Internal Revenue Service
Revenue Ruling
Rev. Rul. 77-402
1977-2 C.B. 222
Section 671 -- Trust Grantors as Owners
Section 741 -- Partnership Sale or Exchange
Section 752 -- Partnership Liabilities
IRS Headnote
Transfer of partnership interest; grantor trust powers renounced. An
individual who creates an irrevocable trust classified as a grantor trust,
purchases, as trustee, an interest in a partnership generating losses
derived from accelerated depreciation deductions that reduce the basis of
the partnership interest almost to zero, and who renounces the powers that
cause the grantor trust classification just before the partnership begins
generating income, has recognized gain or loss under section 741 of the
Code measured by the difference between the trust's adjusted basis of the
partnership interest and its share of the partnership's liabilities.
Full Text
Rev. Rul. 77-402
Advice has been requested whether, under the circumstances described below,
gain or loss on the sale or exchange of a partnership interest is
recognized under section 741 of the Internal Revenue Code of 1954.
A, an individual, created T, an irrevocable trust. A and B (A's spouse) are
the trustees. All trust income is currently distributable for life to C, A
and B's child. At C's death, the corpus is distributable to D, A and B's
grandchild. A has expressly retained certain powers of the kind described
in subpart E of part I of subchapter J of the Code. Therefore, for Federal
income tax purposes, T is a "grantor trust" and A is considered the owner
of the entire trust.
A, as the trustee, then used the funds that A, as grantor, initially
contributed to T, to purchase on behalf of the trust an interest in P, a
partnership. The principal activity of P is investing in real property, and
P uses both recourse and nonrecourse financing. P properly elected to
deduct accelerated depreciation, which generated large operating losses
that P's partners were entitled to deduct on their income tax returns. A,
as owner of T, deducted the distributive share of partnership losses
attributable to the partnership interest held by T.
When the adjusted basis of the partnership interest held by T had been
reduced nearly to zero, and just before the so-called "cross-over point"
(when P no longer generated losses but began generating income), A, as
grantor, renounced the powers previously and expressly retained that
initially resulted in T being classified as a grantor trust. Consequently,
T ceased to be a grantor trust and A was no longer considered to be the
owner of the trust. Thereafter, C, as life beneficiary, was subject to tax
on the income generated by the trust.
Section 671 of the Code provides, where it is specified in sections 673
through 679 that a grantor or another person shall be treated as the owner
of any portion of a trust, that there shall be included in computing the
taxable income and credits of the grantor or other person, the items of
income, deductions, and credits of the trust attributable to the portion of
the trust considered owned by such grantor or other person to the extent
such items would be taken into account in computing the taxable income or
credits of an individual.
Section 741 of the Code provides that in the case of a sale or exchange of
an interest in a partnership, gain or loss shall be recognized to the
transferor partner.
Section 752(d) of the Code provides that in the case of a sale or exchange
of an interest in a partnership, liabilities shall be treated in the same
manner as liabilities in connection with the sale or exchange of property
not associated with partnerships.
In the instant case, since A was the owner of the entire trust, A was
considered the owner of all the trust property for Federal income tax
purposes, including the partnership interest, Since A was considered to be
the owner of the partnership interest, A, not T, was considered to be the
partner in P during the time T was a "grantor trust" under subpart E of
part I of subchapter J of the Code.
However, at the time A renounced the powers that gave rise to T's
classification as a grantor trust, T no longer qualified as a grantor
trust, with the result that A was no longer considered to be the owner of
the trust and trust property for Federal income tax purposes. Consequently,
at that time, A is considered to have transferred ownership of the interest
in P to T, now a separate taxable entity, independent of its grantor, A.
When a transfer of an interest in a partnership occurs and the transferor's
share of partnership liabilities is reduced or eliminated, the transferor
is treated as having sold the partnership interest for an amount equal to
the share of liabilities reduced or eliminated. Under section 752(d) of the
Code, the amount realized by the transferor A includes the reduction in or
elimination of such liabilities. See Rev. Rul. 74-40, 1974-1 C.B. 159; Rev.
Rul. 75-194, 1975-1 C.B. 80; and Johnson v. Commissioner, 495 F.2d 1079
(6th Cir. 1974), aff'g 59 T.C. 791 (1973), cert. denied, 419 U.S. 1040
(1975). Any gain or loss realized on a sale or exchange of a partnership
interest is recognized pursuant to section 741 of the Code.
Accordingly, in the instant case, A realized an amount equal to the share
of partnership liabilities that existed immediately before T converted from
grantor to nongrantor status for Federal income tax purposes. The gain or
loss realized by A is the difference between the amount realized from the
reduction of the share of P's liabilities and the adjusted basis in the
partnership interest under section 705 of the Code immediately prior to the
change in T's tax status. The gain or loss so realized must be recognized
by A under section 741.
Furthermore, the result would be the same if the trust ceases to be a
grantor trust by reason of the expiration or lapse of the powers. The
result would also be the same if the trust were treated as a grantor trust
by reason of powers exercisable by a party other than the grantor and
ceased to be a grantor trust upon the release or renunciation of those
powers by such other party or upon the expiration or lapse of such powers.
