When property is contributed to the partnership in exchange for a partnership interest?

Contributions of Property

Generally, no gain or loss is recognized by either the partnership or the partner on the contribution of property to a partnership in exchange for a partnership interest. These rules apply both to property transferred in connection with a newly formed partnership as well as to property transferred to an existing partnership. [Cash is considered "property."]IRC Sec. 721

Exceptions to Nonrecognition Rules

In certain circumstances, the nonrecognition rules may not apply to the partners due to a variety of reasons. The following situations, discussed in detail later, might cause a taxable event.

1. Contributions.Property must be contributed to the partnership and distinguished from a disguised sale which will produce gains or losses to the selling partner.IRC Sec. 707[a][2] and Regs. Sec. 1.721-1[a]

2. Property.Although not specifically defined, the term property does not include services. Gain must be recognized if a partner performs services for the partnership in exchange for a partnership interest. Regs. Sec. 1.721-1[b][2]

3. Investment partnerships.Gain or loss must be recognized on contributions of property to partnerships established as investment companies [often referred to as Swap Funds].IRC Sec. 721[b]

4. Liabilities. Gain may have to be recognized by a contributing partner if liabilities are transferred or assumed by the partnership as a result of the transfer. IRC Sec. 752 and Regs. Sec. 1.752-lT[a]

Contributions of property with recapture potential

Depreciation recapture property

A contributing partner who contributes property subject to depreciation recapture does not trigger the recapture unless gain is recognized under Section 731 [a] [i.e., liabilities creating a negative basis]. IRC Sec. 1245[b][3]

If gain is recognized under Section 731[a], the amount of recapture is the lesser of:

1. The gain recognized, or
2. The recapture that would have been recognized if the property had been disposed of at its fair market value in a taxable transaction. Regs. Sec. 1.1245-4[c][1]

If no gain is recognized, the adjusted basis of the property contributed carries over to the partnership and the partnership becomes responsible for the depreciation recapture. Regs. Secs. 1.1245-2[c][2] and 1.1250-3[c][3]

Investment or Business Credit Recapture

The transfer of Section 38 property to a partnership does not trigger the investment credit recapture if:

1. The property is retained as Section 38 property; and b. The transferor retains a substantial interest in the trade or business. IRC Sec. 47
2. If there is no investment credit recapture as a result of a tax-free contribution of the property to the partnership pursuant to Section 721, the transferor partner remains directly liable for the recapture potential. Regs. Sec. 1.47-3[f]

A partner's basis in the partnership interest The basis of the contributing partner's interest is determined under the general rule of Section 722. The partner's basis in the partnership interest equals:

1. the amount of any cash contribution;
2. the adjusted basis of any property contributed; plus
3. the amount, if any, of gain recognized.

When property is transferred to a partnership and is subject to a liability, the transfer has immediate ramifications to the basis of all partners. Section 752, which governs the transaction, adopts the aggregate concept requiring that:

1. An increase in liabilities of the partnership will increase a partner's basis because the increased burden is treated as a constructive contribution of money.
2. A decrease in liabilities of the partnership will decrease a partners basis because the decreased burden is treated as a constructive distribution of money.

The application of Section 752 coupled with the standard basis rules of Section 722 create the following steps for determining a partner's basis in a partnership interest:

1. A partners basis is determined under Section 722.
2. The basis is increased by the partners proportionate share of all liabilities assumed by the partnership.
3. The basis is decreased by the amount of the partner's personal liabilities relieved/assumed by the partnership in connection with the contributed property.

Since contributing partners may never have a negative basis in their partnership interest, gain must be recognized when the partnership assumes a sufficient sum of a partner's liabilities to eliminate all of the existing basis. The amount of gain recognized is the quantity necessary to restore the partner's basis back to zero. Regs. Sec. 1.752-lT

The Treasury Department, as directed by Congress, issued new Regulations under Section 752 effective January 30, 1989. The new Regulations revamped some of the traditional rules for liabilities by attempting to determine who bears the ultimate liability for loans assumed by the partnership. The partner[s] bearing ultimate liability become the partner[s] who increase their basis. These new Regulations are discussed in detail in a later lesson.

A partner's holding period in a partnership interest depends upon the characterization of the property contributed.

• Capital assets. If the partner contributes a capital asset or a Section 1231 asset, the holding period of the partnership interest includes the period the partner held the contributed property [i.e., a substituted basis]. IRC Sec. 1223[l]
• Other property. If cash, noncapital assets, or non-Section 1231 assets are contributed, the holding period begins the day the partnership interest is acquired, Regs. Sec. 1. 1223-1[a]
• Combined properties. It is not totally clear how the holding period of a partners partnership interest is determined when both capital and Section 1231 assets are contributed.

The basis of property contributed to a partnership is a carryover basis from the contributing partner. The basis will be increased by any gain recognized by the contributing partner. However, as the result of extensive court decisions, it appears only gains related to Section 721[b] investment partnerships are added to the carryover basis. IRC Sec. 723

The partnership's holding period for contributed property includes the holding period of the property in the hands of the contributing partner. IRC Sec. 1223[2]

Receipt of Partnership Interest for Services

The nonrecognition provisions of IRC Sec. 721 do not apply to the transfer of services in exchange for a partnership interest. The taxable partnership interest received in exchange for the services may be a capital interest, a profits interest, or both.

A capital interest refers to a partner's entitlement to a portion of the initial and subsequent contributions of capital to the partnership,- in other words, an interest in the assets [net of any liabilities] of the partnership. The receipt of a capital interest is taxable immediately at its fair market value [FMV].

A profits interest generally refers to the right to share in the future income of the partnership and in the appreciation in the value of the assets. The receipt of an interest for future profits is usually taxable only when and as those profits are actually realized.

Tax consequences of the services

The Regulations provide that when a partnership interest is exchanged for services, the service partner must recognize income to the extent of the fair market value of the interest received. The value of the interest, so determined, will be recognized by the service partner as compensation. This compensation must be recognized at the time of the transfer if the interest in the partnership is for past services. A transfer conditioned on the performance of future services will be taxed at the completion of such services.

The basis to a service partner for a partnership interest is the amount of income recognized. If the service partner is an existing partner, the amount recognized is added to the old basis.

The partnership will treat the amount of services performed in exchange for an interest as either a capitalized cost or as an expense item. This treatment will vary depending upon the nature of the services performed. IRC Sec. 707[c]

The previous discussion has been primarily concerned with unrestricted interests. That is, partnership interests that are transferred for services without strings attached. Many times, partnerships want to restrict the complete passage of an interest until some contingent event occurs. That event could be the passage of time, a partner's performance, or any other condition to which the partner and the partnership agree. When a transfer is restricted, the timing of income recognition can vary.

A restricted partnership interest for services is one that is nontransferable until some contingency is fulfilled and is subject to a substantial risk of forfeiture. In a restricted interest, income is deferred until the restrictions lapse or the interest is no longer subject to a substantial risk of forfeiture, whichever comes first. A substantial risk of forfeiture simply means that the partner will forfeit the right to the partnership interest if all conditions of the contingency are not met.

The advantage of making the election is to fix the amount of compensation currently so that any subsequent appreciation goes untaxed as ordinary income. However, should a partner make this election and subsequently forfeit his or her interest, no deduction is allowed for the amount of income recognized at the time of transfer.

General rule: Partnership organization and syndication expenses are not deductible when incurred. Organizational costs may be amortized over a period of not less than 60 months, if the partnership so elects. Syndication fees, under no circumstances, may be amortized or deducted. IRC Sec. 709

Start-up costs are those expenditures that precede organizational expenses, The election to amortize these costs is found outside of Subchapter K.

Organizational costs are defined as:

1. those costs incident to the creation of the partnership;
2. those costs that would ordinarily be capitalizable; and
3. those costs that would normally be amortized over the life of the partnership.

In order to elect the amortization, organizational costs must be incurred during a period which begins at some reasonable time before the partnership begins business and ends with the due date [excluding extensions] of the tax return. An attempt should be made to distinguish these costs from start-up costs mentioned later.

Syndication expenses are defined to include the following items:

• Expenses of issuing and marketing partnership interests which include registration and brokerage fees.

• Accounting fees and legal fees relating to opinions included in the offering materials.

• Printing costs of the offering materials.

• The fee paid by syndicated limited partnerships for the tax opinion used in the partnership's prospectus.

Partnerships may elect under Section 195 to amortize start-up expenses over a period of not less than 60 months. These expenditures are defined as any amount paid or incurred in connection with:

• investigating the creation or acquisition of an active trade or business;
• creating an active trade or business, or
• any activity engaged in for a profit before the day on which the active trade or business begins.

These expenses are only amortizable if the amount expended would ordinarily be deductible if paid or incurred in connection with the expansion of an existing business.

The election for organizational and start-up costs should be made separately and as an attachment to the initial Form 1065. The election can be in the form of a written statement authorizing the election, or it ran be made as a mathematical computation. Failure to make the election on the initial return will require that these costs be capitalized until such time that the corporation is fully liquidated or terminated.

What happens to the property contributed by a partner to the partnership?

When property is contributed to a partnership in exchange for a capital and profits interest when does the partner's holding period begin for the partnership interest?

Do partnerships ever realize a gain or loss when they contribute property to partnerships?

What is an exchange of partnership interest?