Liquidating Distributions IRC 754 Elections, Section 736(b) - - PowerPoint PPT Presentation

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Structuring Redemptions of Partnership and LLC Interests: Navigating Issues Unique to Liquidating Distributions

IRC 754 Elections, Section 736(b) Payments, Character and Timing of Gain, Installment Sales, and More Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNESDAY, JUNE 14, 2017

Presenting a live 90-minute webinar with interactive Q&A Robert A.N. Cudd, Senior Partner, Polsinelli, New York Michelle M. Jewett, Partner, Stroock & Stroock & Lavan, New York

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Structuring Redemptions of Partnership and LLC Interests: Navigating Issues Unique to Liquidating Distributions

Robert A.N. Cudd, Senior Partner at Polsinelli Michelle M. Jewett, Partner at Stroock & Stroock & Lavan

June 14th, 2017

5

Outline

• Key Differences in Treatment of Sales vs. Redemptions
• Overview of Partnership Redemption Rules under Code Section 736
• Treatment of Section 751 “Hot Assets” in Redemption Transactions
• Treatment of Goodwill in Redemption Transactions
• Installment Sale Treatment of Partnership Redemptions
• Liquidating Distributions of “Property” Rather than Cash
• Consequences if Section 754 Elections are in Effect or not in Effect
• Stuffing Allocations Prior to Redemption

6

Key Differences in Treatment of Sales vs. Redemptions

• Sale vs. Redemption Characterization
• Form typically determines characterization – make sure that documentation is consistent

with intention for sale or redemption of interest.

• If the proportionate interests of some partners but not all partners increase, this suggests that

the transaction was a sale.

• Disguised Sale of Partnership Interest
• Under Proposed § 707 Regulations, withdrawing partners generally would be treated as

selling their partnership interests to continuing partners, rather than receiving liquidating distributions, where (1) the continuing partners make related contributions to the partnership and (2) based on all the facts and circumstances, the distributions to the withdrawing partners would not have been made but for the continuing partners' related contributions.

• There is a presumption in Prop. Treas. Reg. § 1.707-7(e) that if a withdrawing partner

receives only cash or marketable securities (rather than property), the transaction will be treated as a distribution (rather than a sale) unless the facts and circumstances clearly indicate otherwise.

• What about Two Person Partnerships?
• Rev. Rul. 99-6: The buyer is taxed as if there had been a liquidating distribution of the LLC

assets to both members. The seller is viewed as selling its partnership interest.

7

Key Differences in Treatment of Sales vs. Redemptions

• Application of Section 751 “Hot Asset” Rules
• For redemptions, Section 751 applies to narrower scope of “unrealized

receivables” and applies through a deemed sale transaction giving the partnership a step-up in tax basis in those receivables (even if no Section 754 election has been made).

• Section 751 only applies to “substantially appreciated” inventory in a

redemption.

• The higher tax rate on Section 1250 unrecaptured gain applies in a sale but not

in a redemption of a partnership interest.

• Goodwill
• For redemptions, the treatment of the redeemed partner and the remaining

partners depends on whether (i) the partnership is a service partnership, (ii) the redeemed partner is a GP or LP, and (iii) the partnership agreement provides for payments with respect to goodwill.

8

Key Differences in Treatment of Sales vs. Redemptions

• Installment Sales
• For sales of partnership interests, gain or loss is recognized over period in

which payments are made under the installment method of Section 453.

• For redemptions, basis can be recovered before gain is recognized but loss is

deferred until final payment, and there is no imputed interest.

• Basis Adjustments
• In a sale, the purchasing partners have a basis step up in the partnership’s

assets equal to the full purchase price when payment is made (even if subsequent payments will be made as part of an installment sale).

• In a redemption, the partnership itself gets a step-up in the tax basis of its

Section 751(b) “hot assets” over time as gain is recognized by the redeemed partner.

9

Key Differences in Treatment of Sales vs. Redemptions

• Partnership Termination
• A redemption is not treated as a sale or exchange for purposes of the technical

termination rules under Code Section 708(b)(1)(B).

• Others
• Potential application of self-employment taxes
• Timing of closing of tax year with respect to partner whose interest is

redeemed

• Timing of recognition of suspended losses under passive loss rules
• Optional capital account book-ups

10

Overview of Partnership Redemption Rules Under Code Section 736

• Section 736 does not alter the total amount of income/gain to be

recognized by the redeemed partner, but

• determines the treatment of such income or gain as either ordinary income or

capital gain, and

• whether the remaining partners will obtain a deduction (or reduced

distributive share of income) for the liquidation payments.

• The redeemed partner and the remaining partners have flexibility in

determining what portion of total liquidating payments is attributable to Section 736(b) property and what portion is taxable under Section 736(a).

• Amounts distributed include any deemed distributions under Section

752(b) as a result of a decrease in the redeemed partner’s share of the partnership’s liabilities.

11

Overview of Partnership Redemption Rules Under Code Section 736

• Divides partnership withdrawal payments between:
• (i) payments under Section 736(a) which are generally income to the

redeemed partner and deductible (or excludible from income) for the remaining partners; and

• (ii) payments covered under Section 736(b) which are generally considered

payments for the redeemed partner’s interest in the partnership assets and result in gain or loss to such partner but are not deductible for the remaining partners.

• Section 736(b) Payments
• Generally consist of all liquidation payments to the redeemed partner that are

in exchange for the partner’s interest in partnership assets.

• For this purpose a partner’s share of the partnership’s assets is determined based on

gross rather than net value.

12

Overview of Partnership Redemption Rules Under Code Section 736

• Section 736(b) Payments Cont.
• The tax consequences are determined by the normal partnership distribution

rules (including the hot asset rules under Section 751(b)).

• Section 736(b) payments result in gain only to the extent that the amount of

cash distributed exceeds the redeemed partner’s basis and result in loss only when the liquidating distribution is limited to cash, unrealized receivables, and/or inventory.

• Generally, any gain or loss is characterized as capital in nature (except for
• rdinary income treatment under Section 751(b)).
• Payments are not deductible by the partnership, and the basis of remaining

partnership assets is adjusted only if:

• the partnership has made a Section 754 election or
• a portion of the distribution is characterized as a sale or exchange under Section 751(b).

13

Overview of Partnership Redemption Rules Under Section 736

• Section 736(a) Payments
• Payments made to a partner classified as a “general partner” in partnership in

which capital is not a material income producing factor (i.e., a service partnership) for:

• Unrealized receivables (not including depreciation recapture gain and similar items) and
• Payments for the goodwill of the partnership to the extent that the partnership agreement

does not expressly provide for goodwill payments.

• The third category of Section 736(a) payments consists of liquidation

payments in excess of the value of the redeemed partner’s interest.

• Section 736(a) payments are characterized either as (i) a distributive share of

partnership income or (ii)“guaranteed payments” depending on whether the payments are determined based on the partnership’s income.

• Guaranteed payments are ordinary income to the redeemed partner and are

deductible by the partnership.

• A distributive share may include capital gain or other tax-favored income, as

well as ordinary income, and reduces the other partners’ shares of partnership income.

15

Treatment of “Hot Assets” in Redemption Transactions: Differences Between Sale and Redemption Treatment

• The definition of unrealized receivables is narrower under Section 751(b)

for redemptions than for sales of partnership interests.

• Under Section 751(b), in a redemption inventory items are treated as hot

assets only if they have appreciated substantially in value.

• Section 751(b)(3)(A) defines substantial appreciation if the fair market value
• f the inventory exceeds 120 percent of the partnership’s adjusted basis.
• The partners can agree on the properties exchanged in the Section 751(b)

transaction which can affect the amount of gain recognized in the deemed

• sale. Treas. Reg. Section 1.751-1(g). In a sale of partnership interest

there is no ability to allocate the Section 751(a) gain which applies to a pro rata interest in each partnership asset.

• Section 751(b) only applies if the deemed exchange of Section 751(b)

property for other property or vice versa results in gain as opposed to Section 751(a) which applies to the amount realized.

16

• In a partial redemption unlike a sale or complete redemption of a partnership

interest, a book-up of capital accounts to revalue unrealized receivables can mitigate or eliminate the adverse effects of a Section 751(b) distribution.

• Since a Section 751(b) exchange requires a reduction in Section 751(b) property

retained by the partnership a revaluation of capital accounts will have the effect

• f increasing the gross value of the zero basis unrealized receivable so that there

is no reduction.

• Under Section 704(c) principles the taxable income of the unrealized receivable is

allocated to the partially redeemed partner under his pre-redemption percentage interest to reduce or eliminate a Section 751(b) distribution.

• Sale of an interest in a partnership owning real estate will trigger unrecaptured

Section 1250 gain taxed at 28%. Section 1(h)(7) and Treas. Reg. Section 1.1(h)- 1(b)(3).

• No unrecaptured Section 1250 gain will be recognized in a redemption of a partnership
• interest. Treas. Reg. Section 1.1(h)-1(b)(3)(ii).

Treatment of “Hot Assets” in Redemption Transactions: Differences Between Sale and Redemption Treatment

17

Treatment of “Hot Assets” in Redemption Transactions: Basic Rules of Section 751(b)

• A distribution of cash or property in a redemption of a partner’s interest

in a partnership holding “hot assets” may be subject to Section 751(b).

• Section 751(b) only applies if the distributee partner’s interest in the gross value of one

class of property increases and his interest in the gross value of the other class decreases.

• A pro rata distribution of Section 751(b) properties to all partners would not trigger a

Section 751(b) exchange because there is no decrease in share of Section 751(b) property.

• Section 751(b) does not apply to disguised sale of property to a partnership or partnership

interests.

• Under Section 751(b)(2)(A), Section 751(b) does not apply to distributions of property

contributed by the distributee partner.

• A distribution subject to Section 751(b) is divided into two parts.
• The Section 751(b) rules apply first by treating a portion of the distribution as a sale or

exchange of the excess distribution property for the other property between the distributee partner and the partnership.

• The portion of the distribution not subject to the Section 751(b) rules is analyzed as a

distribution governed by Section 731 through Section 736.

18

• The interest of a partner in Section 751(b) property or other property must

take into account his remaining interest in the property remaining in the partnership.

• For example, partner A has a 30% interest in ABC partnership which has

$100,000 of Section 751(b) property. If A receives $20,000 of Section 751(b) property and continues to have a 30% interest in the $80,000 of Section 751(b) property remaining in the partnership, only $6,000 of the property received by him will be Section 751(b) property ($30,000 - $24,000 (30% x $80,000) = $6,000). The remaining $14,000 will be treated as in excess of his

• share. Treas. Reg. Section 1.751-1(b)(1)(ii).
• Partnership ABC makes a distribution to Partner C in liquidation of his

entire partnership interest. The distribution consists of $10,000 cash and depreciable property with a fair market value of $15,000 with a $15,000

• basis. The distribution is not subject to Section 736(a). At the time of the

distribution, the balance sheet is as follows: Treatment of “Hot Assets” in Redemption Transactions: Basic Rules of Section 751(b)

19

Treatment of “Hot Assets” in Redemption Transactions: Example of Distribution in Liquidation of Partners Interest under Treas. Reg. Section 1.751-1(g), Ex. 2 [slightly modified].

20

Consequences to Distributee Partner

• As testing for the application of Section 751(b), the example concludes that

Section 751(b) property exists because the value of the inventory is $30,000 which exceeds the $21,000 basis by more than 120%.

• The example bifurcates the distribution between a Section 751(b) exchange and

Section 731 exchange.

• The Section 751(b) property exchanged has a fair market value of $13,000

($10,000 inventory + $3,000 accounts receivable). This is the amount received from the sale of the 751(b) property.

• The basis of the property is determined as if the distribution were a current

distribution under Section 732(a) so that the basis is the same as that of the partnership ($7,000 inventory and $3,000 for the A/R). Thus, C recognizes $3,000 of ordinary income.

Treatment of “Hot Assets” in Redemption Transactions: Example of Distribution in Liquidation of Partners Interest under Treas. Reg. Section 1.751-1(g), Ex. 2 [slightly modified].

21

Consequences to Distributee Partner

• Section 751(b) does not apply to the remainder of the exchange consisting of

$22,000 of cash and relief from liabilities ($10,000 + 1/3 x $36,000) plus $15,000

• f depreciable property. The depreciable property is not treated as Section

751(b) property because it’s basis is equal to the value of such property.

• The non-Section 751(b) distribution is treated as a distribution under Section 731

and the basis of C’s partnership interest is determined under Section 732(b) based

• n the basis of his partnership interest in ABC. After the Section 751(b)

exchange C has a $22,000 basis ($32,000 - $10,000 basis of Section 752(b) property) under Section 733.

• In the Section 731 distribution, C is treated as receiving cash of $9,000 ($22,000

– $13,000 proceeds of cash from Section 751(b) sale) and $13,000 of depreciable

• property. C recognizes no gain.

Treatment of “Hot Assets” in Redemption Transactions: Example of Distribution in Liquidation of Partners Interest under Treas. Reg. Section 1.751-1(g), Ex. 2 [slightly modified].

22

Consequences to Partnership

• The partnership is treated as acquiring the inventory for $10,000 and A/R for

$3,000 from the $13,000 distributed to C. The partnership has a basis in those assets equal to $3,000 and $13,000, respectively.

• The non-Section 751(b) property distributed to C does not have any tax

consequences to the partnership or the remaining partners.

Treatment of “Hot Assets” in Redemption Transactions: Example of Distribution in Liquidation of Partners Interest under Treas. Reg. Section 1.751-1(g), Ex. 2 [slightly modified].

23

• The interaction of Section 752(b) and Section 751(b) can result in a

Section 751(b) exchange in the case of a partnership with unrealized receivables where the profits of the partners are shifting. This occurs because a reduction in a partner’s share of partnership liabilities is treated as a distribution of cash.

• Partnership ABC has three equal partners in a service business with

unrealized receivables of $75 and nonrecourse debt of $100.

• ABC partners admits another equal partner so that each partner owns 25%
• f the profits and losses and liabilities of ABC partnership.
• As a result of the reduction in the existing partners’ shares of ABC’s

liabilities caused by a shift in profits interests, the ABC partners will collectively be deemed to have received a deemed distribution of cash of $25 under Section 752(b). ($100 – 75% (100) = $25).

Treatment of “Hot Assets” in Redemption Transactions: Non-Liquidating Distribution by Services Partnership

24

Treatment of “Hot Assets” in Redemption Transactions: Non-Liquidating Distribution by Services Partnership

• Since the ABC partners received a deemed cash distribution and reduced

their interest in the unrealized receivables from $75 to $56.25, they would collectively be viewed under Section 751(b) as having sold $18.75 of the unrealized receivables to the ABCD partnership for cash thereby recognizing $18.75 of ordinary income.

• If ABC partnership makes a revaluation election to book-up its assets

under Treas. Reg. Section 1.704-1(b)(2)(iv)(f), the unrealized receivables would no longer be a Section 751(b) property and any gain realized would be allocated to the ABC partners.

• The ability to book-up the capital accounts of the partners and revalue the

assets of a partnership will eliminate unpleasant surprises and cover many

• f the problems relating to the admission of new partners or current

distributions by partnerships with unrealized receivables with little or no basis.

25

Treatment of “Hot Assets” in Redemption Transactions: Example of Current Distribution Under Treas. Reg. Section 1.751-1(g) Ex. 5

Facts: Partner C in ABC partnership reduces his capital and profits interest from 1/3 to 1/5 for a current distribution of $5,000 cash, $7,500 accounts receivable with a basis to the partnership of $7,500. The total liabilities of the partnership are not reduced. Therefore, after the distribution C’s share of partnership liabilities has been reduced by $4,800 from $12,000 (1/3 x $36,000) to $7,200 (1/5 x $36,000).

• The ABC partnership holds Section 751(b) property due to its substantially

appreciated inventory.

• C’s interest in the fair market value of the ABC properties before and after

the distribution are shown in the table below:

26

Treatment of “Hot Assets” in Redemption Transactions: Example of Current Distribution Under Treas. Reg. Section 1.751-1(g) Ex. 5

27

Treatment of “Hot Assets” in Redemption Transactions: Example of Current Distribution Under Treas. Reg. Section 1.751-1(g) Ex. 5

Consequences to Distributee Partner of Section 751(b) Sale

• C relinquished $4,000 of inventory but received $4,800 of accounts

receivable both of which are Section 751(b) property and are netted so that C is treating as receiving only $800 of accounts receivable in exchange for either $800 of depreciable property or land.

• If the partners agreed that the $800 of accounts receivable was paid for $800
• f relinquished depreciable property, C would be treated as selling $800 of

depreciable property to the partnership. If the basis of that property were $700, C would recognize $100 of gain.

• Alternatively, if the partners agreed that C exchanged his relinquished interest

in the land for $800, no gain would be recognized because the basis in the land under the current distribution regime of Section 732(a) would be $800.

• Note that to the extent the inventory is exchanged for accounts receivable or

to the extent cash was distributed for depreciable property or land the transaction is not described in Section 751(b).

28

Treatment of “Hot Assets” in Redemption Transactions: Example of Current Distribution Under Treas. Reg. Section 1.751-1(g) Ex. 5

Consequences to Distributee Partner of Non-Section 751(b) Distribution

• The non-Section 751(b) distribution of the $7,500 accounts receivable does not result in any

gain to C under Section 731. C’s basis in the $7,500 of accounts receivable will be $800 for the portion purchased in the Section 751(b) exchange plus $6,700 of a carryover basis under Section 732(a).

Consequences to the Partnership of the Section 751(b) Exchange

• The partnership realizes no gain in the Section 751(b) transaction because it had a basis of

$800 in the accounts receivable for which it received other property. If the partnership is deemed to have purchased depreciable property, the basis of the property would be reduced by the constructive distribution with a $700 basis and increased by the $800 purchase price.

Consequences to Partnership of Non-Section 751(b) Distributions

• The partnership realizes no gain on the distribution under Section 731 since the property in

C’s hands will have the same basis it had in the partnership. After the Section 731(a) distribution, the basis will not be adjusted whether or not a Section 754 election is in effect.

29

Treatment of “Hot Assets” in Redemption Transactions: Proposed Treasury Regulations Section 1.751-1

• Proposed Treasury Regulations (“Proposed Regulations”) under Section

751(b) were issued on November 3, 2014 and will be effective when finalized.

• The Proposed Regulations replace the gross asset value approach with a

“net Section 751 unrealized gain” approach. To the extent a partner’s net Section 751 unrealized gain is reduced by a distribution he recognizes

• rdinary income.
• The partnership is required to revalue its assets on any distribution if it
• wns Section 751 property.

30

Treatment of “Hot Assets” in Redemption Transactions: Example of Current Distribution under Proposed Treasury Regulations 1.751-1(g) Ex. 2

Facts The ABC partnership holds $260 in cash, $100 in land and $90 of unrealized receivables. ABC distributes $50 of cash to C which reduces his interest from 1/3 to 1/4. ABC has a Section 754 election in place.

• In the first step, ABC revalues its assets and adjusts capital accounts to reflect

each partner’s share of the unrealized gain in the partnerships assets.

• The ABC is then treated as if it sold all of its assets immediately prior to the

distribution which would result in a net Section 751 unrealized gain for each partner ($90 x 1/3 = $30).

31

Treatment of “Hot Assets” in Redemption Transactions: Example of Current Distribution under Proposed Treasury Regulations 1.751-1(g) Ex. 2

• After the distribution, the Section 751 unrealized gain of each partner

would remain at $30 because each of the ABC partners would be allocated $30 of Section 751 unrealized gain. Section 751(b) does not apply to this transaction.

• By requiring a revaluation of assets in all cases, the amount of net Section

751 unrealized gain will usually be reduced.

• The focus on net Section 761 unrealized gain more accurately reflects the

purposes of Section 751(b), than allocations based on gross value which does not measure the Section 751 unrealized gain.

32

Treatment of “Hot Assets” in Redemption Transactions: Proposed Treasury Regulations Section 1.751-1

• The partners can agree on the properties exchanged in the Section 751(b)

transaction which can affect the amount of gain recognized in the deemed

• sale. Treas. Reg. Section 1.751-1(g), Ex. 3. In a sale of partnership

interest there is no ability to allocate the Section 751(a) gain which applies to a pro rata interest in each partnership property.

• In a current distribution, a book-up of capital accounts to revalue

unrealized receivables can mitigate or eliminate the adverse effects of a Section 751(b) distribution.

• Since a Section 751(b) exchange requires a reduction in Section 751(b)

property retained by the partnership a reevaluation of capital accounts will have the effect of increasing the gross value of the zero basis unrealized receivable so that there is no reduction.

• Under Section 704(c) principles the taxable income of the unrealized

receivable is allocated to the partially redeemed partner under his pre- redemption percentage interest to reduce or eliminate a Section 751(b) distribution.

34

Treatment of Goodwill in Redemption Transactions

• Payments for goodwill generally are treated as payments for partnership

property under Section 736(b)

• result in capital gain or loss to the redeemed partner
• nondeductible by the ongoing partners.
• However, goodwill is treated as a Section 736(a) payment if:
• the redeemed partner is a general partner,
• capital is not a material income-producing factor for the partnership, and
• the partnership agreement does not expressly provide for goodwill payments.
• It is unclear how the requirement that the requirement that the redeemed

partner be a “general partner” applies in the case of LLCs.

• If a Section 754 election is made, the remaining partners will be able to

amortize the redeemed partner’s share of the partnership’s goodwill.

35

Installment Sale Treatment of Partnership Redemptions

• In a redemption, the installment method under Section 453 does not
• apply. Instead, full basis recovery is possible before gain is recognized

and there is no imputed interest.

• Another important difference in the treatment of installment sales and

redemptions is that, for redemptions, the partner is treated as continuing to be a partner until the last payment is received. In an installment sale, the selling partner ceases to be a partner when the first payment is made.

• If a Section 754 election has been made, the basis step up for the

partnership in its assets will occur at the same time as the redeemed partner recognized gain.

• The characterization of payments made in redemption of a partner’s

interest in installments over several taxable years as between Section 736(a) and Section 736(b) depends on whether the payments are contingent or fixed.

36

Installment Sale Treatment of Partnership Redemptions

• Fixed Payments: the total Section 736(b) payments for a year are that amount that bears “the

same ratio to the total fixed agreed payments for such year as the total fixed payments under Section 736(b) bear to the total fixed agreed payments under Sections 736(a) and (b).” The balance of the payments received during the year are taxed under Section 736(a).

• Contingent Payments: treated first as Section 736(b) payments to the full extent of the value
• f the redeemed partner’s interest in Section 736(b) property, and, thereafter, as Section

736(a) payments.

• Both Fixed and Contingent: If fixed payments exceed the value of the redeemed partner’s

interest in Section 736(b) property, a portion of each fixed payment and all contingent payments are treated as Section 736(a) payments. Otherwise, all fixed payments are treated as Section 736(b) payments, and contingent payments are allocated first to the remaining value of the retiring partner’s interest in Section 736(b) property and then to Section 736(a) payments.

• Election: Allocation may be made in any manner to which all the remaining partners and the

withdrawing partner agree, provided that the total amount allocated to property under Section 736(b) does not exceed the fair market value of such property.

37

Liquidating Distributions of “Property” Rather than Cash

• It is not entirely clear that Section 736 applies to property distributions

(although its application is assumed in the Section 751 regulations).

• Assuming that it does apply, the tax treatment would be expected to differ

depending on whether there are “unrealized receivables” under Section 751(b) and whether there are any Section 736(a) payments.

• No unrealized receivables or Section 736(a) payments: if cash received does

not exceed partner’s basis in partnership interest, no gain is recognized and redeemed partner takes a tax basis in the property equal to the difference between the amount of cash distributed and his tax basis.

• Otherwise: incredible complexity and uncertainty regarding allocation of

distribution to Section 736(a) property and Section 736(b) property, treatment

• f distribution of unrealized receivables (particularly if coupled with a

distribution of other assets), and uncertainty if distribution is characterized as a distributive share of partnership income.

• Unfortunately there is no clear guidance on these issues.

38

Section 754 Elections in Effect or not in Effect

• Even though a Section 736(b) distribution is “made in exchange for the

interest of a partner in partnership property,” the transaction is treated as a normal partnership distribution and the basis of partnership property is not adjusted as a result of distributions to partners.

• However, if the partnership has made a Section 754 election, the basis

adjustment rules of Section 734(b) require the partnership to adjust the basis

• f its assets:
• if an amount of money is distributed that exceeds the redeemed partner's basis in his

partnership interest and the redeemed partner recognizes gain,

• if a partnership interest is completely liquidated solely in exchange for money,

unrealized receivables, and inventory and the redeemed partner recognizes a loss,

• if the partnership's basis in assets distributed to a partner exceeds the redeemed

partner's basis in his interest, or

• if a redeemed partner's interest is completely liquidated and the aggregate basis of

distributed assets in his hands is greater than the partnership's predistribution basis in the assets.

39

Section 754 Elections in Effect or not in Effect

• The basis adjustment is applicable to the partnership’s property and all

remaining partners are affected.

• In the case of a redemption with multiple distributions, a partnership that

makes a Section 754 election is not entitled to any adjustment to the basis

• f its property under Section 734(b) until the retired partner recognizes

gain from such payments.

• Even if a Section 754 election is not in effect, a Section 734(b) basis

adjustment is required in the context of a liquidation of a partner's interest if the downward adjustment to the basis of partnership assets would exceed $250,000 if a Section 754 election had been in effect.

40

Stuffing Allocations Prior to Redemption

• Many hedge funds use so-called “stuffing” or “fill-up” allocations which are a
• ne-time special allocation of realized gain or loss to a partner immediately prior

to that partner's redemption.

• Most hedge funds do not make Section 754 elections because of the administrative

costs if there are frequent redemptions and admissions of new partners and because many hedge funds can make a mark-to-market election under Section 475(f).

• The goal of the special allocation is to cause the partner’s tax capital account and

tax basis at a level equal to what the partner receives on redemption of its interest so that the partner recognizes no additional gain in connection with the distribution in redemption of his interest.

• A stuffing allocation reduces the amount of partnership income or gain allocated

to continuing partners by disproportionately allocating partnership gain or income to the redeemed partner.

• There is uncertainty regarding whether would be viewed as violating the

principles of Section 704(c) or could be subject to challenge under the partnership anti-abuse rules.

Robert A.N. Cudd Polsinelli rcudd@polsinelli.com Michelle M. Jewett Stroock & Stroock & Lavan mjewett@stroock.com