Limited Partnerships and Master Limited Partnerships

<div class="Section1">Current cash distributions (i.e., not in liquidation of a partner&rsquo;s interest) that are not in excess of the partner&rsquo;s adjusted basis in the partnership interest immediately before the distribution are a nontaxable return of capital.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;The partner&rsquo;s adjusted basis in the partnership interest is reduced by the amount of such cash distributions.<a href="#_ftn2" name="_ftnref2">²</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7737">7737</a>.<div class="Section1"><br /> <br /> To the extent that a cash distribution to a partner exceeds the partner&rsquo;s basis in the partnership interest immediately before the distribution, the partner realizes a gain that is taxed as if there were a sale of a partnership interest.<a href="#_ftn3" name="_ftnref3">³</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7755">7755</a>.&nbsp;This is true of a current cash distribution or a cash distribution in liquidation of a partner&rsquo;s interest.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> A decrease in a partner&rsquo;s share of nonrecourse liabilities is considered, for tax purposes, a cash distribution.<a href="#_ftn5" name="_ftnref5">⁵</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7737">7737</a>.Such a decrease can occur when a mortgage is satisfied, a liability is discharged through foreclosure, or the partnership sells property subject to a mortgage.&nbsp;To the extent that such a deemed distribution exceeds the partner&rsquo;s adjusted basis in the partnership interest, the partner has a taxable gain.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> Loss is not recognized on a distribution other than a liquidating distribution.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;731(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;733.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;731(a).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.731-1(a)(1)(i).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect;&nbsp;752(b).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; IRC &sect;&nbsp;731(a).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect;&nbsp;731(a)(2).<br /> <br /> </div></div><br />

<div class="Section1">The initial basis of a purchased interest is its cost basis and thereafter it is adjusted, as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.742-1.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A partner includes the distributive share of partnership items up to the time of the gift of the interest.&nbsp;The taxable year of the partnership closes with respect to the partner when the partner gives away his or her entire interest in the partnership, but does not close with respect to any other partner.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;Thus, the distributive share of income or loss for the short partnership year resulting from the gift is included in the tax year in which the gift is made, because that is the year in which the short partnership year ends as to the donor partner. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7736">7736</a>.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> If the partnership and partner have different years (i.e., the partnership is on a fiscal year and the individual uses a calendar tax year), it is possible that both a regular full partnership year and the short partnership year will end in the same year of the individual. Consequently, there can be a bunching of more than one year&rsquo;s partnership income (or loss) in one year&rsquo;s return of the individual.&nbsp;The partnership year does not end as to a partner who terminates less than the entire interest.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <hr><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;706(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;706(c)(2)(B).<br /> <br /> </div></div><br />

<div class="Section1">The IRS and the&nbsp;Tax Court take the position that there is gain.&nbsp;They reason that where a grantor of a trust retains certain powers, and as a result is treated as owner of the trust for tax purposes, the grantor is considered, for tax purposes, owner of a partnership interest purchased by the trust. As owner, the grantor reports the distributive share of partnership income, gains, losses, deductions, and credits allocable to the trust. When the grantor renounces the retained powers that resulted in the trust&rsquo;s being classified as a grantor trust, the grantor is no longer considered owner of the trust&rsquo;s assets. In effect, the grantor has transferred ownership of the partnership interest to the trust. On the transfer, the grantor is deemed to receive a share of partnership liabilities.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;The amount realized is taxable as proceeds of a sale, as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7755">7755</a>.&nbsp;The fair market value of the interest in excess of the liability is a gift to the trust. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7760">7760</a>.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; <em>Madorin v. Comm</em>., 84&nbsp;TC 667 (1985);&nbsp;Treas. Reg. &sect;&nbsp;1.1001-2(c)(Ex. 5); Rev. Rul. 77-402, 1977-2 CB 222.<br /> <br /> </div></div><br />

<div class="Section1">The taxable year of a partnership will close with respect to a limited partner whose entire interest in the partnership terminates for any reason, including the death of the limited partner.<a href="#_ftn1" name="_ftnref1">¹</a> A decedent&rsquo;s own tax year also ends on the date of death and is ordinarily a short year.<a href="#_ftn2" name="_ftnref2">²</a>&nbsp;Thus, since the partnership tax year and the decedent&rsquo;s tax year will end on the same day, partnership income or loss will be included in the decedent&rsquo;s final return.<div class="Section1"><br /> <br /> If the successor sells or exchanges its entire interest, or its interest is liquidated, the partnership year will end as to the selling successor at the date of sale. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7753">7753</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;706(c)(2)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.443-1(a)(2).<br /> <br /> </div></div><br />

<div class="Section1">The estate or other successor in interest has a basis in the partnership interest &ldquo;stepped up&rdquo; (or down) to the fair market value of the interest on the date of death, or alternative valuation date used for estate tax purposes, increased by the estate&rsquo;s (or successor&rsquo;s) share of partnership liabilities on that date, and reduced to the extent the value is attributable to items of income in respect of a decedent.<a href="#_ftn1" name="_ftnref1">¹</a> A modified carryover basis may replace stepped up basis for property acquired from a decedent dying in 2010. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="692">692</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="747">747</a>. For partnership tax years beginning after 1997, the partnership tax year ends with respect to a partner who dies (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7763">7763</a>). For partnership tax years beginning before 1998, the distributive share attributable to the period ending with the date of death which was taxable to the estate or successor was income in respect of a decedent, not part of the basis.<a href="#_ftn2" name="_ftnref2">²</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.742-1.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.753-1(b), 1.706-1(c)(2).<br /> <br /> </div></div><br />

<div class="Section1">MLPs were not common real estate investment vehicles until Congress reduced individual tax rates below corporate tax rates pursuant to the Tax Reform Act of 1986 (TRA ’86).<a href="#_ftn1" name="_ftnref1">¹</a> TRA ’86 lowered the individual tax rate from 50 percent to 28 percent, and the corporate tax rate was reduced from 46 percent to 34 percent (the highest individual income tax bracket is currently 37 percent and the highest corporate tax rate is 21 percent).<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> The following year, to counter the threat of revenue erosion, Congress added IRC Section 7704 that provides that a publicly traded partnership will be taxed as a corporation unless the partnership meets certain gross income requirements.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> A partnership satisfies the gross income requirements of IRC Section 7704 when at least 90 percent of the partnership’s gross income is “qualified income.”<a href="#_ftn4" name="_ftnref4">⁴</a> Some forms of qualified income include interest, dividends, real property rents, income and gains derived from the exploration, development, mining or production, processing, refining, transportation (pipelines, ships, trucks), or the marketing of any mineral or natural resource.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  <em>See</em> Joint Committee on Taxation, <em>General Explanation of the Tax Reform Act of 1986</em> (JCS-10-87) May 4, 1987.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Pub. Law No. 115-97 (the 2017 tax reform legislation).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC §§ 7704(a), (c)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 7704(c)(2).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 7704(d)(1).<br /> <br /> </div>

<div class="Section1">In the past many mutual funds have been reluctant to invest in MLPs because of the RIC investment restrictions of IRC Section&nbsp;851.&nbsp;To maintain its RIC election, a RIC must derive at least 90&nbsp;percent of its gross income from certain sources specified within the IRC, including dividends and interest.<a href="#_ftn1" name="_ftnref1">¹</a> Because as a partnership, an MLP does not distribute &ldquo;dividends,&rdquo; a RIC was unable to derive more than 10&nbsp;percent of its income from MLPs.<div class="Section1"><br /> <br /> However, in 2004 Congress amended IRC Section&nbsp;851 to provide that a RIC may include &ldquo;net income derived from an interest in a qualified publicly traded partnership&rdquo; in calculating its 90&nbsp;percent income requirement.<a href="#_ftn2" name="_ftnref2">²</a> Essentially, this amendment provided mutual funds the ability to diversify their portfolios because any income derived from the MLP will not affect its status as a RIC.<br /> <br /> A RIC still faces limitations in its ability to invest in MLPs. A mutual fund is not permitted to invest more than 25&nbsp;percent of its assets in a MLP.<a href="#_ftn3" name="_ftnref3">³</a> Nor are mutual funds permitted to own more than 10&nbsp;percent of the interests issued by a MLP.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7922">7922</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7935">7935</a> for a detailed discussion of the rules governing RICs.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect;&nbsp;851(b)(1), (2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;851(b)(2)(B); <em>see also</em> Public Law 108-357 &sect;&nbsp;331 (2004).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;851(3)(B).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;851(3)(B).<br /> <br /> </div></div><br />

<div class="Section1">A partner includes on a return the distributive share of partnership items of income, gain, loss, deductions, and credits for the partnership year that ends in or at the same time as his or her own taxable year. Since most individuals report on a calendar year basis, an individual partner generally includes partnership income for the same calendar year as a partnership that reports on the calendar year basis. If the partnership uses a non-calendar fiscal year, the calendar year partner includes partnership income, gains, losses, deductions, and credits for the partnership year that <em>ends</em> in the partner&rsquo;s calendar year.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> The amounts included in the year a partnership interest is acquired, or in which a partner sells, liquidates, or gives away his or her partnership interest or the year a partner dies, are explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7746">7746</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7753">7753</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7759">7759</a>, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7763">7763</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;706(a);&nbsp;Treas. Reg. &sect;&nbsp;1.706-1(a).<br /> <br /> </div></div><br />

<div class="Section1">The partnership agreement can dictate the allocation of separately stated items of partnership income, gain, loss, deductions, credits, and other bottom line income and loss, even if the allocation is disproportionate to the capital contributions of the partners (a so-called &ldquo;special allocation&rdquo;). However, if the method of allocation lacks &ldquo;substantial economic effect&rdquo; (or if no allocation is specified in the partnership agreement), the distributive shares will be determined in accordance with the partner&rsquo;s interest in the partnership, based on all the facts and circumstances.<a href="#_ftn1" name="_ftnref1">¹</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7767">7767</a> regarding the partnership anti-abuse rule.<div class="Section1"><br /> <br /> The purpose of the substantial economic effect test is to &ldquo;prevent use of special allocations for tax avoidance purposes, while allowing their use for bona fide business purposes.&rdquo;<a href="#_ftn2" name="_ftnref2">²</a> Regulations provide that generally an allocation will not have economic effect unless the partners&rsquo; capital accounts are maintained properly, liquidation proceeds are required to be distributed in accordance with the partners&rsquo; capital account balances and, following distribution of such proceeds, partners are required to restore any deficits in their capital accounts to the partnership.&nbsp;The economic effect will generally not be considered substantial unless the allocation has a reasonable possibility of affecting substantially the dollar amounts received by partners, independent of tax consequences. Allocations are insubstantial if they merely shift tax consequences within a partnership tax year or are likely to be offset by other allocations in subsequent tax years.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect;&nbsp;704(a), 704(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Sen. Fin. Comm. Report No.&nbsp;938, 94th Cong., 2d Sess. 100 (1976).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.704-1(b)(2).<br /> <br /> </div></div><br />