754 ELECTION WILL APPLY TO INCOMING PARTNER'S ADJUSTED BASIS ON DEEMED DISTRIBUTION AFTER SECTION 708(b)(1)(B) TERMINATION

Rev. Rul. 86-73

ISSUE

If a 50 percent interest in a partnership is sold causing the partnership to terminate under section 708(b)(1)(B) of the Internal Revenue Code and a section 754 election is in effect for the taxable year in which the sale occurs, does the election apply with respect to the incoming partner so that the bases of any partnership assets are adjusted prior to their deemed distribution to the partner.

FACTS

T, a 50 percent partner in PT, a partnership, sold T's interest to A. For the taxable year in which the sale occurred, PT had an election in effect under section 754 of the Code, and the fair market value of PT's property exceeded its adjusted basis.

LAW AND ANALYSIS

Section 708(b)(1)(B) of the Code provides that a partnership shall be considered as terminated if within a twelve month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.

Section 1.708-1(b)(1)(iv) of the Income Tax Regulations provides that if a partnership is terminated by a sale or exchange of an interest, the partnership is deemed to distribute its properties to the purchaser and to the other remaining partners in proportion to their respective interests in the partnership properties. Immediately thereafter, the purchaser and the other remaining partners are deemed to contribute the properties to a new partnership. The last sentence of that provision states that, for an election of basis adjustments by the purchaser and other remaining partners, see section 732(d) and 743(b) of the Code and the regulations thereunder.

Section 732(b) of the Code provides that the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest shall be an amount equal to the adjusted basis of such partner's interest in the partnership reduced by any money distributed in the same transaction.

Section 732(c) of the Code provides that the basis of distributed properties to which section 732(b) is applicable generally shall be allocated first to any unrealized receivables and inventory items in an amount equal to the adjusted basis of each such property to the partnership and, to the extent of any remaining basis, to any other distributed properties in proportion to their adjusted based to the partnership.

Section 1.732-2(b) of the regulations provides that in the case of a distribution of property to a partner who acquired any part of an interest in a transfer as to which an election under section 754 of the Code was in effect, then, for the purposes of section 732, the adjusted partnership basis of the distributed property shall take into account the transferee's special basis adjustment for the distributed property under section 743(b).

Section 743(b) of the Code provides that in the case of a transfer of an interest in a partnership by sale or exchange, a partnership as to which the election provided in section 754 is in effect shall (1) increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of the partner's interest in the partnership over the partner's proportionate share of the adjusted basis of the partnership property, or (2) decrease the adjusted basis of the partnership property by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of the partner's interest in the partnership. Such increase or decrease generally constitutes an adjustment to the basis of partnership property with respect to the transferee partner only.

Section 754 of the Code provides the manner in which a partnership shall file an election to adjust the basis of partnership property under section 743.

Section 755(a) of the Code provides that any increase or decrease in the adjusted basis of partnership property under section 743(b) shall be allocated in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties.

The issue here is whether the section 754 election applies to adjust the basis of partnership assets with respect to the incoming 50 percent partner before the constructive liquidation of the partnership that occurs under section 1.708-1(b)(1)(iv) of the regulations, or whether the sale of the 50 percent interest to the incoming partner extinguishes the section 754 election before it can be applied.

The language of section 1.708-1(b)(1)(iv) of the regulations treats the partnership property as constructively distributed to the incoming purchaser and the remaining partners. This indicates that the purchaser is a partner for the instant before the constructive liquidating distribution is deemed to occur; thus, the purchaser is a partner at least for the purpose of the termination. Since the purchaser is a partner in the instant before termination, the section 754 election applies in that instant, and the incoming partner's basis in the partnership assets is correspondingly adjusted. Upon the deemed distribution-recontribution under section 1.708-1(b)(1)(iv), the special basis adjustment under section 743(b) of the Code is taken into account in applying sections 732(b) and (c). If the new partnership, PA, wants to make a section 754 election, it will have to file a new election.

The legislative history of section 743 buttresses the conclusion that the adjustment the conclusion that the adjustment of basis of partnership assets is made before the deemed liquidating distribution occurs. The report of the Senate Finance Committee, S. Rep. No. 1622, 83d Cong., 2d Sess. 399 (1954), contains an example in which a section 754 election is applies to adjust the basis of partnership assets when a fifty percent interest in a partnership is sold.

HOLDING

If a 50 percent interest in a partnership is sold causing the partnership to terminate under section 708(b)(1)(B) of the Code, a section 754 election that is in effect for the taxable year in which the sale occurs applies with respect to the incoming partner. Therefore, the bases of any partnership assets are adjusted pursuant to section 743 and 755 prior to their deemed distribution to the incoming partner.