The Mysterious Partnership Loss Allocation Ordering Rule

Monte A. Jackel

Monte A. Jackel is of counsel with Leo Berwick.

In this article, Jackel analyzes the ordering rule set forth in sections 704(d) and 705 in determining gain on distributions and allowable loss allocations.

Introduction

A partnership generally allocates items of income and loss to its partners on an annual or more frequent basis. A partnership also makes distributions to its partners of cash or other property periodically, and those distributions may or may not match the amount of the allocations to the partner. This article addresses what many — including me — had thought was clearly established law. That is, in what order are distributions and gain and loss allocations taken into account by the partner in applying the loss limitation of section 704(d)? And are income and loss allocations taken into account for this purpose gross items of income and deduction or, alternatively, are they net of both income and deduction items?

For this purpose, assume the following facts. A, a partner in partnership PRS, begins the year with a $0 tax basis in his partnership interest, makes a capital contribution of $50, and receives cash distributions of $100 during the year.

But for the limitation on loss allocations set forth in section 704(d), A would be allocated and take into account in computing his own taxable income a net taxable loss of $200. The $200 net taxable loss would consist of $250 of gross taxable loss and $50 of gross taxable income. The character of the gain and loss items may or may not be the same depending upon the order of the distributions and the ordering of the gain and loss allocations (that is, the income could be ordinary and the losses capital, or the income could be capital but the losses ordinary), and the timing of the income, gain, or loss can vary depending upon the ordering of those items.

This seems like a fairly simple fact pattern. The question, for which there is a dearth of authority, is whether the proper ordering under sections 704(d) and 705(a) is: (1) calculating $50 of section 731(a) gain ($100 distribution less $50 basis in the partnership interest because of the capital contribution under section 722), $0 of gross income inclusion because the income under section 705(a)(1)(A) is determined on a net basis, but then disallowing $200 of the remaining loss allocation because of the remaining $0 tax basis in the partnership interest. This results in the suspension of all of the remaining $200 of allocable loss under section 705(a)(2)(A) because of the section 704(d) limitation of zero ($50 of a capital contribution less $50 of the distribution); or (2) calculating $0 of section 731(a) gain ($100 distribution less $50 tax basis in the partnership interest attributable to the capital contribution plus $50 of tax basis attributable to the gross allocable income of $50 under section 705(a)(1)(A), equaling tax basis of $100 which in turn equals the amount of the distribution). This results in disallowing all of the loss of $250 because of the remaining $0 tax basis in the partnership interest ($100 distribution less $100 of tax basis), resulting in all of the $250 of section 704(d) loss being suspended.

But this raises another question: What if the losses above were capital losses and the income ordinary gross income? Do you then apply the limitations of section 1211 depending on the status of the partner as an individual or corporate partner in applying the loss ordering rule? Conversely, if the income was capital gain but the losses ordinary operating losses, is the loss allocation allowed in full without regard to the status of the partner as individual or corporate? Should these matters make a difference in performing the computations under sections 704(d) and 705(a)?

Section 705(a) does reference “taxable income” and not “items of income” as does section 1367(a), and this implies a netting concept. But carrying out the netting concept in full under section 705(a)1)(A) would seemingly require applying at least some (which ones?) of the loss limitation provisions of the code in performing the netting.

Allowing netting of deductions against gross income then would appear to allow losses first (to the extent of gross income) before distributions, with only excess losses (gross losses in excess of gross income) allocable after distributions occur. If items are taken into account on a gross basis, however, partnership distributions would clearly come before losses, which is what the statute seems to provide and is consistent with Rev. Rul. 66-94, 1966-1 C.B. 166, discussed below.

Depending on your choice of options, character and timing differences for the partners may arise. This is the result of either accelerating the separate inclusion in gross income of the allocation of the income item that is part of the net loss, which results in less gain under section 731(a)(because of an increased tax basis to absorb distributions) but the same aggregate amount of gain and gross income. Alternatively, the gross income item of $50 could be offset against $50 of the gross loss resulting in having no income item to separately allocate for purposes of section 705(a)(1)(A) and a smaller net loss to allocate to the partner under section 705(a)(2)(A). Other fact patterns can, of course, arise.

Analysis

Section 704(d)(1) provides that a partner’s distributive share of partnership loss allocated from a partnership to the partner (including capital loss) shall be allowed to the partner only to the extent of the adjusted basis of that partner’s interest in the partnership at the end of the partnership tax year in which that loss occurred.

In turn, section 705(a)(1)(A) and (2)(A) further provide that the adjusted basis of a partner’s interest in a partnership is equal to the basis of that interest determined under section 722 (regarding contributions to a partnership) or section 742 (concerning transfers of partnership interests), increased by the sum of the partner’s distributive share for the tax year and prior tax years of taxable income of the partnership as determined under section 703(a), and decreased (but not below zero) by distributions by the partnership as provided in section 733 and by the sum of the partner’s distributive share for the tax year and prior tax years of losses of the partnership.

This raises the question whether the term “losses” in the preceding statutes reference gross losses or net losses. Answering this question, of course, will also provide the answer to the question discussed here of how the ordering rules of sections 704(d) and 705(a) work.

Reg. section 1.704-1(d)(2) provides that in computing the adjusted basis of a partner’s interest for the purpose of determining the extent to which the partner’s distributive share of partnership loss is allowed as a deduction for the tax year under section 704(d), the basis is first increased under section 705(a)(1) and then decreased under section 705(a)(2), except for losses of the tax year and losses previously disallowed. In applying this rule, if the partner’s distributive share of the aggregate of items of loss specified in section 702(a)(1), (2), (3), (7), and (8) exceeds the basis of the partner’s interest in the partnership, the limitation on losses under section 704(d) must be allocated to the partner’s distributive share of each loss. This allocation is determined by taking the proportion that each loss bears to the total of all of those losses. For this purpose, the total loss for the tax year is the sum of the partner’s distributive share of loss for the current year and losses disallowed and carried forward from prior tax years.

Reg. section 1.704-1(d)(4), Example 3, illustrates these principles as follows:

At the end of partnership tax year 1955, partner C has the following distributive share of partnership items described in section 702(a): Long-term capital loss, $4,000; short-term capital loss, $2,000; income as described in section 702(a)(8) [formerly section 702(a)(9)], $4,000. Partner C’s adjusted basis for his partnership interest at the end of 1955, before adjustment for any of the above items, is $1,000. As adjusted under section 705(a)(1)(A), C’s basis is increased from $1,000 to $5,000 at the end of the year. C’s total distributive share of partnership loss is $6,000. Since without regard to losses, C has a basis of only $5,000, C is allowed only $5,000/$6,000 of each loss, that is, $3,333 of his long-term capital loss, and $1,667 of his short-term capital loss. C must carry forward to succeeding tax years $667 as a long-term capital loss and $333 as a short-term capital loss.

Note that under the facts of this example, the partnership has an item of residual income that was not required to be separately stated.¹ What would have been the result if the partnership in the example also had either or both of long-term capital gain and short-term capital gain? Would the long- and short-term capital gains first be netted against the long- and short-term capital loss in determining the “income item” to be included under section 705(a)(1)(A)? The answer appears to be that there will be no netting of the gains and losses for this purpose even if the items are netted for purposes of section 702(a).

Section 1367(a)(1)(A) and (2)(A) and (B), the analogues to section 705(a), provide that the basis of each shareholder’s stock in an S corporation is increased by the items of income described in section 1366(a)(1)(A), and the basis of each shareholder’s stock in the S corporation is then decreased (but not below zero) by distributions from the corporation that were not includible in the gross income of the shareholder under section 1368 (generally distributions not in excess of basis), and then by the items of loss and deduction described in section 1366(a)(1)(A).

In turn, section 1366(a)(1)(A) and (B) provides that in determining the tax of a shareholder for the shareholder’s tax year in which the tax year of the S corporation ends, there is taken into account the shareholder’s pro rata share of the corporation’s items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and then the non-separately stated income or loss.

Reg. section 1.702-1(a)(1) and (2) provides that each partner takes into account, as part of his gains and losses, gains and losses from sales or exchanges of capital assets held for less than the long-term holding period, and separately the gains and losses from sales or exchanges of capital assets held for the long-term capital gain holding period. The partnership keeps the long-term capital gains and losses and the short-term capital gains and losses separate from each other, but it reports to each partner the net amount of each of those two separate category of items.

Reg. section 1.1367-1(f) provides that the adjustments required by section 1367(a) should be made in this order: (1) any increase in basis attributable to the income items described in section 1367(a)(1)(A) and (B); (2) any decrease in basis attributable to distributions by the corporation described in section 1367(a)(2)(A); (3) any decrease in basis attributable to noncapital, nondeductible expenses described in section 1367(a)(2)(D); and (4) any decrease in basis attributable to items of loss or deduction described in section 1367(a)(2)(B) and (C). As can be readily seen, this regime applies to income and losses on a gross — not on a net — basis.

This was not always the case for S corporations. As originally enacted in 1982, both income and deductions were taken into account before distributions.² However, as part of the Small Business Job Protection Act of 1996, Congress expressly changed the ordering rule so that losses would be taken into account after distributions, with the expressed intent of conforming the S corporation rules to the partnership rules on this issue.³

Example 1 of the 1996 Blue Book applies the new rule to a set of facts that involve capital gain gross income, a partnership distribution, and an operating loss in which the example takes the capital gain income into account before the distribution and the entire operating loss is taken into account after the distribution. The example states:

X is the sole shareholder of corporation A, a calendar year S corporation with no accumulated earnings and profits. X’s adjusted basis in the stock of A on January 1, 1998, is $1,000 and X holds no debt of A. During 1998, A makes a distribution to X of $600, recognizes a capital gain of $200 and sustains an operating loss of $900. Under the provision, X’s adjusted basis in the A stock is increased to $1,200 ($1,000 plus $200 capital gain recognized) pursuant to section 1368(d) to determine the effect of the distribution. X’s adjusted basis is then reduced by the amount of the distribution to $600 ($1,200 less $600) to determine the application of the loss limitation of section 1366(d)(l). X is allowed to take into account $600 of A’s operating loss, which reduces X’s adjusted basis to zero. The remaining $300 loss is carried forward pursuant to section 1366(d)(2).

Section 731(a)(1) provides that, in the case of a distribution by a partnership to a partner, gain is not recognized to the partner except to the extent that any money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. Reg. section 1.731-1(a) in turn provides that when money is distributed by a partnership to a partner, no gain or loss is recognized to that partner except to the extent that the amount of money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. The regulation further provides that advances or drawings of money or property against a partner’s distributive share of income are treated as current distributions made on the last day of the partnership tax year for that partner.⁴

Rev. Rul. 66-94 dealt with this loss allocation ordering rule in the context of the absence of any gross income items but only a capital contribution, a distribution, and a loss. Thus, the partner’s basis in his partnership interest in the ruling was first increased by the partner’s capital contributions to the partnership under section 722, and then decreased by distributions from the partnership to the partner under section 733, and the remaining basis was applied against any allocable losses for purposes of section 704(d). Any excess losses were suspended and carried over to the next tax year.⁵

Conclusion

It is curious that such a seemingly basic question about the application of the loss allocation ordering rule under sections 704(d) and 705(a) remains unclear after all of this time. The issue should be cleared up and clarified so that the law can be applied in a rational and consistent manner.