Section of Taxation Publications
  VOL. 58
NO. 3
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 Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
 Repairing Inside Basis Adjustments
Karen C. Burke*

*Warren Distinguished Professor, University of San Diego School of Law; Smith College, B.A., 1972; Harvard University, M.A., 1975, Ph.D., 1979; Stanford Law School, J.D., 1982.


Optional basis adjustments under Subchapter K have come under increased scrutiny as a result of tax shelter abuses involving partnerships. Recent legislation requires mandatory adjustments under sections 734(b) and 743(b) upon certain distributions of partnership property and transfers of partnership interests. These amendments were targeted at situations in which the failure to make such adjustments potentially gave rise to duplication of losses. Thus, a section 743(b) adjustment is mandatory upon a sale of an interest in a partnership with a “substantial built-in loss” to ensure that the purchasing partner cannot duplicate the selling partner’s built-in loss inherent in the partnership assets. Similarly, a section 734(b) adjustment is mandatory where a distribution in liquidation of a partner’s interest would give rise to a “substantial basis reduction” if a section 754 election were in effect. The provision is intended to prevent a liquidating distribution of low-basis property to a departing partner with a high outside basis from leaving the continuing partners with lower net built-in gain (or higher net built-in loss) than before the distribution. With respect to all current distributions and many liquidating distributions, inside basis adjustments remain optional.

While preventing loss duplication may be particularly urgent, these anti-tax-shelter measures represent a retreat from broader proposals calling for mandatory section 734(b) adjustments for both current and liquidating distributions. Although recent regulations integrate section 743(b) adjustments and section 704(c) allocations, the basic mechanics of section 734(b) adjustments have remained largely unchanged since 1954. In a recent article, Professor Abrams criticizes the common basis approach of section 734(b) for failing to allocate adjustments properly when partnership property is revalued following a non-pro rata current distribution of appreciated property. His central claim is that, by analogy to section 743(b), the section 734(b) adjustment should benefit only the distributee partner rather than all of the continuing partners. Abrams also proposes treating a distribution of appreciated property as triggering remedial allocations of income and offsetting loss to prevent shifting of built-in gain as a result of the distribution. If these changes were made, Abrams argues that the section 734(b) adjustment would reach sensible results consistent with the purpose of the optional basis adjustments.

Part II of this article provides an overview of Abrams’ proposed repairs to section 734(b). Part III suggests an alternative approach that would treat a non-pro rata current distribution of appreciated property as a deemed sale and extend section 704(c) principles to allocate the section 734(b) adjustment in a manner that aligns the continuing partners’ post-distribution shares of inside basis, gain, and value. Part IV argues that the common basis approach of section 734(b), modified by section 704(c) principles, produces the correct results when revalued partnership property is depreciable or the distributee sells her reduced partnership interest. Finally, Part V suggests that a partial liquidation approach would remedy the underlying flaws in the common basis approach of section 734(b), without the need for complex section 704(c) special allocations, and would also cure defects in the 2004 legislation. While Congress recognized the need for at least partially mandatory section 734(b) adjustments, it remains to be seen whether mandatory adjustments will be extended to distributions (both liquidating and nonliquidating) that shift gains as well as losses.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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