| ||The Section 734(b) Basis Adjustment Needs Repair |
Howard E. Abrams*
*Of counsel, Steptoe & Johnson, and Professor of Law, Emory Law School. University of California at Irvine, B.A. 1976; Harvard Law School, J.D. 1980. The author would like to thank Professor William D. Andrews for his comments and insights.
The partnership tax provisions-Subchapter K of the Internal Revenue Code-work pretty well. Those provisions have a difficult job of providing a reasonable mechanism for taxing arrangements between parties that can be far from off-the-rack. It should not be difficult to figure out how to tax two individuals who contribute equal amounts of cash to start a joint business in which each will own a one-half interest. It quickly becomes problematic, however, when one of the two partners wants a greater share of early receipts in exchange for a lower share of back-end gains. If the amounts the partners contribute are unequal, they will have some arrangement to account for that difference which the taxing structure must digest. A partnership is the most flexible form of business organization, and the rules of Subchapter K capture that flexibility surprisingly well.
The basic paradigm upon which Subchapter K is best described is tax transparency; that is, that a partnership should be all but invisible to the taxing system. In particular, transactions between a partner and the partnership should be tax-free as much as possible, with the taxable events being dealings between the partnership (or the partners) and third parties. Thus, most contributions and distributions are tax-free, but transfers of partnership assets or interests to non-partners generally are taxable.
A corollary of tax transparency is the general equality of aggregate inside and outside bases. "Inside basis" is the partnership's adjusted basis in its assets, while outside basis is a partner's adjusted basis in his partnership interest. Because aggregate inside basis and aggregate outside basis each represent the after-tax (and debt-financed) investment in partnership assets, they should equal each other. They start equal by reason of the basis rules applicable to contributions of property (including the debt allocation rules of section 752), and will in general remain equal throughout the life of the partnership. The examples presented in this Article do not consider the case of partnership indebtedness, although adding debt to the transaction should not create any change to the analysis.
When inside and outside basis are not equal, astute taxpayers can exploit the difference. Suppose, for example, that aggregate outside basis is higher than aggregate inside basis. A sale of all the partnership interests would transfer the partnership's assets just as would a direct asset sale, but by selling the higher-basis interests, aggregate gain is reduced. Conversely, if inside basis were higher, the assets rather than the interests would be sold.
Nonetheless, there are transactions that can break the equality of aggregate inside and aggregate outside basis. An election is provided by section 754 which ensures, by adjusting inside basis, that this equality is in fact always maintained so long as the election is made early enough. Indeed, the basis adjustments provided by the section 754 election are so well designed-and the equality between aggregate inside and aggregate outside basis so important-that commentators have called for making these basis adjustments mandatory rather than optional.
When an election under section 754 is made, the electing partnership becomes subject to two basis adjustment provisions: (1) section 734(b), providing for certain inside basis adjustments upon the occurrence of specified triggering distributions of cash or property from the partnership; and (2) section 743(b), providing for certain inside basis adjustments upon the sale or exchange of a partnership interest. The regulations specifying the manner of making these adjustments have recently undergone major revisions, with the greatest attention focused on the section 743(b) adjustments. Now, despite the lack of any real statutory support, an incoming partner will in effect take a share of inside basis in each of the partnership's assets equal to that partner's share of each asset's fair market value, an outcome so reasonable that one could only have wished Congress rather than the Treasury had seen fit to specify it.
Unfortunately, the regulations applicable to section 734(b) adjustments were not much changed, and that is indeed unfortunate. While the amount of the section 734(b) adjustment is computed properly, the allocation of that adjustment is not right. Absent a correction, the statute as written offers significant tax reduction strategies.