Rev. Rul. 73-301

Advice has been requested as to the Federal income tax consequences of cash withdrawals by a member of a partnership under the circumstances described below.

A, B, and C are general partners in the ABC partnership, with capital and profits interests of 25 percent, 25 percent, and 50 percent respectively. ABC is engaged in the construction business and reports its income on the completed contract method of accounting. The partnership and all of the partners use the calendar year accounting period.

On July 1, 1971, ABC was awarded a two-year contract for the construction of a building at a bid price of 460x dollars. This was the only construction contract to which the partnership was a party during the year and the partnership had no liabilities other than those attributable to this construction contract.

Under the terms of the contract, ABC was entitled to and received progress payments of 100x dollars during 1971 that it was not required to report in gross income under its method of accounting. ABC posted the 100x dollars in its book of accounts as a debit to "cash" and a credit to "deferred income." Under the contract, the partnership had performed all the services required in order to be entitled to receive the progress payment and there was no obligation to return the payment or perform any additional services in order to retain it.

As of December 31, 1971, ABC had performed the work for which progress payments of 100x dollars had been received. In addition, as of that date, ABC had performed work for which it had a right to an additional payment of 20x dollars and it had incurred liabilities for total costs of 80x dollars under the contract.

As of January 1, 1971, A's capital account on the books of the partnership was 4x dollars. He made no contribution to capital during 1971. A withdrew 17x dollars from the partnership during 1971, thereby creating a deficit of 13x dollars in his capital account as of December 31, 1971.

The partnership agreement stated that upon withdrawal by a partner from the partnership or upon termination of the partnership, there should be deducted from disbursements to the partner any "indebtedness" which he owed to the partnership.

Before the cash withdrawal by A of 17x dollars from ABC, the adjusted basis of A's partnership interest (as determined under section 705 of the Internal Revenue Code of 1954) was 25x dollars, 20x dollars of which represented his share (25%) of ABC's outstanding liabilities for total costs of 80x dollars incurred on the construction contract.

The first issue is whether the deferred income of 100x dollars as of December 31, 1971 (representing progress payments on the contract), represents "liabilities of a partnership" within the meaning of section 752(a) of the Code and, as such, additions to basis of the partnership interests of the partners.

Section 752(a) of the Code provides that any increase in a partner's share of the liabilities of the partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership. Under sections 705 and 722, this will give rise to an increase in the partner's basis in the partnership.

The progress payments of 100x dollars received by the partnership and reflected as "deferred income" on the books of the partnership as of December 31, 1971, represent amounts received on account of services performed on the contract not yet reported as gross income. This amount together with the right of the partnership to an additional payment of 20x dollars for work performed constitute "unrealized receivables" within the meaning of section 751(c) of the Code, and the progress payments are not a "liability" as referred to in section 752 which increases the adjusted basis of the partnership interests of the partners. The income or loss from performance of the contract will affect the basis of the partnership interests of the partners, as provided in section 705(a), when such income or loss is recognized for Federal income tax purposes.

Accordingly, no increase in the adjusted basis of the partnership interests of A and his co-partners is made as a result of the receipt by the partnership of the advance payments, within the meaning of section 752(a) of the Code.

The second issue is whether any part of the cash withdrawal by A, that caused the deficit in his capital account, represents a loan made to him by the partnership.

Section 707(a) of the Code provides that if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction will generally be considered as occurring between the partnership and one who is not a partner. Under section 1.707-1(a) of the Income Tax Regulations, a loan of money by the partnership to the partner is considered to be such a transaction. However, a transfer of money by the partnership to the partner as a distribution is not considered as a transaction which the partner enters into in a capacity other than as a partner.

The receipt of money by a partner from the partnership under an obligation to repay the money is a loan rather than a distribution. See section 1.731-1(c)(2) of the regulations. For purposes of section 707(a) of the Code and the regulations thereunder, however, a loan by a partnership to a partner is considered to have been made only where the partner is under an unconditional and legally enforceable obligation to repay a sum certain at a determinable date. Such obligation to repay will be recognized as a loan if it is created at the time of the withdrawal of funds from the partnership.

Bookkeeping entries alone are not determinative of whether there exists an unconditional and legally enforceable obligation on the part of a partner to repay withdrawals from the partnership. Thus, the mere showing of the existence of a deficit capital account is not sufficient to establish the creation of a loan. Similarly, the fact that on a final accounting the partners will take a deficit capital account into consideration is not sufficient to create an obligation to repay a loan.

In the instant case, there was no unconditional and legally enforceable obligation that required the taxpayer to repay any of the amounts withdrawn to the partnership on or before a determinable date. Therefore, it is held that the withdrawals by A that created a deficit in his capital account are not loans governed by section 707(a) of the Code but are partnership distributions received by him in his capacity as a partner.

Rev. Rul. 57-318, 1957-2 C.B. 362, involves the sale of a partner's interest in a partnership. Under the terms of the agreement of sale, the selling partner is released from his liability to repay the deficit in his capital account. The Revenue Ruling treats the partner's release from liability to repay the deficit as a distribution of money to him. The facts of the Revenue Ruling imply that the selling partner is subject to an unconditional and legally enforceable obligation to repay the deficit in his capital account and that the withdrawals giving rise to the deficit represented loans made by the partnership to the partner in a capacity other than as a member of such partnership. However, Rev. Rul. 57-318 should not be interpreted as suggesting that the mere existence of a deficit in a partner's capital account creates a loan of money within the meaning of section 1.707-1(a) of the regulations. Nor should it be read as suggesting that the capital account of a partner is significant in determining the adjusted basis of his partnership interest under section 705 of the Code.

Rev. Rul. 57-318 is hereby clarified to remove any implication that it applies to deficit situations that are not the result of loans to partners within the meaning of section 707(a) of the Code and regulation 1.707-1(a) thereunder.