The IRS has issued a frequently asked questions document related to changes made by the Tax Cuts and Jobs Act of 2017 (TCJA) in the computation of a partner’s outside basis limitations due to the payment of foreign taxes and certain charitable contributions.[1]

The IRS outlines the changes in a set of three examples discussing how a partner computes his/her limitations on claiming a tax benefit from charitable contributions and payment of foreign taxes dependent on basis in the partnership under IRC §704(d).

The IRS first outlines the law as it generally applies with regard to §704(d) and the limitations on claiming tax benefits due to basis limitations:

Section 704(d) of the Code provides, in general, that a partner's distributive share of partnership loss (including capital loss) is allowed only to the extent of the adjusted basis of such partner's interest in the partnership (outside basis) at the end of the partnership year in which such loss occurred. If, in a given taxable year, a partner's share of partnership losses exceeds its outside basis, then the losses are allowed to the extent of basis and any excess amount is carried over for use in the next taxable year in which the partner has outside basis available. Except for deductions relating to charitable contributions and foreign taxes, current law and prior law are the same.

The FAQ notes that prior to the Tax Cuts and Jobs Act, §704(d) did not apply in the same manner to charitable contributions of appreciated property and payments of foreign taxes:

…[U]nder prior law a partner’s share of a partnership’s charitable contributions and foreign tax payments were not subject to the § 704(d) basis limitation. This meant that partners could take into account their entire distributive shares of charitable contributions or foreign tax payments even if they were in excess of outside basis. Although a portion of certain charitable contributions and the entire amount attributable to foreign tax payments were (and still are) subject to basis reduction under § 705(a)(2), prior law did not limit a partner’s deductions for payments in excess of basis.

The IRS gives first a general example of the application of §704(b) and the basis limitation rules when neither partner has a basis issue.

Example

Application of §704(b) When Partners Have No Basis Problems (Example 1)

Facts

Jen and Dave are equal partners in JD Partnership.  At the end of the partnership taxable year, but prior to taking into account the partnership’s income and loss items, Jen and Dave each have a $50 basis in the JD partnership.  For the taxable year the JD partnership has $20 of non-separately stated taxable income and a $150 long-term capital loss.

Analysis

To determine each partner’s basis limitation under §704(d), Jen and Dave increase their outside bases from $50 to $60 under § 705(a)(1) for their $10 distributive shares of the partnership’s non-separately stated income.  Their $75 shares of long-term capital loss are limited by §704(d) and, as a result, Jen and Dave can each take $60 of the loss into account in the current taxable year.  The remaining $15 of long-term capital loss is carried forward. This result is the same under current and prior law.

The IRS then gives an example of the application of the law prior to TCJA:

Example

Law Prior to TCJA – Charitable Contributions and §704(d) (FAQ Example 2)

Facts

Assume the same facts as in Example 1, except that, at the end of the partnership taxable year (and before partnership allocations), Jen’s outside basis is $50 and Dave’s is $30. For the taxable year, the partnership makes a contribution to a § 501(c)(3) charity of property that has a fair market value of $300 and a basis of $100, but has no other items of income, gain, loss, or deduction.

Analysis

Under prior law, Jen and Dave each would have been able to take into account (on their personal returns) their $150 shares of the charitable contribution. Jen would have been required to decrease her outside basis by $50 (her share of the partnership’s basis in the property) to zero ($50-$50=0). However, because Dave only has $30 of outside basis, any basis reduction would have been limited to $30 because outside basis cannot be decreased below zero. Therefore, under prior law, Jen would have had to decrease her outside basis by $50 to receive the benefit the entire $150 contribution deduction whereas Dave only would have had to decrease his outside basis by $30 to receive the same $150 benefit.

The IRS goes on to describe the limitation imposed on charitable contributions of appreciated property under the new provision:

The TCJA adds new § 704(d)(3)(A). That section provides that charitable contributions and foreign taxes are taken into account under the basis limitation rules, thereby putting those items on par with other losses and, as a result, limiting the benefit of such items by a partner’s outside basis. However, new § 704(d)(3)(B) provides that, in the case of a charitable contribution of built-in gain property (i.e., property whose fair market value exceeds its adjusted basis), the excess amount is not limited by outside basis. These changes apply to partnership taxable years beginning after December 31, 2017. This new rule means that, for charitable contributions of appreciated property, the amount allocable to the partners will effectively be split into two parts, one equaling the property’s built-in-gain amount, the other the property’s basis. The deduction for the built-in gain portion neither reduces the partner’s bases nor is subject to limitation under section 704(d) (as under prior law). However, the part reflecting the property’s basis is limited by section 704(d).

The FAQ concludes with a third example applying this new limitation—and note that the partner without basis loses a pro rata portion of the entire deduction, not the just portion of the basis of the donated property in excess of basis in the partner’s interest.

Example

Applying New §704(b) Limitation to Donation of Appreciated Property (FAQ Example 3)

Facts

Assume the same facts as in Example 2, except that the partnership makes the contribution of appreciated property to charity in a taxable year of the partnership beginning after December 31, 2017.

Analysis

Under the new law, the portion of the contribution that is equal to the property's basis ($100) both reduces the partner's outside bases and is subject to section 704(d). The excess portion neither reduces outside basis nor is subject to section 704(d). Jen, whose outside basis is $50, would reduce her outside basis by $50 (her share of the basis of the contributed property) and receive a charitable contribution allocation of $150. For Dave, whose outside basis is $30, the basis reduction and charitable contribution with respect to the basis portion of the contribution would be limited to $30. The $20 excess would carry over to the following year. Dave's total charitable contribution would be $130.

In an article describing the new FAQ that appeared in Tax Notes Today Federal, Glenn Dance of Holthouse Carlin & Van Trigt LLP is quoted as pointing out that if the property had been distributed to the partners and then a contribution made of the proprety, the result would be very different.[2] 

In that situation the partners would have taken a basis in the property equal to the lesser of their basis in their interest prior to the distribution or their share of the partnership’s basis in the property, very likely (but not necessarily) with no gain or loss recognized at the partner partnership level.[3]  Assuming the asset would be a capital asset eligible to long-term capital gain treatment of gain on sale in the hands of the partners, a contribution of that property would nevertheless be eligible for a deduction based on the partners’ portion of the fair market value of the property.[4]  This treatment is effectively what the prior law provided to the partners when the partnership made the contribution.

But before you advise a client to “drop and contribute” the interests in the property a couple of cautions should be observed:

• The distribution may be taxable due to various provisions found in the law for special cases (remember that it’s only very likely there’s no taxable gain on the distribution).  Mr. Dance in the article cited above noted the potential issue with a distribution of marketable securities,[5] which is only possible way that the distribution could trigger a tax event.

• A drop of undivided interests to the partners followed shortly thereafter by a contribution to a charity is likely to be attacked by the IRS as a purely tax motivated transaction subject to recharacterization under the substance over form doctrine—and the IRS would have a good chance of prevailing with that argument.

[1] “Frequently Asked Questions – Tax Cuts and Jobs Act (TCJA) changes to Charitable Contributions and Foreign Taxes Taken into Account in Determining Limitations on Allowance of Partner’s Share of Loss,” Internal Revenue Service, July 9, 2019, https://www.irs.gov/newsroom/frequently-asked-questions-tax-cuts-and-jobs-act-tcja-changes-to-charitable-contributions-and-foreign-taxes-taken-into-account-in-determining-limitations-on-allowance-of-partners-share-of-loss, retrieved July 10, 2019

[2] Eric Yauch, “FAQ Highlights Partner Basis Limitation Changes,” Tax Notes Today Federal, July 10, 2019, 2019 TNTF 132-1, https://www.taxnotes.com/tax-notes-today-federal/basis/faq-highlights-partner-basis-limitation-changes/2019/07/10/29q5w (subscription required)

[3] IRC §§721, 731

[4] IRC §170(e)

[5] Eric Yauch, “FAQ Highlights Partner Basis Limitation Changes,” Tax Notes Today Federal, July 10, 2019, 2019 TNTF 132-1, https://www.taxnotes.com/tax-notes-today-federal/basis/faq-highlights-partner-basis-limitation-changes/2019/07/10/29q5w (subscription required)