Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations 

    PARTNERS & PARTNERSHIPS 
    by James M. Greenwell, CPA, MST 
    Published February 01, 2014

     

    EXECUTIVE
    SUMMARY

     
    • Photo by Janet Eastwood/iStock/ThinkstockSec. 704(c) is intended to prevent the shifting of tax items among partners when a partner contributes property with a fair market value different from its tax basis to a partnership.
    • Under Sec. 704(c), the allocation of tax items for property contributed with a built-in gain or loss must be made using a reasonable method. The regulations identify three methods that are generally reasonable: the traditional method, the traditional method with curative allocations, and the remedial method.
    • There are two types of Sec. 704(c) allocations, “forward’ allocations on the contribution of property to a partnership and “reverse” allocations on the occurrence of certain specified events.
    • Under an anti-abuse rule, forward or reverse Sec. 704(c) allocations are considered unreasonable if they are made to shift tax consequences among the partners to reduce the present value of the partners’ combined tax liabilities.

    Under Sec. 704(a), a partner’s distributive share of income, gain, loss, or credit is determined, except as otherwise provided in subchapter K, in the partnership agreement. This flexibility allows partnership agreements to reflect any economic arrangement of the partners. This flexibility, however, also opened the door for taxpayers to abuse the provision. In response, Congress enacted Sec. 704(b) to prevent the shifting of tax items among partners through special allocations.1

    Sec. 704(b) generally requires allocations to have “substantial economic effect” or to be in accordance with the “partner’s interest in the partnership.” No matter the test met, the regulations require that partnership allocations follow the partners’ true economic arrangement.2

    The Need for Sec. 704(b) Capital Accounts

    The regulations generally require partnerships to maintain a Sec. 704(b) book capital account for each partner to reflect the partner’s economic interest in the partnership.3 To pass the substantial economic effect safe harbor, the partnership agreement must require these capital accounts to be maintained in accordance with the subchapter K regulations.4 If capital accounts are not maintained properly throughout the partnership’s full term, allocations will be deemed to lack substantial economic effect. By and large, capital accounts are determined to be in accordance with the Sec. 704(b) regulations if adjusted as required by Regs. Sec. 1.704-1(b)(2)(iv)(b).

    The flexibility of subchapter K is limited further by rules in the regulations, such as the anti-abuse rule5 and other rules regarding allocations attributable to nonrecourse liabilities,6 mixing bowl transactions,7 and allocations in connection with contributed8 and distributed9 property. These rules were included in the regulations with the intent of ensuring that book, and consequently tax, allocations are made in accordance with the partners’ economic arrangement.

    Contributions of Property: Forward Sec. 704(c) Allocations

    Sec. 704(c) limits the flexibility partnerships have to make special allocations for contributed property. When a partner contributes property to a partnership (including liabilities identified in Regs. Sec. 1.752-7) with a fair market value (FMV) different from its tax basis, there is a gain or loss inherent in the property that originated while the partner owned the property outside the partnership. To prevent the shifting of tax items among partners for the appreciated or depreciated property, Congress enacted Sec. 704(c).10 Sec. 704(c) prevents the assignment of income by allocating the built-in gain or loss that arose prior to the contribution to the contributing partner. Separate from Sec. 704(b), which allows partners to allocate Sec. 704(b) book items in any manner they desire so long as certain requirements are met (i.e., substantial economic effect safe harbor, partner’s interest in the partnership, anti-abuse requirements, Regs. Sec. 1.704-2 nonrecourse liabilities), items subject to Sec. 704(c) must be allocated so as to recognize the built-in gain or loss at the time of contribution.11 These allocations are generally known as “forward” Sec. 704(c) allocations.

    Built-in loss property is taken into account only in determining the value of items allocated to the contributor. When determining the value of items allocated to the noncontributing partners, the partnership’s basis in the contributed property is treated as being equal to its FMV at the time of contribution. This ensures the partner who contributed the built-in loss property cannot transfer the loss to another partner through the transfer of the partner’s interest.12

    The allocation of tax items relating to property contributed with a built-in gain or loss must be made using a reasonable method.13 Regs. Sec. 1.704-3 identifies three methods that are generally permissible: traditional, traditional with curative allocations, and remedial. A partnership may use a different method for each contributed property so long as (1) it consistently uses a single reasonable method for each contributed property, and (2) the overall combination of methods is reasonable.14 Partnership agreements usually identify one method to be used for all contributed property, unless the partners agree otherwise. Although partnerships have the flexibility to use different methods for different assets, they must be cautious to select a reasonable method since the IRS has the authority to reconstruct the contribution to avoid tax results it deems are inconsistent with the intent of subchapter K.15

    Traditional Method

    The traditional method requires a partnership to allocate its income, deductions, gains, or losses directly associated with Sec. 704(c) property to avoid shifting income tax consequences among its partners. Tax allocations to noncontributing partners for Sec. 704(c) property must generally, to the extent possible, equal their Sec. 704(b) book allocations. However, the total allocation cannot exceed the partnership’s total income, deductions, gains, or losses from the property in that tax year. This is known as the “ceiling rule.”16

    Example 1, Scenario 1: On Jan. 1, 2012, A and B formed Partnership. A contributed equipment worth $500 with a tax basis of $300 to Partnership in exchange for a 50% interest in its capital, profits, and losses. B contributed $500 for the same interest.

    At the time of A’s contribution, the equipment had a built-in gain of $200 ($500 FMV less $300 tax basis). Partnership uses the traditional method for all of its Sec. 704(c) property. The equipment is depreciated straight-line over 14 years with 10 years remaining. For 2012, Partnership would receive Sec. 704(b) book and tax depreciation of $50 ($500 ÷ 10) and $30 ($300 ÷ 10), respectively. Generally, for the traditional method, there are five key steps to correctly allocate Sec. 704(b) book and tax depreciation:

    1. Compute tax depreciation.
    2. Compute Sec. 704(b) book depreciation.
    3. Allocate Sec. 704(b) book depreciation.
    4. Allocate tax depreciation to the noncontributing partners up to the amount of their allocation of Sec. 704(b) book depreciation. If any tax depreciation remains to be allocated, move on to step 5.
    5. Allocate remaining tax depreciation to the contributing partner.

    Exhibit 1 shows the allocations of depreciation for Sec. 704(b) book and tax purposes. Steps 1 and 2 were completed above.



    Note:
    The allocation of tax depreciation first to the noncontributing partners has two primary effects. First, it ensures the noncontributing partner, B, does not have a disparity between his Sec. 704(b) book and tax capital accounts. B’s Sec. 704(b) and tax capital accounts were equal at the time of his contribution and are equal after the allocation of depreciation. Second, the contributing partner, A, recognizes the built-in gain over the remaining depreciable life of the contributed asset. A’s built-in gain at the time of his contribution was $200, but is now decreased by $20, the excess of his Sec. 704(b) book depreciation over his tax depreciation. These two effects would be limited if the ceiling rule applied.

    Example 1, Scenario 2: The facts are the same as Scenario 1, except when A contributed the equipment, it had a tax basis of $200. The 2012 depreciation for Sec. 704(b) book and tax would be $50 ($500 ÷ 10) and $20 ($200 ÷ 10), respectively.

    Due to the ceiling rule, the allocation of tax depreciation to B is limited to the partnership’s total depreciation related to the equipment. This causes a $5 distortion between the allocation of Sec. 704(b) book and tax depreciation to the noncontributing partner. Thus, under the traditional method, the ceiling rule can cause a noncontributing partner to incur an economic loss without an equal loss for tax purposes. Exhibit 2 shows the allocations of depreciation for Sec. 704(b) book and tax purposes.

    Note: The $5 distortion caused by the ceiling rule can be seen when comparing B’s Sec. 704(b) book and tax capital accounts.

    Traditional Method With Curative Allocations

    Due to the potential limitations of the ceiling rule, a noncontributing partner may not want to defer a tax deduction when an economic expense is incurred. As such, the regulations permit partnerships to use “curative allocations” to correct distortions the ceiling rule caused. Using curative allocations, partnerships may allocate tax items of income, deduction, gain, or loss that differ from the allocation of the Sec. 704(b) book item. A partnership may limit its curative allocations to allocations of one or more particular tax items. For that reason, the partnership agreement should detail the extent to which curative allocations may apply.17

    Example 2: The facts are the same as Example 1, Scenario 2, except Partnership had $10 of ordinary income during 2012 and it uses the traditional method with curative allocations for all of its Sec. 704(c) property. The partnership agreement allows curative allocations of ordinary income to be made for depreciation allocation distortions caused by the ceiling rule. Under these facts, the allocations would be as shown in Exhibit 3.



    Note:
    The “curative allocation” of a similar tax item “cures” the $5 distortion between B’s Sec. 704(b) book and tax capital accounts caused by the ceiling rule.

    Remedial Method

    In contrast to the traditional method with curative allocations, the remedial method does not require the partnership to have a matching tax item to cure ceiling rule distortions. It simply creates tax allocations the noncontributing partners need in order to match their Sec. 704(b) book allocations. The opposite of these allocations is offset against the contributing partner. These allocations only affect tax, not Sec. 704(b) book, capital accounts.18

    In addition, the remedial method computes the Sec. 704(b) book depreciation and amortization in relation to the built-in gain (not loss) based upon the recovery period and method that would apply if the property were newly purchased. Therefore, under the remedial method, the tax basis of contributed property subject to depreciation (or amortization) is recovered over the remaining life of the property; however, the built-in gain (not loss) is recovered over the full life of the property.19

    Example 3: The facts are the same as Example 1, Scenario 2, except Partnership uses the remedial method for all of its Sec. 704(c) property. Under this method, the allocations would be as shown in Exhibit 4.

    Note: There are two main differences from the traditional method: (1) The remedial method generally slows down the Sec. 704(b) book depreciation, and (2) the remedial method does not require the partnership, as does the traditional method with curative allocations, to have an actual tax item with the same tax character to cure the ceiling rule distortion.

    Thus, if Partnership used the traditional method with curative allocations in this example, the ceiling rule would still cause the distortion because Partnership did not have any other tax items to allocate to cure the distortion. Generally, the only difference between the three methods when the ceiling rule does not apply is the slowdown of Sec. 704(b) book depreciation under the remedial method; however, when the ceiling rule does apply, there can be significant differences in the current tax consequences between the partners based upon the method chosen.

    Revaluations of the Partnership: Reverse
    Sec. 704(c) Allocations

    When a new partner contributes property to a partnership in exchange for an interest in the partnership, he or she normally will not want to pay tax on the appreciation of the partnership’s property that occurred prior to admission as a partner. Likewise, the existing partners normally will not want to share any depreciation (i.e., loss of value) of the partnership’s property. Under the capital account rules of Sec. 704(b), if agreed upon in the partnership agreement, partnerships may adjust20 Sec. 704(b) capital accounts to reflect the FMV of the partnership’s property if done in connection with a qualifying event.21 These revaluations can be made to any asset and are generally known as “reverse” Sec. 704(c) allocations or “capital account book-ups (book-downs).” Revaluations cause the partnership to recognize all of its existing built-in gains and losses for Sec. 704(b) book purposes only. The tax items (i.e., depreciation) recognized as a result of the step-up (or step-down) are then allocated in accordance with the partnership agreement.

    A revaluation may be performed only if done (1) principally for a substantial nontax business purpose and (2) in connection with one of the following events.22 (Instead of a revaluation, the regulations do permit partners to agree to specially allocate the necessary items to avoid the shifting of capital items from one partner to another and consequently have substantial economic effect.23)

    • Contribution of cash or other property (excluding a de minimis amount) to the partnership by a new or existing partner in exchange for an interest in the partnership.
    • Liquidation of the partnership or the partnership’s distribution of cash or other property (excluding a de minimis amount) to a retiring or continuing partner in redemption of an interest in the partnership.
    • The grant of a partnership interest (excluding a de minimis interest) in exchange for services to or for the partnership’s benefit by an existing, new, or anticipated partner.
    • The partnership’s issuance of a noncompensatory option (excluding a de minimis one).
    • Under GAAP, substantially all of the partnership’s property (excluding money) consists of readily marketable securities, such as stock, commodities, options, futures, etc.

      There is no requirement to use the same Sec. 704(c) allocation method for each reverse Sec. 704(c) allocation, even if it is for the same property. Furthermore, there is no requirement to use the same allocation method for reverse and forward Sec. 704(c) allocations for the same property.24 Although the statute does not require reverse Sec. 704(c) adjustments, they are often necessary to maintain substantial economic effect (or to be in accordance with the partners’ interest in the partnership) and to comply with the anti-abuse regulations.

      To simplify the understanding of reverse Sec. 704(c) revaluations, they are often described in the context of partnership liquidations and formations. The same Sec. 704(c) treatment would be applied if the partnership liquidated immediately before the revaluation event and the partners immediately formed a new partnership when the revaluation event occurred, contributing all of the liquidated partnership’s assets to the new partnership, including the assets contributed (or distributed) as part of the revaluation event.

      Example 4. Traditional method, single layer: On Jan. 1, 2012, C and D form Partnership. Each of them contributes $150 in exchange for a 50% interest in the capital, profits, and losses. On Jan. 1, 2012, Partnership purchases equipment from a third party for $300. The equipment is depreciated straight-line over five years. Partnership uses the traditional method for all of its allocations, including reverse Sec. 704(c) revaluations, and has included in its partnership agreement a provision requiring reverse Sec. 704(c) revaluations for all qualifying events.

      Exhibit 5 shows the Sec. 704(b) book and tax balance sheets immediately after the purchase of the equipment.



      On Jan. 1, 2015, Partnership admits E as an equal partner in exchange for $210. The equipment is worth $420 when E is admitted into the partnership. Partnership must recover its Sec. 704(b) book and tax basis in its equipment over the remaining two years of its recovery period. The balance sheet and capital accounts at the end of 2015, without a reverse Sec. 704(c) revaluation or special allocation, would be as shown in Exhibit 6.



      Note:
      Without a reverse Sec. 704(c) revaluation or special allocation agreed to by the partners, the Sec. 704(b) book and tax depreciation remains equal since there was no step-up in the Sec. 704(b) book value of the equipment. As a consequence, E will receive less depreciation while C and D will receive more. Furthermore, each partner does not have an equal one-third share of Partnership’s total capital, and, as such, the capital accounts do not reflect the economic equality of the partners. It is important to understand the regulations’ caution on the potential negative tax consequences of a capital shift from one partner to another if neither a revaluation nor special allocation approach is followed.25

      If a reverse Sec. 704(c) revaluation was made when E became a partner, the $300 built-in gain ($420 FMV less $120 tax basis of equipment at Jan. 1, 2015) would be recognized 50-50 by C and D for Sec. 704(b) book purposes. Depreciation on the equipment for 2015 would be $210 ($420 ÷ 2 years remaining) and $60 ($120 ÷ 2 years remaining) for Sec. 704(b) book and tax, respectively (see Exhibit 7).

      Note: The reverse Sec. 704(c) revaluation corrects the Sec. 704(b) capital disparity between the partners, and as a result, the Sec. 704(b) book capital accounts reflect the economic equality of the partners. In an ideal situation, E would be allocated tax depreciation equal to the amount of her Sec. 704(b) book depreciation; however, the ceiling rule created a $10 disparity in her capital account. This disparity will likely exist until she disposes of her interest. The requirement that E (the noncontributing partner) be allocated tax depreciation in the amount of her Sec. 704(b) book depreciation causes C and D to, at least partially, recognize their share of the built-in gain inherent in the equipment at the time of revaluation.

      Example 5. Traditional method with curative allocations, single layer: The facts are the same as Example 4, except Partnership has $60 of ordinary income each year starting in 2015, and it uses the traditional method with curative allocations for the equipment (see Exhibit 8).

      Note: The use of curative allocations in this example cures the $10 distortion caused by the use of the traditional method. However, this was only possible because Partnership had other tax items with the same tax character of the depreciation (the ordinary income) to offset the distortion. If Partnership had less than $30 of ordinary income, a distortion would have still existed.

      Example 6. Remedial method, single layer: The facts are the same as in Example 4, except Partnership uses the remedial method for the equipment. This method means Partnership depreciates the Sec. 704(b) built-in gain (this does not apply to built-in losses) over the original life of the asset; the depreciation on the remaining tax basis at the time of revaluation would be over its remaining depreciable life. Therefore, the depreciation of the built-in gain on the equipment would be $60 ($300 ÷ 5 years) per year for Sec. 704(b) book purposes only and the depreciation on the remaining tax basis would be $60 ($120 ÷ 2 years) per year for Sec. 704(b) book and tax purposes (see Exhibit 9).



      Note:
      The use of the remedial method, in this example, postponed the ceiling rule distortion until 2017 since the depreciation of the built-in gain was slowed down. However, Partnership no longer has any tax depreciation on the equipment after 2016, while it has Sec. 704(b) book depreciation in 2017, 2018, and 2019. Consequently, there is a distortion in these years under the remedial method; however, Partnership is able to make notional remedial allocations to cure the distortion. The reverse Sec. 704(c) revaluation and corresponding depreciation make the noncontributing or “new” partner whole and avoid shifting tax items between partners. Should Partnership sell the equipment at any point through the equipment’s life, the tracking of forward and/or reverse Sec. 704(c) layers should ensure the correct allocation of Sec. 704(b) book and tax items and that the Sec. 704(b) book capital accounts reflect the equality of the partners’ economic interests. This would be true for any of the three methods.

      Multiple Layers of Forward and Reverse Sec. 704(c) Allocations

      Each time a triggering event occurs under Regs. Sec. 1.704-1(b)(2)(iv)(f)(5), a new Sec. 704(c) layer, forward or reverse, may need to be created. If a partnership chooses to revalue its assets, and it already has an asset that is considered forward or reverse Sec. 704(c) property, the new revaluation will create an additional layer of disparity between the Sec. 704(b) book and tax capital accounts. This additional layer is distinct and separate from the other layer(s) and can use any method allowed under Sec. 704(c), even if it is different from the initial method chosen for that asset.26 However, the anti-abuse rules still apply. There are two primary things to remember when dealing with multiple Sec. 704(c) layers:

      1. Each layer is separate and distinct from the other.
      2. If the property is depreciable, and tax depreciation is less than Sec. 704(b) book depreciation, one partner will lose out on tax depreciation in order for the other partner to minimize the distortion between its Sec. 704(b) book and tax depreciation.
      1. For forward Sec. 704(c) layers, the noncontributing partners will be entitled to tax depreciation equal to Sec. 704(b) book depreciation (unless limited by the ceiling rule).
      2. For reverse Sec. 704(c) layers, the partner who caused the revaluation event (i.e., a newly admitted partner who contributed cash for its interest) will be entitled to tax depreciation equal to its Sec. 704(b) book depreciation (unless limited by the ceiling rule).

      Example 7. Revaluation of contributed property, multiple layers: On Jan. 1, 2012, F and G form Partnership. F contributes equipment worth $150 with a tax basis of $60 to Partnership in exchange for a 50% interest in its capital, profits, and losses. G contributes $150 to Partnership in exchange for the same interest. Partnership uses the remedial method for all of its Sec. 704(c) layers and has in its agreement a provision requiring reverse Sec. 704(c) revaluations for all qualifying events.

      The equipment is depreciated over 10 years using the straight-line method with four years remaining. On Jan. 1, 2014, Partnership admits H as an equal partner in exchange for $216. At that time, the equipment is worth $282. The regulations note the potential for multiple layers of Sec. 704(c) allocations; however, they do not provide any examples that deal with the revaluation of contributed property nor do they provide any guidance on how the allocations are to be made. Thus, taxpayers are left with the principles found within Sec. 704 and its regulations to construct a reasonable allocation method. The following is an example of a potential option where the partnership is consistent with the Sec. 704(c) methods it chooses.27

      1. Layer 1: Forward Sec. 704(c)—built-in gain of $90 ($150 FMV less $60 basis at time of contribution) on the equipment contributed by F on Jan. 1, 2012. Under the remedial method, the depreciation of the built-in gain on the equipment would be $9 ($90 ÷ 10 years) per year for Sec. 704(b) book purposes only, and the depreciation on the remaining tax basis would be $15 ($60 ÷ 4 years) per year for Sec. 704(b) book and tax purposes.
      2. Layer 2: Reverse Sec. 704(c)—built-in gain on the equipment that existed prior to H’s admission on Jan. 1, 2014. At the time of H’s admission, two additional years of Sec. 704(b) book and tax depreciation were taken on the equipment. Therefore, at that time, the equipment has a net book value for Sec. 704(b) book and tax purposes of $102 and $30, respectively, and its Sec. 704(b) basis will be booked up to $282, resulting in a $180 ($282 FMV less $102 Sec. 704(b) book basis) built-in gain for layer 2. The annual Sec. 704(b) book depreciation of the $180 built-in gain would be $18 ($180 BIG ÷ 10 years). Exhibit 10 shows an analysis of the equipment’s Sec. 704(c) layers.

      Now that the Sec. 704(b) book and tax depreciations are computed for the tax years 2012 through 2014, depreciation can be allocated to the partners accordingly, as shown in Exhibit 11.



      Note:
      If Partnership had used the traditional method, there would have been two disparities caused by the ceiling rule. For layer 1 (forward 704(c) allocation), neither G nor H (the noncontributing partners) received tax depreciation equal to the amount of his Sec. 704(b) book depreciation. For layer 2 (reverse 704(c) allocation), H (the noncontributing partner) did not receive tax depreciation equal to his Sec. 704(b) book depreciation. These disparities would still exist even if Partnership used the traditional with curative allocations method since there are no other tax items with the same tax character as the depreciation to cure the distortion. Because Partnership uses the remedial allocation method for all of its Sec. 704(c) allocations, there are no distortions caused by the ceiling rule, and the difference between the Sec. 704(b) book and tax capital accounts for each partner reflects his share of the remaining built-in gain for both layers 1 and 2. Furthermore, the reverse Sec. 704(c) revaluation causes the Sec. 704(b) book capital accounts to reflect the equality of the economic arrangement between the partners with each partner owning a one-third interest in Partnership’s capital.

      In the above method, Partnership uses a first-in, first-out (FIFO) approach for its Sec. 704(c) layers when allocating its tax depreciation since it allocated tax depreciation to the first Sec. 704(c) layer created. Generally, the use of a last-in, first-out (LIFO) or FIFO approach will not be different when the remedial method is used for all Sec. 704(c) layers. However, there can be significant differences in the amount of tax depreciation each partner gets if the partnership uses the traditional method and the ceiling rule applies, limiting the amount of tax depreciation a noncontributing partner gets to less than its share of Sec. 704(b) book depreciation. Whatever method is chosen, it is important to ensure each method follows the principles of Sec. 704.

      Small Disparity Exception

      A partnership may elect to disregard (or defer until the contributed property is disposed of) the application of Sec. 704(c) (including forward and reverse Sec. 704(c) items) to one or more items of property contributed within a single tax year if the following requirements are met:28

      • The total disparity between the FMV and the adjusted tax basis of all properties the partner contributed during the tax year is not greater than 15% of the adjusted basis of the contributed properties, and
      • The total gross disparity between FMV and the adjusted tax basis of all properties the partner contributed during the tax year does not exceed $20,000.

      Aggregation Rules for Securities Partnerships

      Under the general rules of Sec. 704(c), partnerships are not permitted to aggregate built-in gains and losses. However, as with most provisions, some exceptions apply. For reverse Sec. 704(c) allocations only, a “securities partnership”29 may aggregate built-in gains and losses from qualified financial assets (i.e., any personal property (including stock) that is actively traded) using any reasonable approach, so long as it is consistent with the principles of Sec. 704(c). Once the partnership adopts an aggregation method, it must use that same method for all of its “qualified financial assets” for all tax years the partnership qualifies as a securities partnership.30 The IRS may permit a partnership to aggregate its reverse Sec. 704(c) allocations with forward Sec. 704(c) allocations.31

      The Anti-Abuse Rule

      As previously noted, forward or reverse Sec. 704(c) allocations are deemed unreasonable if they are made to shift tax consequences among the partners to reduce the present value of the partners’ combined tax liabilities.32 Indirect partners, as well as direct partners, must be considered when determining if there is taxpayer abuse. Indirect partners include any direct or indirect owner of a partnership, S corporation, or controlled foreign corporation that is a partner in the partnership. They also include a direct or indirect beneficiary of a trust that is a partner in the partnership and any consolidated group of which the partner in the partnership is a member. A shareholder of a controlled foreign corporation is treated as an indirect owner only to the extent it is allocated items of subpart F income under Sec. 951(a).33

      Planning Considerations

      The provisions of Sec. 704 are designed to avoid the shifting of tax consequences among partners (for tax purposes only), ensuring tax allocations follow the true economics of the partners’ relationship. However, as with most other provisions of subchapter K, there is great flexibility as to the treatment of these allocations. If the contributing partner contributes property with built-in gain that may be limited by the ceiling rule, the traditional method may be best for the contributing partner. Conversely, the traditional method with curative allocations may be best for the noncontributing partner should sufficient curative allocations exist.

      Often the remedial method can be the middle ground where there can be a reduction, for the noncontributing partner, in the risk of insufficient curative items. On the other hand, if the contributed property is subject to cost recovery (i.e., depreciation), it may benefit the contributing partner to have a lower Sec. 704(b) cost recovery of the built-in gain. Similar principles apply in the revaluation context and can be especially important for partnerships where partnership interests are exchanged frequently.

      No matter which method is chosen, it is imperative to understand all of the risks and benefits associated with each method along with any impacts of the anti-abuse and other rules under Sec. 704. The choice of method is often negotiated during business transactions and should be determined carefully based on an in-depth analysis of the facts and the law.

      Footnotes

      1 Section 213, Tax Reform Act of 1976, P.L. 94-455.

      2 Regs. Sec. 1.704-1(b)(1)(i).

      3 Regs. Sec. 1.704-1(b)(2)(iv)(a).

      4 Regs. Sec. 1.704-1(b)(2)(ii)(b)(1).

      5 Regs. Sec. 1.701-2.

      6 Regs. Sec. 1.704-2.

      7 Regs. Sec. 1.707-3(f), Example (8).

      8 Regs. Sec. 1.704-3.

      9 Regs. Sec. 1.704-4.

      10 Regs. Sec. 1.704-3(a)(1).

      11 Sec. 704(c)(1)(A).

      12 Sec. 704(c)(1)(C).

      13 Regs. Sec. 1.704-3(a)(1).

      14 Regs. Sec. 1.704-3(a)(2).

      15 Regs. Sec. 1.704-3(a)(1).

      16 Regs. Sec. 1.704-3(b).

      17 Regs. Sec. 1.704-3(c).

      18 Regs. Sec. 1.704-3(d).

      19 Regs. Sec. 1.704-3(d)(2).

      20 Regs. Sec. 1.704-1(b)(2)(iv)(g)(1).

      21Regs. Sec. 1.704-1(b)(2)(iv)(f).

      22Regs. Sec. 1.704-1(b)(2)(iv)(f)(5).

      23Regs. Sec. 1.704-1(b)(5), Example (14)(iv).

      24Regs. Sec. 1.704-3(a)(6)(i).

      25Regs. Secs. 1.704-1(b)(1)(iii) and (iv).

      26Regs. Sec. 1.704-3(a)(6)(i).

      27Obviously, this gets more difficult as additional layers are added and if different Sec. 704(c) methods are chosen for different Sec. 704(c) layers of the same property. In 2009, the IRS solicited comments in the development of its Sec. 704 and Sec. 737 regulations regarding the application of Sec. 704(c) to revaluations in tiered partnerships, mergers, and divisions (Notice 2009-70). Under this example, there would be two separate Sec. 704(c) layers.

      28Regs. Sec. 1.704-3(e)(1).

      29Under Regs. Sec. 1.704-3(e)(3)(iii)(A), a securities partnership is either a management company or an investment partnership that makes all of its book allocations in proportion to the partners’ relative book capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership).

      30Regs. Sec. 1.704-3(e)(3).

      31Regs. Sec. 1.704-3(e)(4).

      32Regs. Sec. 1.704-3(a)(10)(i).

      33Regs. Sec. 1.704-3(a)(10)(ii).

       

       

      EditorNotes

      James Greenwell is a tax specialist–partnerships with Phillips 66 in Bartlesville, Okla. For more information on this article, please contact Mr. Greenwell at jim.m.greenwell@p66.com.




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