of a partnership interest, and certain partnership distributions. In many of these cases the partnership is permitted to adjust the inside basis of its assets by filing a Code Sec. 754 election. This has the result of preserving equality between outside and inside basis. See ¶20,080—¶20,083for a discussion of the Code Sec. 754 election.EXAMPLE 19.16 A partnership owns a warehouse with an adjusted basis of $300,000 and a fair market value of $600,000. Cindy buys a one-third interest in the partnership for $200,000 (an amount equal to one-third of the warehouse’s value.) Cindy’s outside basis in her partnership interest is $200,000, i.e., the price she paid for her partnership interest. The inside basis of her share of the warehouse is $100,000 (1/3 x $300,00). Although Cindy’s purchase price was based on fair market value, the warehouse’s depreciation continues to be determined on the partnership’s related inside basis of $300,000, of which Cindy’s share is only $100,000. However, if the partnership makes a Code Sec. 754 election, the basis of the warehouse can be increased by $100,000, and all of the increase would be allocated to Cindy’s “share” of the warehouse’s basis.¶19,0 55 PARTNER’S INTEREST IN A PARTNERSHIPA partner usually owns both a capital interest and a profits or loss interest in the partnership. While a capital interest ratio reflects a partner’s percentage ownership in the capital of a partnership, a profit or loss sharing ratio represents a partner’s percentage allocation of the partnership’s ordinary taxable income or loss and separately stated items. Code Sec. 704(a).Each partner’s capital, profit, and loss sharing ratios may appear on the partner’s Schedule K-1. Often the three ratios are equal, particularly when profit and loss allocations for each year of the partnership’s existence are in the same proportion as the partner’s initial contributions to the partnership. However, the partnership agreement may stipulate a special allocation of certain items to specified partners, or it may allocate items in a different proportion from general profit
and loss sharing ratios. These items are separately reported to the partner receiving the allocation.For a special allocation to be recognized for tax purposes, it must have substantial economic effect to the partners receiving the special allocation. Code Sec. 704(b). An allocation has substantial economic effect if (1) there is a reasonable possibility that the allocation will substantially affect the dollar amount the partners will receive from the partnership, independent of tax consequences and (2) the partner to whom an allocation is made actually receives the economic benefit or bears the economic burden corresponding to the allocation. Reg. §1.704-1(b)(2)(ii)(a) and (iii)(a). For a detailed discussion of the allocation rules see ¶19,345.EXAMPLE 19.17 A partnership transfers a 20 percent capital interest to Stuart Bondurant in exchange for his contribution of municipal bonds that he held for investment purposes. The partnership agreement allocates all of the tax-exempt bond interest to Bondurant as an inducement for him to join the partnership.
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