Rev. Rul. 80-235

ISSUES

(1) Is the liability created by the Purchase Note given as the purchase price for a synthetic oil converter included in the partnership's basis in the converter for purposes of the investment tax credits?

(2) Is the liability created by the 180x dollar written obligation given as part of the purchase price for a partnership interest included in the basis of the partnership interest? FACTS

A, an individual, claimed to have developed a process for the conversion of coal into synthetic fuel. This process has not been commercially tested. In 1979, P, a newly organized limited partnership, entered into an agreement whereby A is to construct and install the synthetic oil converter for a total purchase price of 18,000x dollars. In payment for the converter, P issued A a ten-year interest-bearing non-recourse note in the principal amount of 18,000x dollars ("Purchase Note"). Principal and interest at 10 percent are payable out of P's net cash flow, beginning on September 1, 1980. If net cash flow is inadequate to meet the annual installment, payment is not due until there is sufficient cash flow, but no later than 1990. The Purchase Note is secured only by the synthetic oil converter.

P has 100 limited partners. Each limited partner acquired its partnership interest for a total purchase price of 200x dollars, paid with 20x dollars in cash and a 180x dollar written obligation to repay a pro rata portion of the principal of the Purchase Note in six equal annual installments, with interest, starting September 1, 1980. Principal and interest on the written obligations, however, will be paid by the limited partners only from cash distributions from P that result from the production activities.

LAW AND ANALYSIS

Section 1011(a) of the Internal Revenue Code provides that, in general, the adjusted basis for determining gain or loss from the sale or disposition of property, whenever acquired, will be the basis determined under section 1012, adjusted as provided in section 1016.

Section 1012 of the Code provides that, in general, the basis of property will be its cost.

Section 722 of the Code provides that the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership will be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution.

Section 38 of the Code allows a credit against federal income tax for qualified investment in "section 38 property" as defined in section 48(a)(1). Pursuant to section 48(1), for the period beginning on October 1, 1978 (and ending on December 31, 1982), any energy property, as defined in section 48(1)(2), will be treated as "section 38 property." The amount of the credit will be equal to the sum of the percentages, set forth in section 46(a)(2), of the qualified investment. Section 46(c) provides that the qualified investment is the aggregate of the applicable percentages, determined under section 46(c)(2), of the basis of each new section 38 property placed in service by the taxpayer during the taxable year.

Section 1.46-3(c)(1) of the Income Tax Regulations provides that the basis of any new section 38 property will be determined under the general rules for determining the basis of property and, therefore, the basis of property would generally be its cost.

An obligation, the payment of which is so speculative as to create a contingent liability, cannot be included in the basis of property. Denver & Rio Grande Western R.R. Co. v. United States, 505 F.2d 1266 (Ct. Cl. 1974); Columbus and Greenville Railway Co. v. Commissioner, 42 T.C. 834 (1964), aff'd per curiam, 358 F.2d 294 (5th Cir. 1966); Albany Car Wheel Co. v. Commissioner, 40 T.C. 831 (1963), aff'd per curiam, 333 F. 2d 653 (2d Cir. 1964); Rev. Rul. 77-110, 1977-1 C.B. 58; and Rev. Rul. 78-29, 1978-1 C.B. 62. The Court of Appeals for the Third Circuit, in Pierce Estates v. Commissioner, 195 F.2d 475 (3d Cir. 1952), indicated that a liability is contingent of it is dependent upon the happening of a subsequent event, such as the earning of profits.

There must be adequate net cash flow before P has to make a payment of principal of the Purchase Note. Considering the nature of this new business and the fact that A's process is commercially untested, among other factors, no realistic predictions can be made about the success of the converter and therefore the net cash flow of P for any year. Because payment under the Purchase Note is contingent upon future cash flow the Purchase Note is a contingent liability.

A limited partner's written obligation to repay a portion of the principal of the Purchase Note also is a contingent liability because it is nothing more than a mere promise to repay a contingent liability and its payment is contingent upon the receipt of cash distributions from P. Furthermore, the contribution of a partner's written obligation, its personal note, to the partnership does not increase the basis of the partner's interest under section 722 of the Code because the partner has a zero basis in the written obligation. Payments on the written obligation are added to the partner's basis in the partnership as the payments are actually made.

HOLDINGS

(1) The liability created by the Purchase Note may not be included in P's basis in the synthetic oil converter for purposes of regular and energy investment credits.

(2) The liability created by the written obligation of a limited partner may not be included in the basis of the limited partnership interest.