IRC 732: Basis of Distributed Property in Partnerships Explained

Internal Revenue Code (IRC) Section 732 determines how the basis of distributed property is managed within partnerships. It establishes rules for adjusting the basis of property distributed to partners, affecting both nonliquidating and liquidating distributions. These adjustments influence tax liabilities and subsequent transactions involving distributed assets.

Nonliquidating Distributions

Nonliquidating distributions occur when a partnership distributes assets to a partner without ending the partner’s interest in the partnership. These require basis adjustments to ensure proper tax treatment.

Basis Relief

In nonliquidating distributions, basis relief prevents double taxation on distributed property. A partner’s outside basis in the partnership is reduced by the amount of cash and the adjusted basis of property received, but not below zero. If the adjusted basis of the property exceeds the partner’s outside basis, the property’s basis is limited to the remaining outside basis. This aligns with IRC Section 705, which governs how a partner’s basis is affected by partnership operations, ensuring proper taxation while avoiding unnecessary burdens.

Adjusted Basis of Partner

The adjusted basis of a partner is critical during nonliquidating distributions as it determines tax consequences for both the partnership and the partner. Adjustments reflect the partner’s share of income, losses, and other partnership-related items. When property is distributed, the partner reduces their outside basis by the amount of cash and the adjusted basis of property received. If the outside basis is insufficient to cover the distribution, the excess is treated as a capital gain under IRC Section 731(a).

Allocation Across Assets

When multiple assets are distributed, basis allocation is required. The basis is proportionally allocated according to the fair market value of each asset. Cash is allocated first against the partner’s outside basis, with any remaining basis applied to the property received. Following the allocation rules under IRC Section 732(c) ensures accurate reporting in subsequent sales or exchanges.

Liquidating Distributions

Liquidating distributions occur when a partnership dissolves or a partner’s interest is terminated. These require comprehensive adjustments to the partner’s outside basis.

Full Reduction of Outside Basis

In a liquidating distribution, the partner’s entire outside basis must be reduced to zero. IRC Section 732(b) stipulates that the distributed property’s basis equals the partner’s remaining outside basis. For example, if a partner’s outside basis is $100,000 and they receive property with an adjusted basis of $80,000, the entire $100,000 basis is allocated to the property, even if it exceeds its fair market value.

Multiple Asset Distribution

When multiple assets are distributed during liquidation, basis allocation follows IRC Section 732(c). First, basis is allocated to unrealized receivables and inventory items, and then to other property. For instance, if a partner receives both inventory and a building, the inventory receives basis first, with any remaining basis assigned to the building.

Excess Liabilities

If a partner assumes liabilities exceeding their outside basis in a liquidating distribution, the excess is treated as a taxable gain under IRC Section 731(a). For example, if a partner with an outside basis of $50,000 assumes $60,000 in liabilities, the $10,000 excess is recognized as a capital gain. IRC Section 752 governs the effects of liability assumptions on a partner’s basis.

Coordination With Other Partnership Sections

Partnership taxation involves interplay between IRC Section 732 and other sections. IRC Section 704 governs how partnership income, deductions, and credits are allocated among partners, directly affecting a partner’s outside basis. Special allocations under IRC Section 704(b) may alter a partner’s basis, impacting the tax treatment of distributions.

IRC Section 707 distinguishes between transactions within the partnership and those treated as occurring between the partnership and a partner acting in a non-partner capacity. Payments for services or the use of capital, treated as guaranteed payments under IRC Section 707(c), affect taxable income independently of distributive shares.

IRC Section 743 addresses basis adjustments to partnership property during transfers of partnership interests. These adjustments ensure accurate reflection of remaining partners’ interests and influence future distributions and tax liabilities.

Property Disposition After Distribution

When distributed property is sold or exchanged, its adjusted basis at the time of disposition determines the gain or loss. The character of the gain or loss depends on the property’s classification. If the property was a capital asset in the partnership’s hands, the gain or loss is treated as capital. If it was inventory or a receivable, the gain or loss is ordinary, affecting taxable income differently. Understanding these distinctions is essential for accurate tax reporting.