2 competing concept throughout subchapter K: (1) Aggregate & (2) Entity concepts (1) Purely Aggregate Conception = partners

would be viewed as co-owners, each with an undivided interest in the partnerships assets, and each partner would amount separately for her share of all partnership transactions (2) Purely Entity Conception = the partnership would be treated as a separate and distinct taxpayer, adopting a method of accounting and a taxable year and annually reporting its taxable income. The partners would each own an undivided interest in the partnership entity, and would be viewed very much like shareholders of a corporation. (3) At times a Hybrid Approach is adopted by the Code which is a combination of 2 above (4) Overall Intent of SubChapter K = Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax. 1.701-2(a). I. Contributions Pertinent Sections a. 721; 722; 723; 724; 752 and 704(c) i. Remember the tax principle tax must follow book b. Concept of partnership i. Easy in and easy out maximum flexibility ii. Rationale: Consistent with Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax c. Theory a. 721 gain or loss is not recognized by either the Pship or P on contribution of the property to the Pship in exchange for a Pship interest. 1. applies to newly formed and existing Pships i. Rationale/Policy: is the contribution of property to a Pship is a mere change in the form of the taxpayers investment into a Pship interest and not a closed transaction, thus not an appropriate taxable event. ii. FURTHER RATIONALE: 721 could be a result of the implications of 704[c] this could be a reason for 721 because of the problem that 704[c] property in that contributing appreciated property with a built in gain was ordinarily a taxable event [otherwise, your rationale for continuing the investment under 721 would be defeated]. a. Under 704[c], there are 3 different methods that Treasury will utilize that will require partners to share tax items so as to take in account the built in gain or loss at the time of contribution. See blow section on Allocations for more detailed analysis ii. Property Protected by 721 very broad definition 1. cash, inventory, accounts receivable, patents, installment obligations, & other intangibles such as Goodwill and industrial know how (even a letter of intent Stafford v. US) iii. Property not included b. exceptions Services OR transfer of property that would be an investment company if the partnership would be incorporated. 721(b) 1. The rationale is that promising a future event, that is services, is not considered an asset in the company, and therefore, services in exchange for an [carried] interest in the company is generally a taxable event. services not property throughout the

code (i.e. charitable contributions). Future services not really an asset, they dont bear any economic risk of loss. If the Pship goes under, they walk and can provide their services somewhere else and not incur any loss of anything. d. Other Property/Contributions of encumbered property 752 i. The partnership will step into the shoes of the P and assume the liability and act as the P on the loan. 752 ii. Each partner is treated as contributing cash to the Pship in an amount equal to any increase in their share of Pship liabilities. 752(a). 1. Ps increase their share of liabilities when encumbered property is contributed to the Pship 2. Rationale: thus net increase in your liabilities, same as making a cash contribution and thus increase in basis. iii. A P is treated as having received a distribution of cash from the Pship in an amount equal to any decrease in her share of Pship liabilities. 752(b). 1. Contributing Ps outside basis will be the adj. basis of the contributed property reduced by the entire amount of the liability on the prop that he is relieved of and increased by his increase of Pship liabilities. 2. Rationale: thus net decrease in liabilities = same as a cash distribution from the Pship and a net increase of liabilities = same as a cash contribution. a. Rationale is that the partner is spreading her liability amongst the partnership and its partners. 3. 2 important consequences: (1) a Ps outside basis reflects her share of Pship liabilities, and (2) under some circumstances, the deemed cash distribution which occurs on a contribution of encumbered property may result in recognition of gain. a. If the contributing Ps net decrease in liabilities is greater than her total basis in all the assets that she contributes, the contributions will result in a gain. e. 83 Receipt of Partnership Interest in Exchange for Services Capital interest v. Profits Interest a. If receive a PROFITS INTEREST = not taxable when receive the profits interest (however argument that it is worth money today because someone would give you money today for that interest even though it might be worth absolutely nothing because you never receive any income when the partnership makes no money). b. If receive a CAPITAL INTEREST = taxable when receive the capital interest. i. Rationale: if the Pship were to liquidate today the P receiving a Profits interest for rendering services would receive nothing, while a P receiving a capital interest for rendering services would receive an allocation from the capital accounts. 1. Q#1 = is there a priority distribution to the capital contributors? a. If NO, then new partner = Capital Interest b. If Yes, then have to ask Q#2 2. Q #2 = Is all of the current value (original capital contributions plus increased value of partnership assets as of today), today, of the partnership allocated to the original partners before the new partner gets anything? a. If NO, then Capital Interest b. If Yes, then Profits Interest 1. 83 = taxed to the extent that a partner receives property (same as when receive $$ cash)

a. 83(b) = safe harbor mechanism way to recognize income today to have any

increase in value as capital gain rather than additional compensation gain. i. If a partner receives a 1/3 interest in a partnership today and tells the IRS it is property and valued at $X, any appreciation over $X is treated as capital gains (short or long depending on length of time owned). ii. Should do a 83(b) safe harbor election for a Profits interest, however if it is assumed to not be taxable, what do you need it for then? These profits interest are being recorded at a value of $0 and any appreciation above that is capital gain (long or short term) f. Related Issues i. 721 Preservation/deferral of gain, loss, recapture, in the Pships basis rationale = continuing investment. 721 transactions are excluded from 1245 & 1250 recapture. ii. The contributed property remains subject to recapture upon a later disposition by the Pship, and the Pships potential recapture gain includes the deprecation taken by the contributing partner. (704(c) requires the dep taken by contributing partner to be recaptured by the contributing partner upon the time of disposition of the 704(c) prop) iii. Pship steps into the shoes of the contributing P and continues with the Ps method of cost recovery (dep method). iv. Neither organization nor syndication expenses are deductible 709(a). v. Similarly, installment obligations are overridden by 721. vi. Additionally, 721 does not apply when the transaction is between the Pship and the P, but the P is not acting in his capacity as a P in the Pship. E.g. Leasing my warehouse to the Pship but not within the Pship. 1. Rationale: This is not considered a contribution to the partnership g. Basis Rationale: is that it is a way to track gain or loss for administration purposes. i. 722 partners outside basis 1. Each contributing partner takes as her basis in the Pship interest received an amount equal to the sum of the adjusted basis she had in any contributed property, PLUS any cash contributed. 722 2. Rationale: Administrative way of keeping track of the differed gain/loss, recapture. The theory is that the partnership has merely changed the form of investment. 3. Note for book purposes we use the FMV instead of adjusted basis ii. 723 Pships inside basis 1. The Pship takes a transferred basis in the contributed property equal to that of the contributing P. 723 2. Rationale: Administrative way of keeping track of the differed gain/loss, recapture. The rationale is that the investment continues; however, the form has merely changed. h. Holding Period [for property] i. Tacks, but for other property (cash and Ordinary income assets (Hot Assets?)) the holding period starts on the date of exchange. ii. Mixed contributions, both capital asset, 1231 property, & the other property = it takes a split holding period based on the FMV of the contributed assets until it is sufficiently aged (I.e. over one year later), so that it has been held long-term. iii. Rationale: Same as nonrecognition in that youre continuing the use of the asset but just changing form in that it is in the Pships hands.

iv. Holding period tacks for the Pship in the Ps contributed Property v. Rationale is the same as non-recognition in that you are continuing use of the asset, but changing form. Now, it is in the partnerships hands. 1. Tax Years page 3 of outline if applicable. i. 704(c) Property appreciated property = most common, but applies to built-in loss property (adj. basis > FMV). i. If a partner contributes property that has an inherent gain or loss at the time of contribution, this built-in gain or loss MUST be taken into account by the contributing partner. 704(c)(1)(A). ii. See Allocations and Distributions for more in depth discussion iii. 704(c)(3) to ensure the cash basis contributing partner does not shift OI when it contributes A/R to the Pship, Subchapter K: (1) treats the A/R as property for purposes of 721; (2) assigns the Pship a $0 basis in the A/R under 723; (3) characterizes the income realized by the Pship upon collection of the A/R as Ordinary under 724; and (4) allocates the income to the contributing P under 704(c). 1. This prevents (1) the recognition of gain on the contribution of certain ongoing businesses to Pships, & (2) the equivalent (of the reverse) of assigning income (i.e. assigning deductions (A/P). II. ALLOCATIONS I. Capital Accounting Rules i. The financial accounts of a Pship, including its capital accounts, are maintained using the Pships normal method of accounting and must be adjusted periodically to take into account the Pships operations for the year, as well as any contributions to, or distributions from, the Pship that may have occurred. 1.704-(1)(b)(2)(iv)(b). o Rationale: we maintain tax capital accounts because book/tax disparities highlight and help keep track of 704(c) and reverse 704(c) allocation problems. Furthermore, the purpose of financial accounting is to reflect the economic wellbeing of a Pship and the relationship among its Ps, and it is quite independent of determining tax liability of the Ps. For this purpose, the book allocations of a Pship are used as a surrogate for economic arrangement and the fundamental rule is that tax must follow book, although that does not always occur. Further, maintaining capital accounts relates to financial accounting, and
1. A Ps capital account is INCREASED by (1) the amount of money PLUS the FMV of

any property (net of liabilities) contributed by that partner and (2) her share of Pships income for the year, and is DECREASED by (1) her share of the Pships losses for the year and (2) the amount of money plus the FMV of any property (net of liabilities) distributed to that P.
a. Liabilities do not affect the capital accounts, but solely the tax basis account.

Thus, no adjustments are made to capital accounts when a Pship borrows or repays a loan, and the adjustments to capital accounts for contributed and distributed property are made net of liabilities.

b. Contributing Ps tax basis in the contributed property is irrelevant because the Ps have struck their business deal on the basis of the contributed propertys FMV.
c. In addition, the adjustment to the capital account is NET of liabilities on the

property, thus reflecting the equity of the partner after liabilities are deducted (makes sense because property value and liabilities are separately stated on the balance sheet)
d. The function of capital accounts is to reflect the Ps economic shares of the Pships

assets, thus the tax character of any receipt, and the deductibility of any expense, is irrelevant: if the book value of the Pship assets increases or decreases for any reason other than increased or decreased liabilities, then a corresponding increase or decrease in the capital must occur.
1. Rationale: The capital accounts represent the economic amount of risk that

each P bears and represents the amount that each P is entitled to if the entire Pship was terminated and liquidated and all gains and losses recognized. The Ps book capital accounts reflect the manner in which they share Pship equity, i.e. how much each would receive were the Pship to sell its assets at book value, pay off its creditors, and distribute the balance to the Ps.
a.

e. Any inherent gain or loss in the property distributed, even though not recognized for tax purposes, must be taken into account for book purposes.
1. Rationale: Book Capital uses FMV while tax uses adj basis and thus the

book capital accounts recognize the true economic results of the business deal/transaction. f. Tax Capital Accounts i. Tax capital accounts provide the information to be able to identify how the Ps share inside basis. ii. Upon formation of a Pship the balance in each Ps tax capital account is that partners share of inside basis (i.e. the contribution that she has made to inside basis) and each Ps tax capital account equals her outside basis. However, it changes. II. Pship Allocations: Substantial Economic Effect
a. As a general proposition, 704(a) provides that the Ps agreement regarding allocation of

Pship income & deductions, including special allocations (i.e. those which deviate from

the Ps proportionate interests in capital), will be respected. 704(a). However, the IRS can reallocate the Pship income and loss in accordance with the Ps interests in the Pship if it determines that the Ps agreed method of sharing these items lacks SSE. 704(b). b. 704(b) overrides 704(a) and reallocates the Pship income or loss in accordance with the Ps interests in the Pship if the Ps agreed method of sharing these items lacks substantial economic effect.
1. Rationale: Although Subchapter K was drafted to provide great flexibility, it was not

intended to permit taxpayers to circumvent general principles prohibiting tax avoidance and assignment of income and losses.
2. Purpose of 704(b) = to prohibit the allocation of items that were allocated with the

principal purpose of tax avoidance or evasion by reallocating them in accordance with the Pship agreement.
a. Rationale: If allocations of items for tax purposes are not reflected in capital

accounts, the tax allocations lack independent economic significance, and hence SEE.
b. The Orrisch v. CIR. case resulted in 704(b) codifying the phrase substantial

economic effect. c. However, a finding that an allocation lacks SEE means only that the Pship is outside the safe harbor. It may still be true that the allocation is consistent with the Ps interest in the Pship, and no reallocation is required. c. Requirements:
a. SEE is broken into two tests: (1) is quite mechanical and determines whether the

allocation has economic effect. 1.704-1(b)(2)(ii). Generally speaking an allocation will have EE if the Pship keeps meaningful capital accounts and maintains them in accordance with a strict set of rules. 1.704-1(b)(2)(iv); and (2) is whether the EE of an allocation is Substantial. 1.704(b)(2)(iii). This test is necessarily more subjective and generally for an allocation to be substantial, there must be a reasonable possibility that the allocation will affect substantially the dollar amounts received by partners independently of tax considerations.
1. Rationale for the Requirements: A special allocation will be respected for

tax purposes as long as it reflects the economies of the Ps deal. If for example, it is merely a device to reduce the aggregate taxes of the Ps, the allocation will not be respected and the item will be reallocated in a manner that does reflect the true economies of the Ps deal.

ii. Test #1: Economic Effect: Objective Test 1. Fundamental Principle: To have economic effect, an allocation must be consistent

with the underlying economic arrangement of the Ps. The economic benefit or burden corresponding to an allocation must be borne by the partner receiving the allocation. Reg. 1.704-1(b)(2)(ii)(a). 2. Three Tests are available to determine Economic Effect (EE) i. Basic Test 1. An allocation will have economic effect only if the Pship agreement meets the following three requirements: a. Capital Account Requirement: i. The Pship must maintain its capital accounts in accordance with the rules found in 1.704-1(b)(2)(iv).
b. Liquidation Requirement, and

i. Upon liquidation, liquidating distributions must be made in accordance with the positive balances in the Ps capital accounts. 1.704-1(b)(2)(ii)(b) (2). c. Deficit Makeup Requirement i. Is after liquidation any P has a deficit in their capital account, they must be unconditionally obligated to restore the deficit. 1.704-1(b)(2)(ii)(b)(3).
ii. As long as a P has an unconditional obligation to restore a deficit in her

capital account, allocations of losses and deductions will be considered to have EE even though they create or increase a deficit in her capital account.

Thus, b/c the partner is eventually obligated to contribute sufficient capital to eliminate a deficit, she is in a very real position of bearing the burden of economic risk of losses or deductions.

2. As long as the Pship fulfills all three requirements, both the Service and the courts can be assured that the Pships allocations of income, loss or deduction for tax purposes will be consistent with the economic benefits and burdens corresponding to those items.
ii. Alternative Test, and

1. Resulted in response to most LPs being formed to limit the financial exposure of its LPs, and an unlimited deficit makeup obligation is contrary to this purpose. Thus, allocations made to LPs would never have EE under the Basic Test, thus the Alternative Test was created.
a. An allocation is considered to have EE as long as (1) the Pship agreement

satisfies the 1st two requirements of the Basic Test, (2) the agreement contains a qualified income offset (QIO) provision, AND (3) the allocation does not create (or increase) a deficit in a Ps capital account in excess of the Ps obligation to restore a deficit. 1.704-1(b)(2)(ii)(d).
2. Premise of the Alternative Test: Even in the absence of an unlimited deficit

makeup provision, one can still generally rely on allocation having economic effect so long as the P has a positive balance in her capital account. 3. In the event that an unexpected distribution occurs, the regulations protect prior allocations by requiring the Pship to eliminate the unexpected deficit as quickly as possible through income allocations.
a. QIO provision states that if a P receives an unexpected distribution

creating a deficit in her capital account in excess of that which she is required to restore, the Pship will allocate items of income and gain (including gross income) to that P in an amount sufficient to eliminate that deficit as quickly as possible. iii. Economic Equivalence Test 1. Designed for GPship that does not technically comply with the requirements of the Basic Test, but whose practices would produce the same economic results to the partners that would have been generated if they had complied with all the requirements of the Basic Test. 1.704-1(b)(2)(ii)(i).
iii. Test #2 Substantiality: Subjective Test a. Must be able to demonstrate that the special allocation has some effect other than tax

savings (i.e., the economic effect of the allocation must be substantial). b. There is both a pre-tax and post-tax view test for substantiality.
a. General Rule = is a pretax test and requires that there be a reasonable possibility

that the allocation (or allocations) will affect substantially the dollar amounts received by partners independent of the tax consequences.
i. The Role of this requirement is to identify any allocation that has little

significance except as to reduce the governments share of the Pship

operations. For, example, an allocation lacks substantiality under the shifting tax consequences rule if the Ps have allocated types of income or loss among themselves within a given year solely to reduce their total tax liability & transitory allocations lack substantiality when a Pship makes an original allocation in one year, and then cancels out the economic effects of that allocations in a later year when the Pship makes an offsetting allocation
b. After-tax exception = focuses on the after-tax consequences of one or more Ps

without adversely affecting any other P, the allocation will not be substantial. c. The EE of an allocation is NOT substantial if, at the time the allocation becomes part of the Pship agreement: (1) the allocation may enhance the after-tax economic consequences of one partner, in present value terms, AND (2) there is a strong likelihood that the aftertax economic consequences of no partner will be diminished.
a. Rationale of After-tax Exception: to deal with the increasing sophistication of

the Pship tax bar, and the ability of talented tax planners to take advantage of the time valueof$ to significantly alter the pre-tax consequences of transaction III. 704(c) Built-in gain and loss Allocation Methods
a. There are three methods under the regulations for allocating: 1. Traditional Method which treats each P as if she purchased a pro-rata interest in the

property [ceiling rule imposes a limit upon the amount a Pship may allocate to its Ps]
2. Traditional Method with Curative Measures: the rationale behind this method is to

cure distortions resulting from the ceiling rule.

3. Remedial Method permits Ps to ignore the ceiling rule and create allocations to

match and offset their book allocations.

a. RATIONALE: behind these methods is that 704[c] requires that tax items

with respect to the contributed property must be shared such that it takes into account the built-in gain or loss at the time of contribution.
IV. Book Up/Book Down between Capital Accounts and Inside Basis - 754 election a. Often times, the Book/tax accounts are the same. However, there are two differences:

i. Where an asset has a FMV that is different from its basis.

ii. Where the Pship revalues its historical cost to current FMV. iii. Reevaluations or [book-up and book downs]1are permitted when:
1

This is prescribed in 1.704-[1][b][2][iv][f]

1. a new or existing P contributes property to a Pship as consideration for an interest in

the Pship, AND

2. when money or property is distributed to a P in liquidation for all of his interest. 3. The Rationale for the book up/book down is that any inherent gain or loss in the

property distributed, even though not recognized for tax purposes, must be taken into account for book purposes to represent the economic reality of the business transaction b. Recourse Liabilities i. If the economic risk of loss associated with a liability is borne by one or more of the Ps, or persons related to the Ps, the liability is characterized as recourse.
1. Recourse liabilities must be shared among Ps in the same way that they share the

economic risk of loss represented by the liability, and to determine how that economic risk is shared one must first apply the allocation rules of the 704(b) regs. 1.7522(a),
ii. NONrecourse defined = if no P or related person bears the economic risk of loss

associated with the liability, then the liability is nonrecourse.

1. Generally must be shared, at least in part, in a manner consistent with the allocation of

nonrecourse deductions. Rationale: so that the partners to whom the nonrecourse deductions are allocated will have enough basis to use the nonrecourse deductions. iii. Sharing Recourse Liabilities
1. Recourse liabilities must be shared among Ps in the same way that they share the

economic risk of loss represented by the liability. 1.752-2(a).

2. To determine who bares the economic risk of loss at the end of the day, the regs posit a

disaster scenario, called a constructive liquidation during which the following five events are deemed to occur: i. All Pship liabilities become due and payable in full; ii. All Pship assets, including cash, become worthless (solely excluding certain property held by the Pship in name only for the purposes of securing indebtedness); iii. All Pship assets are disposed of in taxable transactions for no consideration (other than satisfaction of nonrecourse liabilities secured by the property); iv. The Pship allocates all items of income, gain, loss, etc. for its taxable year ending on the date of the constructive liquidation; AND

v. The Pship liquidates.

3. Following the constructive liquidation, if, and to the extent that a partner (or related

person) is ultimately responsible for paying a Pship liability, either directly to the creditor or by way of a contribution to the Pship or to her other Ps, that P bears the economic risk of loss for the liability and shares in the liability to that extent. a. An all facts and circumstances test is followed Sharing NONrecourse Liabilities Partners share of partnerships NONRECOURSE liabilities is equal to the sum of: 1. Partners share of partnership minimum gain (PMG); 2. Partners share of 704(c) minimum gain; and 3. Partners share of the excess nonrecourse liabilities Rules in action 1. PMG = for each partners share of PMG is generally equal to the sum of the nonrecourse deductions allocated to that partner, PLUS any nonrecourse distributions made to her. NO PMG exists if the partnership is just formed. 2. 704(c) minimum gain [(the amount of gain that would be allocable to her under 704(c) if the property were disposed of for no consideration other than satisfaction of the liability)(the excess of NONRECOURSE liabilities encumbering the contributed property over basis)] = amount of gain allocated to a partner that contributes appreciated property to a partnership 3. Ps share of excess NR liabilities (anything not allocated under 1 & 2 above) b. 4 exceptions to PMG being triggered = (1) conversions and refinancing; (2) contributions of capital, (3) Revaluations, and (4) Waiver
V.

The Allocations of Nonrecourse Deductions in detail a. When Pship property is pledged as security for a nonrecourse loan, it is the lender, not the Pship, who bears the economic risk associated with the property. Therefore, the allocations of the deductions generated by the property to the Ps cannot have SEE. 1.704-2(b)(1).
i. In Crane v. CIR., the Supreme Court held that when property is purchased with the

proceeds of a nonrecourse mortgage, the purchaser is the sole owner of the property. Crane v. CIR. Thus, the Pship takes deductions as the sole owner of the property, even though none of the Ps are economically at risk.
ii. As a result of CIR. v. Tufts, when property is transferred subject to a nonrecourse liability

which exceeds the propertys basis, the debtor will be forced to include in income an amount equal to the difference. This inclusion offsets the nonrecourse deductions previously allowed to the debtor, i.e., those for which the lender ultimately bore the economic burden.

1. Purpose of Regs = to determine how much flexibility Pships should be given in

allocating these deductions among their Ps. The Regs take a very liberal and flexible approach to the allocation of nonrecourse deductions, but are quite strict with respect to how the resulting Tufts gain must be allocated. b. Safe Harbor Approach i. If the Pship agreement complies with all of the requirements of the safe harbor, then the allocations of nonrecourse deductions will be respected, i.e. they are deemed to be in accordance with the Ps interests in the Pship. 1.704-2(b). 1. Safe Harbor Requirements: Found in 1.704-2(e) i. The Pship agreement must satisfy either the Basic or the Alternative Test for EE; ii. Nonrecourse deductions must be allocated by the Pship agreement in a manner that is reasonably consistent allocations of some other significant Pship item attributable to the property securing the debt;
iii. The Pship agreement must contain a minimum gain chargeback provision; AND

iv. All other material allocations & capital account adjustments must be respected under 1.704-1(b). 2. Minimum Gain Chargeback Provision: a. This provision simply requires those partners who received allocations of nonrecourse deductions to report an offsetting amount of gain when the Pship disposes of the property. b. If there is a net decrease in PMG for a taxable year, each P must be allocated an amount of income or gain equal to her share of the decrease. i. A Ps share of a net decease in PMG equals the amount of the decrease times each Ps share of the total PMG.
1. Rationale: The P who enjoyed the benefit of a nonrecourse deduction (or

distribution) should be required to report a corresponding share of the Pships minimum gain.
c. Partnership Minimum Gain (PMG) aka Tufts Gain

i. The minimum amount of gain that the Pship would realize were it to make a taxable disposition of property secured by nonrecourse financing.

ii. An increase in PMG for a particular year generally will equal the sum of the nonrecourse distributions and nonrecourse deductions for that year. The total amount of PMG at any time represents the total of deductions taken by the Pship and distributions made by the Pship for which the lender has borne the burden. d. Nonrecourse Deductions (NRDs) i. NRDs are those deductions attributable to nonrecourse financing and represent amounts for which no partner bears the economic burden.
ii. NRDs are measured annually and are equal to the net increase in the Pships

minimum gain during the taxable year, less any nonrecourse distributions made during the year. iii. Normally, NRDs are compromised of the cost recovery deductions taken on the encumbered property. e. Partners Share of Partnership Minimum Gain i. The ultimate objective of Regs is to ensure that each P will eventually report an amount of income or gain equal to her share of nonrecourse deductions & distributions.
1. Rationale: Treasury did not want one partner to be allocated all of the NRDs

and another all of the Tufts gains. This disposes of the disparity between book and tax for noncontributing Ps, and secondly it causes the contributing P to recognize gain sooner as opposed to deferring it until the final disposition.
ii. Ps share of PMG of the Pship is equal to the EXCESS of: (1) the sum of the

NRDs allocated to her and nonrecourse distributions she has received, OVER (2) that Ps share of net decreases in PMG.

III.DISTRIBUTIONS demonstrate how distributions relates to capital accounts and basis. - more importantly why the rules make sense? Substantial Economic Effect 1. 731- 736 a. These rules generally prescribe policies of deferring gains whenever possible. i. It is only when deferral is impracticable or when it result in a change of character that gain or loss is recognized upon a distribution. ii. The basic objective is to remove tax disincentives to movement of property in and out of the partnership. Instead the rationale behind this provision to make their decisions pursuant to business, not tax, considerations. iii. The distribution rules as a whole further this basic objective by permitting partners to withdraw their previously taxed profits without further tax consequences

iv. For example, If you distribute appreciate property in a corporation, then it triggers

gain. Not IN A PSHIP that underlies distribution rules under Subchapter K. 2. Preliminary issues relating to Capital Accounting a. 706[c]& [d] b. Note that under capital accounting rules, the partnership must recognize gain or loss inherent in property on distributions for book [not tax] purposes. 1.704-1[b][2][iv] i. This is reflected by adjusting the capital accounts to reflect the way partners have agreed to share the inherent book gain or loss on distributed property, the economic realities of the transaction. c. Capital Account i. - Hybrid between an accounting concept and commercial concept. ii. - Very comparable to basis iii. - Purely economic concept iv. - They have nothing to do with tax* v. - Unlike basis, liabilities are not include in a capital account. vi. - Assume that A & B each of 100,000 in interest in X, and 800,000 in appreciation a. - Note that capital accounts always zero out at liquidation. vii. As related to distributions, the rationale behind capital accounts in partnerships is that they are used as a mechanism to prevent disproportionate allocations. d. Basis and Distributions i. 732 & 733 basis of distributed property. 1. basis depends on whether it is a current or liquidating distribution. ii. 733 requires the distributee to reduce her outside basis by any money received plus basis she takes in distributed property. 1. For example, if it is cash distributions, then the distributee simply reduces her outside basis by the amount of cash. 2. On the other hand, in the case of property distributions, the distributees outside basis is allocated among both the property received and her continuing basis. a. Rationale is that any predistribution inherent gain or loss in the distributees partnership interest is preserved either in her property received or continuing interest in the property. iii. Current (aka Nonliquidating) Distributions 1. 732[a] For current distributions, the distributee takes a transferred basis. This is generally straightforward; however, 732[a][2] imposes a limit on basis in that she would take the basis of the property and allocate her outside basis among the properties, even if it exceeds her outside basis [and reduce her capital account to zero]. a. rat. if you bought my share tomorrow my outside basis is what I determine for my gain or loss on the sale of partnership interest. iv. Liquidating Distributions 1. The rules for basis on liquidating distributions is to allocate the partners outside basis among the distributed properties 2. Congresss intent behind this rule is to meet the ultimate goal of having the sum of the bases in the distributed property precisely equal the distributees outside basis. 3. two other scenarios

751 if you have a capital gain and your assets consist of hot assets [that is inventory], then you would recognize ordinary income based on the % of assets that are hot assets. b. 751d you do not recognize loss except for liquidating distributions v. Two other possible scenarios that are treated as cash: 1. [1] A partners decrease in liability results in cash. a. Rat. Is that liabilities generally increase your basis this is different from S-Corps b/c liabilities do not increase your basis in those entities. b. Hypo when one partner guarantees a loan, according to 752 liablities are allocated to the party that bears the loss. i. Note whenever there is something going on with liabilities take note b/c it is something you should watch out for. Look at the books and the Code. 2. [2] Marketable Securities a. this is the HUGE exception to distributions on property. b. SEE special rule on page 164 concerning treatment of these securities. c. Rationale. is that you are just changing the form of the investment d. The gain is preserved in a carryover basis. See basis below e. Special Rule under 732[d] i. As to a partner who acquires an interest by purchase or transfer during the first two years prior to a distribution, that partner may elect to be treated as if a 754 election has been made. 1. The rationale for this election is designed to prevent an unintended windfall or hardship to a partner who received a property distribution after purchasing her partnership interest. f. Holding Period i. Holding period is tacked when it is received it does not apply to inventory or other HOT ASSETS ii. Rationale - [you cannot transmute ordinary income into capital gains] g. Gains/Losses i. 731[a][1] gain shall not be recognized except to the extent that it exceeds her outside basis; shall be considered a capital gain. ii. Hypo No distributions gives rise to a loss while you are still a partner. So, on nonliquidating distribution, you do not recognize LOSSSSSSES! 3. Effects on the Partnership a. Basis of the partnerships undistributed property i. 751 unless there is a 754 election or substantial basis reduction, the partnerships basis of the property is unaffected. ii. Discussion on 754 election and why it is important b. what happens to the inside basis? There is an opportunity for the partnership to STEP UP the basis in other properties. i. Specifically, the adjustment is elective unless there is a substantial basis reduction and is triggered when a partner more than her share of inside basis in the partnership in partnership property [or less in the case of a liquidating distribution]. ii. Under 734[b] if the distributee partner recognizes gain on a distribution, then the 734[b] adjustment increases the basis of partnership assets by the amount of that gain.
a.

Alternatively, if that partner recognizes a loss on a liquidating distribution, the 734[b] adjustment decreases the basis in those properties. 1. The rationale behind this adjustment is that the partnership may create disparities between inside and outside basis. Therefore, these disparities create artificial increase or decrease potential income [or loss] at the partnership level. These disparities can only be cured by adjusting the partnerships inside basis. iii. Further, the partnership will then allocate its 734[b] adjustment among its remaining assets pursuant to 755: first to capital assets and then to non-capital assets. 4. Disproportionate Distribution of Hot Assets - 751 Assets a. 751[b] [The Cure]relates to the partnership distributes hold/cold assets and the distributees interest in those assets changes as a result of that distribution. i. This statute tells us that if a partner receives hot assets in exchange for cold assets, then it will be treated as a sale or exchange. ii. As to cold assets, it maintains the taint of inventory for 5 years [even if it becomes a capital asset in the distributee partners hands]. b. Rationale: 751[b] essentially is required solely because of the preferential gain, and its purpose it prevent people from converting ordinary income into a capital gain [The Evil] by ensuring that each partner report her share of that partnerships ordinary income. i. To explain, absent 751[a]& [b], the normal distribution rules would a distributee to avoid her share of the partnerships income by taking a capital asset in the distribution. 5. Transactions Between Partnerships [talk about it briefly] a. - The threshold issues when dealing with Transactions between partners are: i. whether partner was acting as a partner, or as a stranger? 1. If as a stranger, then 707[a][1] applies. 2. If as a partner, then the payment will be a guaranteed payment if its amount is determined without respect to the income of the partnership; otherwise it will be part of her distributive share. ii. As related to distributions, this is a very small section that related to distributions, and the only time that a partner in this context will have a transaction that is a distribution is when the partner is acting her capacity as a partner, and will therefore treat that income as part of her distributive share of the partnership that year. 706[a] 1. The Rationale is that the partner is merely acting as a partner, and therefore any money received is treated as a distribution under this provision. iii. Further, a hybrid approach allows guaranteed payments, those payments that are not dependent on the partners income, to include in the income of the recipient in her partnership income on the last day of the year. 1. Again, where the partner is acting as a partner, even where payments are fixed, the rules give effect to distribution treatment because the payments are not dependent on the partners income in the partnership.
IV. Anti-Abuse & Disguised Sales - 707[a][2][B], 704[c][1][B], and 737 were enacted to stem the abuse of Subchapter K. For example, the Sub. K regime [arguably] allowed taxpayers to use partnerships to exchange property for another, or even to sell property for cash, without recognizing any gains.

 704, 707, 737 enacted to stem the abuse of subchapter K. c. Examples of Abuse i. Disguised sales of property - 704(c)(1)(B) ii. Mixed bowl transactions - 707(a)(2)(B) iii. Disguised sale of partnership interests. - 737 d. Mixed Bowl Transactions - 707(a)(2)(B)
704(c)(1)(B) to back up 707(a)(2)(B)

1. Addresses the Mixing Bowl Transactions problems which essentially permitted taxpayers to exchange property without recognition of gain. 2. Under 704(c)(1)(B), if 704(c) property is distributed to any partner, other than the contributing partner, within seven (7) years of the original contribution, the contributing partner must recognize gain or loss in the amount and character that would have been allocated to her under 704(c)(1)(A) had the property been sold to the distribute at its fair market value on the date of the distribution. a. As an exception to 704(c)(1)(B), if within a specified time following the distribution of the 704(c) property, the partnership also distributes property which is of a like kind to the contributing partner, she is essentially treated as though she engaged in a like-kind exchange. The amount of gain or loss that the contributing partner would otherwise have to recognize under 704(c)(1)(B) is reduced by the amount of built-in gain or loss in the distributed like-kind property immediately after the distribution. b. Rationale: Absent the disguised sales provisions, the parties could effectively swap these non-like-kind properties without recognizing gain.
e. Disguised sales of property - 707(a)(2)(B) a. A contribution and a related distribution will be characterized as a sale2 only if, based on

all of the facts and circumstances, two conditions are met: i. The partnership would not have transferred money or property to the partner BUT FOR the transfer of the property by the partner to the partnership;3 and 1. Requires a contribution and a distribution to be reciprocal transfers, each in consideration of the other. 2. If simultaneous, this is the only factor that will be considered and are automatically highly suspect, and most be recharacterized as sales. ii. In the case of transfers that are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risks of the partnerships operations. 1. Applies when transactions are NOT simultaneous,4 requires that the subsequent transfer (usually the distribution) be independent of the entrepreneurial risks of the partnership. RATIONALE: it prevents the contributing partner from contributing property and effectively cashing out his investment. 707(a)(2)(B) prevents a partner from
2

In the event that the two transfers are recharacterized as a sale (in whole or in part), the transaction is treated as a sale or exchange for all purposes of the IRC, including 453, 1001, 1012, 1031, and 1274. 3 If a sale is deemed to occur, it is deemed to occur on the date the partnership becomes the owner of the property for Federal income tax purposes, i.e. on the date of contribution. 4 If the transfers are not simultaneous, the parties are treated as though the contributing partner exchanged the contributed property for the partnerships obligation (i.e., an installment obligation 453) to make the subsequent transfer of money or other property.

disguising immediate cash out as a contribution and therefore, treating it as a sale with ordinary gain.
Two Year Presumptions

1. The regs create 2 alternative presumptions that will determine the fate of most related transfers: i. Transfers that occur within 2 years of one another are presumed to constitute a sale. ii. Transfers separated by more than two years are presumed not to constitute a sale. a. Rationale of the 2 presumptions: If the taxpayers capital at risk of the venture for at least two years, then the transfer is generally treated as a valid business purpose and not a sale. 2. The Treasury lists 10 of the most important facts and circumstances that tend to prove the existence of a sale and are: (can be found on page 221 - 222). 3. All 10 factors tend to prove the existence of a sale; none tends to disprove its existence. These factors may only be used by the government to rebut a presumption that a sale did not occur, but the absence of these factors may be used by a taxpayer to rebut the presumption that a sale did occur. 4. The first 7 factors all go to the same issue: The extent to which the contributing partners capital is subject to the entrepreneurial risk of the venture. 2. Partnerships make distributions all the time so how do I differentiate these normal distributions from a disguised sale? Look at all the circumstances and facts. For instance, A, B, & C all get $50 then presumed not disguised sale. Also, guaranteed payments and preferred returns can be considered normal distributions or could be considered a disguised sale depending on all of the facts and circumstances. Have to look at this objectively a BUT FOR TEST. a. BUT FOR WHAT AM I RECEIVING THIS DISTRIBUTION? i. Look at the facts and circumstances Liabilities & Disguised Sales of Property 1. General rule = contributing partner of encumbered property is deemed to receive a cash distribution in the amount of the net relief of liabilities. 2. Only liabilities which are incurred in anticipation of the transfer of the property to the Pship (NONQUALIFIED LIABILITIES) should be fully subject to the disguised sale rules. a. If a Pship assumes or takes property subject to a nonqualified liability, the Pship is treated as transferring consideration to the contributor to the extent that the amount of the liability exceeds the contributors share of liability immediately after the transfer. 3. QUALIFIED LIABILITIES are subject to the disguised sale rules only to a very limited extent (generally do not apply) a. 2 most important factors in determining whether a particular liability is qualified are: (1) when it was incurred and (2) for what were the proceeds used. i. The Regs conclusively presume that a liability is qualified if it was incurred more than 2 years prior to the transfer of the property to the partnership and encumbered the property throughout that period. Therefore, if a liability is OLD AND COLD, it does not matter why it was incurred, or to what use its proceeds were put. ii. If a liability is incurred within two years of the transfer, it can still be qualified and the regs set out to rules, (1) for capital expenditures and (2) incurred in the ordinary course of business.

1. Rationale: is the taxpayer has not cashed out her investment because she invested them in the property or because they are involved with all ongoing businesses.

b. All other liabilities incurred within this two year time period are presumed to have been incurred in anticipation of the transfer (hence, nonqualified) unless the relevant facts and circumstances clearly establish the contrary. Distribution of Loan Proceeds If immediately after a partner contributes unencumbered property to a partnership, the partnership incurs a liability and distributes all or a portion of the proceeds to the contributing partner results in recognition for the contributing partner. a. Special Rule: If a partner transfers unencumbered property to a partnership, and if the partnership incurs a liability and distributes all or a portion of the proceeds to the partner within 90 days of incurring the liability (determined under 1.163-8T), then the distribution to the partner is taken into account only to the extent that it exceeds the partners allocable share of that liability. b. Rationale: This puts the contributing partner in precisely the same position that he would have been in if he had taken out the mortgage just before the contribution. f. Disguised sales of partnership interests
737 Only GAIN is recognized, LOSS is NOT recognized

1. 737 may trigger gain (BUT NOT LOSS) to a contributing partner if, within seven (7) years of a contribution, the contributing partner receives a distribution of property, other than the property the partner contributed. If this occurs, the contributing partner must recognize gain equal to the LESSOR OF: i. The excess distribution (i.e., the excess of the propertys value over the partners outside basis (reduced by any money distributed)), or ii. The partners net precontribution gain. 1. Net precontribution gain means the net gain that would have been recognized under 704(c)(1)(B) by that partner if all property that she had contributed within seven (7) years of the distribution and still held by the partnership were distributed to another partner. Rationale: the selling P is cashing out his Pship interest (his investment) in the Pship and that is closely related to the purchasing Ps transfer to the Pship in that the selling P would not have cashed out BUT FOR the purchasing Ps contribution. Disguised Sales of Partnership Interests 1. The incoming transfer to the partnership by the purchasing partner and outgoing transfer to the existing partner (the selling partner) will be characterized as a purchase and sale of the selling partners interest only if, based on all the facts and circumstances, the transfer to the selling partner would have been made but for the purchasing partners transfer and, in cases where the two transfers are not simultaneous, the subsequent transfer is not subject to the entrepreneurial risks of the venture. 2. If related transfers are treated as a sale under the general rule, they are treated as a sale for all purposes of the IRC. In addition, the regulations provide: i. A list of 10 facts and circumstances all of which tend to prove a sale; ii. Two alternative presumptions: (1) is that if the transfers occur within two (2) years of one another they are presumed to constitute a sale; (2) if they are separated by more than two (2) years, they are presumed not to constitute a sale; iii. An exception for normal distributions; and

iv. A special rule for liabilities that provides that the reallocation of liabilities under 752 does NOT constitute consideration UNLESS the transaction is otherwise treated as a sale. A. Partnership Anti-Abuse Rules 701 Reg. 1.701-2(b) a. 2 General Rules i. General Anti-Abuse Rule, AND ii. Abuse of Entity Rule b. 5 Judicial Doctrines that can be used to combat abusive rules (not in book) Rationale: To not allow overly knowledgeable taxpayers to use the literal words of the sections of the code to obtain tax benefits that were not contemplated by Congress when they enacted the IRC sections. The General Anti-Abuse Rule & Abuse of Entity Rule have essentially codified portions of the below judicial doctrines. i. Substance over form 1. Substance (end result) of the transaction prevails over the form (steps taken) of the transaction ii. Sham transaction 1. The transaction had no valid existence other than for the tax result iii. Business purpose 1. Need to have a valid business purpose for the transaction (cant solely enter the transaction for tax savings). As long as you have a valid business purpose the transaction will be respected, otherwise the IRS can recast it. iv. Step transaction doctrine 1. Collapses the steps (i.e. A to B to C and goes from A to C) a. A binding commitment b. An interdependence c. An end result v. Failure to form a valid partnership for tax purposes 1. Involves a lot of all the doctrines above and the partnership was formed for the sole purpose of tax savings. Rationale of the 5 doctrines: is that if the Pship is acting according to these doctrines, the n it is more likely that the Pship is acting in accordance with the intent of SupChapter K. c. General Anti-Abuse Rule 1. If a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners aggregate federal tax liability in a manner which is inconsistent with the intent of subchapter K, the Commissioner can recast the transaction for federal tax purposes. a. The Commissioner has five (5) weapons to enforce the above rules, for example the purported partnership could be disregarded in whole or in part, and the partnership's assets and activities should be considered, in whole or in part, to be owned and conducted, respectively, by one or more of its purported partners; 2. To not be abusive the transactions must be within the intent of Subchapter K which has the following 3 requirements: i. The partnership must be bona fide and each transaction, or series of transactions, must be entered into for a substantial business purpose,

ii. The form of the transaction must be respected under the substance over form

principles, and iii. The tax consequences to each partner and the partnership must accurately reflect their economic agreement and clearly reflect the partners income. 1. This third requirement is referred to as the proper reflection of income requirement. 2. If the first two implicit requirements are met, the proper reflection of income requirement is also considered met as long as the manner in which the particular provision is applied to the transaction and the ultimate tax results are clearly contemplated by the provision, even though these results distort income. 3. Facts & Circumstance Analysis to determine if the transaction runs a foul of the Anti-Abuse Rules a. Most important = purported business purpose for the transaction and the claimed tax benefits resulting therefrom. b. Even if one has a bona fide business purpose for planning a transaction in a certain way, if the claimed tax consequences are too favorable, the structure may not be respected. c. The regs state 7 factors which may indicate abuse is present. i. Rationale: Does it look right & smell right? Too Good 2b True Doctrine 4. Scope of Anti-Abuse Rules: although the general anti-abuse rule could potentially apply to ALL Pship transactions, the scope of the regulation is not entirely clear. a. The Treasury certainly intended to limit the use of certain uneconomic rules found in Subchapter K and to backstop the Pship allocation rules of 704(b). b. The regulation makes it clear that the general ant-abuse rule is intended to be a new weapon in addition to all other nonstatutory principles and other statutory and regulatory authorities to challenge transactions. d. Abuse of Entity Rule The Commissioner can treat a partnership as an aggregate of its partners in whole or in part as appropriate to carry out the purpose of any provision of the Internal Revenue Code or the regulations promulgated thereunder. 1.701-2(e)(1) Rationale: The abuse of entity rule is meant to clarify when a partnership should be viewed as an entity and when as an aggregate of the partners. If a particular code or regulatory provision explicitly calls for the treatment of partnerships as entities, and the ultimate tax results are clearly contemplated by that provision, then the abuse rule does not apply. Nevertheless, even if the provision does explicitly provide for the entity treatment of a partnership, if entity treatment would undermine the very purpose of the provision, then the abuse of entity rule will require the partnership to be treated as an aggregate of its partners. Most, if not all, of those transactions could have been successfully attacked under existing judicial doctrines or other statutory and regulatory authorities, even in the absence of the anti-abuse regulation.

Treasury made it clear that partnerships must be bona fide, transactions need a business purpose and that the doctrine of substance over form applies to Subchapter K.