SERVICE EXPLAINS EFFECT OF SECTION 754 ELECTION ON SALE OF UPPER-TIER PARTNERSHIP INTEREST THAT HAS INTEREST IN LOWER-TIER PARTNERSHIP.

Rev. Rul. 87-115

ISSUES

Under section 743(b) of the Internal Revenue Code, does a sale of an interest in an upper-tier partnership (UTP) result in an adjustment to the basis of the property of a lower-tier partnership (LTP) in which UTP has an interest if:

(1) both UTP and LTP have made an election under section 754?

(2) Only UTP has made the election under section 754?

(3) only LTP has made the election under section 754?

FACTS

UTP is a partnership in which A, B, C, and D are equal partners. A, B, C, and D each contributed 30x dollar interest in partnership capital and surplus. A's share of the adjusted basis of partnership property is 30x dollars, the sum of A's interest as a partner in partnership capital and surplus, plus A's share of partnership liabilities (neither UTP nor LTP have any liabilities). UTP is an equal partner in LTP, along with X and Y. LTP was formed by X, Y, and Z, who each contributed 110x dollars of cash to LTP upon its formation. UTP purchased its interest in LTP from Z for 80x dollars in a taxable year for which LTP did not have an election under section 754 in effect. UTP, X, and Y each have a 110x dollar interest in partnership capital and surplus.

UTP has an adjusted basis of 120x dollars in its property as follows: an adjusted basis of 80 dollars in its partnership interest in LTP and an adjusted basis of 40x dollars in inventory. UTP's partnership interest in LTP has a fair market value of 120x dollars, and UTP's inventory has a fair market value of 80x dollars. LTP has only one asset, a capital asset that is not a section 751 asset. LTP's asset has an adjusted basis of 330x dollars and a fair market value of 360x dollars.

In 1985, A sold A's entire interest in UTP to E for 50x dollars.

SITUATION 1

Both UTP and LTP have valid section 754 elections in effect.

SITUATION 2

UTP has a section 754 election in effect, but LTP does not.

SITUATION 3

UTP does not have a section 754 election in effect, but LTP does.

LAW AND ANALYSIS

Section 742 of the Code provides that the basis of an interest in a partnership acquired other than by contribution shall be determined under part II of subchapter O of chapter 1 (sections 1011 through 1015).

Section 1012 of the Code provides, with certain exceptions, that the basis of property shall be the cost of such property.

Section 754 of the Code provides that if a partnership files an election, in accordance with regulations prescribed by the Secretary, the basis of partnership property shall be adjusted, in the case of a transfer of a partnership interest, in the manner provided in section 743(b). Such election shall apply with respect to all transfers of interests in the partnership during the taxable year with respect to which such election was filed and all subsequent years.

Section 743(a) of the Code provides the general rule that the basis of partnership property shall not be adjusted as the result of a transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 754 is in effect with respect to such partnership.

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

Section 1.743-1(b)(1) of the Income Tax Regulations provides that, in general, a partner's share of the adjusted basis of partnership property is equal to the sum of that partner's interest as a partner in partnership capital and surplus, plus that partner's share of partnership liabilities.

Section 755(a) of the Code requires that, in general, the amount of the basis adjustment be allocated among partnership assets in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of those assets, or in any other manner permitted by the regulations prescribed by the Secretary.

Section 755(b) of the Code provides that in applying the allocation rules provided in section 755(a), increases or decreases in the adjusted basis of partnership property arising from the transfer of an interest attributable to (1) capital assets and property described in section 1231(b)("capital assets"), or (2) any other property of the partnership, shall in general be allocated to partnership property of like character.

Section 1.755-1(b)(2) of the Income Tax Regulations provides that to the extent an amount paid by a purchaser of a partnership interest is attributable to the value of capital assets, any difference between the amount so attributable and the transferee partner's share of the partnership basis of such property shall constitute a special basis adjustment with respect to partnership capital assets. Similarly, any such difference attributable to any other property of the partnership shall constitute a special basis adjustment with respect to such property.

Section 741 of the Code provides that, except as provided in section 751, the gain or loss on the exchange of an interest in a partnership shall be considered as a gain or loss from the sale of a capital asset.

Rev. Rul. 78-2, 1978-1 C.B. 202, concerns the transfer of an interest in an investment partnership, X, which is a partner of an operating partnership, Y. The ruling concludes that if elections under section 754 of the Code are in effect for X and Y, the adjustment to the basis of partnership property under section 743(b) includes (a) an adjustment to X's partnership interest in Y and (b) a corresponding basis adjustment to Y's property with respect to X and the transferee partner of X only.

In essence, if an election under section 754 is not in effect, the partnership is treated as an independent entity, separate from its partners. Thus, absent a section 754 election, even though the transferee receives a cost basis for the acquired partnership interest, the partnership does not adjust the transferee's share of the adjusted basis of partnership property. If, however, an election under section 754 is in effect, the partnership is treated more like an aggregate of its partners, and the transferee's overall basis in the assets of the partnership is generally the same as it would have been had the transferee acquired a direct interest in its share of those assets. Nevertheless, the transferee's adjusted basis for specific partnership assets will not necessarily equal the basis the assets would have had if the transferee had acquired a direct interest in the assets. The difference is due to the fact that the transferee's basis in specific partnership assets is controlled by section 755, which does not adopt a pure aggregate approach. See section 1.755-1(c) of the regulations.

SITUATION 1

E purchased A's interest for 50x dollars. Thus, under section 742, E's basis in E's partnership interest is 50x dollars. Because UTP made a valid section 754 election, under section 743(b) UTP must increase the adjusted basis of its property by 20x dollars, the excess of the transferee partner's basis in the partnership interest (50x dollars) over the partner's share of the adjusted basis of such property. Under section 1.743-1(b)(1), E's share of the adjusted basis of partnership property is 30x dollars, because E succeeds to A's interest in partnership capital and surplus. See, e.g., section 1.743-1(b)(1) Example (2). The 20x dollar special basis adjustment raises UTP's adjusted basis in its partnership property to 140x dollars, but the additional 20x dollars must be segregated and allocated solely to E. Under section 755, the 20x dollars must be allocated between capital assets (UTP's interest in LTP) and other assets (UTP's inventory).

Under section 1.755-1(b)(2) of the regulations, to the extent that an amount paid by a purchaser of a partnership interest (here, 50x dollars) is attributable to the value of capital assets (here, 120x dollars, the value of UTP's interest in LTP), any difference between the amount so attributable and the transferee partner's share of the partnership basis of such property constitutes a special basis adjustment with respect to such capital assets. In the instant case, 30x dollars (60 percent of 50x dollars) of E's purchase price is attributable to the value of UTP's interest in LTP, because 120x dollars, the value of UTP's interest in LTP, is 60 percent of 200x dollars, the total value of UTP's property. Thus, 10x dollars, the difference between the 30x dollars attributable to the value of UTP's interest in LTP and 20x dollars, E's proportionate share of UTP's basis in LTP, is a special basis adjustment to UTP's interest in LTP. This adjustment gives E an adjusted basis of 30x dollars in UTP's in LTP. The remaining 10x dollars of the 20x dollar special basis adjustment is allocated to the adjusted basis of UTP's inventory. This gives E a 20x dollar adjusted basis in UTP's inventory.

Because UTP made a section 754 election manifesting an intent to be treated as an aggregate for purposes of sections 754 and 743, it is appropriate, for purposes of section 743 and 754, to treat the sale of A's partnership interest in UTP as a deemed sale of an interest in LTP. The selling price of E's share of UTP's interest in LTP is deemed to equal E's share of UTP's adjusted basis in LTP, 30x dollars (1/4 of 80x dollars plus 10x dollars, E's special basis adjustment). Further, this deemed sale of an interest in LTP triggers the application of section 743(b) to LTP. Because LTP made a valid section 754 election, under section 743(b) LTP must increase the adjusted basis of its partnership property by 2.5x dollars, the excess of E's share of UTP's adjusted basis in LTP (30x dollars) over E's share of the adjusted basis of LTP's property (1/4 of 110x dollars, or 27.5 dollars). Section 755 applies to LTP to allocate this basis adjustment, but because LTP has only one asset, no allocation is necessary. The 2.5x dollar adjustment must be segregated and allocated solely to UTP and E, the transferee partner of UTP.

SITUATION 2

UTP has made a valid section 754 election. Thus, as in SITUATION 1, E gets an adjusted basis of 30x dollars in UTP's interest in LTP and an adjusted basis of 20x dollars in UTP's inventory. Also, as in SITUATION 1, because UTP made a section 754 election, it is appropriate, for purposes of sections 754 and 743, to treat the sale of A's interest in UTP as the sale of an interest in LTP. However, in this situation, LTP does not have a section 754 election in effect. That is, under section 743(a), LTP chose not to have the basis of its property adjusted as the result of the transfer of an interest in it. Thus, E's purchase of a partnership interest in UTP has no effect on LTP's adjusted basis in its property.

SITUATION 3

LTP has made a valid election under section 754, but UTP does not make a section 754 election. On the sale by A of an interest in UTP, E succeeds to A's 20x dollar adjusted basis in UTP's interest in LTP and to A's 10x dollar adjusted basis in UTP's inventory. E succeeds to these bases because, by not making a section 754 election, UTP chose not to have the basis of its property adjusted as the result of the transfer of an interest in UTP.

In addition, by not making a section 754 election, UTP manifested an intent to be treated as an entity for purposes of sections 754 and 743. Thus, it is inappropriate, for purposes of sections 754 and 743, to treat A's sale of an interest in UTP as the sale of an interest in LTP. Consequently, UTP cannot increase E's share of the basis of LTP's property. Nevertheless, LTP's section 754 election is not meaningless. If UTP were to sell its partnership interest in LTP, the purchaser's share of the adjusted basis of LTP's assets would be adjusted.

HOLDINGS

SITUATION 1

Upon the sale of A's partnership interest in UTP, the transferee's (E's) shares of UTP's adjusted basis in its assets is adjusted by the amount by which the basis in E's partnership interest differs from E's share of UTP's adjusted basis in its assets. In addition, E's share of LTP's adjusted basis in its assets is adjusted by the amount by which E's share of UTP's adjusted basis in LTP differs from E's share of the adjusted basis of LTP's property.

SITUATION 2

Upon the sale of A's partnership interest in UTP, E's share of UTP's adjusted basis in its assets is adjusted by the amount by which the basis in E's partnership interest differs from E's share of UTP's adjusted basis in its assets. However, because LTP did not make a section 754 election, the transfer does not affect LTP's adjusted basis in its property.

SITUATION 3

The sale of A's partnership interest in UTP does not affect either UTP's adjusted basis in its property or LTP's adjusted basis in its property.

EFFECT ON OTHER REVENUE RULINGS.

Rev. Rul. 78-2 is clarified and amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Scott Feldstein of the Interpretative Division. For further information regarding this revenue ruling contact Mr. Feldstein on (202) 566-4324 (not a toll free number).