Reforming Subchapter K

Transcription

1 Reforming Subchapter K University of Chicago Tax Conference Stuart Rosow Eric Solomon Stephen Rose Jennifer Alexander November 7, 2015

2 Introduction Flexibility and Fairness Administrability The current system of partnership taxation has championed unbridled flexibility at the cost of creating a system that is almost impossible for taxpayers to fully comprehend and for the IRS to enforce. At the same time, the system, which evolved in complexity in part to stem specific taxpayer abuses, does not in fact prevent taxpayer abuse. Both taxpayers and the government would be better served by a system that was simpler and easier to administer. This presentation will propose four areas for simplification. For each of these, the contention is that gains in compliance and ability to administer outweigh the loss of flexibility. - Substantial economic effect safe harbor; - Treatment of partnership liabilities; - Section 704(c); and - Basis adjustments 2

3 3 Substantial Economic Effect

4 Substantial Economic Effect Current Law: Section 704(b) provides that allocations will be as provided in the partnership agreement unless the allocation in the partnership agreement lacks "substantial economic effect," or SEE. Rationale: SEE is intended to provide a great deal of flexibility to partners in allocating income and loss so long as the partner receiving the allocation ultimately bears the corresponding economic benefit or burden of the related tax consequences. Issues: The SEE rules are enormously complex, permit abuses and often can produce nonsensical, non-economic results. 4

5 Substantial Economic Effect Proposal: Eliminate determination based upon capital accounts. - Require that income and loss be allocated on the basis of a fixed percentage for each partner, determined by reference to each partner's entitlement to current distributions. Gain or loss on the sale of a specific property may be allocated based upon each partner's entitlement to proceeds from the sale of that property. Limited exceptions for allocations of current losses to partners funding those expenses would be permitted. - As an alternative, a circumscribed target method could be permitted. Allocations would be keyed to distributions. 5

6 Substantial Economic Effect Current Law SEE has two components: (1) the allocations must have economic effect, and (2) the economic effect of the allocations must be substantial. "Economic effect" requires: - Capital account maintenance; - Liquidation in accordance with positive capital account balances; - Deficit capital account balance restoration obligation ("DRO"); - or - "qualified income offset." "Substantiality" requires: - A reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of the tax consequences, unless one of three rules below is violated. - Overall Tax Effect Rule - No Shifting Allocations - No Transitory Allocations 6 Reforming Subchapter K _3 October 29, 2015

7 Substantial Economic Effect Current Law If allocations do not have SEE, the IRS will look to each "partner's interest in the partnership" ("PIP") in determining allocations. - PIP is intended to signify the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction or credit (or item thereof) that is allocated. - It is determined by taking into account all facts and circumstances relating to the economic arrangement of the partners. - Factors include (a) partners' relative contributions; (b) partners' interests in economic profits and losses (if different than that in taxable income or loss); (c) partners' interests in cash flow and other nonliquidating distributions; and (d) partners' rights to distributions of capital upon liquidation. - There is very little guidance as to how the IRS will weigh the various factor in determining PIP. 7

8 Substantial Economic Effect Rationale Internal Revenue Code of 1954: Congress intended to maximize flexibility while still ensuring that a partnership s allocations had substance, but largely took a hands-off approach. Allocations under the 1954 Code were respected so long as there was no tax avoidance motive. Substantial economic effect was later introduced in the 1956 regulations as one of the tools to identify abusive allocations in an effort to alleviate the growing concern that all tax-advantaged allocations would be deemed invalid under the broad anti-abuse standard in section 704(b). Tax Reform Act of 1976: Substantial economic effect was codified as the standard for determining when allocations in a partnership agreement would be respected. The subsequent section 704(b) regulations focused on ensuring that the allocations corresponded with the benefits and burdens of the related tax consequences rather than policing tax avoidance motives. 8

9 Substantial Economic Effect Issues: Complexity Complexity quickly arises in a variety of circumstances, including as a result of "book"/"tax" differences and the interaction of the SEE rules with other Code provisions. - Example 1: Partnership ABC has the following balance sheet: Book Tax Asset 1 $200 $200 Capital % Interest A $100 50% B $80 40% C $20 10% - New capital of $25 is needed when Asset 1 has declined in value to $150. A contributes $25 and receives $50 credit in determining percentage interest, which is based upon total contributed capital. 9

10 Substantial Economic Effect Issues: Complexity What are the resulting capital account balances and how do the balances equate to the business deal? - Book Adjustments are Made: No Book Adjustments are Made: Book Tax Asset 1 $150 $200 Cash $25 $25 Capital % Interest A $100 60% B $60 32% C $15 8% Book Tax Asset 1 $200 $200 Cash $25 $25 Capital % Interest A $125 60% B $80 32% C $20 8% 10

11 Substantial Economic Effect Issues: Shifting Tax Benefits The rules permit shifting of tax attributes among taxpayers that lacks economic substance or impact. - Example 2: Assume A contributes $100 and B contributes zero to partnership AB. Under the AB partnership agreement, A is entitled to a return of capital, and then all proceeds are shared 50/50. AB borrows $900 to buy property that is net leased to a AAA credit tenant. AB's partnership agreement complies with SEE, including having a DRO. Assume AB has a net loss of $100 for tax purposes (attributable to depreciation) and allocates all of the loss to B. The partnership agreement also provides that the first income or gain on disposition of the property will be allocated to B. - The allocation of loss would have SEE, even though A has supplied the capital. 11

12 Substantial Economic Effect Issues: Non-Economic Results The SEE rules can cause nonsensical and non-economic results. - Example 3: Partnership XYZ is engaged in the development of a medical device. XYZ's partnership agreement complies with SEE. At inception, X contributes money and Y and Z have profits interests. After X's return of capital, all proceeds are shared pro rata. XYZ has no income, but only research and development expenses. All deductions are allocated to X, who is funding operations. At the end of year 1, new partners are admitted and XYZ books up its capital accounts to reflect the value of patents that have been applied for. In year 2, XYZ continues to have no gross income, but only R&D expenses, which related deductions are shared pro rata among X, Y and Z. - Assuming the business arrangement is that X is first returned capital, does it make sense that Y and Z share in the deductions associated with the R&D expenditures? - Example 4: Private Equity Fund has multiple investments. Investors are entitled to a return of their investment in the aggregate together with a preferred return. The general partner is entitled to a 20% carry. There are no losses or income other than from sales of portfolio companies. One portfolio company is sold with gain recognized. The proceeds are used to return a portion of the investors' capital (together will all accrued preferred return). Investors will continue to accrue preferred return in future years. - To whom should the gain be allocated? Does any allocation have substantial economic effect and what are the criteria for making that determination? 12

13 Substantial Economic Effect Issues: Reliance on SEE limited The requirement that distributions must be made in accordance with capital account balances upon liquidation cause many to reject the safe harbor approach and rely on PIP. - Example 5: Law firm distributes all of its earnings each year in varying amounts, with its partnership agreement providing for a return of capital contributions. The agreement provides that on retirement, a partner receives a distribution of his or her invested capital. - The allocation of income is in accordance with PIP but arguably does not have SEE. Target allocations lack SEE but attempt to match capital account provisions with distributions. However, target allocations can be complex and, as is the case with all allocation methods based on capital accounts, can be based on assumptions that do not comport with economic reality. 13

14 Substantial Economic Effect Proposals Eliminate reliance on capital accounts. Partnerships must use either fixed percentage method or circumscribed target method. 14

15 Substantial Economic Effect Proposal Fixed Percentage Interest Method 15 Fixed percentage interest method requires that all items of income or loss be allocated on the basis of a single percentage. - Allocations based upon how partners share current distributions, whether or not distributions are actually made. - Percentages may vary from year to year (or during year) based upon objective standards i.e., changes in rights to distributions. - Special allocations of gain or loss on sale of property would be permitted to be consistent with distribution of proceeds from sale of that property. - Special allocations of losses would be permitted if partners contributed capital to fund losses. Allocations would need to be consistent with amounts of capital contributed by each partner.

16 Substantial Economic Effect Proposal Fixed Percentage Interest Method In the context of the previous examples, the fixed percentage interest method would work as follows. - Example 1: Allocations would follow percentage interests with any adjustments to gain or loss resulting from liquidation of partnership. - Example 2: B could be allocated 50% of loss if all items allocated equally. Alternatively, partnership could allocate $100 of loss to A (and then $100 of income to A), and thereafter 50% to each. - Example 3: X would be entitled to all deductions up to and until aggregate deductions equal X's aggregate capital contributions. Thereafter, deductions are shared pro rata. - Example 4: The gain would be allocated among the investors in proportion to their entitlement to the proceeds from the sale of the portfolio company. - Example 5: Income would be generally allocated to the partners in proportion to their relative entitlements to earnings each year. 16

17 Substantial Economic Effect Proposal Target Allocation An alternative to the fixed percentage method would be a target allocation based upon changes in entitlements to cash distributions upon liquidation. A target allocation method could work as follows: - Determine each partner s share of cash if partnership assets were sold at tax basis at the beginning and end of the year. - For section 704(c) property, basis would include the built-in gain remaining to be recognized; basis would not include section 704(c)(1)(C) basis adjustments. - Take into account distributions during the year. - Allocate income/gain proportionately based upon difference between entitlements and loss for each partner at the beginning and end of the year. - Allocations would be a pro rata share of each item comprising income, gain or loss. 17

18 18 Treatment of Partnership Liabilities

19 Treatment of Partnership Liabilities Current Law: Different treatment for recourse and non-recourse debt. Recourse debt is allocated to the partner for which the debt is recourse. Non-recourse debt is allocated based upon a tier system that is intended to allocate in accordance with share of profits. Rationale: Treatment of partnership liabilities is intended to mirror the economics i.e., partner or partners actually bearing risk of loss associated with debt are intended to be allocated the debt in proportion to their relative risk. Issues: Flexible recourse debt rules allow taxpayers to benefit from tax items associated with recourse debt without incurring a true risk of loss. Proposal: Treat all partnership debt as non-recourse. 19

20 Treatment of Partnership Liabilities Current Law Current rules maximize opportunities for taxpayer mischief. - Debt is divided into recourse and non-recourse debt and depending upon that characterization taxpayers can manipulate allocation of profits, deductions and defer or accelerate gain recognition. Determination of whether debt is recourse or non-recourse is made under a "doomsday" scenario. All partnership assets are assumed to become worthless and all agreements among the partners are given effect. Likelihood of either worthlessness or intra-partner agreements being honored are not taken into account. If any partner would be required to pay debt (directly or indirectly) then debt is considered recourse with respect to that partner; if no partner is required to pay debt, then the debt is considered non-recourse. Proposed regulations attempt to set standards for determining whether partners have liability for debt. The attempt is to treat as recourse only those debts for which there is a commercial motivation for the guarantee or liability and where there are adequate assets supporting the partner's liability. 20

21 Treatment of Partnership Liabilities Rationale Code and Current Regulations: For recourse debt, the theory is that tax attributes should be allocated based upon which partner bears the risk of loss. For non-recourse debt, the theory is that the debt will be repaid out of future profits and the debt should be allocated to each of the partners in accordance with their shares of those profits. - Allocation is based upon a three-tier system: first to "partnership minimum gain", second to "section 704(c) minimum gain" and last in accordance with the partners' respective shares of residual profits. 21

22 Treatment of Partnership Liabilities Issues Ability to manipulate characterization of debt as recourse or non-recourse permits taxpayer to shift income or deductions as well as defer or accelerate timing of gain or loss recognition. Characterization of debt impacts the following: - Taxpayer's basis for its interest in the partnership: under section 752 a partner includes in its basis for its partnership interest its share of partnership debt. - How partnership income and deductions attributable to the debt are being allocated: section 704(b) rules in certain circumstances effectively compel allocation of losses funded by recourse debt to person who is liable for debt and allocation of income to that partner when debt is repaid. - Amount of any deemed distribution to a partner, particularly in order to avoid a disguised sale of property when leveraged property is contributed or there are distributions of debt proceeds to a partner. 22

23 Treatment of Partnership Liabilities Issues Shifting of Deductions or Income Consider the facts in Example 2 in which AB has borrowed $900 to acquire property. Assume in addition that B guarantees debt and has a DRO of $100. Under these facts, all of the losses from the property would be required to be allocated to B. Even if there is just a guarantee of the debt, but not a DRO, B would be allocated losses after the first $100 of loss is allocated to A. Because of the credit rating of the tenant, the likelihood is that the debt will be repaid out of the rent; it is highly unlikely that B would have any liability. Should this nominal risk be sufficient to govern tax consequences? This result would be the same even under the proposed regulations since B has guaranteed the entire debt, provided B had sufficient net worth to support the obligation. 23

24 Treatment of Partnership Liabilities Issues Timing of Gain Recognition Converting non-recourse debt into recourse debt avoids gain recognition on contributed property. - Example 6: A contributes Property X to Partnership subject to $900 of non-recourse debt in exchange for a 20% interest in Partnership profits, losses and capital. A's basis in Property X is $50 and Property X has a value of $1, X has a remaining useful life for depreciation purposes of 5 years. Partnership Balance Sheet: Book Tax Property X $1,000 $50 Other Assets $4,000 $4,000 Debt $900 Capital Book Tax A $100 ($850) Other Partners $4,000 $4,000 24

25 Treatment of Partnership Liabilities Issues Timing of Gain Recognition A recognizes no gain upon the contribution because at least $850 of debt is allocated to A under the second tier section 704(c) minimum gain. However, under Treas. Reg debt will be allocated to the other partners as the Partnership has partnership minimum gain, with the result that in subsequent years there would be a deemed distribution to A resulting in gain recognition. For example, see the balance sheet below after one year (assuming there is no income or loss other than depreciation on Property X). Partnership Balance Sheet: Book Tax Property X $800 $40 Other Assets $4,000 $4,000 Debt $900 Book Tax A $60? Other Partners $3,840 $3, At the end of the Partnership's first year, there is partnership minimum gain of $100 and therefore there is only $800 of remaining debt to be allocated. A will need to guarantee the debt in order to avoid a distribution in excess of its basis. Alternatively, A can guarantee or become liable for other, even less risky, partnership debt.

26 Treatment of Partnership Liabilities Issues Leveraged Partnerships or Tax Deferred Cash The folly of determining the tax consequences of a transaction through the treatment of certain liabilities as recourse is highlighted through the leveraged partnership transactions. In those situations, the taxpayer seeking to dispose of a business transfers the business to a new partnership which borrows money to fund a distribution to the transferor partners, reducing its interest in the partnership to a small amount. The transferor partner guarantees the debt or otherwise enters into agreements with the other partners so that it is considered to bear the risk of loss on the debt under Treas. Reg As a result of this classification of the debt, the distribution of the money is considered to be debt proceeds and therefore not part of a disguised sale. Treas. Reg

27 Treatment of Partnership Liabilities Issues Leveraged Partnerships or Tax Deferred Cash Seller GP Business Debt Financed Distribution Business LLC Financing Example 7: Seller and GP form a partnership to which Seller contributes twothirds of LLC s assets in exchange for 5% interests plus a debt financed distribution. GP contributes assets for 95% interest. LLC borrows from third party and distributes the loan proceeds to Seller. Seller s interest is reduced to less than 5%. GP guarantees debt and Seller agrees to indemnify GP if GP has to pay debt. Indemnification obligation applies only if LLC assets are first exhausted. 27

28 Treatment of Partnership Liabilities Issues Leveraged Partnerships or Tax Deferred Cash Purported justification for the result that a taxpayer can borrow money on appreciated property without recognition of gain belies common sense. - General rule that a financing of property does not result in gain recognition makes sense when the taxpayer owns all or almost all of the property. - Result should be different in the partnership context; rules should not permit a small minority partner to be treated as being liable on debt substantially disproportionate to its economic interest. 28

29 Treatment of Partnership Liabilities Proposal All partnership debt should be treated as non-recourse debt. Rule is consistent with economic reality: all partners and lenders expect that the debt will be paid out of the profits of the business or the proceeds of sales of the assets. - Rare circumstances in which guaranteed debt is a substitute for future contributions that are required to be made. - Manipulation of tax attributes attributable to partnership debt will be harder if all partnership debt is considered non-recourse. 29

30 Treatment of Partnership Liabilities Proposal Critical issue is the manner in which non-recourse liabilities should be allocated. Answer depends upon choice of overall section 704(b) method. - Under fixed percentage method, in general allocation will be based upon the partner s fixed percentage interest either in profits or, if referenced to a particular property, then in accordance with the interests in that property. - Under target method, allocation will be based upon share of profits each year. 30

31 Treatment of Partnership Liabilities Proposal Recommendations for Leveraged Partnerships or Tax Deferred Cash - Should we maintain the three tier system currently in place? - Principal question is whether the allocation of liabilities on the contribution of property with liabilities in excess of basis should continue to prevent recognition of gain. - Deferral of immediate gain is consistent with the general approach provided that mechanism is in place to ensure gain will be recognized in a manner consistent with economic arrangement. - Deferral would be appropriate if gain is recognized using remedial method under section 704(c) as described in the slides. 31

32 Treatment of Partnership Liabilities Proposal Under this approach, different results are reached under the examples. - In Example 2, there is no ability to shift deductions among the partners. - In Example 6 there is no gain recognized upon contribution. Rather, the gain will be recognized in accordance with the remedial method. - In Example 7, there will be gain recognized as the debt proceeds will be treated as consideration in a disguised sale. 32

33 33 Section 704(c)

34 Section 704(c) Current Law: Section 704(c) requires that allocations of gain, loss and other tax attributes with respect to contributed property take into account the difference between the property s tax basis and its value. Regulations provide three generally acceptable methods: traditional method, traditional method with curatives and remedial method. Rationale: Section 704(c) is intended to ensure that tax attributes of contributed property remain with the contributing partner. Issues: Current rules under section 704(c) do not prevent shifting of tax attributes among partners. Also, although rules are fairly straightforward if only one property is involved, application is much more complicated if there are multiple properties with different methods and multiple layers. Further complexity arises from the interaction with other Code provisions, particularly section 743 and section 734. Proposal: Require the use of a simplified remedial method for all contributions of property and permit grouping of assets to simplify computations. 34

35 Section 704(c) Current Law Section 704(c)(1)(C) provides special rules for contributions of property with built-in losses intended to prevent any shifting of the benefit of the tax basis in excess of value to another partner - Section 704(c)(1)(C) applies to actual contributions and therefore impacts forward section 704(c) allocations; proposed regulations would not apply that rule to situations involving reverse section 704(c) allocations. 35 Regulations provide three generally acceptable methods - Traditional Method: allocates tax items to the non-contributing partner(s) to attempt to match book allocation; if insufficient tax items, then ceiling rule prevents further allocations. - Traditional Method with Curatives: allocates items of like character from contributing partner to non-contributing partner(s) to offset the impact of the ceiling rule; complete offset can be accomplished only if there are sufficient items of like character and all parties agree to such an allocation. - Remedial Method: contribution is treated in the manner similar to a deferred sale and any ceiling rule limitation is offset through the creation of additional deductions and offsetting income.

36 Section 704(c) Current Law Rules generally apply on an asset-by-asset basis. - Partnerships have the option to choose different methods for different assets, even if contributed at the same time by the same partner. Regulations provide for limited aggregation of contributed property. - Depreciable property with the same class life may be aggregated. - For reverse section 704(c) allocations only, aggregation of builtin loss property and built-in gain property is permitted for securities partnerships. 36

37 Section 704(c) Rationale Internal Revenue Code of 1954: Congress was not concerned with inter-partner allocations on the theory that it would not substantially impact government revenue. It was additionally assumed that any misallocations occurring as a result of the ceiling rule would be completely unwound upon final disposition of the contributed property. Deficit Reduction Act of 1984: Misapprehension that interpartner shifting creates minimal costs to revenue acknowledged. However, assumption that ceiling rule misallocations are perfectly unwound persists. 37

38 Section 704(c) Issues Current rules under section 704(c) do not prevent shifting of tax attributes among partners. - Ability to use traditional method allows for deferral of income/gain recognition. - Failure to apply section 704(c)(1)(C) to reverse section 704(c) allocations permits transfer of benefit of excess basis to other partners. - Example 8: A contributes Property X with a basis of $100 and value of $1,000 to Partnership in exchange for a 20% partnership interest. X is depreciated over 10 years. Other partners would be entitled to $80 of depreciation. However, there is only $10 available to be allocated. The net effect under the ceiling rule will be to defer A s recognition of the realized gain on the transfer of the property. 38

39 Section 704(c) Proposal Simplified Remedial Method Mandate use of a simplified remedial method: - Excess of value over basis would be considered a special positive basis adjustment to the partnership. - Benefit of special basis adjustment would be recognized at the time of the sale or other disposition of underlying property and through cost recovery or amortization deductions; computation would be made as if the special basis adjustment was newly acquired property of the same class as the underlying property. - Non-contributing partners and contributing partners would be allocated appropriate distributive share of deductions or take into account special basis adjustment on sale; contributing partner would be allocated additional income or gain to reflect allocation of deductions or reduction in gain or increase in loss allocated to all partners. 39

40 Section 704(c) Proposal Grouping of Assets Section 704(c) rules would also be simplified by permitting grouping of assets beyond what is permitted under the current regulations. Assets with built-in gains would be segregated from assets with built-in losses, with built in-gain assets being grouped only with other built-in gain assets and built-in loss assets being grouped only with other built-in loss assets. Groups would then include: - Ordinary income assets - Non-depreciable and non-amortizable assets - Depreciable assets 40

41 Section 704(c) Proposal Special Positive Basis Adjustment The special positive basis adjustment would be recovered in the following manner: - For ordinary income and non-depreciable property, the special basis adjustment would be recovered ratably as assets are sold or otherwise disposed. - Depreciation and amortization would be computed on a weighted average basis for the determination of remaining useful life and would be recovered on a straight line basis. 41

42 Section 704(c) Proposal 42 Example 9: A contributed Property X to Partnership ABC in exchange for a 10% interest. Property X has a value of $1,000 and basis of $400. Assume that Property X is depreciable on a straight line basis over 10 years if newly acquired, but has two years remaining. Property X with a basis of $400 would be depreciable over the remaining life of two years, or $200 per year. That amount would be allocated $20 to A and $180 to the other partners. The excess of value over basis of $600 would be treated as a special basis adjustment which would be depreciable over 10 years, or $60 per year. That would be allocated $54 to the non-contributing partners and $6 to A. A would also be allocated $60 of additional income, resulting in a net inclusion for A of $54.

43 43 Basis Adjustments

44 Basis Adjustments Current Law: Section 743 provides for optional basis adjustments to all assets of a partnership on a taxable sale of a partnership interest; the adjustments are intended to offset any gain or loss that would be allocated to the transferee partner if the partnership s assets were sold immediately after the transaction. Section 734 provides for optional basis adjustments to certain partnership assets after certain distributions of partnership property; intended to reduce the built-in gain or built-in loss of the retained assets, depending upon whether the adjustment is an increase or decrease in partnership basis. Rationale: Section 743 and Section 734 are intended to eliminate inside/outside basis disparities thereby preventing taxpayers from exploiting discontinuities to general losses or defer gains. However, provisions were made elective in recognition of the administrative burden. Issues: Elective nature of provisions allows for inappropriate tax planning. Legislation and recent regulation requiring mandatory adjustments in some circumstances undermine the argument that electivity is necessary to ease administrative burdens. Proposal: Make section 754 elections mandatory for all partnerships and permit grouping of assets to simplify computations. 44

45 Basis Adjustments Current Law Basis adjustments are generally elective. Once made, however, adjustments are irrevocable without IRS consent. Since 2004, adjustments are mandatory in limited circumstances: - Under section 743(b), adjustments are mandatory upon the transfer of a partnership interest if the partnership has a substantial net built-in loss, defined as assets with a basis exceeding their value by more than $250, Under section 734(b), adjustments are mandatory upon a distribution of partnership property if a section 754 election was not in effect and the amount of the reduction in the basis of partnership assets would be substantial, defined as more than $250, These adjustments are mandatory for the particular transaction at issue. Making these adjustments is not making a section 754 election. 45

46 Basis Adjustments Current Law Section 743 Section 743 adjustments apply a super aggregate theory with adjustments made to all assets when there is a purchase of a partnership interest. - Section 755 allocation provides that even if there is no difference between the transferee partner s share of inside basis and its outside basis, the basis of each asset is adjusted to effectively equal the asset s fair market value. - Value for these purposes is based upon a hypothetical sale similar to the hypothetical sale used to determine aggregate amount of adjustment. All adjustments are treated as newly acquired property for depreciation purposes. 46

47 Basis Adjustments Current Law Section 734 Adjustments are made when (i) there is a distribution of money (or money and/or assets) and gain or loss is recognized or (ii) a partner receives a distribution of property and there is substituted basis. Adjustments are generally made only to undistributed partnership property that is similar in character to the property distributed; for these purposes, money is considered property other than ordinary income property. Allocations are also made within a class of assets with respect to those assets that have either unrealized appreciation (for increase in basis) or unrealized depreciation (for decrease in basis). 47

48 Basis Adjustments Rationale Internal Revenue Code of 1954: Congress first enacted basis adjustments both in the context of transfers of partnership interests and distributions of partnership assets in recognition of the desirability of minimizing the amount and timing of distortions of income and loss. Electivity was included as an acknowledgement of the burdensome administrative costs of basis adjustments, especially for partnerships with many assets. Jobs Act of 2004: Congress made basis adjustments mandatory for partnerships in substantial loss positions in certain circumstances out of concern for taxpayer abuse of loss duplication. 48

49 Basis Adjustments Issues Optional nature of election offers taxpayers inappropriate planning opportunities (e.g., duplication of losses). Example 10: Partnership PS1 has four partners A, B, C and D, and one property with $100 built-in gain. PS1 has no section 754 election in effect. D sells his interest to E for $40. Tax Basis FMV E C B A $40 $40 40% $0 $20 20% $0 $20 20% PS1 20% Property Tax Basis $0 FMV $100 $0 $20 - If PS1 sells property for $100, E has artificial tax gain of $40 and E s PS1 interest has an artificial built-in loss of $40. - What if E has expiring capital losses, NOLs or SRLY limited losses? What if E has carryforward passive losses usable against the gain? 49

50 Basis Adjustments Proposal Mandatory section 754 elections for all partnerships. Excess of value over basis or basis over value would be considered a special basis adjustment to the partnership, in a manner similar to the proposal under 704(c) As with the special basis adjustment in the 704(c) context, in the 754 context: - Grouping of assets similar to 704(c) proposal, i.e. built-in gain assets grouped separately from built-in loss assets, and within built-in gain assets and built-in loss assets, further grouping as ordinary income assets, non-depreciable and non-amortizable assets or depreciable assets. - Recovery of special basis adjustment will be at the time of sale for ordinary income and non-depreciable/non-amortizable assets and will be pro rata for depreciable assets. 50

51 Reforming Subchapter K November 7, 2015 The information provided in this slide presentation is not, is not intended to be, and shall not be construed to be, either the provision of legal advice or an offer to provide legal services, nor does it necessarily reflect the opinions of the firm, our lawyers or our clients. No client-lawyer relationship between you and the firm is or may be created by your access to or use of this presentation or any information contained on them. Rather, the content is intended as a general overview of the subject matter covered. Proskauer Rose LLP (Proskauer) is not obligated to provide updates on the information presented herein. Those viewing this presentation are encouraged to seek direct counsel on legal questions. Proskauer Rose LLP. All Rights Reserved.