Because while the amount of the section 734(b) adjustment is computed properly, the allocation of that adjustment is not right.Absent a correction, the statute as written offers significant tax reduction strategies.The partnership uses of its cash to purchase nondepreciable Blackacre, and after Blackacre has increased in value to 0, cash of 0 is distributed to P in a nonliquidating distribution.After the distribution, the books of the partnership read (where “CA” stands for capital account and “OB” stands for outside basis): If the partnership has an election under §754 in effect, it is entitled to an inside basis increase of ; such an adjustment will equalize aggregate inside basis (now , in the remaining cash and in Blackacre) with aggregate outside basis (now 0, all in Q’s outside basis).Given that P contributed cash of 0 and the partnership‟s only asset grew by 0 while P was a 50% owner, this means that the distribution will have reduced P‟s total return from 0 to 3.
When they are not equal, astute taxpayers can exploit the difference. Suppose, for example, that aggregate outside basis is higher than aggregate inside basis.Nonetheless, there are transactions that can break the equality of aggregate inside and aggregate outside basis.An election is provided by section 754 which ensures, by adjusting inside basis, that this equality is in fact always maintained so long as the election is made soon enough.Since each partner invested 0, each should be taxed on 0, and for Q is exactly what happened: the only taxable event was the sale of Blackacre, and Q reported a gain of 0 as a result.Thus, the liquidation is tax-free to Q, as it should be. The initial distribution of 0 was taxable to the extent of because, at the time of the distribution, P‟s outside basis was only 0;[27 ]distributed cash is taxable to the extent that it cannot be absorbed by the distributee‟s outside basis.And if the amounts they contribute are unequal, they will have some arrangement to account for that difference which the taxing structure must digest.A partnership is the most flexible form of business organization, and the rules of Subchapter K capture that flexibility surprisingly well.Presumably P and Q will agree to share future profit and loss in these new proportions.But that has no effect on the taxation of the accrued gain in Blackacre of 0; that accrued gain should be shared equally between the partners because it was a return on their investments when their investments were equal.The way to ensure that the distribution does not inappropriately affect the economics of the venture is to restate the partner‟s capitals accounts immediately prior to the distribution (called an asset “book-up”). That is, because Blackacre is now worth 0, each partner‟s capital account should be increased by his share of the 0 increase from cost of to current value of 0.Thus, the books of the partnership really should be: The books accurately show that P now has a one-third interest in the capital of the partnership while Q‟s interest has grown to two-thirds.