ALLOCATION OF PARTN ERSHIP LIABILITIES AND

ALLOCATION OF PARTN ERSHIP LIABILITIES AND NONRECOURSE DEDUCTIO N S M.Celeste Pickron and H.KarlZesw itz,jr. Sutherland,Asbill& B rennan LLP Atlanta,G eorgia and W ashington,d.c. TABLE OF C O N TENTS Page I. G ENERAL CONCEPTS... 1 A. W hen Basis Is Im portant...1 1. G ain orloss on Sale ofpartnership Interest...1 2. Taxability ofd istributions to Partners...1 3. D eterm ining Basis ofd istributed Property...1 4. Lim itation on C urrentd eductibility oflosses...1 B. EffectofLiabilities...1 1. C onstructive C ash C ontribution...2 2. C onstructive C ash D istribution...2 3. Assum ption ofliability...2 I. PARTNER S OUTSIDE BASIS...3 A. Basis C om putationalrules...3 1. InitialBasis...3 2. Adjustm ents...3 3. C om parison ofinside and O utside Basis...5 4. Unified Basis...5 5. No Negative Basis Rule...5 B. Tim ing ofbasis C alculations and Adjustm ents...6 1. W hen Basis C om putation Required...6 2. O rdering Rules forbasis Purposes...6 3. O theradjustm entrules...7 C. EffectofBasis on Property D istributions...11 1. Nonliquidating D istributions...11 2. D istributions ofm ultiple Properties...11 D. D istributions to a C orporate Partner--Basis Adjustm ents...15 E. Inclusion ofliabilities in Basis...18 I. D EFINING LIABILITY... 19 A. NotD efined in the C ode...19 B. Possible D efinition in Regulations and C ase Law...19 1. PriorRegulations...19

2. C ase Law...19 IV. LIABILITY SHARING...20 A. Distinction Between Recourse and Nonrecourse Liabilities and D eductions...20 1. Recourse Liability...20 2. Nonrecourse Liability...21 3. Recourse Againstthe Entity...21 4. Bifurcated Liability...21 B. Sharing PerEROL...21 V. MORE ON ECONOM IC RISK OF LO SS...24 A. Som e Background...24 B. Elem ents ofthe Regulations...25 1. An Obligation... 25 2. EffectofO theragreem ents...26 3. Lim ited Partners...26 4. G eneralpartners...26 C. A location ofrecourse Liabilities Am ong the Partners...27 1. C onstructive Liquidation ofpartnership...27 2. Assum ption ofw orthlessness...28 D. O bligations Recognized...30 1. Reim bursem entrights...31 2. D eem ed Satisfaction...31 3. Partneras a Lender...31 4. Exceptions to D eem ed EROL...31 5. D ebtvs.equity...31 E. OtherIlustrations --D eficitrestoration O bligation ( D RO ).32 1. D ROs are O bligations... 32 2. C onsiderrevenue Ruling 97-38...33 F. Related Persons...34 1. Nature ofrelationship...34 2. Persons Related to M ore Than O ne Partner...36 G. Tim e-value-of-m oney C onsiderations...37 H. PartnerProviding Security forpartnership Liability...38 I. Anti-Abuse Rules...39 J. Partnership M ergerrules...39 1. M ergerrules...39 2. Liability Sharing in a M erger...39 K. A W ord AboutD isguised Sales...41 VI. NONRECOURSE DEDUCTIO NS...42 A. Som e Background and Effective D ates...42 B. GeneralRules...43 C. M inim um G ain C hargeback and Nonrecourse D ebt...45 D. Tax C ourtinterpretation...53

V I. ALLO C ATING NONRECOURSE LIABILITIES...62 A. DebtA location Rules...62 B. A locations ofd ebtw hen There is C ontributed Property...63 C. FinalRegulations on Tier-3...64 ALLOCATION OF PARTN ERSHIP LIABILITIES AND NONRECOURSE DEDUCTIO N S I. G ENERAL CONCEPTS The adjusted basis ofa partner s interestin the partnership (or outside basis ) is im portant for m any purposes. Note: The partner s outside basis is not the partner s capitalaccount. A. W hen Basis Is Im portant. 1. G ain orloss on Sale ofpartnership Interest. The com putation ofgain or loss on sale or exchange of a partnership interest is m easured by the am ountrealized less any applicable expenses and adjusted basis. 2. Taxability ofd istributions to Partners. Adjusted basis is a vitalaspectin determ ining the taxation of a partner s receipt ofa partnership distribution. Forexam ple,a partnerwilrecognize gain ifa distribution of cash orm arketable securities exceeds the partner s outside basis. 3. D eterm ining Basis ofd istributed Property. The basis a partner takes in distributed property largely is derived from the partner s outside basis. C om pare:liquidating versus nonliquidating distributions. 4. Lim itation on C urrentd eductibility oflosses. Section 704(d) lim its a partner s use for tax purposes of his or her distributive share ofpartnership loss for any year to the adjusted basis of his or her interest in the partnership atthe end ofthatyear. B. EffectofLiabilities. Partnership tax principles invoke the C rane doctrine. A partner s outside basis wilinclude the partner s share ofpartnership liabilities. The a location of partnership liabilities am ong the partners, then, is im portant in determ ining each partner s adjusted basis in its partnership interest. Section 752 is the

operative statute for determ ining a partner s share of partnership liabilities. The regulations under section 752 provide the substantive guidance. Basica ly, a partner who has a share ofa partnership liability gets credit in its outside basis. 1. C onstructive C ash C ontribution. Any increase in a partner s share of partnership liabilities (or assum ption of a partnership liability) is considered a contribution of m oney by that partner. Section 752(a). 2. C onstructive C ash D istribution. Any decrease in a partner s share ofpartnership liabilities (or assum ption of the partner s liabilities)is considered a distribution ofm oney to thatpartner. Section 752(b). 3. Assum ption ofliability. To constitute an assum ption, the assum ing person m ustbe persona ly obligated to pay the liability and,ifa partner assum es a partnership liability, the person to whom the liability is owed m ust know of the assum ption and be able to enforce against the assum ing person (and no other partner or related person has econom ic risk of loss on the liability). Illustration: AB Partnership; A and B each contribute $10,000. AB Partnership purchases property for $100,000 with a ten-year depreciation period, paying $20,000 in cash and $80,000 borrowed under a note requiring no principalpaym ents for 10 years. In each ofthe first5 years,the partnership has a net loss of $5,000 after depreciation. The netcash flow of$5,000 peryearis distributed equa ly to partners A and B. Ifliabilities are not included in basis, the originalbasis of $10,000 would decrease to zero atthe end ofthe second year,because adjusted basis is reduced each year by each partner s share ofthe $5,000 partnership loss and the $2,500 in cash distributed to each partner. Section 704(d) then would bar each partner from deducting partnership losses, unless the partner m akes additional capital contributions or engages in som e other transaction increasing basis. W hat if the partner contributes its own prom issory note to the partnership? C onsiderperacchi v.c om m issioner,143 F.3d 487 (9th C ir.1998). If the liability is a located equa ly between the partners, each partner s original outside basis of$10,000 is increased by $40,000 as a result of the loan to the

partnership. Thus, each partner has sufficient basis to absorb the share of partnership losses a located to thatpartner. II. PARTN ER S OUTSIDE BASIS A partner s outside basis reflects the partner s tax investm entin the partnership. By com parison,the partner s capitalaccountessentia ly reflects the value ofthe partner s interest. A. Basis C om putationalrules. 1. InitialBasis. Undersection 722,the basis ofa partnership interestacquired by contribution of property,including m oney,is equalto the am ountofm oney orthe adjusted basis ofother property contributed to the partnership. Under section 742, the basis of an interest acquired otherthan by contribution is determ ined undersections 1011,etseq.(e.g.,cost basis fora purchased partnership interest). 2. Adjustm ents. Section 705(a) contains the com putationalrules for adjusting a partner s basis in its partnership interestoverthe life ofthe partnership. a. Aggregate Approach. These rules reflect the aggregate approach, which is consistent with the overriding notion of the partnership as a conduit for the taxation of partnership incom e and loss directly to the partners. This approach is in contrastto the entity approach of the corporate tax provisions under which incom e and loss at the corporate level are neithertaxed to the shareholders norreflected in the basis oftheirshares. b. Specific Adjustm ents. Undersection 705,outside basis is increased by additionalcontributions and by: i. taxable incom e ofthe partnership (as determ ined undersection 703(a)); ii. iii. incom e ofthe partnership exem ptfrom tax;and the excess of the deductions for depletion over the basis of property subjectto depletion. O utside basis is decreased (butnotbelow zero)by the partner s share of: i. losses ofthe partnership;