Problem. Assume a one-person partnership. There is deferred income of $90 (for example, under Revenue Procedure 2004-34 which authorizes the deferral of revenue from certain contracts if the conditions set forth in the revenue procedure are satisfied), and that it will cost $10 to produce this revenue over a period of years. The partnership interest is then sold to an unrelated third party and there is a section 754 election in effect for the partnership. Thus, one would think that the purchaser would pay $80 for the contract (subject to assuming the $10 future obligation) and there would be an $80 positive section 743(b) adjustment on the sale of the partnership interest. That would then leave $10 of income inclusion and $10 of future deductions to account for; meaning that the buyer would have $10 of income in the very early years of the contract after the purchase of the partnership interest and $10 of deductions in the later years of the contract. However, if the $10 is a contingent liability, it arguably attracts a $10 negative adjustment and there is a $90 positive adjustment, all under regulation section 1.755-1(b)(2), and so there is no net income to the purchaser in the early years of the contract and no future deductions for the purchaser in the later years of the contract.
Is this all correct? Too good to be true?
First, a little bit of background. Is the obligation to incur future costs an “obligation” under the section 752 regulations? Under regulation section 1.752-1(a)(4)(ii), “obligations” are taken into account if it is an obligation “to make payment”. Obligations to provide future services do not seem to be taken into account for this purpose. Or are they?
T.D. 9137, the Treasury decision that promulgated final regulations under regulation section 1.460-4(k), is far from clear on answering this question but it does seem to lean toward obligations to provide services not being liabilities under section 752:
“In Rev. Rul. 73-301 (1973-2 C.B. 215), the IRS ruled that the progress payments described in the ruling did not constitute a liability within the meaning of section 752. See also Rev. Rul. 81-241 (1981-2 C.B. 146) (citing and following Rev. Rul. 73-301). The proposed regulations requested comments regarding whether there are circumstances under which the receipt of progress payments under a contract accounted for under a long-term contract method of accounting could give rise to a liability under section 752, and, if so, how the regulations would need to be revised to account for such liabilities. No written comments were received. However, if a contract accounted for under a long-term contract method of accounting is contributed to a partnership, then, to the extent that progress payments give rise to a liability, section 752(b) would require the transferring partner to reduce its basis in its partnership by the amount of that liability, either when the contract is contributed (to the extent that the liability is allocated to other partners) or when the liability is extinguished. Thus, because the proposed regulations require the partner to reduce the partner’s basis in its partnership interest by the amount of progress payments received, the proposed regulations could require two reductions in basis for the same payments….Ordinarily, progress payments do not give rise to liabilities within the meaning of section 752 and the regulations thereunder. However, to the extent that there is a case in which a progress payment gives rise to such a liability, the Treasury Department and IRS agree that taxpayers should not be required to reduce their basis twice for the same progress payment, and believe that a similar rule should be provided for transfers to corporations. Accordingly, upon a contribution of a contract accounted for under a long-term contract method of accounting to a partnership or corporation, the final regulations provide that the required reduction in basis for progress payments received does not apply to the extent that such progress payments give rise to a liability (other than a liability described in section 357(c)(3)).” (emphasis added).
Revenue Ruling 81-241, upon close examination, does not appear to be particularly favorable on this issue for the taxpayer. It appears to say that the deferred income attributable to the fact that the partnership was on the completed contract method of accounting is not income or a liability or frankly anything else until the contract is completed. That said, the revenue ruling then concludes that distributions to partners in the years prior to the completion of the contract was not offset by any tax basis the partners would ultimately derive from this future but deferred income. This appears to be the result forced upon the IRS by the annual accounting concept for determining income set forth in the Internal Revenue Code.
Revenue Ruling 73-301 stated that the partnership had the absolute right to retain the payments received for services rendered to date. It is a fair inference, I think, that if the partnership could not keep the payments received if it did not perform future services, then those payments would most likely be treated as loans under the case law. In an article that I co-authored several years ago with Jerred Blanchard (Reflections On Liabilities, Tax Notes, May 29, 2001), we stated:
“In Orr v. Commissioner, a taxpayer operated a travel agency as a sole proprietorship using the cash method of accounting. As part of the taxpayer’s business, the taxpayer received cash deposits from customers for future vacations that were not included in income on receipt under the taxpayer’s accounting method. The taxpayer transferred the low-basis assets of his travel agency (other than the cash deposits) to a corporation in exchange for all the transferee corporation’s stock, plus the transferee’s assumption of the obligation to provide the future travel services. The Tax Court held that the transferor’s undertaking to provide vacation trips to customers constituted a liability for purposes of section 357(c) to the extent of the customer deposits initially received by the transferor that (a) were not included in the transferor’s gross income before the incorporation transaction, but (b) were assets of the transferor that increased the total basis of the transferor’s assets. The Tax Court placed significant reliance on the fact that the deposits had to be returned if the travel services were not rendered in a timely fashion. However, the fact that, absent application of section 357(c), the transferor would have retained the cash deposits without ever recognizing income attributable to the cash deposits was likely a key consideration in the court’s decision…..
“The progress payments in Revenue Ruling 73-301 appear to have represented an inchoate income item that would ultimately be recognized by the partnership, such that there was merely a timing difference between the receipt of the cash and the inclusion of the cash in the partnership’s gross income. This timing difference was solely attributable to the partnership’s tax accounting method. The partnership’s deferral of the progress payments previously received did not bear any rational relationship to the extent to which the partnership was obligated to render construction services under the contract in future taxable periods. It also appears that, as and when the partnership rendered construction services under the contract in future periods, additional progress payments would be received by the partnership that would adequately compensate the partnership for those future services, again with income being deferred until the contract was completed. As such, Revenue Ruling 73-301 appears to stand for the proposition that, where cash is received for past services under an accounting method that permits the recipient to defer the inclusion of the cash in gross income, and where that deferral is not rationally related to an executory obligation to render services in future periods because future payments will be received and will adequately compensate the performance of those future services, the executory obligation will not be viewed as a tax liability the incurrence of which has generated tax basis equal to the cash received for the performance of past services….
“In short, it appears that the Orr decision, the Salina decision, Revenue Ruling 95-26, and Revenue Ruling 95-45, can be rationalized as consistent examples of contingent or executory obligations that should be treated as liabilities for federal income tax purposes under the theory that a liability is any obligation the incurrence of which: (i) results in the generation of cash, tax basis, a tax deduction, or a deduction equivalent; and (ii) permits the taxpayer to avoid the inclusion of an equivalent amount of gross income. It also appears that Revenue Ruling 73-301, La Rue, Long, and Revenue Ruling 95-74 are consistent with this rationale in concluding that an executory obligation to render future services under a long- term construction contract, a contingent tort liability, a contingent back-room securities liability, and a contingent environmental liability, none of which generated any cash, tax basis, tax deduction, or deduction equivalent, are not liabilities for federal income tax purposes. On the other hand, Helmer does not seem to be consistent with the foregoing rationale unless one believes that the built-in feature of every call option, which permits the optionee to forgive the obligation to transfer the optioned property by simply not exercising the call and paying the exercise price before expiration, renders the call option too ambiguous or uncertain to merit characterization as a liability for federal income tax purposes.” (footnotes omitted).
Intuitively, in the facts set forth at the beginning of this discussion, I think that there should be a section 743(b) net adjustment to fully offset the future income from the contract. The question remains, however, whether the law as it exists today supports that answer. Example 13 of regulation section 1.460-4(k)(6) (which implements regulation section 1.460-4(k)(3)(v)(B)) has an example of a section 743(b) adjustment with a partnership using the percentage of completion method of accounting for a long-term contract. If the purchaser pays fair market value for the partnership interest and the fair market value of the contract matches the fair market value of the purchased interest (the assumption made in the example I believe), then the inside tax basis adjustment will be the amount of accelerated income that would be allocated to the purchaser on the sale by the partnership of its assets immediately after the purchase (this is what happened in example 13 I think).
The pertinent provisions from the section 460 regulations are set forth in the Appendix at the end of this article.
Now, the final regulations under regulation section 1.752-7 (T.D. 9207, May 23, 2005) have this to say about assuming a contractual obligation:
“[T]he final regulations clarify that, if the obligation arose under a contract in exchange for rights granted to the obligor under that contract, and those contractual rights are contributed to the partnership in connection with the partnership’s assumption of the contractual obligation, then the amount of the §1.752-7 liability is the amount of cash, if any, that a willing assignor would pay to a willing assignee to assume the entire contract.”
Now, here comes the real conundrum. In order to completely shelter the deferred income from tax to the purchaser in the early years of the contract, the obligation to provide future services needs to be viewed, in effect, as a built-in loss asset with actual tax basis equal to the future deductions. This is because, under regulation section 1.755-1(b)(2)(i), the tax basis of ordinary income assets is stepped up to eliminate the ordinary income to the purchaser on the purchase of a partnership interest with a section 754 election in effect, but the cost of this approach is that the tax basis of capital assets has to be reduced by the excess of the step up to the ordinary income assets over the amount of the computed adjustment under section 743(b). If there are no capital assets whose basis can be reduced, this regulation requires the tax basis of the ordinary income assets to be reduced. That would not be good for this taxpayer as it would result in the $10 of income in the early years of the contract referenced earlier being taxed to that taxpayer (to be offset in later years by the deferred deductions). If, however, the obligation to provide future services is a built-in loss asset with tax basis that can be reduced, then there will be a positive $90 adjustment to the ordinary income assets and a negative $10 adjustment to the future cost asset (if I may call it that), resulting in net income to the purchaser of zero.
In a report issued by the New York State Bar Association tax section (October 9, 2012) that addressed specifically whether and under what circumstances a partnership should be required to allocate basis adjustments under section 743(b) to contingent liabilities, the NYSBA made these recommendations:
1. The Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) should issue guidance confirming that contingent liabilities constitute “built-in loss” property for purposes of computing basis adjustments under section 743(b) following the sale of a partnership interest and allocating those adjustments among partnership assets under section 755, regardless of whether the partnership has revalued its property and regardless of whether (i) the partnership previously assumed (or took property subject to) those contingent liabilities from a partner, or (ii) the contingent liabilities originated in the partnership before the sale.
2. Treasury and the IRS should issue guidance that disregards contingent liabilities in the initial calculation of basis adjustments to the transferee partner under section 743(b) and the allocation of such adjustments among the partnership’s assets under section 755, deferring any future basis adjustments until the contingent liabilities are satisfied (either in whole or in part).
3. If [the] second recommendation is accepted, such guidance should also include specific rules addressing how and when the basis adjustment to the transferee partner under section 743(b) should be determined and how it should be allocated among the partnership’s assets under section 755.
The recommendations of the NYSBA in this report have a lot of merit to them. And guidance on this issue is listed as one of the remaining items of priority guidance under the joint IRS and Treasury business plan. But still, the fact that these recommendations make good tax policy sense does not solve the problem of what one should do under the rules as written today.
This issue remains an open question today (at least to me) subject to differences of opinion among practitioners. The New York State Bar report set forth its position that contingent liabilities qualify as “property” under sections 743 and 755 stating “It is…clear that sections 704(c), 743(b), and 755 are inextricably linked. In spite of this linkage, however, the regulations under sections 743 and 755 do not expressly provide that contingent liabilities also qualify as property for purposes of sections 743 and 755 [footnote omitted]. Nevertheless, we believe that contingent liabilities qualify as property for these purposes as well.”
This conclusion should, in my opinion, be balanced against the statement in regulation section 1.743-1(d)(1)(ii) that inside tax basis in computing a section 743(b) adjustment is computed by adding to the amount that would be received in liquidation “the amount of tax loss…that would be allocated to the transferee from the hypothetical transaction [as defined in regulation section 1.743-1(d)(2)].” Contingent liabilities, it may be argued, is not a “tax loss” but, rather, future tax deductions. They are economic equivalents but that does not mean they are legal equivalents, whatever the merits of the tax policy arguments on this issue may be (and the NYSBA report admittedly sets forth some very good tax policy arguments in support of its recommendations).
Nevertheless, this issue is an important one and should be resolved quickly by the IRS and Treasury by issuing the promised guidance on a timely basis.
1. “1.460-4(k)(3)(v)(B) Basis adjustments under sections 743(b) and 734(b). For purposes of §§1.743-1(d), 1.755-1(b), and 1.755-1(c), the amount of ordinary income or loss attributable to a contract accounted for under a long-term contract method of accounting is the amount of income or loss that the partnership would take into account under the constructive completion rules of paragraph (k)(2) of this section if, at the time of the sale of a partnership interest or the distribution to a partner, the partnership disposed of the contract for its fair market value in a constructive completion transaction. If all or part of the transferee’s basis adjustment under section 743(b) or the partnership’s basis adjustment under section 734(b) is allocated to a contract accounted for under a long-term contract method of accounting, the basis adjustment shall reduce or increase, as the case may be, the affected party’s income or loss from the contract. In the case of a contract accounted for under the CCM, the basis adjustment is taken into account in the year in which the contract is completed. In the case of a contract accounted for under a long-term contract method of accounting other than the CCM, the portion of that basis adjustment that is recovered in each taxable year of the partnership must be determined by the partnership in a manner that reasonably accounts for the adjustment over the remaining term of the contract…..
2. “Example 13. Step-in-the-shoes — PCM — transfer of a partnership interest — (i) Facts. In Year 1, W, X, Y, and Z each contribute $100,000 to form equal partnership PRS. In Year 1, PRS enters into a contract. The total contract price is $1,000,000 and the estimated total allocable contract costs are $800,000. In Year 1, PRS incurs costs of $600,000 and receives $650,000 in progress payments under the contract. Under the contract, PRS performed all of the services required in order to be entitled to receive the progress payments, and there was no obligation to return the payment or perform any additional services in order to retain the payments. PRS properly accounts for the contract under the PCM. In Year 2, W transfers W’s interest in PRS to T for $150,000. Assume that $10,000 of PRS’s Year 2 costs are incurred prior to the transfer, $40,000 are incurred after the transfer; and that PRS receives no progress payments in Year 2. Also assume that the fair market value of the contract on the date of the transfer is $160,000, that PRS closes its books with respect to the contract under section 706 on the date of the transfer, and that PRS correctly estimates at the end of Year 2 that it will have to incur an additional $75,000 of allocable contract costs in Year 3 to complete the contract (rather than $150,000 as originally estimated by PRS).
(ii) Income reporting for period ending on date of transfer. For Year 1, PRS reports receipts of $750,000 (the completion factor multiplied by total contract price ($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of $150,000. This profit is allocated equally among W, X, Y, and Z ($37,500 each). Under paragraph (k)(3)(ii)(A) of this section, for the part of Year 2 ending on the date of the transfer of W’s interest, PRS reports receipts of $12,500 (the completion factor multiplied by the total contract price ($610,000/$800,000 x $1,000,000) minus receipts already reported ($750,000)) and costs of $10,000 for a profit of $2,500. This profit is allocated equally among W, X, Y, and Z ($625 each).
(iii) Income reporting for period after transfer. PRS must continue to use the PCM. For the part of Year 2 beginning on the day after the transfer, PRS reports receipts of $134,052 (the completion factor multiplied by the total contract price decreased by receipts reported by PRS for the period ending on the date of the transfer [($650,000/$725,000 x $1,000,000) – $762,500]) and costs of $40,000, for a profit of $94,052. This profit is shared equally among T, X, Y, and Z ($23,513 each). For Year 3, PRS reports receipts of $103,448 (the total contract price minus prior year receipts ($1,000,000 – $896,552)) and costs of $75,000, for a profit of $28,448. The profit for Year 3 is shared equally among T, X, Y, and Z ($7,112 each).
(iv) Tax Consequences to W. W’s amount realized is $150,000. W’s adjusted basis in its interest in PRS is $138,125 ($100,000 originally contributed, plus $37,500, W’s distributive share of PRS’s Year 1 income, and $625, W’s distributive share of PRS’s Year 2 income prior to the transfer). Accordingly, W’s income from the sale of W’s interest in PRS is $11,875. Under paragraph (k)(2)(iv)(E) of this section, for purposes of section 751(a), the amount of ordinary income attributable to the contract is determined as follows. First, the partnership must determine the amount of income or loss from the contract that is allocated under section 706 to the period ending on the date of the sale ($625). Second, the partnership must determine the amount of income or loss that the partnership would take into account under the constructive completion rules of paragraph (k)(2) of this section if the contract were disposed of for its fair market value in a constructive completion transaction. Because PRS closed its books under section 706 with respect to the contract on the date of the sale, this calculation is treated as occurring immediately after the partnership has applied paragraph (k)(3)(ii)(A) of this section on the date of the sale. In a constructive completion transaction, the total contract price would be $810,000 (the sum of the amounts received under the contract and the amount realized in the deemed sale ($650,000 + $160,000)). PRS would report receipts of $47,500 (total contract price minus receipts already reported ($810,000 – $762,500)) and costs of $0, for a profit of $47,500. Thus, the amount of ordinary income attributable to the contract is $47,500, and W’s share of that income is $11,875. Thus, under §1.751-1(a), all of W’s $11,875 of income from the sale of W’s interest in PRS is ordinary income.
(v) Tax Consequences to T. T’s adjusted basis for its interest in PRS is $150,000. Under §1.743-1(d)(2), the amount of income that would be allocated to T if the contract were disposed of for its fair market value (adjusted to account for income from the contract for the portion of PRS’s taxable year that ends on the date of the transfer) is $11,875. Under §1.743-1(b), the amount of T’s basis adjustment under section 743(b) is $11,875. Under paragraph (k)(3)(v)(B) of this section, the portion of T’s basis adjustment that is recovered in Year 2 and Year 3 must be determined by PRS in a manner that reasonably accounts for the adjustment over the remaining term of the contract. For example, PRS could recover $6,703 of the adjustment in Year 2 (the amount of the basis adjustment, $11,875, multiplied by a fraction, the numerator of which is the excess of the completion factor for the year, $650,000/$725,000, less the completion factor for the prior year, $610,000/$800,000, and the denominator of which is 100 percent reduced by the completion factor for the taxable year preceding the transfer, $610,000/$800,000). T’s distributive share of income in Year 2 from the contract would be adjusted from $23,513 to $16,810 as a result of the basis adjustment. In Year 3, the completion year, PRS could recover $5,172 of the adjustment ($11,875 x [($725,000/$725,000 – $650,000/$725,000) / (100 percent – $610,000/$800,000)]). T’s distributive share of income in Year 3, the completion year, from the contract would be adjusted from $7,112 to $1,940 as a result of the basis adjustment.”