State and Local Tax Alert - June 2017
New York City Department of Finance Issues Statement of Audit Procedure Clarifying Treatment of Federal Partnership Step-up Adjustments for Unincorporated Business Tax Purposes
Summary
On May 5, 2017, the New York City Department of Finance (“DOF”) issued a Statement of Audit Procedure UBT-2017-1 (the “SAP”), addressing the application of tax basis adjustments under Internal Revenue Code (“IRC”) Sections 734 and 743 to the New York City Unincorporated Business Tax (“UBT”). The SAP reaffirms the understanding that tax basis step-up adjustments arising from transactions governed by Section 743(b) do not impact the computation of a partnership’s NYC unincorporated business taxable income (“UBTI”). However, the SAP clarifies that the UBT conforms to the federal deductions resulting from tax basis step-up adjustments under Section 734(b).
Details
Background
NYC imposes the UBT on entities taxed as partnerships for federal income tax purposes, and the terms used in the IRC will generally have the same meaning for UBT purposes unless a different meaning is clearly required. Thus, a partnership’s UBTI is generally the same as its federal taxable income prior to UBT modifications. The SAP explains that the “UBT does not include any specific statutory modification to the federal calculation of basis for the purposes of determining UBTI.”
For federal income tax purposes, if an election under Section 754 is executed, or if the transaction would result in a substantial basis reduction, a partnership is required to adjust the tax basis of partnership assets (upward or downward) to the respective fair market value of the assets. The effect of this basis adjustment is to equalize discrepancies between the partner’s “outside” tax basis in the partnership interest as compared to the partner’s share of the partnership’s tax basis in the partnership assets, i.e., “inside” tax basis. The nature of the transaction that gives rise to the basis adjustment dictates whether the basis adjustment is determined under Section 734(b) or Section 743(b).
Prior to the SAP, partnerships subject to the UBT had minimal guidance to rely upon when reporting Section 743(b) basis adjustments, and no guidance with respect to Section 734(b) basis adjustments. One court case, Dolly Company v. Tully, 65 A.D. 2d 99 (N.Y. App. Div. 3d Dep’t 1978), held that a partnership could not consider the basis adjustments allowable under Section 743(b) in calculating its New York State unincorporated business tax, a tax that New York State repealed effective December 31, 1982. The court’s decision in Dolly Company did not address Section 734(b). Partnerships could find additional guidance in the DOF’s instructions to NYC Form 204, Unincorporated Business Tax Return for Partnerships (including Limited Liability Companies), stating that a partnership that makes an election under Section 754 may not adjust the basis of its assets on the sale or purchase of an interest in the partnership. However, the reference to “sale or purchase of an interest in the partnership” is ambiguous as to whether the UBT disallowed any tax benefits resulting from basis step-ups governed under both Sections 734 and 743. This is because gain recognized on a distribution that creates a Section 734(b) adjustment is considered gain on the disposition of a partnership interest potentially captured as not permitted under the verbiage in the instructions to the Form.
Section 743(b)
Basis adjustments under Section 743(b) may arise in the case of a transfer of an interest in a partnership by sale or exchange, or upon the death of a partner. Basis adjustments can be allocated to the assets of the partnership, including fixed assets or goodwill, and such adjustments are deemed to be attributed to the purchasing or inheriting partner only. Therefore, the depreciation and amortization deductions arising from the step-up adjustments are specially allocated to the transferee partner and do not otherwise affect the partnership’s calculations of income, gain, loss and deduction.
Section 734(b)
Under Section 734(b), a tax basis step-up is recognized in the case of a distribution of money or property to a partner by a partnership. In the case of a distribution of money, a basis step-up is recognized as a result of a distribution of money in excess of the partner’s outside tax basis, including his/her share of partnership liabilities. A step-up may also be recognized when the partnership distributes property whereby the receiving partner takes a basis in the property that is less than the distributing partnership’s inside basis in the property. In these situations, the step-up is recognized by the partnership as an asset of the partnership, rather than attributed to one partner specifically.
Clarification by the SAP
The SAP clarifies that basis adjustments under Section 734(b) are permissible when computing NYC UBTI because, under the IRC, the Section 734 basis adjustments are considered partnership assets and affect the partnership’s subsequent calculations of income, gain, loss, and deduction, which then flow through to its UBTI. The SAP also provides examples to illustrate this point.
The SAP also indicates that the DOF will follow the federal allocation of basis adjustments, which result when comparing the fair market value to tax basis of partnership assets.
In addition, the SAP notes that the DOF will follow the federal treatment of disguised sales, which generally result in step-up adjustments under Section 743(b) and would not result in deductible amortization for UBT purposes. Finally, the DOF indicated that it will also follow the Federal tax treatment of entity conversions “to” or “from” partnership form under either Revenue Ruling (“Rev. Rul.”) 99-5 or Rev. Rul. 99-6.
Rev. Rul. 99-5 provides guidance with respect to the income tax treatment of the conversion of an entity wholly-owned by one party, and treated as disregarded, to a multi-owner entity treated as a partnership. Rev. Rul. 99-6 describes two situations in which a multi-owner entity treated as a partnership for income tax purposes is converted to a single-owner entity treated as disregarded. In either case, basis step-ups under Sections 734 or 743 are not generally produced. The purchaser in each transaction is deemed to acquire assets under Sec. 1001 and as a result is permitted a cost basis in the acquired assets under Sec. 1012 equal to their purchase price, effectuating a step-up in basis to fair value.
BDO Insights
- The clarification as to how Federal tax basis adjustments apply to the UBT is a favorable development for taxpayers, as the SAP permits additional deductions for items that were previously thought to be non-deductible in calculating UBTI.
- Because SAPs merely reflect the DOF’s interpretation of the law and do not have the effect of laws or regulations, taxpayers should work with their tax advisers to determine whether a position reaches substantial authority, thus not requiring disclosure.
- Taxpayers may consider amending previously filed returns, as permissible, in order to claim missed deductions.
- Tax advisers should be mindful of these potential deductions on future NYC UBT returns.
- Taxpayers affected by the DOF’s issuance of this SAP should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures.
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