Partnership Operating Agreement Tax Matters
A discussion of some of the common tax terminology included in many partnership and LLC operating agreements.
Partnership Operating Agreement Tax Matters
Disclaimer: The information contained within this document is highly summarized and should not be construed to be complete or used as a sole source of information, nor should it be relied upon, interpreted, or used as any type of authority, advice, or opinion, in any form. The information is applicable as of the original publish date. All citations related to federal income tax codes and regulations within this document are abbreviated for readability purposes only, however are intended to be clear as to the sections and subparagraphs referenced. The content is provided for general purposes only; all information within should be independently verified. The use of this disclaimer does not affect the degree of care given to the summary information written or sources referenced. Please contact your tax advisor to discuss any topics pertaining to your business or situation. Originally published September 17, 2021.
Partnership Operating Agreement Tax Matters
Tax partnerships, including multi-member limited liability companies (LLCs), are one of the most versatile and relatively easy to form entity structures. LLCs in Michigan for example require minimal paperwork to establish, with multi-member LLCs generally treated as partnerships by the IRS for federal income tax purposes by default (unless an election to be classified as another tax entity structure is specifically made).
Federal income tax regulations applicable to partnerships, though intricate and often complex, can offer opportunities for flexibility and creativity in structuring partnership agreements that are unique compared to other entity structure types. In general, a partnership agreement, including modifications, can be oral or written, and modified during or after the close of the tax year through the statutory return filing due date, generally so long as the partners are all in agreement with the original terms and any modifications thereof. (§ 1.761-1(c).). For a calendar year partnership, the statutory due date is generally March 15th. (§ 6072(b).). Additionally, allocations of a partner’s distributive share of any item or class of items of income, gain, loss, deduction, or credit may generally be determined by the partnership agreement, assuming other rules, some of which are discussed below, are also followed. (§ 1.704-1(a).). Effectively, special allocations of this kind might be made amongst the partners that differ from their ownership interest percentages. Adding contributions of property, or special basis adjustment rules when partnership property is distributed or interest sold can add to or limit the applicability of the various tax matters attributable to tax partnerships.
While the above mentions are certainly not the only nuances often making tax partnerships a desirable structure and common planning tool in many areas of taxation, flexibility is granted through adherence to a complex set of regulations that can work together to support the goals of the partnership. In the cannabis industry tax partnerships are common, with structures ranging from simple or equitable partnership interests with contributed cash only, to partnerships with varying membership interest rights, contributed property, or other more robust operating agreement requirements.
In order to comply with regulations, many partnership operating agreements may contain reference to the below matters or terminology. Sometimes this language is included in template versions of operating agreements to ensure certain safe harbors are met, or as generic inclusions regardless of whether the partnership actually intends to exercise any rights under a particular regulation that is not otherwise required. The greater the complexity of the partnership however, the more likely these matters will actually matter. It is important to have an understanding to determine whether a provision in your operating agreement is in fact known and being followed correctly. The burden and proof of conformance is first and foremost on the taxpayer.
Common tax matter partnership operating agreement terminology to be aware of:
Maintenance of capital accounts in accordance with § 704(b) or § 1.704-1(b)(2)(iv), including reference to substantial economic effect, and qualified income offset or deficit restoration order;
Reference to § 704(c) and contributions of property with built-in gain or loss or when the property’s adjusted basis is not equal to its fair market value; and
Reference to a § 754 election or basis adjustments under § 734(b) or § 743(b).
While there may be other matters also referenced, the above items are at least in part generally required inclusions of partnership operating agreements, as well as items treated uniquely in partnership entities. Because of this, template language can be unintentionally overlooked or misunderstood as to its importance to the partnership and partners in maintaining compliance if activities having effect under these regulations are occurring. Understanding the effects to the partnership’s members, record keeping requirements, and risks of non compliance are important for both operating and investing members to be aware of.
The following further summarizes the above mentioned tax matters. The context is meant to provide general information and technical references related to the various topics in order for tax partnership members to be aware of how these provisions may affect them and the partnership, and whether or not their business is addressing the related requirements. All applicable federal income tax internal revenue codes and treasury regulations are informally identified and cited. This content should be discussed with your attorney and tax advisor and should not be relied upon for any specific scenario.
Determination of a partner’s distributive share under § 704(b)
§ 704(a) generally allows for a partner’s distributive share to be determined in accordance with what the partnership operating agreement says, or in other words, special allocations of income and other allocable items may be allowed as long as the partnership agreement provides for these (simply, as long as the partners are in agreement to whatever terms they agree to). § 704(b) provides exceptions to the allowance of special allocations generally however, unless specific rules are complied with. With this provision, the burden is placed on the taxpayer, with the IRS having legal grounds to re-determine or disallow any special allocations where the rules under § 704(b) are not met.
Practically speaking, if a partnership wants to distribute allocable items in a way other than aligned with what each partner’s ownership interest is, rules under § 704(b) must be intentionally followed.
§ 704(b): Determination of distributive share states:
“A partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances), if -
the partnership agreement does not provide as to the partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof), or
the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect.”
Sounds simple enough, right? In fact, the regulations under § 704(b) are somewhat more lengthy, in particular concerning the requirements regarding determining and maintaining support of substantial economic effect. Generally, this means that special allocations must be in accordance with partnership interests, unless the allocation has economic effect and is substantial. For example, if Partner A and Partner B each own a 50% interest in AB Partnership, however Partner A is to receive 80% of the allocation of all profit and loss items, this type of special allocation would generally not be allowed, unless the partnership can prove substantial economic effect for the special allocation of 80% to Partner A, instead of the 50% supported by their ownership interest.
§ 1.704-1(b)(2) provides for a two part analysis and definition of the terminology “substantial economic effect”. “Economic effect” is defined first under § 1.704-1(b)(2)(ii), including three specific inclusions required to be in a partnership’s operating agreement and that must occur throughout the full term of the partnership. These requirements directly correlate to this language being included in many standard partnership operating agreement templates.The partnership agreement must provide:
For the determination and maintenance of the partners’ capital accounts in accordance with the rules of paragraph (b)(2)(iv) - certain maintenance of capital account requirements are discussed below. (§ 1.704-1(b)(2)(ii)(b)(1).).
Upon liquidation of the partnership (or any partner’s interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs [...] - a few differences between a partner’s capital account and adjusted basis are discussed below. (§ 1.704-1(b)(2)(ii)(b)(2).). This subparagraph helps to illustrate the practical importance of capital accounts - capital account balances are what liquidating distributions are based off of, or generally, what a partner would be entitled to if their partnership interest was sold for fair market value.
If a partner has a deficit balance in their capital account following the liquidation of their interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs, the partner is unconditionally obligated to restore the amount of such deficit to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances [...] (§ 1.704-1(b)(2)(ii)(b)(3).).
This last provision may often not be included in LLC tax partnership operating agreements, and instead a qualified income offset is included, as provided for under § 1.704-1(b)(2)(ii)(d). The latter subparagraph again helps to illustrate the practical importance of capital accounts and information partners must be aware of, especially if they intend to ultimately sell or liquidate their interests. Capital account balances can be negative, with the negative balance effectively owed to the partnership or other partners. Partners may not generally ‘deduct’ this negative capital account balance however. If a negative capital account balance is not repaid upon liquidation of the partner’s interest, the negative balance may potentially be treated as income to the partner (discharge of debt). Some operating agreements may contain a provision that allocations may not cause a partner’s capital account to become negative with this reasoning in mind, however the practicality of a limitation like this also needs to be considered as to whether it is reasonable based on the nature of the partnership.
Note also that certain partnership agreements may contain for targeted distributions, where the agreement requires allocations to be made to maintain capital accounts with targeted distribution amounts, generally in relation to item #2 above. While these types of agreements may be common, sufficient regulatory or authoritative guidance is lacking in terms of whether these types of distribution and allocation scenarios will hold up to have economic effect under IRS scrutiny. In general, the allocations may be unknown and cause risk to the partnership if the allocations were to be audited and economic effect not be able to be proven. The discussion of this topic, while important for partnership members to generally be aware of, is beyond the scope of this material.
Effectively, the rules under § 704(b) prevent special allocations from occurring that are not consistent with the underlying economic arrangement of the partners. A partner who receives an allocation must also receive the economic benefit or burden of the allocation. The rules also prohibit allocations for tax avoidance purposes.
In the above example with AB Partnership, if both Partner A and Partner B each contribute $50,000 to form the partnership, and all other things are equal, what supports the economic effect of Partner A being allocated 80% of the profits and losses of the partnership?
Substantiality is defined under § 1.704-1(b)(2)(iii). Generally, an allocation may be considered substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences [...].
Supporting substantial economic effect first relies on the maintenance of capital accounts in accordance with the regulations. Without this, liquidating distributions upon the sale or termination of a partnership interest can not be properly calculated, nor can remaining obligations related to negative capital account balances be remedied. While a partnership may not have events triggering liquidating distributions or negative capital account balances from year to year, the partnership continuously has the requirement to maintain capital account balances in accordance with regulations. Under scrutiny, providing proof of maintenance of the capital account balances would likely be required.
Maintenance of capital accounts in accordance with § 1.704-1(b)(2)(iv)
The ‘accounting’ behind the maintenance of capital account balances under § 704(b) differs in several ways from traditional financial reporting and accounting for taxable income methodologies, along with calculating a partner’s adjusted basis in their partnership interest. While financial reporting and accounting for taxable income generally focus on historical costs, one significant difference to be aware of in maintaining capital accounts under § 704(b) is the focus on fair market value, and the concept of what the partnership would be worth in a hypothetical liquidation scenario.
To illustrate this difference, let’s say that Partner A contributes $50,000 in cash to the partnership and Partner B contributes inventory and equipment with a total fair market value of $50,000, but that B only paid $30,000 for (assume the equipment was not yet placed in service). Here, Partner A would generally have an adjusted basis in their partnership interest and capital account of $50,000, however Partner B would have an adjusted basis in their partnership interest of $30,000 and a capital account balance of $50,000. (Generally, an example related to § 1.704-1(b)(2)(iv)(d)(1), with § 722).
Several subparagraphs under § 1.704-1(b)(2)(iv) describe the rules for the maintenance of capital accounts based on various types of transactions and concepts. The treatment of many of these items may differ from the treatment under financial accounting or accounting for a partnership’s or partner’s tax basis. Partnerships may essentially require multiple ‘sets of books’ in order to track all bases properly. Here are a few subparagraphs of note that may commonly be applicable to occurrences in partnerships operating in the cannabis industry, as well as partnerships in general.
§ 1.704-1(b)(2)(iv)(c): Treatment of liabilities
Recourse, nonrecourse, and qualified nonrecourse liabilities may each come into play in tax partnerships, with liabilities generally treated differently compared to other entity types. Under § 752(a), an increase in a partner’s share of liabilities of a partnership is generally considered as a contribution of money to the partnership, and then included in their adjusted basis. However when accounting for capital account maintenance under § 1.704-1(b)(2)(iv)(c) “money contributed by a partner to a partnership includes the amount of any partnership liabilities that are assumed by such partner [...] but does not include increases in such partner’s share of partnership liabilities [...]. If the partnership has debt on its books, there likely may be a disparity between basis and the capital accounts of the partners. For the purposes of capital account maintenance, liabilities are considered assumed only to the extent the assuming party is thereby subjected to personal liability for the debt obligation. This rule may be somewhat similar to the concepts related to the treatment of recourse debt, for example. However the treatment of qualified nonrecourse financing generally would be different when comparing the treatment inclusion in at risk basis amounts, versus § 704(b) capital account balances, for example.
Rules related to allocations of nonrecourse liabilities are detailed in § 1.704-2, the scope of which is beyond this material. In an LLC, generally all liabilities may be considered to be nonrecourse by default, unless criteria for recourse or qualified nonrecourse treatment are met. Note that in general, the allocation of nonrecourse debt follows a three tiered process. For example, in AB Partnership with Partner B contributing equipment, also assume the equipment is subject to a nonrecourse loan that the partnership will take on, and that the partnership agreement states Partner B will be specially allocated the depreciation deduction for this equipment. The allocation of the debt must follow the tiered allocation steps among both partners, with allocation based on profits interest the last tier to be applied. Here, in an example with the equipment subject to debt and also being contributed property, each of the three allocation tiers likely may need to be applied. This is worth noting if in general, the partnership agreement otherwise states nonrecourse debt allocations will be based on profits interest, as the tiered allocation requirements may not be expected among the partners.
§ 1.704-1(b)(2)(iv)(d)(2): Contribution of promissory notes
Cannabis businesses operating under Michigan’s Medical Marihuana Facilities Licensing Act (MMFLA) likely are familiar with the term promissory note as a component of their licensing application, which have historically been required by the Michigan Marijuana Regulatory Agency in support of sufficient capitalization availability. (Promissory notes that were drafted solely for the purpose of satisfying these requirements but were not in fact intended to be genuinely put in place may still be contained in the entity’s books and records, and therefore may need to be evaluated for relevancy and correctness.)
Regulations for capital account maintenance here under this subparagraph may again result in different treatment between capital accounts and financial reporting, for example. Let’s assume that instead of Partner A contributing cash, Partner A contributed a promissory note to pay $50,000 for their membership interest, with payments to be made to the partnership over two years. In the meantime however, they received all rights to their membership, including distributions. In the accounting records, this transaction might be recorded on day 1 as an increase to Partner A’s contribution account, and an increase in assets receivable held by the partnership. However, under § 1.704-1(b)(2)(iv)(d)(2), generally, “if a promissory note is contributed to a partnership by a partner who is the maker of such note, such partner’s capital account will be increased with respect to such note only when there is a taxable disposition of such note by the partnership or when the partner makes principal payments on such note [...]. In the example of AB Partnership, Partner A’s capital account will not show the full balance of their ‘contribution’ until the promissory note is fully paid to the partnership at the end of year two, however will show the balance of payments made to date in the meantime.
§ 1.704-1(b)(2)(iv)(g): Adjustments to reflect book value
In general, contributed property and revalued property may be properly reflected on the books of the partnership at a book value that differs from the adjusted tax basis of the property, such as in the earlier above example of Partner A contributing cash and Partner B contributing inventory and equipment. In these circumstances, capital accounts of the partners are not considered to be properly maintained unless the capital accounts are also adjusted for allocations computed based on book purposes with respect to the underlying property. A common example of this concept relates to depreciation, which is often different for book and tax purposes. Depreciable assets may have a different depreciable book base causing a disparity in the amount of depreciation expense calculated. A scenario like this can affect the depreciation allocations among the partners, as described further below related to allocation methods under § 704(c).
§ 1.704-1(b)(2)(iv)(h): Determination of fair market value
It is important to note here, that in general, the fair market value assigned to property contributed to a partnership, distributed by the partnership, or revalued by the partnership, will be regarded as correct (by the IRS), provided however that the value is reasonably agreed to among the partners in arm’s-length negotiations, and the partners have sufficiently adverse interests. If property is overstated or understated (by more than an insignificant amount), the capital accounts of the partners will not be considered to be determined and maintained compliantly in accordance with the rules. This rule generally applies on a property by property basis. Partners in closely held partnerships, or when interests are not otherwise inherently adverse in nature, may need to increase their awareness when determining reasonable fair market values.
§ 1.704-1(b)(2)(iv)(i): Section 705(a)(2)(B) expenditures
§ 705 governs the determination of basis of a partner’s interest in the partnership, post contribution or transfer of interest. Generally, basis is increased from contributions and distributed share of income, and decreased with distributions and distributed share of losses and non deductible expenses. Adjusted basis cannot go below zero however.Under § 1.704-1(b)(2)(iv)(i), the applicability of decreases to partner capital accounts is effectively expanded. In general, the distributed allocations must still have economic effect; if they do not, the allocations will be reallocated in accordance with partnership interests. However, deductions to the capital accounts also include:
§ 709 expenses, or expenses related to the organization or syndication of the partnership. For taxable income purposes, organization costs and costs to promote the sale of the partnership or partnership interests are generally only deductible by the partnership up to $5,000 (if at all). Excess expenditures are capitalized and then amortized over 180 months. Conversely, solely for the purpose of maintaining capital accounts, amounts paid or incurred to organize a partnership or to promote the sale of (or to sell) an interest in such partnership, shall be treated as 705(a)(2)(B) expenditures, thereby reducing the capital accounts. (§ 1.704-1(b)(2)(iv)(i)(2).).
Disallowed losses on the sale or exchange of property under § 267(a)(1) and § 707(b) (generally, disallowed losses from related party transactions) are also treated as 705(a)(2)(B) expenditures per regulations, thereby reducing the capital accounts. (§ 1.704-1(b)(2)(iv)(i)(3).).
To note in general, the inclusion of these generally non deductible and non adjusting expenditures of this nature in the capital account maintenance helps to further illustrate the concept of economic effect, even if such transactions are limited or disallowed for taxable income purposes.
While these are a few of the items partnerships may encounter under § 704(b) in maintaining capital accounts in support of substantial economic effect that may vary between traditional financial reporting and income tax accounting methodologies, it is important to be aware in general that differences may and likely do exist. Cannabis partnerships should be especially mindful as well of the effect of non deductible expenses on the partners’ capital accounts, as well as distributions to cover tax payments, both of which are generally higher than compared to other industries due to the effects of § 280E.
§ 704(c) and § 1.704-3 Contributed property
Reference to § 704(c) appears several times throughout the rules related to § 704(b). In general, regulations under § 704(c) determine allocations related to property that is contributed and whose fair market value is different from the contributing partner’s adjusted tax basis in the property at the time of contribution. In the earlier example of AB Partnership, Partner B’s contribution of inventory and equipment with fair market values totaling $50,000 and total adjusted basis of $30,000 represents property where rules under § 704(c) are applicable.
A partnership must allocate income, gain, loss, and deduction items with respect to the contributed property so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution. Rules apply on a property by property basis and are intended to prevent the shifting of tax consequences among partners with respect to the pre-contribution built-in gain or loss in the contributed property, or difference between the property’s fair market value and adjusted basis. Allocations of distributive items must therefore be reasonable within this intended purpose. Guidance on reasonable allocations methods that may be applied are included under § 1.704-3(b)-(d). (Generally § 1.704-3(a).).
For example, under the traditional allocation method, the partnership is required to allocate income, gain, loss, or deduction items attributable to the contributed property as they occur. Tax allocations to the non contributing partners must generally equal computed book allocations to them to the extent possible. Under this rule, if the partnership sells § 704(c) property and recognizes gain or loss, generally the gain or loss is allocated to the contributing partner. In the example of AB Partnership, when the inventory that Partner B contributed is sold, the entire ordinary income (gain) related to this inventory would be allocated to Partner B. Without these rules in place, both partners might be allocated the income in line with their ownership interest, causing an undue shift in tax consequences to Partner A from Partner B. See § 1.704-3(b).
Similarly, in general if any property contributed by a partner is then distributed by the partnership (to another partner), within 7 years of being contributed, the contributing partner shall recognize, or be allocated, the gain or loss from the property, as if the partnership sold the distributed property for its fair market value at the time of contribution. (§ 704(c)(1)(B).). This inclusion also prevents gain or loss shifting among the partners, as in general otherwise, non money property distributions alone from the partnership would not trigger a taxable event to a partner, per rules under § 731 and § 732.
Other allocation methods that may be considered reasonable are the traditional method with curative allocations method and remedial method. Some partnership operating agreements might also include specifically which method must be followed (assuming the method is reasonable and complies with regulations otherwise).
The curative allocations method might be used in conjunction with the traditional method in cases where allocations under the traditional method are subject to a ceiling rule, or when book allocations differ from allocations available for tax purposes. For example, with AB Partnership, the equipment that Partner B contributed likely will have a disparity in the tax depreciation recognized versus the related book depreciation. In the case of an insufficient actual tax depreciation deduction available to cover the property’s computed book depreciation deduction, curative allocations of depreciation related to similar property may be made (if similar property is available). See § 1.704-3(c).
The remedial allocation method also partially applies the concept of the traditional method. In general under this method, the partnership eliminates distortions caused by the ceiling rule by creating a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the non contributing partner, while simultaneously creating an offsetting remedial item of an identical amount and allocating it to the contributing partner. See § 1.704-3(d).
Several examples of calculations of allocations under the above methods are included in the regulations. In general, it is important to be aware that if a partnership has contributed property applicable under § 704(c), allocations of related distributive items will need to follow the rules outlined in § 1.704-3, which may differ from expected allocations otherwise outlined in the partnership operating agreement.
§ 754 Manner of electing optional adjustment to basis of partnership property [in accordance with § 734 and § 743]
Many partnership operating agreements contain language related to making adjustments in accordance with § 734 and § 743, which effectively require the revaluation of the basis of undistributed partnership property upon distribution of (other) partnership property, or upon a sale or transfer of partnership interest. Some partnership operating agreements may even prohibit adjustments of this nature. Regardless, adjustments under § 734 and § 743 may generally only be made by electing to follow § 754, or if the related basis reduction or built in loss exceeds $250,000. A § 754 election is made with the partnership’s tax return, not by inclusion in the operating agreement alone. It is important to understand both the effect of these adjustments and the general requirement for making the election. Once made, a § 754 election remains in place until revoked by the partnership, with related adjustments of this nature required each time there is a triggering event.
§ 734 Adjustment to basis of undistributed partnership property where [there is a] § 754 election or substantial basis reduction
In the case of a distribution of property to a partner by a partnership with respect to which the election provided in § 754 is in effect or with respect to which there is a substantial basis reduction, the partnership shall increase the adjusted basis of partnership property by the amount of any gain recognized to the distributee partner with respect to, generally, distributions of money; and generally in the case of distributed property other than money, the excess of the adjusted basis of the distributed property to the partnership over the basis of the distributed property to the distributee partner. (§ 734(b)(1).).
Decreases to the adjusted basis of partnership property generally follow the opposite, but similar logic related to losses and distributions of property whose basis to the partnership was lower than the basis to the recipient/distributee. Effectively, if there is a disparity in the partnership’s basis in the property distributed compared to the basis the recipient takes in the property, the partnership adjusts the basis in the remaining partnership property as provided for under § 734 regulations.
For example, Partner B has an adjusted basis in the partnership of $30,000. The partnership then distributes a parcel of land to Partner B in liquidation of their interest, which the partnership purchased for and has a basis of $35,000. Partner B’s basis in the land will be $30,000 after distribution. (Generally, § 732(b).). Here, the adjustment to the basis of remaining partnership property would be an increase of $5,000. (§ 1.734-1(b)(1)(ii).). The adjustment effectively prevents Partner B’s excess “gain” in the basis difference from being recognized again in the future by the remaining partners.
Rules for the allocation of an adjustment in basis are found under § 755, including adjustments related to both § 734 and § 743. A partnership that must make adjustments under § 734 is required to attach a statement with the partnership tax return showing the computation of the adjustment and the partnership properties to which the adjustment was allocated to. (§ 1.734-1(c)-(d).). Similar requirements apply under § 743.
§ 743 Special rules where [there is a] § 754 election or substantial built-in loss
While § 734 is triggered upon distributions of partnership property, § 743 applies to sales, exchanges, or transfers of a partnership interest. Adjustments relate to the difference between the fair market value of the underlying interest, or generally, what the incoming partner pays for the interest, compared to that incoming partner’s share of the adjusted basis of the partnership’s property. Adjustments are made to the partnership property for this difference, with the basis adjustment made with respect to the transferee/incoming partner only. Adjustments are made as a result of the transfer of interests only and not by a contribution of property or money to the partnership.
In the case of the transfer of an interest in a partnership, either by sale or exchange or as a result of the death of a partner, a partnership that has an election under § 754 in effect:
increases the adjusted basis of partnership property by the excess of the transferee’s basis for the transferred partnership interest over the transferee’s proportionate share of the adjusted basis of the partnership property;
decreases the adjusted basis of the partnership property by the excess of the transferee’s share of the adjusted basis to the partnership of the partnership’s property over the transferee’s basis for the transferred partnership interest. (§ 1.743-1(b).).
The transferee’s basis in the transferred partnership interest is governed by § 742 and other basis rules for acquired property applicable overall. However, generally, basis is the cost of property in a purchase transaction, or the fair market value of property if acquired from a decedent.
The transferee’s share of the adjusted basis to the partnership of the partnership’s property is generally equal to the sum of the transferee’s interest as a partner in the partnership’s previously taxed capital, plus the transferee’s share of partnership liabilities. Generally, a transferee’s interest as a partner in the partnership’s previously taxed capital is the amount of cash the transferee would receive in a hypothetical transaction should the partnership liquidate for cash equal to the fair market value of the partnership’s assets, and then adjusted for any tax losses or gains that would be allocated to the transferee partner in such hypothetical transaction. (§ 1.743-1(d).).
For example, in the case of a transferee partner paying more for their partnership interest than what their share of the partnership’s inside basis value is, a § 743(b) adjustment would increase the basis of the partnership property for this partner only, generally reflective of the excess paid. If a partnership does not already have a § 754 election in place, and thereby requiring § 743(b) adjustments, an incoming partner might consider requiring this as a condition of becoming a partner. In the example of AB Partnership, the inside basis of partnership property is lower than its fair market value. If Partner B sells their interest to new Partner C based on the fair market value of the interest, Partner C’s share of the basis of the partnership property would be increased or ‘stepped up’ accordingly under § 743.
In general, the effects of § 743(b) adjustments affect the incoming transferee partner only. Effectively, the adjustments prevent the incoming partner from recognizing the “gain” or “loss” on the transfer “twice” due to the fair market value of their interest differing from the adjusted basis value of their share of interest in the partnership’s property, as by paying fair market value for their interest, the incoming partner is already recognizing the appreciated or depreciated value of the partnership’s underlying property. The value of the adjustment is then depreciated or amortized, based on its character. For example, if an increase in fair market value is due to goodwill or brand recognition, then the § 743(b) adjustment and related amortization will be treated similarly to other § 197 intangible assets.
Note that in general, partners in a partnership are responsible for maintaining records of their adjusted basis in the partnership, as well as their capital accounts. While the partnership may maintain these records as well, the burden of proof is ultimately on the individual partners (taxpayers). Similarly, transferee partners who acquire an interest in a partnership with a § 754 election in place are generally required to notify the partnership of such sale, exchange, or transfer. The partnership is not required to make § 743 adjustments until receiving such notice from the transferee partner. The regulations provide for the timing of this notice based on the type of transfer (whether by sale, exchange, or death of a partner), as well as requirements if the transferee partner fails to provide timely notice. In this case, generally the partnership still is not required to make the adjustments until notice is provided by the transferee/incoming partner. (§ 1.743-1(k).).
Record keeping related to § 734 and § 743 requirements can become burdensome if a partnership has multiple or recurring triggering events, as each event requires an adjustment if applicable once an election is in place. Partnerships should take care to ensure the reasoning and applicability of these provisions to their overall partnership goals and strategy.
The Tax Advisor recently published an article related to some of these regulations and potential issues of complex partnership scenarios, with expanded awareness of effects related to a business subject to § 280E. Check out the article here.
When entering into or reviewing a partnership operating agreement, it is important to be aware of the various tax matter references within and their general potential effects to the current partners and future incoming partners. Partnership tax law may allow for complex or creative partnership agreements, however intricate rules must be followed and cause and effect relationships considered. The above information is certainly not complete, and any information presented has been summarized.
While cannabis businesses often find themselves in conversations related to § 280E or entity (tax) classification elections, discussing and being aware of the more detailed tax issues related to a partnership, or any entity classification type they choose is crucial. Partner members should have a basic awareness of all tax matter concepts within their operating agreement and should discuss these matters with their tax attorney, tax advisor, and return preparer.
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