The New York City Department of Finance has issued a Statement of Audit Procedure (“SAP”) addressing how adjustments made to the basis of partnership assets pursuant to IRC §§ 734 and 743 impact the calculation of unincorporated business taxable income under the unincorporated business tax (“UBT”). Statement of Audit Procedure, UBT-2017-1, (N.Y.C. Dep’t of Fin., May 5, 2017). The SAP explains that basis adjustments to partnership assets made pursuant to IRC § 734 following a distribution of property will result in corresponding basis adjustments to partnership assets for UBT purposes, while basis adjustments to partnership assets made pursuant to IRC § 743 following a transfer of a partnership interest will not result in corresponding basis adjustments for UBT purposes.
Calculation of UBT Taxable Income. Under the UBT, the taxable income of an unincorporated business is the excess of its “unincorporated business gross income” over its “unincorporated business deductions.” Admin. Code. § 11-505. Federal gross income and federal deductions are the starting points for unincorporated business gross income and unincorporated business deductions. Gains, which are included in federal gross income, are defined as “the excess of the amount realized over the . . . basis for the property sold or exchanged.” Treas. Reg. § 1.61-6(a).
The UBT does not contain any specific statutory modification to the federal calculation of basis, which is generally the cost of acquiring the property, subject to adjustment for depreciation and amortization. Since depreciation and amortization deductions are derived from, and reflected in, the basis of partnership assets, adjustments to the basis of a partnership’s assets affect the size of the corresponding amortization and depreciation deductions for both federal and UBT purposes.
IRC Section 734. IRC § 734 provides the conditions for an adjustment to the basis of undistributed partnership property after a partnership distributes property to a partner. While generally a partnership may not adjust the basis of its assets following a distribution of property to a partner, where the partnership makes an election under IRC § 754, the partnership adjusts its basis in its undistributed property and does not make adjustments that apply separately to any particular partner. Treas. Reg. § 1.734-1.
For example, where a partner recognizes a gain on a liquidating distribution of her partnership interest, the partnership increases its basis in partnership property by the same amount. IRC § 734(b)(1)(A). The SAP confirms that a partnership’s § 734 basis adjustments, which affect the partnership’s subsequent calculations of federal income, gain, loss, and deduction, will be incorporated into the computation of the partnership’s UBT taxable income. The SAP also provides an example of how § 734 affects UBT taxable income where there is a liquidating distribution of a partnership interest.
IRC Section 743. IRC § 743 provides conditions for an adjustment to the basis of partnership property following the transfer of an interest in a partnership. Under § 743, when a partner transfers its interest in the partnership, if the partnership makes an election under § 754, the partnership is permitted to adjust its basis in partnership property, but only with respect to the transferee partner.
For example, where a partnership interest is sold for an amount that is greater than the selling partner’s basis in the partnership property, the partnership is permitted to increase its basis in the partnership property by the excess of the purchasing partner’s basis in his newly acquired partnership interest (generally the purchase price) over the purchasing partner’s proportionate share of the adjusted basis in the partnership’s assets. IRC § 743(b)(1). However, this basis adjustment is made with respect to the transferee partner—the partnership may not adjust the common basis of the partnership assets. The SAP explains that in such a case, the partnership’s UBT taxable income will not be affected because the basis adjustment made pursuant to § 743 affects only the transferee’s income, gain, loss, and deduction. The SAP also provides an example where a sale of a partnership interest and the corresponding adjustment made pursuant to § 743(b) does not affect UBT taxable income.
Other Issues. The SAP also clarifies that in analyzing transfers of partnership interests and assets, the Department will follow (i) IRC § 707(a)(2)(B) (transactions between partner and partnership); (ii) IRC § 755 (rules for allocation of basis); (iii) Revenue Ruling 99-5 (1999-1 C.B. 434) (sale or contribution resulting in a disregarded entity becoming a partnership); and (iv) Revenue Ruling 99-6 (1999-1 C.B. 432) (sale resulting in a partnership becoming a disregarded entity).
SAPs are issued by the Department of Finance primarily for use by audit staff and, while they do not have legal force or effect, they can be a useful source of guidance for understanding the audit process and the Department’s policies. This SAP in particular provides welcome guidance in an area where there is almost none. With the exception of Matter of Dolly Co. v. Tully, 65 A.D.2d 99 (3d Dep’t 1978), appeal denied, 46 N.Y.2d 710 (1979), which held that a partnership was not permitted to use § 743(b) to adjust the basis of partnership assets upward to take amortization deductions because § 743(b) adjustments affect the transferee partner only under the long-repealed New York State UBT, there do not appear to be any other cases or pronouncements addressing UBT basis adjustments resulting from an IRC § 754 election.