Solving Section 734(b)

The partnership tax contribution and distribution rules pursue a policy of maximum nonrecognition. Partners can move property in and out of partnerships with the least possible tax disincentive. This policy is essential to ensure efficient partnership formation and operation decisions.However, the nonrecognition rules also allow partners to shift and defer gain. This threatens tax revenues and encourages inefficient transactions. Subchapter K has a number of contribution and distribution rules that serve as a backstop to the nonrecognition regime by curbing gain shifting and deferral. Section 734(b) is one such rule. This section seeks to preserve the right amount of income upon distributions. Specifically, section 734(b) requires basis adjustments inside the partnership when a distributee partner recognizes gain or loss on distribution or when the distributee partner has to change the asset's basis in her hands upon distribution. A number of simple examples elucidate section 734(b)'s role. First, section 734(b) preserves the right amount of partnership income when a partner has to adjust an asset's basis in her hands upon distribution. If partner A receives a liquidating distribution of Greenacre (which has an inside basis of $100) when A has an outside basis of $300, A must take a basis of $300 in Greenacre. This means that Greenacre's basis has been increased by $200 in A's hands. The partnership has evaded $200 of gain which could be deferred until all of the partners' interests in the partnership are liquidated. Section 734(b) requires a downward adjustment of $200 basis points to an appropriate asset in the partnership to ensure that the partnership maintains the $200 of gain that has been evaded in Greenacre. Similarly, if partner A receives a liquidating distribution of Greenacre (which has an inside basis of $200) when A has an outside basis of 0, A must take a 0 basis in Greenacre. The partnership has failed to get credit for $200 of loss, a condition that could perpetuate until all of the partners' interests are liquidated. Section 734(b) requires an upward adjustment of basis of $200 to an appropriate asset in the partnership to ensure that the partnership maintains the $200 of loss that has been evaded in Greenacre. Second, section 734(b) preserves the right amount of partnership income when a partner recognizes gain or loss upon distribution. If partner A receives a liquidating distribution of $200 in cash when she has an outside basis of zero, she has to recognize $200 gain. The partnership had a basis of $200 in the cash, so $200 more gain is recognized by virtue of the distribution. Therefore, the partnership must raise the basis of an appropriate asset in the partnership by $200 to offset the extra $200 gain from the distribution. Similarly, if partner A receives a liquidating distribution of $200 in cash when she has an outside basis of $400, she has to recognize $200 loss. The partnership had a basis of $200 in the cash, so $200 more loss is recognized by virtue of the distribution. Therefore, the partnership must lower the basis of an appropriate asset in the partnership by $200 to offset the extra $200 loss from the distribution. Partnerships can elect whether or not to perform section 734(b) adjustments. Partnerships wishing to make the adjustments must make a section 754 election. Once such an election has been made, either for section 734(b) adjustments or related section 743(b) adjustments, the adjustments must always be made for all distributions (and transfers of interest) in that taxable year and all subsequent taxable years. However, as a result of the recent American Jobs Creation Act of 2004, even when partnerships do not have a section 754 election in effect, they must make a section 734(b) adjustment when a distribution results in a substantial basis reduction. A substantial basis reduction is a reduction of more than $250,000 that would be required if a section 754 election were in effect. Unfortunately, there are a number of problems with section 734(b). Since it is supposed to serve as a backstop to prevent gain shifting and deferral, these problems threaten the integrity of the partnership taxation system, the revenue that flows from it, and the business decisions that are made in light of it. A number of notable scholars have examined some of the various problems with section 734(b) over the years. But no clear resolution has been reached as of yet on how to fix many of these problems.Two fundamental problems with section 734(b) are most pressing. The first problem is what to do when the distributee partner's share of inside basis does not match her outside basis. The second problem is how to fix section 734(b) for current distributions, or distributions that do not result in complete liquidations. This Article proposes solutions to both fundamental problems.After discussing why section 734(b) should be mandatory, the Article explains how to solve the share of inside basis, outside basis dilemma. The bulk of the Article then deals with the more vexing problem of current distributions.Two main approaches exist for dealing with current distributions. The first main approach follows the section 704(c) scheme laid out in the regulations, but then requires other changes. The second main approach maintains the common basis adjustment of section 734(b) and limits gain or loss recognition to the greatest extent possible, but uses future profit and loss percentages to determine tax gain and loss, rather than the regulations' section 704(c) scheme. This Article favors the second main approach because it is simpler and more consistent with Subchapter K's broader deferral of gain and loss.The second half of this Article sets out a detailed proposal for current distributions under this second main approach. First it describes a more moderate plan of extending complete liquidation methods to current distributions, which is closely based on the work of earlier scholars. The Article then lays out a new and more radical plan for current distributions that can handle all distributions, unlike the complete liquidation approach. If this method is adopted, it can also appropriately deal with the share of inside basis, outside basis dilemma.