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In general, the contribution of property to a partnership in exchange for a partnership interest is a tax-neutral event. The same is true for a limited liability company treated as a partnership for federal income tax purposes. Under Section 721(a) of the Internal Revenue Code, no gain or loss is recognized (either by the partnership or by any of its partners) upon a contribution of property to the partnership in exchange for a partnership interest. The partner’s basis in the contributed property becomes both the basis that the partnership receives in the property and the basis that the partner receives in his partnership interest.

However, if the contributed property is subject to a liability, the situation is more complex. A partner contributing property to a partnership is treated as receiving a cash distribution to the extent of his net relief from liabilities. More specifically, gain is recognized by a contributing partner where his debt relief exceeds his total basis in his partnership interest.

Several methods can be employed to avoid gain on the contribution. Common methods of avoiding gain include the following:

  1. Simply contributing different property subject to less or no debt;
  2. Paying down the debt;
  3. Leasing the property to the partnership rather than contributing it;
  4. Contributing cash or other property along with the contributed property; or
  5. Delaying the contribution of property until after the year-end if the partner expects to receive an allocation of partnership income that will increase his basis in the partnership interest.

A more sophisticated, and often more practical, method of avoiding gain recognition is for the partner to increase the portion of partnership liabilities allocated to him. The rules for allocating liabilities inside a partnership are complex and depend upon whether the liabilities are recourse or non-recourse in nature. The liability allocation rules do, however, permit significant flexibility. With careful planning, a partner can be allocated a greater portion of the partnership’s liabilities in order to avoid an unnecessary tax bill, all without incurring a significant risk of loss if the partnership becomes insolvent.