Revisiting Sec. 704(c)

Partnerships and limited liability companies (LLCs) (collectively, partnerships) have become an increasingly popular operating form for owners of small and mid-sized businesses. Given their flowthrough tax treatment and overall flexibility (both economic and managerial), the increase in popularity is easily understood.

Most small businesses operating in partnership form have a straightforward economic relationship between the partners. A contribution of appreciated or depreciated property, however, may cause unexpected tax complexity for the partners, due to the application of Sec. 704(c). This section contains a sophisticated set of tax allocation rules which, if ignored, can distort the partners economic arrangement. This item revisits Sec. 704(c), so as to provide increased awareness and understanding of these rules.  

Overview

Property is appreciated or depreciated for tax purposes when its fair market value (FMV) does not equal its tax basis. When such property is contributed to a partnership, it is called Sec. 704(c) property. Certain tax items (e.g., taxable gain or loss and tax depreciation or amortization) generated by Sec. 704(c) property are subject to that provisions mandatory allocation rules. The policy objective is to prevent shifting of tax consequences among partners for pre-contribution gain or loss; see Regs. Sec. 1.704-3(a).

Example 1: On Jan. 1, 2004, A and B form partnership AB. A contributes land with a $1,000 FMV and a $500 adjusted basis; B contributes $9,000. The AB partnership agreement provides for a 10%/90% split between A and B, respectively. Immediately after ABs formation, A and B have the following capital accounts:

Shortly after formation, AB sells the land for $1,000. For book purposes, AB would recognize no gain or loss on the land sale, because there was no post-contribution appreciation or depreciation. For tax purposes, however, AB would recognize a $500 gain. In the absence of Sec. 704(c), this gain would presumably be allocated 10% to A and 90% to B, resulting in the following capital accounts:

Thus, in the absence of Sec. 704(c) adjustments, ABs land sale would result in 90% of the lands pre-contribution tax gain being shifted from A to B. The pre-contribution gain shifted to B would not be offset until Bs interest in AB is either sold or liquidated, which could be many years later. On sale or liquidation, B would receive $9,000 in exchange for its partnership interest and recognize a $450 capital loss. What if at the time of the sale or liquidation, the rate differential between ordinary and capital gain has been eliminated or, worse, B has no capital gain to offset the loss? The absence of Sec. 704(c) can create distortions of time, realization and amount.

However, Sec. 704(c) is designed to prevent this type of shifting of pre-contribution gain or loss between partners. In Example 1 above, on the land sale, Sec. 704(c) would cause AB to allocate taxable gain first to A equal to As pre-contribution gain attributable to the land. Taxable gain in excess of As pre-contribution gain (i.e., post-contribution appreciation) would be allocated 10%/90%. The application of Sec. 704(c) would produce the capital accounts shown in Exhibit 1.

Sec. 704(c)s mandatory allocations balance the economic and tax consequences of this transaction, by causing the taxable gain associated with the lands pre-contribution gain to be allocated to A.

If the Sec. 704(c) property contributed to a partnership is depreciable or amortizable, Sec. 704(c) causes the tax depreciation or amortization attributable to such property to be specially allocated between the contributing and noncontributing partners. Much like the special allocation of taxable gain or loss in connection with a disposition of Sec. 704(c) property, the special allocations of tax depreciation or amortization are designed to prevent pre-contribution gain or loss from being shifted from the contributing to the noncontributing partners over the propertys life.

A simple way of understanding the special allocations of tax depreciation or amortization Sec. 704(c) requires is as follows: (1) tax depreciation or amortization attributable to Sec. 704(c) property is allocated first to the noncontributing partners to the extent of their share of such propertys book depreciation and (2) any tax depreciation or amortization remaining is allocated entirely to the contributing partner.

These allocations are intended to achieve economic and tax symmetry for both the contributing and noncontributing partners. For the latter, the special allocations achieve symmetry by maintaining equality between such partners book and tax capital account balances. Symmetry is achieved for the contributing partner by causing such partner to receive a disproportionate share of the Sec. 704(c) propertys tax depreciation or amortization. This disproportionate participation causes the contributing partners pre-contribution gain or loss on its Sec. 704(c) property to be eliminated over the propertys life.

Example 2: A contributes depreciable property (X) with a $400 FMV and $370 adjusted tax basis. The property is depreciated on a straight-line basis; at the time of its contribution, two years remain on its depreciable life. Consequently, ABs annual book and tax depreciation for the property will be $200 and $185, respectively. In exchange for its interest, B contributes $3,600. Once again, A and B agree to a 10%/90% split. At the end of the next two years, A and B would have the following book and tax capital accounts:

Nevertheless, disparities can occur when making Sec. 704(c) allocations. These disparities are referred to as ceiling limits and occur when the tax items of the Sec. 704(c) property are insufficient to maintain the symmetry of the noncontributing partners capital accounts.

Example 3: The facts are the same as in Example 2, except that the property A contributed has a $100 adjusted tax basis. As a result, the book and tax depreciation for such property is $200 and $50, respectively. A and B would have the following capital accounts in each of the following two years:

Because the tax depreciation generated by the Sec. 704(c) property in Example 3 is insufficient to cover Bs share of the book depreciation generated by such property, a disparity is created between Bs book and tax capital accounts, even though none existed at the time of contribution. This annual disparity is the ceiling limit; because of it a portion of As pre-contribution gain is shifted to B in the form of reduced depreciation deductions. Once again, the pre-contribution gain shifted to B as a result of the ceiling limit would not be offset until Bs interest in AB is either sold or liquidated. At that time, B would receive $3,240 in exchange for its partnership interest and recognize a $260 capital loss.

Curative Method

Additional mechanics in the Sec. 704(c) regulations are designed to correct the distortion created by a ceiling limit. Using one of two available methods, a partnership can elect to correct ceiling rule distortions. The first available method is called the curative method. According to Regs. Sec. 1.704-3(c), a curative allocation is an allocation of income, gain, loss or deduction for tax purposes that differs from the partnerships allocation of the corresponding book item. This method corrects the disparity caused by a ceiling limit by using the contributing partners share of tax items (e.g., depreciation) attributable to other partnership assets to make a corrective allocation to the noncontributing partners. Although the curative method preserves the symmetry between the noncontributing partners book and tax capital accounts, the corrective allocations this method uses have an offsetting effect and tax consequences for the contributing partner.

Example 4: The facts are the same as in Example 3, except that Bs $2,000 cash contribution is used to purchase another depreciable property (Y), depreciated over a two-year life on a straight-line basis. A and B agree to share all items 10%/90% and AB elects to use the curative method; A and B would have the following capital accounts in each of the following two years:

In certain instances, however, the curative method can have some limits. For example, to be respected, a curative allocation must be expected to have substantially the same effect on each partners tax liability as the tax item subject to a ceiling limit; see Regs. Sec. 1.704-3(c)(3)(iii)(A). Further, a partnership using the curative method is limited to the tax items generated by the assets within the partnership for purposes of making its corrective allocations. In other words, if in Example 4, AB did not purchase property Y, then it would not have other tax items available and the curative method would not apply.

Remedial Method

The second method available to partnerships, the remedial method, uses notional tax items to correct ceiling limits and, thus, avoids the limits of the curative method; see Regs. Sec. 1.704-3(d). The notional items used to make the corrective allocations to the noncontributing partners are neutralized, however, by offsetting allocations of notional tax items to the contributing partner. Thus, the notional items, in the aggregate, have no effect on the partnerships taxable income or loss. Much like the curative method, the notional items used to make the corrective allocations to the noncontributing partners must be expected to have substantially the same effect on such partners tax liability as the tax item subject to a ceiling limit. Similarly, the tax attributes of the offsetting notional item allocated to the contributing partner are determined by reference to the item limited by the ceiling limit.

Example 5: The facts are the same as in Example 1, except that immediately before the sale, toxic waste is found under the contributed land. As a result, its sale price drops to $750. ABs sale results in a $250 book loss, but a $250 tax gain. AB elects to use the remedial method in making Sec. 704(c) allocations. As and Bs capital following the sale would be as follows:

Caution: For depreciable Sec. 704(c) property with pre-contribution appreciation, there is a cost to the noncontributing partner if the partnership elects the remedial method. The method will extend the period over which corrective allocations are made to the noncontributing partner, by extending the Sec. 704(c) propertys depreciable life for book purposes.

Conclusion

While Sec. 704(c) can lead to complexity for small business owners operating as partnerships or LLCs, the failure to apply Sec. 704(c) can yield something far worse, economic distortion. Once Sec. 704(c)s principles are understood, the complexity is easily overcome. Tax advisers need to sensitize clients as to when it applies and assist them to use it most beneficially.

From Peter C. Mahoney, MST, CPA, Bradford G. Carlson and Elizabeth S. Williams, CPA, Quincy, MA