BASIS ADJUSTMENT ELECTION MAY BE MADE PRIOR TO DEEMED DISTRIBUTION OF ASSETS TO PARTNER WHOSE PURCHASE CAUSED PARTNERSHIP TERMINATION.

Rev. Rul. 88-42

ISSUE

If a partnership makes an election on its final return to adjust the basis of partnership property pursuant to section 754 of the Internal Revenue Code, will that election be effective for the incoming partner whose purchase of a 50-percent interest in the partnership causes the partnership to terminate under section 708(b)(1)(B), so that the bases of partnership assets are adjusted prior to their deemed distribution?

FACTS

In 1983, A and B formed the AB partnership and each received a 50-percent interest in AB. AB filed returns on a calendar year basis. On June 30, 1986, A sold A's 50-percent interest in AB to C. AB had not made a section 754 election as of the time of the sale. However, AB made the section 754 election in a written statement included with its timely filed partnership return for the short taxable year of January 1, 1986, to June 30, 1986.

LAW AND ANALYSIS

Section 708(b)(1)(B) of the Code provides that a partnership shall be considered as terminated if within a 12-month period there is a sale or exchange of 50-percent or more of the total interest in partnership capital and profits.

Section 1.708-1(b)(1)(iii)(b) of the Income Tax Regulations provides that the termination of a partnership pursuant to section 708(b)(1)(B) of the Code closes the terminating partnership's taxable year on the date of the sale or exchange of a partnership interest which transfers an interest of 50-percent or more in both partnership capital and profits. See section 706(c)(1) and section 1.706-1(c) of the regulations.

Section 1.708-1(b)(1)(iv) of the regulations provides that if a partnership is terminated by a sale or exchange of an interest, the partnership is deemed to distribute its properties to the purchaser and the other remaining partners in proportion to their respective interests in the partnership properties. Immediately thereafter, the purchaser and the other remaining partners are deemed to contribute the properties to a new partnership.

Section 743(a) of the Code provides that the basis of partnership property shall not be adjusted as the result of a transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 754 (relating to optional adjustment of basis of partnership property) is in effect with respect to such partnership.

Section 754 of the Code provides the manner in which a partnership shall file an election to adjust the basis of partnership property under section 743.

Section 1.754-1(a) of the regulations provides that an election made under section 754 of the Code applies to all property distributions and transfers of partnership interests taking place in the partnership taxable year for which the election is made and in all subsequent years unless revoked pursuant to section 1.754-1(c).

Section 1.754-1(b)(1) of the regulations provides that the election is made in a written statement filed with the partnership return for the taxable year during which the distribution or transfer occurs. For the election to be valid, the return must be timely filed in accordance with the regulations.

Section 1.754-1(b)(2) of the regulations sets forth an example of the application of section 1.754-1(b). In that example an interest is sold in a partnership that had not previously made a section 754 election. The example holds that a section 754 election may be made in a written statement filed with the partnership return for the year in which that sale is made and that it will be effective for all distributions of property to a partner and to all transfers of interests in the partnership occurring in the year of sale and subsequent years, unless revoked pursuant to section 1.754-1(c).

Rev. Rul. 86-73, 1986-1 C.B. 282, considers a sale of a 50- percent interest in a partnership that has a section 754 election in effect. The ruling concludes that the section 754 election in effect for the taxable year in which the sale occurs applies with respect to the incoming partner because that partner is considered to be a partner of the terminating partnership for the instant prior to its termination. Therefore, the bases of the partnership's assets must be adjusted prior to the termination and deemed distribution to the incoming partner.

In the present case, the sale of the 50-percent interest on June 30, 1986, to C terminates AB pursuant to section 708(b)(1)(B) of the Code, causing a short taxable year of January 1, 1986, to June 30, 1986. See section 1.708-1(b)(1)(iii)(b) of the regulations. The terminating partnership made a section 754 election on its final return. That election was effective for all property distributions and transfers of partnership interests made in the short year ending June 30, 1986. Applying the principles of Rev. Rul. 86-73, C is considered a partner of AB immediately prior to AB's termination and, thus, during AB's short year ended June 30, 1986. Therefore, the bases of the partnership assets will be correspondingly adjusted prior to the deemed distribution to C. If the new partnership, BC, wants to make a section 754 election, it will have to file a new election.

HOLDING

If a partnership makes an election on its final return to adjust the basis of partnership property pursuant to section 754 of the Code, that election is effective for the incoming partner whose purchase of a 50-percent interest in the partnership causes the partnership to terminate under section 708(b)(1)(B). The bases of partnership assets are adjusted pursuant to sections 743(b) and 755 prior to their deemed distribution to the incoming partner.

DRAFTING INFORMATION

The principal author of this revenue ruling is J. Thomas Hines of the Individual Tax Division. For further information regarding this revenue ruling contact Mr. Hines on (202) 566-3352 (not a toll- free call).