By: Stephen T. Byrd
Manning, Fulton & Skinner, P.A.
Raleigh, North Carolina

January 14, 1994

© Stephen T. Byrd 1994 All Rights Reserved

Preface

The purpose of this outline is to discuss certain income tax traps confronting the partnership transactional practitioner, including disguised sales under Code §707, distributions of contributed property under §704(c)(1)(B), recognition of precontribution gain under §737, taxation of receipt of a profits interest upon partnership formation, and tax problems on restructuring partnership debt. An overview of the general tax statutory regime governing partnerships is presented so that the practitioner may appreciate the significance of the pitfalls associated with the remaining topics.

I. Basic Partnership Tax Rules.

A. Contributions.

1.  Gain/Loss Recognition. Section 721(a) provides that no gain or lose shall be recognized to a partnership or to any of its partners with respect to a contribution of property to a partnership in exchange for an interest in the partnership. Section 721(b) provides an exception and results in gain recognition upon a transfer of property to a partnership treated as an investment company (within the meaning of §351(e)(1), assuming the partnership were a corporation). This rule basically precludes investors from using the nonrecognition rules of partnerships in order to effectuate a nontaxable diversification of their interests in readily marketable securities. Other exceptions apply, some of which are discussed below.

2.  Basis of Contributor`s Partnership Interest. A partner`s initial basis is determined under §722 and is the amount of money and the adjusted tax basis of other property contributed by the partner, increased by the amount of gain (if any) recognized by the contributor under §721(b) above. Generally speaking, the initial basis of a partner`s partnership interest thereafter adjusted under §705:

a. by increases for allocations and gain,

b. by decreases deductions and losses, and

c. under §733, by decreases for (i) the amount of any money distributed to such partner and (ii) the amount of adjusted tax basis (as determined under §732 in the hands of the partner; see "C" below) of any property other than money distributed to such partner from the partnership.

            3.  No Negative Basis. Notwithstanding the above, §§705 and 733 provide that a partner`s basis in his interest is never reduced below zero. There is no such thing as negative basis! A partner can nevertheless have a negative capital account which can lead to income recognition problems, some of which are discussed below.

4.  Partnership`s Basis and Holding Period in Property. Section 723 provides that the partnership`s initial income tax basis in contributed property is equal to the adjusted basis in the contributing partner`s hands at the time of the contribution, increased by any gain recognized by the contributor under §721(b). Moreover, Reg. §1.723-1 provides that the partnership`s holding period for such property will include the period during which the property is held by the contributor.

B. Partnership Distributions.

1.  Partner`s Gain. Section 731(x)(1) provides that on partnership distributions to a partner (whether they are current or liquidating distributions), gain shall not be recognized except to the extent that any money distributed exceeds the adjusted tax basis of the partner`s interest in the partnership immediately before the distribution. Special rules apply upon a purchase of a partner`s interest by the partnership (i.e., liquidating distributions); see "E" below.

2.  Partner`s Loss. Except in limited situations described in §731(a)(2), no loss is recognized by a distributee partner upon a distribution.

3.  Character of Gain or Loss. If any gain or loss is recognized by the distributee partner under the foregoing provisions, it shall be considered as gain or loss from the sale or exchange of the distributee`s partnership interest (§731(a)). Section 741 provides that upon a sale or exchange of an interest in a partnership, gain or loss shall be recognized by the transferor partner and shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in §751. Section 751 results in ordinary income treatment corresponding to the partner`s effective disposition of an interest in partnership`s unrealized receivables and inventory items which have appreciated substantially in value (see "7" below).

4. Partnership Gain or Loss Recognition. Section 731(b) provides that generally, no gain or loss is recognized by the partnership upon any distribution to a partner.

5. Exceptions. Section 731(c) notes exceptions to the general nonrecognition rules, in §736 (relating to payments to a retiring partner or decedent`s successor in interest), §751 (dealing with a partner`s interest in partnership unrealized receivables and inventory items), and §737 (regarding recognition of precontribution gain in certain distributions; see "III.B" below).

6.  Basis of Distributee Partner`s Interest.  In the case of any current (i.e., nonliquidating) distribution, the adjusted basis of the distributee partner`s partnership interest is reduced (but not below zero) by (1) the amount of any money distributed to such partner and (2) the amount of the basis to the distributes partner of the distributed property other than money, determined as provided in §732 (see "C" below) (§733).

7.  Section 751. As noted above, §751 provides exceptions to the general nonrecognition rules relative to partners` interests in partnership unrealized receivables and substantially appreciated inventory (also referred to as "hot assets"). These rules were designed to prevent partners or partnerships from "bailing out" of assets which have ordinary income potential by using (i) the general nonrecognition rules governing contributions to and distributions from partnerships, and (ii) §741 providing for sale or exchange of a capital asset treatment on dispositions of partnership interests. After declining into relative obscurity with the compression of ordinary income rates to the capital gain rate level with TRA 86, this issue will again be at the forefront with ordinary income/capital gain rate spreads now being 11.6% or more after RRA 1993. The basic rules are as follows:

a. Section 751(b) provides that if a partner receives in a distribution, either (i) partnership property (including money) which are not hot assets in exchange for all or part of his interest in partnership hot assets, or (ii) partnership hot assets in exchange for all or part of his interest in other partnership property, then such transactions shall be considered as a taxable disposition of such property between the partnership and the partner, according to the rules of legislative Treasury Regulations §1.751-1.

b. Section 751(a) similarly provides that in the case of sale or exchange of a partnership interest, the amount of money or fair market value of any property received by a transferor partner in exchange for all or part of his interest in the partnership attributable to its hot assets results in ordinary income to the transferor as if it were a taxable disposition of ordinary income property.

c. Section 751(c) and (d) define unrealized receivables and  substantially appreciated inventory, respectively.

C.  Basis of Distributed Property.

1.  In Current Distributions. In the case of any distribution other than in liquidation of a partner`s interest, the adjusted income tax basis of any distributed property (other than money) in the hands of the distributee partner shall be its basis to the partnership immediately before the distribution (provided that the basis to the distributee shall not exceed the basis of such partner`s partnership interest reduced by any money distributed to the distributee in the same transaction) (§732(a)).

2.  In Liquidating Distributions. In the case of any distribution in liquidation of a partner`s interest, the basis of the distributed property (excluding money) is an amount equal to the adjusted basis of the distributee`s partnership interest reduced by any money distributed to the distributee in the same transaction (§732(b)).

3.  Holding Period for Distributed Property. Section 735 (b) provides that the distributee partner`s holding period for property distributed to him by the partnership includes the period that such property is held by the partnership.

4.  Basis Allocation. Basis allocation issues related to distributed property in connection with partnership hot assets and when multiple properties are distributed are dealt with in §732(c).

D. Optional Basis Adjustments. If a  §754 election is in effect with respect to a partnership, the basis of remaining partnership property may be adjusted (up or down):

1.  On Distributions. Under  §734, based on the amount of gain or loss (if any) recognized by a distributee partner pursuant to  §731(a), or based on the difference between the adjusted basis of the distributed property in the partnership`s hands and the basis of such property in the distributee`s hands (as determined in "C" above).

2.  On Transfers of a Partnership Interest by Sale or Exchange or Upon Death of a Partner. In such cases, under  §743, based on the difference between the transferee partner`s basis in his partnership interest and such partner`s proportionate share of the adjusted basis of partnership property. Such increase or decrease in the adjusted basis of partnership property shall constitute an adjustment with respect to the transferee partner only.

E. Payments to a Retiring Partner or to a Decedent`s Successor in Interest. All payments to liquidate such a withdrawing partner`s partnership interest are  §736(a) payments, unless they are made in exchange for a partner`s interest in partnership property, in which case they generally are  §736(b) payments. This characterization determines the tax consequences of such payments and distributions to both the partnership and the partner, as follows:

1.  Payments Made in Exchange for Distributee`s Partnership Interest. Section 736(b) provides that payments made in liquidation of a partnership interest, if determined to be made in exchange for the distributee`s interest in partnership property, shall be considered as a distribution by the partnership (not as a distributive share or guaranteed payment; see "2" below). The effect of this provision is to treat  §736(b) payments as  §731 distributions to the partner, resulting in tax consequences described at "B" above and capital gain treatment for gain recognized. No deduction is allowed to the remaining partners for  §736(b) payments since they represent either a distribution or a purchase of the withdrawing partner`s capital. interest (Reg. §1.736-1(a)(2)). Reg. §1.736­1(b)(1) provides that generally the valuation made by the partners in an arms` length agreement of the value of the distributee`s interest in partnership property will be respected. Prior to RRA 1993, S736(b) payments did not include amounts paid for the distributee`s interest in partnership unrealized receivables or goodwill (except to the extent that the partnership agreement provided for a payment for goodwill). Accordingly, payments made to a partner for his interest in partnership goodwill (unless expressly provided for in the partnership agreement) or unrealized receivables were ordinary income to the distributes (and effectively reduced the taxable income of the remaining partners). Effective for partners retiring or dying on or after January 5, 1993, the rules in the last two sentences only apply if the payments were to a general partner in a partnership where capital is not a material income producing factor (e.g., professional service firm).

2.  Payments Made as a Distributive Share or Guaranteed Payment. If the payment made in liquidation of a partner`s interest is not a  §736(b) payment, then

a. §736(a)(1) provides that such payment is considered as a distributive share to the distributee of partnership income if the amount of the payment is determined with regard to the income of the partnership. In other words, these payments "carry out" partnership taxable income which is allocated to the distributes, resulting in the remaining partners not being taxable on income corresponding to such allocation.

b. §736(a)(2) provides that such payment is considered as a guaranteed payment described in  §707(c) (see "F" below) if the amount of the payment is determined without regard to the income of the partnership. In this event, the payment is deductible by the partnership if it is an ordinary and necessary business expense under  §162, or if not deductible then it must be capitalized. The payment is reported as income by the distributes in the year when the item is accrued by the partnership. All partners benefit from the partnership`s tax deduction in proportion to their allocable interest in such deduction. See Reg. §1.704-1(b)(2)(iv)(o).

F. Other Payments to Partners.

1.  More on Payments to Partner Acting other than as a Partner.

a. Guaranteed Payments. Payments to a partner.-for services or for the use of capital, which are determined without regard to the income of the partnership, are guaranteed payments under  §707(c), which as noted above, are ordinary income to the recipient in his tax year within which ends the partnership tax year when the partnership deducted such payment as paid or accrued under its method of accounting (Reg. §1.707-1(c)). Even if the partnership agreement requires the services or use of capital in question, the payment is treated as made to a nonpartner. The payment by the partnership is capitalized unless deductible as an ordinary and necessary business expense under  §162(a), taking into account the  §263 capital expenditure rules. Id. If deductible or amortizable, then the partners would benefit from the tax write-off associated with the payment in proportion to their allocable interests in the same.

b. Section 707(a) Payments - are payments made by a partnership to a   §707(c) guaranteed payment. Reg. §1.707-1(a) lists as examples such transactions as loans of money or property or property sales between the partnership and partner, and payments for services between the partnership and partner. Note that because a partnership and partner are related persons under  §267(a)(2), no deduction is available to the payor for any such payment until the recipient includes the payment in income, which becomes a factor if one party uses accrual and the other uses cash basis accounting.

2.  Payments Made as a Preferred Return on Capital. As contrasted with a  §707(a) payment made to a partner to repay a loan, a payment made as a preferred return on capital is treated as a  §731 distribution to the distributee partner, who also should receive a special allocation of partnership income corresponding to the amount of the payment.

G. Treatment of Partnership Liabilities. Under complex allocation rules contained in the  §752 Regulations, partners may be allocated shares of partnership liabilities which afford tax basis to their partnership interests. To the extent of the adjusted tax basis of a partner`s partnership -interest, such partner may receive allocations of partnership losses and deductions, which may create a negative or deficit capital account for the partner. (Note that other limitations on a partner`s ability to deduct partnership losses include the at risk rules of  §465 and the passive activity rules of  §469.) If unanticipated changes occur in the partners` sharing of partnership liabilities, then taxable income recognition may result without corresponding cash with which to pay the tax liability ("phantom income"), as mentioned in "2" below. The basis changes and income recognition result from partnership liabilities under the following rules:

1.  Increase in Partner`s Liabilities. Section 752 (a) provides that any increase in a partner`s share of partnership liabilities, or any increase in a partner`s individual liabilities by reason of the assumption by such partner of partnership liabilities, is treated as a contribution of money by such partner to the partnership. This increases the basis of the partner`s partnership interest.

2.  Decrease in Partner`s Liabilities. Section 752 (b) provides that any decrease in a partner`s share of partnership liabilities, or any decrease in a partner`s individual liabilities by reason of an assumption of the same by the partnership, is treated as a distribution of money to the partner by the partnership. This reduces the basis of the partner`s partnership interest and may cause gain recognition under  §731(a) or under  §751(b) (see "B.7" above) or pursuant to the minimum gain chargeback rules in the case of nonrecourse liabilities.

3. Transfer of Property Subject to Liability. Section 752(c) and Reg. §1.752-1(e) provide that if property is contributed by a partner to the partnership or distributed by the partnership to the partner and the property is subject to a liability, the transferee is treated as having assumed the liability for purposes of the above rules, to the extent that the amount of the liability does not exceed the fair market value of the property at the time of its transfer.

H. Partnership Income/Loss Allocations.

1.  Partner Responsibility for Income Tax. Section 701 provides that the partners, not the partnership, are taxable on partnership income. Sections 703 and 702 provide for the determination of partnership income, and require that various items related to partnership income or loss be separately stated so that they retain their character on pass- through to the partners as part of each partner`s "distributive share" (i.e., allocable share) of such partnership items for tax purposes.

2.  Partnership Income Allocations. Distributive shares of partnership income are required to be allocated to the partners in accordance with the rules of Section 704 and the accompanying Treasury Regulations. Section 704(b) provides that if allocations of partnership income and loss made to the partners in a partnership agreement have "substantial economic effect", then such allocations will be valid for income tax purposes. "Substantial economic effect" generally means that the income tax allocations made to the partners under the partnership agreement must comply with the technical terms of the interpretive Treasury Regulations, which produces the general result that TAX FOLLOWS ECONOMICS, i.e., the tax allocations must be made consistent with the economic returns realized by the parties. If the partnership agreement makes no provision for the tax allocation of a partnership item, or if the substantial economic test is not met for an item, then it must be allocated in accordance with the partners` "interests in the partnership", which is determined on a facts and circumstances basis that again generally produces the result that TAX FOLLOWS ECONOMICS. In this event, if the allocations actually made to the partners are not consistent with their "interests in the partnership", then the IRS can reallocate them in a manner which does reflect the partners` interests in the partnership. Section 704(c) provides another critical rule which provides in part that as determined under legislative Treasury regulations, income, gain, loss and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of the contribution. A primary goal of this provision is to prevent a partner from shifting (to other partners) the tax consequences associated with built in gain of contributed property (i.e., the tax consequences that would be recognized by the contributing partner if he personally sold the property).

3.  Tax Years. Section 706 provides rules relative to the taxable years of the partnership and its partners, as well as for closing of the partnership year to make gain or loss allocations upon the death of a partner or sale of a partner`s entire partnership interest. Section 706 also provides for allocation of partnership items to the partners in a manner that takes into account their varying interests in the partnership during each year.

4.  Organization Expenses. A special rule for partnership organization or syndication expenses is contained at  §709.

II. Disguised Sales Under Section 707.

A. The Problem in General. Because of the general nonrecognition rules of  §721 and  §731, numerous taxpayers have attempted to structure tax free transactions through joint ventures and partnerships which were the economical equivalent of taxable dispositions of appreciated property. The "mixing bowl" transaction came into vogue, whereby two or more parties contributed properties to a partnership, continued as "partners" for some period of time, and then made distributions from the partnership which resulted in a swap of the properties. Another related transaction involved the admission of new partners into an existing partnership in exchange for contributions of money or other property to the partnership, a reduction in the existing partners` percentage interests in the partnership, and the corresponding distribution of all or part of the newly contributed property to the existing partners. Although the  §721 and  §731 regulations contain authority to treat disguised sales as taxable dispositions of property, the IRS generally had been unable to prevail in cases against taxpayers who postured such transactions as nontaxable through partnerships. See Reg. §1.721-1(a); Reg. §1.731-1(c)(3); Otey v. Comr., 70 T.C. 312 (1978), aff`d per curiam 634 F.2d 1046 (6th Cir. 1980)1 Jupiter Corp. v. U.S., 2 Ct.Cl. 61 (1983); Communications Satellite Corp. v. Comr., 625 F.2d 997 (Ct.Cl. 1980). Example. A and B form general partnership AB, to which A contributes undeveloped real estate worth $200 with an adjusted basis of $75. B contributes cash of $100 to the partnership and obtains on behalf of the partnership a development loan of $100, and B and A have agreed to share partnership net profits and net losses 75% - 25%, respectively. The $100 cash contributed by B is then distributed to A. If  §§721, 731 and 752 are applied mechanically, the basis of A`s partnership interest was increased to $100 by his $25 share of partnership liabilities and then reduced to -0- by the $100 cash distribution, without gain recognition. Does A have gain recognition under the disguised sale rules?

B. Section 707(a)(2)(B) to Deal With Disguised Sales. This section provides as follows: If (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers described in (i) and (ii) when viewed together are properly characterized as a sale or exchange of property, then such transfers shall be treated as transaction between (x) the partnership and a nonpartner or (y) two or more partners acting other than in their capacities as partners of the partnership. In other words, if conditions (i) - (iii) are present, then the "selling" partner must recognize gain or loss based on the payments received from the partnership. Congress authorized the Treasury to promulgate Regulations to further define the scope of the above provisions. The Treasury adopted final regulations for this purpose on September 25, 1992, which are discussed below and generally are effective for such "sales" which occur after April 24, 1991. Reg. §1.707-9(a)(1).

C. General Rules Governing Disguised Sales.

1. Definition and Timing of Sale. Reg. §1.707-3(a)(2) makes clear that if a transaction is treated as a sale under these rules, the general nonrecognition rules of §§721 and 731 do not apply. A transfer treated as a sale is one for all purposes of the Internal Revenue Code (e.g., §§453, 483, 1001, 1012, 1031, and 1274). Id. The sale is deemed to occur on the date that under general principles of federal tax law the partnership would be treated as the owner of the property. Id. Moreover, if a transfer of money or other consideration to the partner occurs after the transfer of the property to the partnership, then the partnership is treated as if it gave the partner on the date of the deemed sale an obligation to transfer to the partner the money or other consideration, with resulting imputed interest concerns. Id. A transaction can be treated as a part sale of the property transferred by the partner to the partnership, with the remaining part of the transaction treated as a nontaxable contribution by the partner covered under  §721 (Reg. §1.707-3(f) Ex. 1).

2. Factors Used to Determine Disguised Sales. Reg. §1.707-3(b)(1) provides that a disguised sale of property (in whole or part) by a partner in exchange for the transfer of money or other consideration (including the assumption of or the taking subject to a liability) by the partnership, will occur only if based on all the facts and circumstances: (x) the transfer by the partnership would not have been made but for the transfer of the property by the partner; and (y) in cases when the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. Reg. §1.707-3(b)(2) lists the following ten factors to be taken into account for this purpose, with the factors to be analyzed as of the date of the earliest of the transfers in question, and factors to be weighted in importance depending on the particular case:

a. The timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer;

b. The transferor has a legally enforceable right to the subsequent transfer;

c. The partner`s right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured;

d. Any person has made or is legally obligated to make contributions to the partnership in order to permit the partnership to make the transfer of money or other consideration;

e. Any person has loaned or has agreed to loan the partnership the money or other consideration required to enable the partnership to make the transfer, taking into account whether any such lender`s obligation is subject to contingencies related to the results of partnership operations;

f. The partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer, taking into account the likelihood that the partnership will be able to incur that debt (considering such factors as whether any person has agreed to guarantee or otherwise assume personal liability for that debt);

g. The partnership holds money or other liquid assets, beyond the reasonable needs of the business, that are expected to be available to make the transfer (taking into account the income that will be earned from those assets);

h. Partnership distributions, allocations and/or control of partnership operations are (is) designed to effect an exchange of the burdens and benefits of ownership of property;

i. The transfer of money or other consideration by the partnership to the partner is disproportionately large in relationship to the partner`s general and continuing interest in partnership profits; and

j. The partner has no obligation to return or repay the money or other consideration to the partnership, or has such an obligation but it is likely to become due at such a distant point in the future that the present value of that obligation is small in relation to the amount of money or other consideration transferred by the partnership to the partner.

3. Rebuttable Presumption that Transfers Within Two Years Are Sales. Reg. §1.707-3(c) provides a presumption that transfers covered by the above rules which occur within a two year period (without regard to the order of the transfers) are sales of the property to the partnership, "unless the facts and circumstances clearly establish that the transfers do not constitute a sale". Likewise, transfers occurring more than two years apart are presumed not to be sales, unless the facts and circumstances clearly establish that the transfers constitute a sale (Reg. §1.707-3(d)). Illustrations of these rules. are contained in the following examples from the Regulations.

4.  Example 1. A transfers property X to partnership AB on April 9, 1992, in exchange for an interest in the partnership. At the time of the transfer, property X has a fair market value of $4,000,000 an adjusted tax basis of $1,200,000. Immediately after the transfer, the partnership transfers $3,000,000 in cash to A. Assume the partnership`s transfer of cash to A is treated as part of a sale of property X to the partnership. Because the amount of cash A receives on April 9, 1992, does not equal the fair market value of the property, A is considered to have sold a portion of property X with a value of $3,000,000 to the partnership in exchange for the cash. Accordingly, A must recognize $2,100,000 of gain (3,000,000 amount realized less $900,000 adjusted tax basis (1,200,00 multiplied by 3,000,000/4,000,000)). Assuming A receives no other transfers that are treated as consideration for the sale of the property under this section, A is considered to have contributed to the partnership, in A`s capacity as a partner, $1,000,000 of the fair market value of the property with an adjusted tax basis of $300,000.  Reg. §1.707-3(f)Ex.l.

5.  Example 2. The facts are the same as in Example 1, except that the $3,000,000 is transferred to A one year after A`s transfer of property X to the partnership. Assume that the partnership`s transfer of cash to A is treated as part of a sale of property X to the partnership. Assume also that the applicable Federal short-term rate for April, 1992, is 10 percent, compounded semiannually. A and the partnership are treated as if, on April 9, 1992, A sold a portion of property X to the partnership in exchange for an obligation to transfer $3,000,000 to A one year later. Section 1274 applies to this obligation because it does not bear interest and is payable more than six months after the date of the sale. As a result, A`s amount realized from the receipt of the partnership`s obligation will be the imputed principal amount of the partnership`s obligation to transfer $3,000,000 to A, which equals $2,721,088 (the present value on April 9, 1992, of a $3,000,000 payment due one year later, determined using a discount rate of 10 percent, compounded semiannually). Therefore, A`s amount realized from the receipt of the partnership`s obligation is $2,721,088 (without regard to whether the sale is reported under the installment method). A is therefore considered to have sold only $2,721,088 of the fair market value of property X. The remainder of the $3,000,000 payment ($278,912) is characterized in accordance with the provisions of section 1272. Accordingly, A must recognize $1,904,761 of gain ($2,721,088 amount realized less $816,327 adjusted tax basis ($1,200,000 multiplied by $2,721,088/$4,000,000)) on the sale of property X to the partnership. The gain is reportable under the installment method of section 453 if the sale is otherwise eligible. Assuming A receives no other transfers that are treated as consideration for the sale of property under this section, A is considered to have contributed to the partnership, in A`s capacity as a partner, $1,278,912 of the fair market value of property X with an adjusted tax basis of $383,673. Reg. §1.707-3(f)Ex.2.

6.  Example 3. C transfers undeveloped land to the CD partnership in exchange for an interest in the partnership. The partnership intends to construct a building on the land. At the time the land is transferred to the partnership, it is unencumbered and has an adjusted tax basis of $500,000 and a fair market value of $1,000,000. The partnership agreement provides that upon completing construction of the building the partnership will distribute $900,000 to C. If, within two years of C`s transfer of land to the partnership, a transfer is made to C pursuant to the provision requiring a distribution upon completion of the building, the transfer is presumed to be part of a sale of the land to the partnership. C may rebut the presumption that the transfer is part of a sale if the facts and circumstances clearly establish that the transfer to C would be made without regard to C`s transfer of land to the partnership; or the partnership`s obligation or ability to make this transfer to C depends, at the time of the transfer to the partnership, on the entrepreneurial risks of partnership operations. For example, if the partnership will be able to fund the transfer of cash to C only to the extent that permanent loan proceeds exceed the cost of constructing the building, the fact that excess permanent loan proceeds will be available only if the cost to complete the building is significantly less than the amount projected by a reasonable budget would be evidence that the transfer to C is not part of a sale. Similarly, a condition that limits the amount of the permanent loan to the cost of constructing the building (and thereby limits the partnership`s ability to make a transfer to C) unless all or a substantial portion of the building is leased would be evidence that the transfer to C is not part of a sale, if a significant risk exists that the partnership may not be able to lease the building to that extent. Another factor that may prove that the transfer of cash to C is not part of a sale would be that, at the time the land is transferred to the partnership, no lender has committed to make a permanent loan to fund the transfer of cash to C. Facts indicating that the transfer of cash to C is not part of a sale, however, may be offset by other factors. An offsetting factor to restrictions on the permanent loan proceeds may be that the permanent loan is to be a recourse loan and certain conditions to .the loan are likely to be waived by the lender because of the creditworthiness of the partners or the value of the partnership`s other assets. Similarly, the factor that no lender has committed to fund the transfer of cash to C may be offset by facts establishing that the partnership is obligated to attempt to obtain such a loan and that its ability to obtain such a loan is not significantly dependent on the value that will be added by successful completion of the building, or that the partnership reasonably anticipates that it will have (and will utilize) an alternative source to fund the transfer of cash to C if- the permanent loan proceeds are inadequate.          Reg. §1.707-3(f)Ex.3.

7.  Example 4. G transfers undeveloped land to the GH partnership in exchange for an interest in the partnership: At the time the land is transferred to the partnership, it is unencumbered and has an adjusted tax basis of $500,000 and a fair market value of $1,000,000. H contributes $1,000,000 in cash in exchange for an interest in the partnership. Under the partnership agreement, the partnership is obligated to construct a building on the land. The projected construction cost is $5,000,000, which the partnership plans to fund with its $1,000,000 in cash and the proceeds of a construction loan secured by the land and improvements. Shortly before G`s transfer of the land to the partnership, the partnership secures commitments from lending institutions for construction and permanent financing. To obtain the construction loan, H guarantees completion of the building for a cost of $5,000,000. The partnership is not obligated to reimburse or indemnify H if H must make payment on the completion guarantee. The permanent loan will be funded upon completion of the building, which is expected to occur two years after G`s transfer of the land. The amount of the permanent loan is to equal the lesser of $5,000,000 or 80 percent of the appraised value of the improved property at the time the permanent loan is closed. Under the partnership agreement, the partnership is obligated to apply the proceeds of the permanent loan to retire the construction loan and to hold any excess proceeds for transfer to G 25 months after G`s transfer of the land to the partnership. The appraised value of the improved property at the time at the permanent loan is closed is expected to exceed $5,000,000 only if the partnership is able to lease a substantial portion of the improvements by that time, and there is significant risk that the partnership will not be able to achieve a satisfactory occupancy level. The partnership completes construction of the building for the projected cost of $5,000,000 approximately two years after G`s transfer of the land. Shortly thereafter, the permanent loan is funded in the amount of $5,000,000. At the time of funding the land and building have an appraised value of $7,000,000. The partnership transfers the $1,000,000 excess permanent loan proceeds to G 25 months after G`s transfer of the land to the partnership. G`s transfer of the land to the partnership and the partnership`s transfer of $1,000,000 to G occurred more than two years apart. Those transfers are presumed not to be a sale unless the facts and circumstances clearly establish that the transfers constitute a sale of the property, in whole or part to the partnership. The transfer of $1,000,000 to G would not have been made but for G`s transfer of the land to the partnership. In addition, at the time G transferred the land to the partnership, G had a legally enforceable right to receive a transfer from the partnership at a specified time an amount that equals the excess of the permanent loan proceeds over $4,000,000. In this case, however, there was a significant risk that the appraised value of the property would be insufficient to support a permanent loan in excess of $4,000,000 because of the risk that the partnership would not be able to achieve a sufficient occupancy level. Therefore, the facts of this example indicate that at the time G transferred the land to the partnership the subsequent transfer of $1,000,000 to G depended on the entrepreneurial risks of partnership operations. Accordingly, G`s transfer of the land to the partnership is not treated as part of a sale. Reg. §. 1.707-3(f) Ex.5.

8. Example 5. The facts are the same as in Example 4, except that the partnership is able to secure a commitment for a permanent loan in the amount of $5,000,000 without regard to the appraised value of the improved property at the time the permanent loan is funded. Under these facts, at the time that G transferred the land to the partnership the subsequent transfer of $1,000,000 to G was not dependent on the entrepreneurial risks of partnership operations, because during the period before the permanent loan is funded, the permanent lender`s obligation to make a loan in the amount necessary to fund the transfer is not subject to contingencies related to the risks of partnership operations, and after the permanent loan is funded, the partnership holds liquid assets sufficient to make the transfer. Therefore, the facts and circumstances clearly establish that G`s transfer of the land to the partnership is part of a sale. Reg. §. 1.707-3(f) Ex. 6.

D. Exceptions; Rules for Guaranteed Payments, Preferred Returns, Etc.

1.  Guaranteed Payments. Reg. §. 1-707-4(a)(1) makes clear that a guaranteed payment for the use of capital made to a partner is not treated as a disguised sale. A "guaranteed payment for capital" is defined by cross reference to §707(c) (see "I.F.1." above), is for the use of the partner`s capital, and is determined without regard to partnership income. Id. Irrespective of the two year presumption applying to transfers discussed in "II.C" above, if a transfer of money to a partner (a) is characterized by the parties as a-guaranteed payment for capital, (b) is determined without regard to the income of the partnership, and (c) is reasonable (as discussed in "3" below), then it is presumed to be a guaranteed payment for capital unless the facts and circumstances clearly establish that the transfer is not a guaranteed payment and instead is part of a sale. Id. Similarly, any such transfer that is not reasonable in amount (as discussed in "3" below) is presumed not to be a guaranteed payment for capital unless the facts and circumstances clearly establish otherwise. Id. Accordingly, the parties` characterization of the payment, while relevant, is not controlling. Id. Moreover, if any such payment(s) is (are) designed to liquidate all or part of the partner`s partnership interest, rather than provide the partner with a return on an investment in the partnership, then it is not a guaranteed payment and instead must be treated under the disguised sale rules. Id.

2.  Preferred Returns. A preferred return is defined as a preferential distribution of partnership cash flow to a partner (with respect to contributed capital) that will be matched, to the extent available, by an allocation to such partner of partnership income or gain (see "I.F.2" above). Reg. §1.707-4(a)(2). Again, irrespective of the two year presumption governing disguised sales, a transfer of money to a partner that (a) is characterized by the parties as a preferred return and (b) is reasonable (as discussed in "3" below), is presumed not to be a disguised sale. Id. This presumption can be rebutted if the facts and circumstances (including the likelihood and expected timing of the subsequent allocation of income or gain to support the preferred return) clearly establish that the transfer is part of a sale. Id.

3.  Reasonableness. A payment characterized as a preferred return or guaranteed payment is reasonable only to the extent that it (a) is made pursuant to a written partnership agreement, (b) is made for the use of capital after the date when the provision is added to the partnership agreement, and (c) is a "reasonable amount" as discussed below. Reg. §1.707-4(a)(3). Under a formula set forth more particularly in the regulations, any such payment to a partner during a partnership taxable year is a "reasonable amount" if all such preferred returns and guaranteed payments for capital to the partner during such year do not exceed (x) the partner`s unreturned capital account balance, multiplied by (y) a safe harbor interest rate (which equals 150% of the highest applicable federal rate in effect during the partnership taxable year). Id. Examples of these rules are contained at Reg. §1.707-4(a)(4).

4.  Operating Cash Flow Distributions. Reg. §1.707-4(b)(1) provides that irrespective of the two year presumption governing disguised sales, "operating cash flow distributions" (as described in this paragraph "4") are not part of a disguised sale, unless the facts and circumstances clearly establish that the transfer is part of a sale.

a. Operating cash flow distributions are one or more transfers of money by the partnership during its taxable year to a partner, to the extent that those transfers:

(1) are not presumed to be guaranteed payments for capital as described above;

(2) are not reasonable preferred returns as described above;

(3) are not characterized by the parties as distributions to the partner acting in a capacity other than as a partner; and

(4) do not exceed the "net cash flow of the partnership from operational` (defined below) for the year, multiplied by the lesser of the partner`s (A) percentage interest in overall partnership profits for that year or (8) percentage interest in overall partnership profits for the life of the partnership. Reg. §1.707-4(b)(2).

b. The "net cash flow of the partnership from operations" for a taxable year is equal to its taxable income or lose arising in the ordinary course of its business and investment activities; increased by tax exempt interest, depreciation, amortization, cost recovery allowances and other noncash charges deducted in determining such taxable income; and decreased by:

(1) principal payments made on any partnership debt,

(2) property replacement or contingency reserves actually established by the partnership,

(3) capital expenditures when made other than from reserves or borrowings, and

(4) any other cash expenditures (including preferred returns) not deducted in determining such taxable income or loss. Id.

5. Reimbursements of Preformation Expenditures. As provided at Reg. §1.707-4(d), certain payments made by the partnership to the partner as reimbursements of preformation expenditures made by the partner are not considered to be part of a disguised sale.

E. Disguised Sales occurring in Connection With Partnership Liabilities.

1. The Problem. Through the partnership`s assumption (or taking contributed property subject to) a partner`s debt, or through the distribution of loan proceeds to the contributing partner of a loan obtained by the partnership against the contributed property, the parties may find themselves in an economic position equivalent to those which Congress sought to address in the disguised sale statute. However, the legislative history of Code §707(a)(2)(8) recognized that the general nonrecognition rules involving the interplay of §§721, 731, and 752 in connection with the assumption of liabilities would continue to apply in appropriate situations. These situations should include contributions to a partnership of property subject to a liability which was not incurred in anticipation of the contribution. S.Rep. No. 169, Vol.l, 98th Cong., 2d Sess. at 230 (4/2/84). Nonetheless, the legislative history also recognized the potential for abusive situations which are economically equivalent to disguised sales. Id. at 231. Reg. §1.707-5 (see below) addressed these issues, although imperfectly.

2. Qualified Liabilities are Good! As provided in the regulations, a partnership`s assumption (or taking contributed property subject to) a "qualified liability" (discussed below) is not a disguised sale and is treated under the general rules of §§721, 731 and 752, except in the limited situation discussed below where the contributing partner also receives some other cash or property from the partnership. Reg. §1.707-5(a)(5)(i). On the other hand, if a partnership assumes a liability of a partner other than a qualified liability, the transaction can result in a disguised sale. Reg. §1.707-5(a)(1). A "qualified liability" of a partner means a liability assumed or taken subject to by a partnership in connection with a transfer of property to the partnership by such partner, but only to the extent that the liability:

a. was incurred by the partner more than two years prior to the earlier of (1) the date the partner agrees in writing to transfer the property, or (2) the date the partner transfers the property to the partnership (in addition, the liability must have encumbered the property throughout such two year period);

b. was incurred within the two year period described in "a" above, but was not incurred in anticipation of the transfer of the property to the partnership (which conclusion must be "clearly established" under the two year presumption rule described in "3" below), and the liability must have encumbered the property since it was incurred;

c. is allocable under the rules of Reg. §1.163-8T to capital expenditures with respect to the property; OR

d. was incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all assets which are material to a continuation of the trade or business are transferred to the partnership in the transaction. Reg. §1.707-5(a)(6)(i).

In addition, if it is a recourse liability, it is a qualified liability only to the extent that its amount does not exceed the fair market value of the transferred property (less the amount of any other liabilities which are senior in priority and either encumber such property or are described in "c" or "d" above) at the time of such transfer. Reg. §1.707­5(a)(6)(1i).

3. Two Year Presumption Rule. If within a two year period a partner incurs a liability (other than one described in "2.c or d" above) and transfers property to a partnership (or agrees in writing to transfer property), and in connection with such transfer the partnership assumes (or be incurred in anticipation of the transfer unless the facts and circumstances clearly establish that the liability was not incurred in anticipation of the transfer. Reg. §1.707-5(a) (7).

4.  Partnership`s Assumption of Nonqualified Liability. If the partnership assumes (or takes property subject to) a liability of a partner other than a qualified liability, the partnership is treated as transferring consideration to the partner to the extent that the amount of the liability exceeds the "partner`s share" of that liability (as determined in "6" below) immediately after the partnership`s assumption of the liability. Reg. 51.707-5(a)(1). This consideration deemed received by the transferring partner is then tested under the rules described at "C" above to determine if it is. part of a disguised sale.

5. Partnership`s Assumption of Qualified Liability When Transferring Partner Also Receives Other Consideration. In connection with such a transfer, if the partner also receives money or other consideration from the partnership (which is determined under the rules at "C" above to be part of a disguised sale without reference to the partnership`s assumption of the liability), then the partner is treated as receiving consideration determined as discussed in "4" above; provided that the amount of the consideration may be limited under a formula contained at Reg. §1.707-5(a)(5).

6.  Partner`s Share of Liability. For purposes of these regulations, a "partner`s share" of any liability of the partnership is determined under the following rules:

a. Reg. §1.707-5(a)(2)(i) provides that a partner`s share of a partnership recourse liability is determined under the rules of §752 and the regulations thereunder. Under those rules (which are discussed at "V.B.5" below), (1) a recourse liability is one for which any partner or related person bears the economic risk of loss, and (2) the partners` shares in the liability are determined based on the extent that each partner ultimately bears such risk of lose, taking into account all statutory and contractual rights concerning guarantees, indemnification, reimbursement agreements, etc. Reg. §1.752-2(a), (b).

b. Reg. §1.707-5(a)(2)(11) provides that a partner`s share of a partnership nonrecourse liability (see "V.B.6" below), which is a partnership liability for which no partner or related person bears the economic risk of lose (Reg. §1.752-1(a)(2)), is determined by using the same percentage used to determine the partner`s share of excess nonrecourse liability as provided in Reg. §1.752-3(a)(3) (i.e., determined in accordance with such partner`s share of partnership profits as provided in .such regulation).

c. Reg. §1.707-5(a)(3) provides that in determining a "partner`s share" of a partnership liability for these purposes, a subsequent reduction in the partner`s share is taken into account if (1) at the time of the partnership`s assumption of the liability it is anticipated that the reduction will occur, and (2) the reduction is part of a plan that has as one of its principal purposes the minimization of the consideration received by a partner in a disguised sale.

d. Reg. §1.707-5(a)(4) contains special rules concerning the determination of a "partner`s share" of a partnership liability when `the partnership assumes liabilities of more than one partner pursuant to a plan.

7.  Debt-financed Transfer of consideration by Partnership to Partner. Reg. §1.707-5(b) addresses the disguised sale issue arising if a partnership borrows money and distributes all or part of the loan proceeds to a partner who transfers property to the partnership. The section provides that if proceeds of such loan are allocable to a transfer of money or other consideration to such partner within 90 days of incurring such liability, then the amount received by the partner is taken into account (as part of a disguised sale) only to the extent that such amount exceeds the "partner`s allocable share of the partnership liability" (which is determined in accordance with special rules in that section).

8.  Refinancings. Reg. §1.707-5(c) provides that to the extent that the proceeds of a partner or partnership liability (the "refinancing debt") are allocable to payments discharging all or part of any other liability of that partner or the partnership (as the case may be), then the refinancing debt will be treated in the same manner as the refinanced debt for purposes of this regulation. It should be noted however that the refinancing debt may be treated differently than the refinanced debt with respect to determinations involving recourse or nonrecourse liabilities.

9.  Example 1. Partnership`s assumption of nonrecourse liability encumbering transferred property. A and B form partnership AB, which will engage in renting office space. A transfers $500,000 in cash to the partnership, and B transfers an office building to the partnership. At the time it is transferred to the partnership, the office building has a fair market value of $1,000,000, an adjusted basis of $400,000, and is encumbered by a $500,000 liability, which B incurred 12 months earlier to finance the acquisition of other property. No facts rebut the presumption that the liability was incurred in anticipation of the transfer of the property to the partnership. Assume that this liability is a nonrecourse liability of the partnership within the meaning of section 752 and the regulations thereunder. The partnership agreement provides that partnership items will be allocated equally between A and B, including excess nonrecourse deductions under §1.752-3(a)(3). The partnership agreement complies with the requirements of §1.704-1(b)(2)(ii)(b). The nonrecourse liability secured by the office building is not a qualified liability. B would be allocated 50 percent of the excess nonrecourse liability under the partnership agreement. Accordingly, immediately after the partnership`s assumption of that liability, B`s share of the liability equals $250,000, which is equal to B`s 50 percent share of the excess nonrecourse liability of the partnership as determined in accordance with B`s share of partnership profits under §1.752-3(a)(3). The partnership`s taking subject to the liability encumbering the office building is treated as a transfer of $250,000 of consideration to B (the amount by which the liability ($500,000) exceeds B`s share of that liability immediately after taking subject to ($250,000)). B is treated as having sold $250,000 of the fair market value of the office building to the partnership in exchange for the partnership`s taking subject to a $250,000 liability. This results in a gain of $150,000 ($250,000 minus ($250,000/$1,000,000 multiplied by $400,000)). Reg. §. 1,707-5(f) Ex. 1.

10.  Example 2. Partnership`s assumption of recourse liability encumbering transferred property. C transfers property Y to a partnership. At the time of its transfer to the partnership, property Y has a fair market value of $10,000,000 and is subject to an $8,000,000 liability that C incurred, immediately before transferring property Y to the partnership, in order to finance other expenditures. Upon the transfer of property Y to the partnership, the partnership assumed the liability encumbering that property. The partnership assumed this liability solely to acquire property Y. Under section 752 and the regulations thereunder, immediately after the partnership`s assumption of the liability encumbering property Y, the liability is a recourse liability of the partnership and C`s share of that liability is $7,000,000. Under the facts of this example, the liability encumbering property Y is not a qualified liability. Accordingly, the partnership`s assumption of the liability results in a transfer of consideration to C in connection with C`s transfer of property Y to the partnership in the amount of $1,000,000 (the excess of the liability assumed by the partnership ($8,000,000) over C`s share of the liability immediately after the assumption ($7,000,000)). Reg. §.1.707­5(f) Ex. 2.

F. Disguised Sales by Partnership to Partner. Reg. §1.707-6 treats disguised sales by a partnership to its partner and contains rules similar to those in Reg. §1.707-3 and 1.707-5 (see "D" and "E" above). Examples of application of these rules are contained in §1.707-6(d) as follows:

Example 1. Sale of property by partnership to partner. A is a member of a partnership. The partnership transfers property X to A. At the time of the transfer, property X has a fair market value of $1,000,000. One year after the transfer, A transfers $1,100,000 to the partnership. Assume that under the rules of section 1274 the imputed principal amount of an obligation to transfer $1,100,000 one year after the transfer of property X is $1,000,000 on the date of the transfer. Since the transfer of $1,100,000 to the partnership by A is made within two years of the transfer of property X to A, under rules similar to those provided in §1.707-3(c), the transfers are presumed to be a sale unless the facts and circumstances clearly establish otherwise. If no facts exist that would rebut this presumption, on the date that the partnership transfers property X to A, the partnership is treated as having sold property X to A in exchange for A`s obligation to transfer $1,100,000 to the partnership one year later.

Example 2. Assumption of liability by partner. B is a member of an existing partnership. The partnership transfers property Y to B. On the date of the transfer, property Y has a fair market value of $1,000,000 and is encumbered by a nonrecourse liability of $600,000. B takes the property subject to the liability. The partnership incurred the nonrecourse liability six months prior to the transfer of property Y to B and used the proceeds to purchase an unrelated asset. Assume that, under rule of §1.707-5(a)(2)(ii) (which determines a partner`s share of a nonrecourse liability), B`s share of the nonrecourse liability immediately before the transfer of property Y was $100,000. The liability is not allocable under the rules of §1.163-8T to capital expenditures with respect to the property transferred to B and was not incurred in the ordinary course of the trade or business in which the property transferred to the partner was used or held. Since the partnership incurred the nonrecourse liability within two years of the transfer to B, under rules similar to those provided in §1.707-5(a)(5), the liability is presumed to be incurred in anticipation of the transfer unless the facts and circumstances clearly establish the contrary. Assuming no facts exist to rebut this presumption, the liability taken subject to by B is not a qualified liability. The partnership is treated as having received, on the date of the transfer of property Y to B, $500,000 ($600,000 liability assumed by B less B`s share of the $100,000 liability immediately prior to the transfer) as consideration for the sale of one-half ($500,000/$1,000,000) of property Y to B. The partnership is also treated as having distributed to B, in B`s capacity as a partner, the other one-half of property Y.

G. Disclosure Requirements. Effective for transactions with respect to which all transfers that are part of a sale of property occur after September 30, 1992 (Reg. §1.707-9(b)), Reg. §1.707-8 requires disclosure related to disguised sales. The disclosure must be made on a completed Form 8275 or on a statement attached to the return of the transferor of the property for the taxable year of the transfer, and must contain the items set forth in §1.707-8(b). The transactions required to be disclosed are as follows:

1.  Transfers Made Within Two Years of Each Other. Reg. §1.707-3(c)(2) requires disclosure if:

a. A partner transfers property to a partnership and the partnership transfers money or other consideration to the partner within a two year period (without regard to the order of the transfers);

b. The partner treats the transfer other than as a sale for tax purposes; and

c. The transfer of money or other consideration to the partner is not presumed to be a guaranteed payment for capital, a reasonable preferred return, or an operating cash. flow distribution (as described in "D" above).

2.  Liability Incurred Within Two Years of a Transfer of Property. Reg. §1.707-5(a)(7)(11) requires disclosure if a partner treats as a qualified liability, a liability which is assumed (or taken subject to) by the partnership within two years of such partner`s transfer of property to the partnership.

3.  Analogous Situations Involving Transfer of Property by Partnership to Partner. Reg. §1.707-6(c) requires disclosure in transactions analogous to those in "1" and "2" above involving transfers of property by the partnership to the partner.

III. Other Recognition Transactions Involving- Contributed Property.

A. Distributions of Contributed Property - Section 704(c)(1)(B).

1. Code §704(c)(1)(B). This section provides that as determined under legislative Treasury regulations, if any property contributed by a partner to the partnership is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 5 years of being contributed, then the contributing partner may recognize gain or lose as follows:

a. The contributing partner shall be treated as recognizing gain or loss (as the case may be) from the sale of such property in an amount equal to the gain or loss which would be allocated to such partner under §704(c)(1)(A) (see "d" below) had the property actually been sold by the partnership at its fair market, value at the time of the distribution.

b. The character of the gain or lose shall be determined by reference to the character of the gain or lose which. would have resulted, if the property had been sold by the partnership to the distributes.

c. Appropriate adjustments shall be made to the adjusted basis of contributing partner`s partnership interest and to the adjusted basis of the distributed property to reflect any gain or, loss recognized under these provisions.

d. Section 704(c)(1)(A) (referred to in "a" above) provides that as determined under legislative Treasury regulations, if there is a difference between the adjusted basis of property to the partnership and its fair market value at the time of its contribution to the partnership then subsequent items of partnership income, gain, lose and deduction shall be allocated to the partners in a manner to take into account such difference.

e. The effective date of §704(c)(1)(B) is for all property contributed to a partnership after October 3, 1989. Congress saw fit to amend the section in the Energy Policy Act of 1992, effective for distributions after June 24, 1992, to add the parenthetical "(directly or indirectly)" after "distributed" (see "1" above).

f. Note that the partnership may distribute the contributed property to the contributing partner without gain recognition under this provision!

2.  Example. The accompanying Senate Finance Committee Report notes that the purpose of the provision is to prevent partners from circumventing the rule (in §704(c)(1)(A)) requiring precontribution gain to be allocated to the contributing partner, and contains the following example: If a partner contributes property (e.g., raw land) with a basis of 20 and a value of 100, and the partnership distributes it to other, partners within the prohibited time period (5 years) at a time when the property`s value is 150, the contributing partner is treated as recognizing a gain of 80 (i.e., the difference between basis and value at the time of contribution). If the property instead had a value of 60 at the time of distribution to the other partners, the contributing partner would .recognize a gain of 40 (i.e., the part of the difference between contribution value and basis that would have been recognized had the partnership sold the property at/ its fair market value at the time of distribution). These examples assume no intervening allocations were made or required to be made to the contributing partner under §704(c). Although the Committee`s example does not so specify, the statute provides that appropriate basis adjustments should be made. In the latter illustration, for example, presumably the contributed property would receive a stepped-up basis from 20 to 60, and the contributing partner`s partnership interest also would be increased by the 40 gain such partner recognizes.

3.  Successor Partner Affected. Section 704(c)(3) makes clear that a successor partner will be treated as the contributing partner for purposes of the above rules. Accordingly, successor partners should consider having the partnership make a §754 election so they may benefit from the corresponding basis adjustment in partnership property under §743 in order to protect against unwelcome gain resulting from the partnership`s distribution of contributed property within the 5 year period following its contribution to the partnership.

4.  Disguised Sale Rules Control. The accompanying Senate Finance Committee Report indicates that in a transaction which is covered both by the contributed property rules above and the disguised sale rules of §707(a)(2)(B), the disguised sale rules govern.

5.  Special Like Kind Exchange Rule. Section 704(c)(2) contains a special rule which provides tax free treatment for certain distributions which have economic results similar to like kind exchanges allowed under §1031. The statute provides that if (a) property contributed by the contributing partner to the partnership is distributed by the partnership to another partner, and (b) other property of a "like kind" (within the meaning of §1031) is distributed by the partnership to the contributing partner not later than the earlier of (1) the 180th day after the date of the distribution to the other partner, or (2) the due date (without regard to extensions) of the contributing partner`s return for the tax year in which the distribution to the other partner occurs, then tax free treatment is available to the contributing partner to the extent provided below. To the extent of the value of the property distributed to the contributing partner, such partner is treated as actually having contributed such property to the partnership, so no gain results to the contributing partner under the rules described in this section "A". As an example, assuming the facts described in the example at "2" above, further assume that the contributed property is distributed to another partner when its value is 100, and within the time period set forth in this paragraph 11511 the partnership distributes "like kind" property valued at 80 to the contributing partner. Under this "like kind exchange" rule, the contributing partner is treated as having originally contributed the property valued at 80 and as having sold 20 of the originally contributed property. Presumably, basis is allocated proportionately such that 20% (i.e., 20 property sold / 100 value of contributed property) of the 20 basis is applied against the 20 realized in the sale, resulting in a recognized gain to the contributing partner of 16 under §704(c)(1)(B).

B. Recognition of Precontribution Gain Under Section 737.

1.  Section 737. Although the rules in "A" above addressed Congressional concern about a partner`s ability to avoid precontribution gain when contributed property was distributed to another partner, Congress perceived a loophole (not covered by the then existing disguised sale rules) in situations where the partnership retained the contributed property but instead distributed other property to the contributing partner. Section 737, effective for partnership distributions after June 24, 1992, generally provides for recognition of "precontribution gain" by the contributing partner within the 5 year period following the contribution of appreciated property to the partnership, if the contributing partner receives a distribution of partnership property (other than money or property which was contributed by such partner) during such period (for purposes of this section "B", hereafter referred to as a "Distribution"). §737(a) provides as follows: generally, upon a Distribution by a partnership to a partner, such partner shall recognize gain equal to the lesser of

a. the excess (if any) of (1) the fair market value of property (other than money) received in the Distribution over (2) the adjusted basis of the partner`s partnership interest immediately before the Distribution reduced (but not below zero) by the money received (if any) in the Distribution; or

b. the "net precontribution gain" of the partner (see "2" below).

Gain recognized as provided above is in addition to any gain recognized under §731 (i.e., because the money received exceeds the basis of the distributes partner`s interest). §737(a). The character of any such §737 gain is determined by reference to the proportionate character of the net precontribution gain. Id. §737(d)(1) provides that property originally contributed by the distributee partner to the partnership, if distributed to the distributee, is disregarded and accordingly will not trigger §737 gain. Note also that an affected partner may be able to avoid or minimize §737 gain by the timely contribution of money or additional property to the partnership in order to increase the basis of his partnership interest such that no gain is recognized upon a Distribution.

2.  Net Precontribution Gain. Section 737(b) defines "net precontribution gain" as the net gain (if any) which would have been recognized by the distributee partner under §704(c)(1)(B) (see "A" above) if all property covered by this §737(b) rule had been distributed by the partnership to another partner at the same time as the Distribution. This §737(b) property is all property which had been contributed by the distributee partner in question within 5 years of the Distribution, and for this purpose the property is treated as owned by the partnership regardless of whether the partnership actually still owns such property at the time of the Distribution. Note that this calculation provides for the netting of precontribution gains and losses, so it may be possible for an affected partner to contribute property with a built in loss to the partnership in order to minimize §737 gain consequences. This planning opportunity may be limited however by the disguised sale rules or by §267 loss limitations on transactions between related parties.

3.  Basis Adjustments. Section 737(c)(1) provides that the adjusted basis of a distributee partner`s partnership interest shall be increased by the amount of any gain recognized by such partner under §737(a). Section 737(c)(2) provides that the partnership`s adjusted basis in contributed property described in §737(b) shall be adjusted appropriately to reflect the gain recognized under §737(a).

4.  Override of Section 751(b). Section 737(d)(2) provides that §737 does not apply to the extent that §751(b) applies with respect to partnership "hot assets".

5.  Distributions Using Related Entities. Section 737(d)(1) provides a rule designed to preclude circumvention of §737 through the use of related entities to avoid the recognition of precontribution gain.

6.  Example. The accompanying Conference Committee Report contains the following example: Assume A and B form a partnership. A contributes appreciated property X and B contributes property Y, which has a basis equal to its value at the time of contribution. Y is distributed to A within 5 years, at a time when there have been no intervening distributions or dispositions of property by the partnership. Under the provision, A includes in income his precontribution gain with respect to B to the extent the value of Y exceeds A`s basis in his partnership interest.

7.  Comparison With Disguised Sale Rules. Although there is an overlap of transactions covered by both §737 and the disguised rules, §737 will "catch" some property transfers which are more than two years apart (up to the 5 year coverage period) which would-not be affected under the disguised sale rules because of §707(a)(2)(B)`s presumption that transfers more that two years apart are not sales unless clearly established otherwise. In addition, note that unlike the disguised sale rules, §737 does not characterize the initial property transfer as a sale, but merely requires that the contributing partner recognize gain. Section 737 application is not dependent on a partner`s intent. If the disguised sale rules apply to a transaction, however, it appears that §737 will not apply since the gain recognized upon the initial property transfer in a disguised sale will eliminate any precontribution gain which otherwise might be taxable under §737.

IV. Taxation of a Partnership Interest Issued for Services.

A. Background; Taxation of Receipt of a Capital Interest. The general rules concerning the tax consequences of a partner`s transfer of "property" to a partnership in exchange for a partnership interest have been discussed above. Generally speaking, the interplay of §§721, 731 and 752 (concerning deemed contributions and distributions of money to the partnership in connection with partnership liabilities) allow for tax free transfers of property between the partnership and a partner, except to the extent that any money distributed exceeds the basis of the distributes partner`s interest. This nonrecognition treatment is substantially modified to result in gain recognition in many cases covered by the disguised sale rules or other tax rules affecting transfers between the partnership and its partners as discussed in "III" above.

1.  Nature of a Partnership Interest. The "partnership interest" received by a partner upon the partner`s transfer of consideration to the partnership is a bundle of rights that may be subdivided into a capital interest, a profits interest, management and voting rights, and possibly others. Income tax analysis in this area focuses principally on the capital interest and the profits interest. Generally speaking, a partner`s capital interest represents the amount of net equity in partnership property which the partner would be entitled to receive upon a liquidating distribution, while a partner`s profits interest is his right to receive subsequent allocations of partnership income and losses and the right to receive distributions corresponding to the same.

2. Section 721 and Receipt of Partnership Interest for Services. As noted above, generally the law and §721 in particular provide for nonrecognition upon the contribution of "property" by a partner in exchange for a partnership interest. The partnership interest received by a contributing partner should include both a capital and a profits interest, unless the contributing partner is not credited with a capital interest because the contributed property is deemed to have no value or unless a taxable transfer of the capital interest occurs. Although §721 does not address the receipt of a capital interest received in exchange for services rendered by the partner, the accompanying regulations provide that a partner`s receipt of a capital interest in exchange for such partner`s services is taxable. Reg. §1.721-1(b)(1). However, the clear inference from these regulations (see "B.1" below) is that the mere receipt of a naked profits interest in exchange for a partner`s services (or promise to render future services) does not create taxable income, and this has been the prevailing view of tax practitioners for years (but see caveats discussed in "B" below).

3.  Application of Section 83 to Capital Interest Received for Services. Although the §721 regulations discussed in "8.1" below set forth valuation principles in determining the amount and timing of taxable income upon receipt of a partnership capital interest in exchange for services, §83 actually governs these issues. Section 83(a) provides generally that if in connection with the performance of services, property is transferred to the one rendering the service (or to any person other than the service recipient), then taxable income can be recognized by the service provider upon the earlier of (a) the time when the property is transferable by the party having the beneficial interest in the property, or (b) the time when such party`s rights are no longer subject to a substantial risk of forfeiture. The amount of income recognized by the service provider is equal to the excess of the fair market value of such property as of the earlier of "(a)" or "(b)" above, over the amount (if any) paid for the property. Id. Note that a person`s rights in property are subject to a substantial risk of forfeiture if such person`s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual. §83(c)(1).

4.  Example. In Mark IV Pictures, Inc., 969 F.2d 669 (8th Cir. 1992), the Eighth Circuit in affirming the Tax Court found that partnership interests received by general partners in film production limited partnerships were taxable to the general partners under §83 because the capital interests received were freely transferable and were not conditioned upon the performance of additional services. The related partnership documentation and offering circulars established that upon monetary capital contributions by the limited partners, the general partners would be credited with 50% of such funds, which indicated a capital account shift to the general partners to this extent. The Tax Court used the amounts computed by this 50% capital shift of the contributions made by the limited partners to determine the amount of §83 income recognized by the general partners. Noting that such a factual finding was reviewable only for clear error, the Appeals Court concluded that "under the unique factual circumstances" of the case, the Tax Court`s valuation finding was not clear error.

B. Taxation of Profits Interest Issued for Services.

1.  Background. The Section 721 regulations provide that "to the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services…, section 721 does not apply"; and "the value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61" (emphasis added). Id. It should be noted that these are merely interpretative regulations. Nonetheless, even allowing for the inference that taxation of receipt of a profits interest in exchange for services is not addressed at all by §721 and its regulations, it is noteworthy that the regulations make no provision for the value of the profits interest received by the service partner in determining the amount of income such partner recognizes (which instead is measured by the value of the capital interest received). This merely recognizes what tax practitioners have long believed, that even if receipt of a profits interest is a taxable event under §61 (i.e., gross income includes "all income from whatever source derived") or under §83, no taxable income generally results because the naked profits interest has no value or because its valuation is entirely speculative.

2.  Diamond v. Commissioner. Notwithstanding the previously existing view that the receipt of a partnership profits interest did not create taxable income, the Tax Court for the first time found a profits interest issued in exchange for services to be taxable in Diamond v. Com`r., 56 T.C. 530 (1971), aff`d 492 F.2d 286 (7th Cir. 1974). The Tax Court found the profits interest to be "property" taxable under §61, found the interest to be taxable within the meaning of the §721 regulations discussed in "1" above, and disregarded the language in such regulations which infers that profits interests are not taxable. The Tax Court also noted that §721 was not intended to provide nonrecognition for the receipt of a partnership interest for past services (i.e., such as those involved in the case). The Seventh Circuit affirmed the Tax Court`s decision but severely restricted its agreement with the decision by holding that, taxation of the profits interest was only appropriate when it had a determinable market value upon its receipt by the partner. In Diamond the Court found this value in the fact the taxpayer sold his partnership interest for $40,000 within three weeks after receiving it. The Seventh Circuit also noted that typically a partnership profits interest will have only speculative value, if any, signaling that it would not be likely to find taxable income in most of these cases.

3.  IRS Position. Both before and after the Diamond decision, the IRS had a long standing internal policy that the receipt of a naked interest in future partnership profits as compensation for services did not create taxable income. G.C.M. 36346, July 23, 1975, Internal Revenue Manual - Audit, Examination Tax Shelter Handbook (CCH) par.7295-87 (1992).

4.  Subsequent Cases (Prior to Campbell). Following the Diamond decision, four cases refused to tax a profits interest issued for services absent evidence sufficient to value the interest, using analysis effectively equivalent to the IRS policy. Saint John v. U.S., 84-1 U.S.T.C. 9158 (C.D. Ill. 1983); Kenroy v. Com`r., 47 T.C.M. (CCH) 1749 (1984); National oil v. Com`r., 51 T.C.M. (CCH) 1223 (1986); Mark IV Pictures, Inc. v. Com`r., 60 T.C.M. (CCH) 1171 (1990) (see "A.4" above). Note that in the Mark IV Pictures case discussed above, the court used a liquidation approach similar to that of the IRS internal position to determine that the taxpayer actually received a partnership capital (as opposed to a profits) interest, which had a readily determinable value. The Ninth Circuit also went on record as embracing the Seventh Circuit`s ascertainable value standard required for taxation of a profits interest issued for services. United States v. Pacheco, 912 F.2d 297, 301-2 (9th Cir. 1990). The Tax Court decision in Diamond stood alone on its unique facts as the only precedent for the taxation of a naked profits interest.

5.  Tax Court Decision in Campbell. The Tax Court once again held that receipt of a partnership profits interest was taxable, on facts far less conducive for such rationale than the Diamond facts, in Campbell v. Com`r., 59 T.C.M. (CCH) 236 (1990), rev`d 943 F.2d 815 (8th Cir. 1991). Mr. Campbell was an employee of a company involved in the syndication of real estate limited partnerships. In consideration of completed services required by his employer in organizing a partnership, Campbell would receive a profits interest in the partnership. These profits interests were residual profits interests which were subordinated to preferred returns paid to the limited partner investors. The Tax Court held that these profits interests were property interests which were vested for purposes of §83 and therefore taxable to Campbell. The Tax Court proceeded to value the profits interests received by Campbell using discounted cash flow calculations based on projections of cash flow and tax benefits contained in the offering memoranda used to market the partnership interests to investors. This shocking approach was used notwithstanding the absence of any facts stated in the opinion concerning whether the partnerships in fact subsequently ever produced any cash flow or profits. Moreover, using a liquidation approach which previously was embraced by the IRS to value profits interests, the Campbell interests likely were worthless or had a completely speculative value.

6.  Reversal of Campbell by the Eighth Circuit. In its reversal, the Eighth Circuit found that the profits interests received by Campbell had only speculative (if any) value. Campbell, supra, 943 F.2d at 823. Because Campbell`s profits interests were residual (subordinated to preferred returns to other investors) and because of difficulty in valuation of the tax benefits projected in the offering materials, the Eighth Circuit`s decision was easily justified. Unfortunately, the Appeals Court did not conclude that profits interests issued for services generally were not taxable. In addition to the valuation analysis, the Court examined two other rationales concerning taxation of a profits interest, as follows:

a. The Court rejected the proposition discussed in "1" above that the §721 regulations preclude the taxation of a profits interest issued for services.

b. The Court examined an argument based on pre-1954 Code case law (the legislative history to §721 indicated that it was intended to codify then existing case law with respect to the issuance of a partnership interest for services). This case law precluded taxation of the receipt of a profits interest under the aggregate theory of partnership taxation, i.e., the partnership and partner were one and therefore an individual could not be his own employee (thus, the consideration for the partnership interest could not be services). The subsequent codifications of §§707(a) and (c) were to be the only exceptions to the case law, and these would not apply to taxation of profits interests for services because (1) a 707(c) guarantee payment must be determined without regard to the income of the partnership, and (2) 707(a) payments only apply for a partner (engaging in transactions with a partnership other than in his capacity as a partner. Issuance of a partnership interest in exchange for services to the partnership, on the other hand, necessarily involves the recipient partner in his capacity as a member of the partnership, according to this theory. Accordingly, the pre-1954 Code case law should continue to apply and preclude taxation of receipt of a profits interest issued for services. While the Eighth Circuit did not reject this argument, it clearly based its holding on the valuation issue.

7.  Current Status. The 7th, 8th, and 9th Circuits are on record as requiring some level of ascertainable standard in valuation of a profits interest issued for services before imposing tax and rejecting the Tax Court`s cavalier approach to the valuation question. The reliance on valuation as the linchpin in the question of taxation of such profits interests continues to leave the matter to some uncertainty, however. For example, we do not know whether the Eighth Circuit in the Campbell case would have reached a different result if Campbell`s profits interest had not been subordinated to profits interests of other investors. Most tax practitioners continue to believe that taxation of a naked profits interest (i.e., a mere right to share in future partnership earnings, unless there is little doubt concerning such future amounts) issued in exchange for services to the partnership is inappropriate. Note that in the Eighth Circuit Campbell appeal, the IRS raised for the first time the "lateral transfer" argument that Campbell should be taxed on the receipt of the profits interest because he received them as compensation from his employer (not as compensation from the partnerships directly). Because this factual distinction nullifies a pro-taxpayer argument advanced along the theory of "6.b" above, taxpayers affected by it would be well advised to structure such "compensation" arrangements to clarify that their services are rendered to the applicable partnerships, not to a third party employer. The Committee on Partnerships of the American Bar Association Section of Taxation recently issued a report as of June 30, 1992 on taxation of profits interests received for services with conclusions comparable to those made herein. See Egerton, "The Tax Consequences of the Receipt of a Partnership Profits Interest for Services", 46 The Tax Lawyer 453 (1993).

V. Tax Problems on Restructuring Partnership_Debt.

A. Cancellation of Indebtness Income; General Rules and as Applied to Partnerships.

1.  General Income Recognition Rule. Section 61(a)(12) provides that gross income subject to income taxation includes "income from discharge of indebtedness" (hereinafter "COD income"). Section 108(d)(1) defines "indebtedness of a taxpayer" as any indebtedness (a) for which the taxpayer is liable, or (b) subject to which the taxpayer holds property. Section 108(a)(1) provides 4 income exclusions for COD income resulting from discharge of indebtedness in whole or part: insolvency, bankruptcy, qualified real property business indebtedness (added by RRA 1993), and qualified farm indebtedness (the latter is not covered in this outline; see §108 (g)). The first three of these exclusions are discussed briefly in "2" - "4" below.

2.  Insolvency Exclusion. Section 108(a)(1)(B) provides that COD income is not recognized if a taxpayer`s debt is discharged when the taxpayer is insolvent.

a. Section 108(a)(3) makes clear that the income exclusion is available only to the extent of the taxpayer`s insolvency. In other words, if the amount of the discharged debt exceeds the amount of the taxpayer`s insolvency (determined immediately prior to the discharge), then the excess will be COD income to the taxpayer; i.e., the taxpayer must recognize COD income to the extent he is made solvent by the discharge.

b. "Insolvent" means the excess of a taxpayer`s liabilities over the fair market value of its assets. §108(d)(3).

c. Uncertainty may exist in a given case regarding the determination of assets and liabilities for this purpose, e.g., intangible assets or contingent or contested liabilities.

d. In connection with nonrecourse liabilities, Rev. Rul. 92-53, 1992­-2 C.B. 48 holds that if a taxpayer`s nonrecourse debt is discharged, then the full amount of the debt is taken into account in determining whether and to what extent the taxpayer is insolvent. The ruling also holds that if the nonrecourse debt is not discharged, then only the amount of the nonrecourse debt which does not exceed the fair market value of the property securing the debt is taken into account for such purposes.

3.  Bankruptcy. COD income is not recognized if the taxpayer (who is under the jurisdiction of the court in a case under title 11 of the United States Code) is discharged from indebtedness by order of the court or pursuant to a plan approved by the court. §108(a)(1)(A), 108(d)(2). Note that this includes discharges occurring under Chapters 7, 11, 12 and 13 of the Bankruptcy Code.

4.  Qualified Real Property Business Indebtedness. RRA 1993 added sec 108(a)(1)(D) to the Code which provides that a taxpayer (other than a C corporation) does not recognize COD income from the discharge of qualified real property business indebtedness (hereafter, "QRPB debt"), subject to limitations described in "d" below, effective for discharges in taxable years ending after December 31, 1992.

a. QRPB debt means any indebtedness (other than qualified farm indebtedness) which

(1) was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property,

(2) was incurred or assumed before January 1,1993, or if incurred or assumed on or after such date, is "qualified acquisition indebtedness" (see "c" below), and

(3) with respect to which such taxpayer makes an election to have this provision apply. §108(c)(3).

b. QRPB debt includes indebtedness resulting from refinancing of QRPB debt, but only to the extent that it does not exceed the amount of the debt being refinanced. Id.

c. "Qualified acquisition indebtedness" means, with respect to any real property described in "a.(1)" above, indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve such property. §108(c)(4).

d. Limitations on exclusion.

(1) Generally speaking, the taxpayer is allowed to exclude only the amount by which the cancelled debt exceeds the taxpayer`s equity in the real property; i.e., the exclusion cannot exceed the excess (if any) of (A) the outstanding principal amount of the debt (immediately before the discharge), over (B) the fair market value of the real property (described in "a.(1)" above) as of such time, reduced by the outstanding principal amount of any other QRPB debt secured by such property, as of such time. §108(a)(2)(A).

(2) An independent limitation also applies; i.e., the income exclusion cannot exceed the aggregate adjusted bases of depreciable real property (determined after attribute reduction; see "e" below) held by the taxpayer immediately before the discharge (excluding for this purpose any depreciable real property which was acquired in contemplation of such discharge). §108 (a)(2)(B).

e. Basis reduction. A basis reduction to the taxpayer`s depreciable real property (using the rules of 51017) is made in an amount equal to the income exclusion resulting from QRPB debt. §108(c)(1).

f. The Treasury was authorized to issue legislative regulations to carry out the section. §108(c)(5).

5.  Priority Rules. Section 108(a)(2) sets forth priority rules which determine which exclusion applies if more than one of the above factors is present, as follows:

a. If the bankruptcy exclusion applies, then the others do not.

b. The insolvency exclusion takes precedence. over the qualified farm exclusion and the QRPB exclusion.

6. Reduction of Tax Attributes as Price for Income Exclusion. As noted in "4.e" above, basis reductions are required in an amount equal to any QRPB debt exclusion. Similarly, in the event of a bankruptcy, insolvency, or qualified farm exclusion, §108(b) provides for the reduction of a taxpayer`s tax attributes (on a dollar for dollar basis to the extent of the income exclusion under §108(b)(3), except as provided below for credits) in the following order:

a. NOL - any net operating loss ("NOL") for the taxable year of the discharge and any NOL carryover to such taxable year;

b. General Business Credit - under §38;

c. Minimum Tax Credit - under §53(b) (effective for taxable years beginning after December 31, 1993;

d. Capital Loss Carryover - any net capital loss for the taxable year of the discharge, and any capital loss carryover to such year;

e. Basis Reduction - of taxpayer`s property as provided at §1017;

f. Passive Activity Losses and Credits - under §469(b), effective for taxable years beginning after December 31, 1993; and

g. Foreign Tax Credit Carryovers - under §27. Section 108(b)(3)(B) provides that the reductions described for the tax credits mentioned in "b", "c", "f", and "g" shall be 33 1/3 cents for each dollar of the applicable income exclusion.

Section 108(b)(5) allows the taxpayer to make an election to apply the required reductions against its basis in its depreciable property (under the rules of §1017) in lieu of the attribute reduction ordering described above, to the extent such basis is available. In the case of a title l1 bankruptcy case, this election is made by the bankruptcy estate. §108(d)(8).

7. General Implications for Partnerships.

a. Exclusions applied at partner level. The bankruptcy, insolvency, QRPB debt, and qualified farm exclusions are all applied at the partner, not the partnership, level. §108(d)(6).

b. Attribute reduction at partner level. The corresponding tax attribute reductions and related election occurs at the partner, not the partnership, level. Id.

c. Depreciable property basis reductions made with respect to partner`s partnership interest. Section 1017(b)(3)(C) provides that for purposes of any depreciable property basis reductions occurring under the foregoing provisions, a partner`s partnership interest shall be treated as depreciable property (to the extent of the partner`s proportionate interest in the depreciable property held by such partnership), if there is a corresponding reduction in the partnership`s basis in depreciable property with respect to such partner. The amount of any such basis reduction is treated as a depreciation deduction, which could give rise to §1245 or 1250 recapture on subsequent disposition of the related property or partnership interest (thereby creating or compounding a hot assets problem). §1017(d)(1).

d. Adverse tax consequences from liability reduction. As discussed at "C.4" below, the reduction in partners` shares of partnership liabilities resulting from debt cancellation may have other severely adverse tax consequences.

B. Partnership Debt Modifications or Refinancings.

1.  Issuance of New Partnership Debt in Satisfaction of Prior Debt. Section 108(e)(10) provides that if a debtor issues a debt instrument in satisfaction of indebtedness, the debtor shall be treated as having satisfied the indebtedness with an amount of money equal to the "issue price" of the newly issued debt instrument. COD income results to the extent that such issue price is less than the "satisfied" indebtedness. Id. The "issue price" is determined under the rules of §1274 and 1273 dealing with debt instruments issued for property and corresponding original issue discount. Id. Note that in these situations, OID may result and be amortized by the issuer partnership and recognized by the holder of the debt instrument over the instrument`s life. Generally speaking, the debt holder recognizes gain or loss according to the difference between its adjusted basis in the "satisfied" indebtedness and the issue price of the new debt, although if the debts in question constitute securities for tax purposes the holder will not be able to recognize lose even though the issuer/partnership recognizes income. Prop.Reg. §1.1274-2(a); §354(a). Furthermore, to the extent that partners` shares in partnership liabilities (such shares determined as provided in "5 - 7" below) are reduced, additional harsh tax results may affect the partners as described in "C.4" below.

2.  Modifications of Existing Partnership Debt. Material modifications of existing partnership debt such as reduction in the principal amount, change in interest rate, and change in maturity date combined with interest rate change, can create COD income (subject to any of the §108 exclusions discussed above). Such modifications must be tested under §1274, where they may be treated as a deemed issuance of a new debt instrument in satisfaction of existing indebtedness (see "1" above).

3.  Allocations of Partnership COD Income. Generally speaking, partnership COD income would be allocated to the partners in accordance with their general profits interests in the partnership, absent some agreement regarding special allocation. However, different allocations might be required because of the minimum gain and qualified income offset allocation requirements of §704(b). If a partner can shield the COD income allocated to him by the partnership with a §108 exclusion (e.g., he is insolvent or in bankruptcy), the partners will have some incentive to specially allocate a disproportionately large share of the COD income to such partner. Special allocations only work if they have "substantial economic effect" or alternatively are in accordance with the partners` "interests in the partnership", as provided in §704 and accompanying regulations. Rev. Rul. 92-97, 1992-2 C.B. 124 sheds light on this issue and holds that an allocation to a partner of the partnership`s COD income, which differs from the partner`s share of the cancelled debt under §752(b), has substantial economic effect if (a) the deficit restoration obligations covering any negative capital account balances resulting from the COD income allocations (i.e., deficits created by the §752 deemed cash distributions resulting from the cancelled debt) can be invoked to satisfy other partners` positive capital account balances, (b) other requirements of the substantial economic effect test are met, and (c) substantiality is independently established. Note also in this regard that when the partnership debt is cancelled in these cases, deemed cash distributions result to the partners to the extent their shares in partnership liabilities are reduced (see "5"-"7" below), in which event a partner may recognize gain under §731 to the extent that cash distributed exceeds the basis of the partner`s partnership interest. Other harsh tax results which may occur are described in "C.4" below.

4.  Reduction in Purchase Money Debt Owed to Seller. Section 108(e)(5) provides that if purchase money debt owed to the seller of the purchased property is reduced, and the debtor is neither insolvent nor bankrupt, then such reduction is treated as a purchase price adjustment rather than as COD income. Note that this insolvency/bankruptcy determination is made at the partnership level (as opposed to the §108 exclusions discussed above which are determined at the partner level). The purchase money debt reduction nevertheless can create §731 income if the deemed cash distributions exceed the basis of a partner`s interest.

5.  Determination of a Partner`s Share of Recourse Liabilities. As discussed above, changes in a partner`s share of partnership liabilities can result in deemed contributions and distributions of money, which affect the partner`s basis and may trigger §731 gain if money distributed exceeds that basis. (Also note that gain recognition may result upon changes in a partner`s share of partnership liabilities as discussed in "C.4" below pursuant to §751(b) or minimum gain chargeback.) Shares of partnership liabilities are allocated to the partners under §752 and its accompanying regulations. For this purpose, partnership liabilities are bifurcated (Reg. §1.752-1(i)) and treated as "recourse" to the extent that any partner or related person (see §1-752-4(b)) bears the economic risk of lose for the liability. Reg. §1-752-1(a)(1). A partner`s share of any recourse liability is equal to the portion of that liability for which such partner bears the economic risk of loss. Reg. §1.752-2(a). "Nonrecourse" liabilities are portions of partnership liabilities for which no partner or related person bears the economic risk of loss, and partners` shares in such liabilities are determined as discussed in "6" below. Reg. §1.752­1(a)(2). Generally speaking, a partner s economic risk of loss for this purpose is determined based on whether such partner would be obligated to make a payment to any person or contribution to the partnership, without any reimbursement (considering all contractual and statutory rights) for the same, upon a hypothetical constructive liquidation taking into account the following events occurring simultaneously:

a. all the partnership`s liabilities become payable in full;

b. all partnership assets including cash are worthless, with the exception of property contributed to secure a partnership liability; c. the partnership disposes of all its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor`s right to repayment is limited solely to partnership assets;

d. all resulting items of partnership income, gain, lose, or deduction are allocated among the partners; and

e. the partnership liquidates. Reg. §1.752-2(b)(1).

In addition, a partner bears the economic risk of loss for a partnership liability if the partner or a related person makes a nonrecourse loan to the partnership and no other partner bears the corresponding risk of loss. Reg. §1.752-2(c). This rule does not apply if the lender/partner (and any related person) has not more than a 10% interest in each item of partnership income, gain, loss, deduction, or credit, and the debt is "qualified nonrecourse financing" within the meaning of §465(b)(6). Reg. §1.752-2(d). A partner also is considered to bear the economic risk of loss for a partnership liability to the extent of the value of such partner`s separate property (except for his interest in the partnership) pledged as security for the liability. Reg. §1.752-2(h).

6.  Determination of a Partner`s Share of Nonrecourse Liabilities. A partner`s share of the nonrecourse liabilities of the partnership equals the sum of:

a. the partner`s share of partnership minimum gain determined under §704(b);

b. the amount of taxable gain that would be allocated to the partner under §704(c) (or in the same manner as 5704(c) in connection with a revaluation of partnership property allowed under the regs), if the sold all partnership property subject to one or more nonrecourse liabilities in full satisfaction of those liabilities for no other consideration; and

c. the partner`s share of the excess nonrecourse liabilities (i.e., those not allocated under "a" or "b"), determined in accordance with the partner`s share of partnership profits. Reg. §1.752-3(a). This share of partnership profits is determined taking into account all facts and circumstances relating to the economic arrangement of the partners. Id. The partnership agreement may specify this share or "interest", which will be respected if the interests so specified are reasonably consistent with allocations (having substantial economic effect) of some other significant item of partnership income or gain. Id. Alternatively, excess nonrecourse liabilities may be allocated among the partners in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated. Id. Excess nonrecourse liabilities are not required to be allocated under the. same method each year. Id.

7.  Effective Date Rules for Determining Partners` Shares of Liabilities. Because of proposed and temporary regulations preceding the final regulations described above, partnerships may apply various rules for allocation of liabilities depending on the dates when such liabilities were incurred, under Reg. §1.752-5.

C. Creditor Becomes Partner in Satisfaction of Debt.

1.  Section 721 Theory. Presumably, the rule of §721 that no gain or lose is recognized upon the transfer of "property" to a partnership in exchange for a partnership interest, makes a creditor`s exchange of his debt for a partnership interest nontaxable (see discussion at "IV.A.2" above), assuming that the debt in question qualifies as "property". Both loans of money and purchase money debt should qualify as property for this purpose. See Reg. §1.721-1(a). If the §721 nonrecognition theory governs the satisfaction of debt in case of a purchase money installment creditor`s obligation subsequent gain or loss allocations made to the partners under §704(c) ultimately should result in the creditor`s gain recognition through the partnership of amounts corresponding to the built in gain in the installment obligation at the time of its "satisfaction" by the partnership`s issuance of a partnership interest. However, the resolution of this problem is unclear, and §453B(f) may result in the note holder`s immediate gain recognition since the note is "canceled or becomes unenforceable" in exchange for the partnership interest. Section 721 indicates, however, that a partnership`s obligation to pay for services does not qualify as property; therefore, satisfaction of such a debt by issuance of a partnership interest is not sheltered from tax under §721. Reg. §1.721-1(b).

2.  Stock for Debt Exception Repealed. Former §108(e)(10), repealed by RRA 1993 §13226 generally effective for stock transferred in satisfaction of debt after December 31, 1994, provided for nonrecognition if a debtor corporation satisfied debt by issuing stock to the creditor in certain circumstances, unless the debtor was bankrupt or insolvent. Tax practitioners speculate that this provision may have afforded a basis for justifying nonrecognition upon issuance of a partnership interest in satisfaction of partnership debt. Although this argument is no longer available after the provision`s effective date, note that RRA 1993 did nothing to preclude (a) a partner`s reliance on the §721 theory ("1" above) to preclude taxation, or (b) a bankrupt or insolvent partner from relying on those general §108 exclusions to shield such partner from income recognition, as discussed in "A.2-3" above.

3.  Contribution to Capital Theory. If a creditor is a partner in the partnership prior to the satisfaction of the debt by issuance of a partnership capital interest, an argument may be made that the partnership has no income recognition by analogy to §108(e)(6) dealing with contributions to corporate capital. This provision, which expressly applies to corporation debtors, treats the corporation as satisfying the debt with an amount of money equal to the creditor`s basis in the debt. If the debt originally was for a loan of money, the creditor should have no gain recognition. However, if the note is an installment obligation with built in gain potential, the creditor may have gain recognition depending on the analysis described at "1" above.

4. Gain Recognition Upon Liability Shifts and Deemed Cash Distributions. Even though the partnership and its partners may avoid immediate gain recognition because of a debt satisfaction or reduction described in "1" - "3" above, note that the resulting elimination or reduction of the partnership debt will cause deemed cash distributions to partners under §752, resulting in gain recognition under §731 if any such distribution exceeds the basis of a partner`s interest. In addition, the admission of a creditor as a partner may result in the new partner obtaining an allocable share of the partnership`s remaining liabilities, diluting the other partners` shares of the same, which triggers additional deemed distributions to the other partners. Note in particular the allocation of a nonrecourse liability to the nonrecourse lender (i.e., treating the liability as recourse since the lender is deemed to bear the economic risk of loss, although this does not occur in the case of "qualified nonrecourse financing" unless the lender also is at least a 10% partner), described at "B.5" above. Any such deemed distribution to a partner which results from the shift in shares of partnership liabilities can trigger ordinary income recognition to such partner if it is determined to be made in exchange for his share in partnership hot assets under §751(b) as discussed in "D.1" below. Note also that as nonrecourse liability shifts occur under the rules described at "B.6" above, subsequent gain allocations may have to be made under the minimum gain chargeback rule to partners whose shares of the nonrecourse liabilities are reduced. Reg. §1.704-2(f);

5.  Other "Interests" Granted to Creditors. Although concerned about liability issues involved with becoming a partner, creditors may extract carefully crafted "interests" related to future partnership cash flow or liquidation proceeds. The issue of whether such "interests" are additional interest related to debt or actually are partnership interests for income tax purposes is challenging and often leads the parties into uncharted waters. Obviously, all facts and circumstances are relevant including intent, profits and loss sharing of entrepreneurial risk, management rights, related services, etc. See, e.g., Farley Realty Corp. v. Com`r., 279 F.2d 701 (2d Cir. 1960). If the parties` characterization of the transaction is recast as a partnership interest, then the analyses of "1" - "4" above may apply if the debt is converted to a capital interest in the partnership. If the creditor is deemed to receive a profits interest, partners` shares of partnership liabilities may be shifted, resulting in deemed cash distributions and other tax consequences as described in "4" above. Moreover, such recharacterization may result in debt modification for income tax purposes, resulting in the tax consequences described at "B.1 and 2" above.

D. Admission of New Partner to Bolster Capital-of-the Partnership.

1.  Liability Shifts; Deemed Cash Distributions and Possible Income Recognition. As discussed above, the admission of new partners may afford them with an allocable share of partnership liabilities, which triggers deemed cash distributions to the other partners to the extent of their reductions in share of partnership liabilities and possible gain recognition resulting under §731 (Note that partner shares of partnership liabilities-upon admission of a new partners-will be redetermined based on the rules described at "B.5 - 7" above.) Although generally this is capital gain, it is converted to ordinary income under §751(b) to the extent that the distribution is deemed to be made for the distributee`s interest in partnership "hot assets" (see "I.B.7" above). This often will be the case since the new partner also is deemed to acquire an interest in partnership hot assets, which reduces existing partners` shares in the same. Note that this hot asset ordinary income recognition can arise even if the distributes otherwise would not recognize gain under §731; §751(b) applies to the extent that a partner is deemed to receive any distribution (whether cash or other property) in exchange for his interest in hot assets! See legislative regulations at §1.751-1(b). This is a significant issue given the possible 11.6% or more rate spreads between ordinary income and capital gain created by RRA 1993. As noted in "C.4" above, shifts in partner shares of partnership nonrecourse liabilities may result in subsequent minimum gain chargeback allocations to partners whose liability shares were reduced. Reg. §1.704-2(f).

2.  Nonrecourse Liabilities; Planning to Prevent Liability Shifts. Note that partners may be able to prevent this liability shift from occurring with respect to partnership nonrecourse liabilities, except those that are treated as recourse liabilities under the rules discussed at "B.5" above. This planning maneuver involves the revaluation of the partnership`s property (with corresponding adjustments to existing partners` capital accounts) pursuant to Reg. §1.704-1(b)(2)(iv)(f) at the time of the new partner`s admission as a partner into the partnership. After the revaluation, the interplay of the §704(c) allocation requirements with the nonrecourse liability allocation rules described in "B.6" above may result in allocation of the shares of partnership nonrecourse liabilities exclusively to the existing partners. In such event, the new partner would not receive a share of such liabilities and none of the gain recognition problems discussed in "1" above would arise.

E. Transfers of Partnership Property in Partial/Whole Satisfaction of Debt. For a concise but excellent discussion of the general tax consequences related to transfers of property in partial or complete satisfaction of indebtedness, see Cogdell, "Basic Bankruptcy and Loan Workout Tax Problems", Vol.ll No. 2 Tax Assessments (1991). This article discusses the gain or lose recognition by the debtor resulting from the taxable disposition of the transferred property, COD income recognition, and differing results obtained depending upon whether the applicable indebtedness is recourse or nonrecourse. If the debtor is a partnership, COD income is treated as discussed in "A" above. Moreover, practitioners should give careful consideration to the subtle but possibly harsh tax results described in "C.4" above resulting from any corresponding reduction in partnership debt and partner shares of that debt, including gain recognition occurring under §731, ordinary income recognition in respect of partnership hot assets under §751(b), and minimum gain chargeback allocations.