partnership income or as a guaranteed
195 I.R.C. §§ 737(a)–(b). The statute requires the distributee partner to recognize the lesser
of the excess of the fair market value of distributed property over the partner’s adjusted basis in the partnership interest or the “net precontribution gain of the partner.” Net precontribution gain is defined in section 737(b) as the amount of any gain that would have been recognized by the partner under section 704(c)(1)(B) if all of the property, which had been contributed by the partner within seven years of the distribution and held by the partnership immediately before the distribution, had been distributed to another partner.
196 Defined“Liquidation distributions” are defined in section 761(d) as distributions that
liquidate a partner’s interest.
197 I.R.C. § 732(b).
198 I.R.C. § 731(a)(2). The basis of distributed inventory and receivables is limited to the
partnership basis in such assets. See I.R.C. § 732(c)(1)(A)(i) (discussed supra note 183 and
infra note 219).
payment.200 Amounts treated as a distributive share of partnership income
reduce the partnership income allocable to other partners.201 Amounts treated
as a guaranteed payment provide a deduction to the other partners.202 There
is thus a trade-off. Section 736(a) payments result in ordinary income to the recipient but reduce ordinary income to the other partners. As a consequence of these conflicting interests, failure to agree on the value of payments for partnership assets along with ambiguities in partnership agreements have led to disputes where the retiring partner claims that payments are in exchange for the partner’s interest in goodwill taxable at capital gains rates while the continuing partners assert that the payment represents a distributive share of income or a guaranteed payment under section 736(a).203 However, the issue
became less significant after the adoption of section 736(b)(3), limiting the choice to retirement of a general partner in a service partnership.204
Section 736(b) limits the application of section 736(a) by providing that payments made in liquidation of the interest of a retiring partner are to be treated as distributions in exchange for the partnership interest except to the extent that payments are made for the retiring partner’s interest in unreal-