nonrecourse deductions 25 percent to A and 75 percent to B and meet the safe harbor. Alternatively, if partnership AB expects to have significant residual profits at the time the nonrecourse liability arises, then it may allocate the nonrecourse deductions in accordance with the partners' residual profit sharing ratio. Assume the residual profit sharing ratio is 50 percent to A and 50 percent to B. Under the safe harbor, partnership AB may allocate the nonrecourse deductions in a 50/50 sharing ratio. If both the 20 percent capitalization rule and the residual profits expectation rule are met, partnership AB may allocate the nonrecourse deductions in any ratio between 50/50 and 25/75. Assuming the other prongs of the safe harbor are also met, the allocation will be deemed to be in accordance with the partners' interest in the partnership.

Partnerships whose capital accounts and recourse liabilities do not constitute at least 20 percent of the total capitalization and that do not reasonably expect to have significant residual profits are not eligible for the safe harbor. It is appropriate to deny a safe harbor in such cases because partnerships whose partners have proportionately less at risk are more likely to be used in tax motivated transactions. Under the general rule of the proposal, their allocations of nonrecourse deductions must be consistent with the partners' interests in the partnership, and it is anticipated that such partnerships will allocate nonrecourse deductions consistent with the most likely allocation of marginal profits (i.e., the last dollar of reasonably expected profits) unless such allocation is not reflective of the partners' interests in the partnership.

Nonrecourse liabilities excluded from outside basis

While the proposed modification to the safe harbor should be more effective than present law in requiring partners to allocate nonrecourse deductions in a manner consistent with their overall economic arrangement, it will not prevent all potential abuses. Thus, the exclusion of nonrecourse liabilities from partners' outside basis functions as a backstop which should prevent the most serious abuses, in which a partner with no economic risk at all is allocated nonrecourse deductions. Because a partner may not deduct allocated losses in excess of its outside basis, the proposal assures that partners benefit from the allocation of nonrecourse deductions only to the extent that they bear economic risk with respect to capital contributions, recourse liabilities, or undistributed partnership income. As under present law, any nonrecourse deductions allocated to a partner with insufficient outside basis are suspended and become deductible only when the partner's outside basis is increased to a sufficient amount.

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In addition to its role in preventing abuses, this proposal brings the tax treatment of partners closer to the tax treatment of S corporation shareholders. In an S corporation, liabilities of the S corporation to persons other than the S corporation shareholders usually have no effect on the shareholders' adjusted bases for their stock or debt claims against the S corporation. Under the proposal, a similar result is achieved for partners in a partnership with respect to nonrecourse liabilities. A partner is still able to include in its outside basis its share of a recourse liability, defined as a partnership liability for which one or more partners bear the economic risk of loss. A partner's share of a recourse liability equals that portion of the liability for which

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that partner bears the economic risk of loss.390 A liability may be part recourse and part nonrecourse in which case only the recourse portion may be included in a partner's outside basis to the extent the partner bears the economic risk of loss for the liability.

The proposal has the additional benefit of allowing recourse liabilities to be included in a partner's outside basis without regard to whether the recourse liability is treated as such because a partner loaned the money to the partnership or whether a partner guaranteed the partnership liability. In the S corporation context, there has been much confusion and litigation with respect to the distinction between a liability of the S corporation guaranteed by a shareholder and a liability of the S corporation to a shareholder. In the former case, the liability is not included as part of a shareholder's debt claim against the corporation while in the latter case the shareholder includes the liability as part of its debt claim. The advantage of inclusion in debt claim is that the shareholder is able to deduct a greater amount of losses flowing through the S corporation to the shareholder.

Under the proposal, no distinction is made between a liability of the partnership guaranteed by a partner and a liability of the partnership to a partner. To the extent a partner bears the economic risk of loss for the liability, however arising, then the partner includes the recourse liability in its outside basis. As a result, the proposal has some similarity to the rules for S corporations (i.e., no inclusion of nonrecourse liabilities in outside basis) while eliminating a perceived weakness of the S corporation regime (i.e., distinguishing between guaranteed debt and shareholder debt).

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The proposal is consistent with the holding of the Supreme Court in Crane v. Commissioner while at the same time acknowledging the increasing adoption of the entity theory of partnership law. A partnership that purchases property using nonrecourse financing includes the nonrecourse debt in its basis in the property. The partnership will compute its depreciation deductions using a basis that includes the nonrecourse debt. The partners are, however, treated as separate from the partnership for purposes of the nonrecourse liability, which represents economic reality. The nonrecourse creditor's remedy in the event of partnership default is limited solely to one or more assets of the partnership, and the partners are not personally liable for the liability under State law or under the contractual terms of the debt (or both). The proposal serves to minimize the flexibility partners may have to allocate deductions relating to debt for which no partner bears the economic risk of loss.

Finally, if the outside basis restrictions prove effective in preventing abuses, it may eventually be possible to modify or replace the existing allocation restrictions, resulting in significant simplification benefits for partners and partnerships.

F. Modify Adjustment Rules for Basis of Undistributed Partnership Property

(sec. 734) Present Law

Present law provides that the basis of partnership property is to be adjusted as the result of a distribution of property if the partnership has so elected under section 754, or if there is a substantial basis reduction with respect to the property distributed (i.e., a basis reduction in excess of $250,000).392 If adjustments are made, the basis of partnership property is to be increased by any gain recognized to the distributee partner, and also to the extent the distributed property had an adjusted basis to the partnership greater than the basis attributed to the property in the hands of the distributee. The basis of partnership property is decreased by any loss recognized to the distributee partner, and also to the extent the distributed property had an adjusted basis to the partnership that is less than the basis attributed to the property in the hands of the distributee.

Reasons for Change

The measurement of the basis adjustment is inaccurate in some cases under present law. The amount of the adjustment does not consistently keep the amount of unrealized partnership gain or loss unchanged with respect to the remaining partnership interests in a partnership, following a distribution of property when basis adjustments are made to partnership property. The adjustment should reflect the difference between the partnership's adjusted basis in the property distributed, and the reduction in the distributee partner's share of the adjusted basis of partnership property. This would more accurately adjust for basis that is shifted to or away from the partnership (and remaining partners) as a result of the property distribution.

Description of Proposal

The method of making the adjustment to remaining partnership property after a distribution of property, when the adjustments are made under section 734, is changed to reflect the difference between the basis to the partnership of the distributed property and the reduction which occurs in the distributee partner's proportionate share of the adjusted basis of the partnership property.

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Effective Date

The proposal applies to distributions made after the date of enactment.

392 Sec. 734.

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This proposal has been recommended by the Advisory Group on Subchapter K of the Internal Revenue Code of 1954 to the Subcommittee on Internal Revenue Taxation of the House Ways and Means Committee (December 30, 1957); the Section of Taxation of the American Bar Association (Recommendation #1974-11, 27 Tax Lawyer 876 (1974); and Professor William D. Andrews, Inside Basis Adjustments and Hot Asset Exchanges in Partnership Distributions, 47 Tax Law Rev. 3 (1991).

Discussion

The rules contained in section 734(b) are intended to permit a partnership to maintain the same adjusted basis for partnership property in the aggregate, as is represented by the aggregate of the adjusted bases of all the partnership interests. However, because this relationship may already have become distorted before the partnership made the election under section 754 (or makes a distribution involving a substantial basis reduction), increasing the basis of partnership property by the amount of gain recognized to the distributee partner or the excess of the basis of the partnership property over the amount of the basis assigned to it in the hands of the distributee may not give the correct result, if upward adjustments are required. Similarly, adjustments for losses or the excess of the basis of a property in the hands of the distributee over the basis to the partnership may not give the correct result, if downward adjustments in the basis of partnership property are required. A more accurate result can be obtained by making an adjustment in the manner recommended by the proposal. Further, the proposal would conform the operation of section 734(b) to that of the similar provision in section 743(b), which provides for an adjustment to the basis of partnership property following the transfer of a partnership interest.

The problem involved can be illustrated by the following examples.

Example 1.-Assume that the assets of the equal partnership ABD had a basis of $9,000 and a fair market value of $15,000. D, who recently purchased his interest in the partnership from C for $5,000 has a $5,000 basis for his partnership interest. A and B each has a basis for his partnership interest of $3,000. Under present law, if a $5,000 cash distribution is made by the partnership to either A or B in liquidation of its partnership interest, the partnership would be entitled to an upward adjustment of $2,000 to the basis of the remaining partnership assets. However, a similar distribution to D would result in no adjustment. Under the proposal, there would be a $2,000 upward adjustment regardless of which partner received the distribution.

Example 2.-Assume that the assets of the equal partnership ABD had a basis of $9,000 and a fair market value of $6,000. D, who recently purchased his interest in the partnership from C for $2,000 has a $2,000 basis for his partnership interest. A and B each has a basis for his partnership interest of $3,000. Under present law, if a $2,000 cash distribution is made by the partnership to either A or B in liquidation of its partnership interest, the partnership would be required to make a downward adjustment of $1,000 to the basis of the remaining partnership assets. However, a similar distribution to D would result in no adjustment. Under the proposal, there would by a $1,000 downward adjustment regardless of which partner received the distribution.

G. Treat Guaranteed Payments to Partners as Payments to Nonpartners

(sec. 707)

Present Law

In general

Under present law, a partner's treatment of items of income, gain, loss, deduction, and credit arising in respect of the partnership depends on several factors.

In general, a partner includes on its own Federal income tax return its distributive share of items of partnership income, gain, loss, deduction, or credit. A partner's distributive share of an item is determined under the partnership agreement. The allocations provided in the partnership agreement will be respected if the allocations have substantial economic effect or are in accordance with the economic interests of the partners. Generally, allocations of partnership tax items are treated as having substantial economic effect if the partnership maintains capital accounts for its partners in accordance with regulations, distributions are made in accordance with the capital accounts, and any partners with a deficit balance in its capital account must make a capital contribution upon liquidation of its interest in the partnership.

Generally, under timing rules applicable to partnership items, the items are included in income for the taxable year of the partner in which the partnership's taxable year ends.394 Guaranteed payments

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If a partner receives a payment that is determined without regard to the income of the partnership, the payment is considered a guaranteed payment rather than a distributive share of partnership income. This provision was adopted in 1954 to clarify the situation in which the amount of the payment exceeded the net income of the partnership and would have resulted in the payment being out of the capital of the partners rather than from partnership income.

396 The

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In 1954, House bill section 707(c) provided a rule with respect to "guaranteed salaries" of a partner. The Ways and Means Committee Report stated, “[a] partner who renders services to the partnership for a fixed salary, payable without regard to partnership income, shall be treated to the extent of such amount like any other employee who is not a partner, and the partnership shall be allowed a deduction for salary expense. The amount ... shall not be considered a distributive share of partnership income or gain." H.R. Rep. No. 1337, 83d Cong., 2d Sess., A226-A227. The provision was modified in the Senate to apply to guaranteed payments for capital as well as for services. S. Rep. No. 1622, 83d Cong., 2d Sess. The evolution of this rule as included in the law in 1954 has been described this way: “To summarize, the genesis of section 707(c) was a desire on the part of the House to obviate the complexity caused under prior law when compensatory payments to partners exceed partnership income. As the provision emerged from the Senate, its scope was limited to that necessary to