Reverse Sec. 704(c) Allocations for Securities Partnerships

Under Sec. 704(c), any unrealized gain or loss on property contributed to a partnership has to be allocated to all partners, to account for any variation between the propertys adjusted basis and its fair market value (FMV) at the time of contribution. Similar rules apply when the property is revalued (e.g., on admission of a new partner) under Regs. Sec. 1.704-1(b)(2)(iv)(f)a reverse Sec. 704(c) allocation.

Regs. Sec. 1.704-3(a)(2) generally requires Sec. 704(c) allocations to be made on a property-by-property basis. However, Regs. Sec. 1.704-3(e)(3)(i) allows certain securities partnerships (as defined in Regs. Sec. 1.704-3(e)(3)(iii); see examples below for qualifications) to apply an aggregate Sec. 704(c) approach to reverse Sec. 704(c) allocations. Such approach can be used only on an allocation resulting from revaluations of partnership property, not from property contributions on partnership formation. This method requires the use of the partial netting approach of Regs. Sec. 1.704-3(e)(3)(iv) or the full netting approach under Regs. Sec. 1.704-3(e)(3)(v). In most cases, once an aggregate approach has been adopted, it has to be applied to all qualified financial assets for all tax years in which the partnership qualifies as a securities partnership.

Example 1: Various partners of Partnership P contribute cash at different times. These cash contributions are not pro rata by partner. The FMV of the underlying partnership assets is different each time a cash contribution is made.

First, it is necessary to analyze whether P qualifies as a securities partnership. Regs. Sec. 1.704-3(e)(3)(iii)(A) defines a securities partnership as a partnership that is either a management company or an investment partnership, and 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).

Investment partnership is defined in Regs. Sec. 1.704-3(e)(3)(iii)(B)(2) as meeting the following criteria:

1. On the date of each capital account restatement, the partnership holds qualified financial assets that constitute at least 90% of the FMV of the partnerships noncash assets; and

2. The partnership reasonably expects, as of the end of the first tax year in which it adopts an aggregate approach under Regs. Sec. 1.704-3(e)(3), to make revaluations at least annually.

Under Regs. Sec. 1.704-3(e)(3)(ii), qualified financial assets are any personal property (including stock) that is actively traded. Actively traded is defined in Regs. Sec. 1.1092(d)-1. According to Regs. Sec. 1.1092(d)-1(a), actively traded personal property includes any personal property for which there is an established financial market. Under Regs. Sec. 1.704-1(b)(2)(iv)(f)(5), revaluations occur when:

1. Money or other property (other than a de minimis amount) is contributed by a new or existing partner as consideration for a partnership interest;

2. The partnership liquidates or distributes money or other property (other than a de minimis amount) to a retiring or continuing partner as consideration for a partnership interest; or

3. Under generally accepted industry accounting practices, substantially all of the partnerships property (excluding money), consists of stock, securities, commodities, options, warrants, futures or similar instruments readily tradable on an established securities market.

Example 2: The facts are the same as in Example 1 and Ps assets are 100% qualified financial assets (stocks tradable on an established securities market). P also reasonably expects to make revaluations at least annually, as a result of non-pro-rata cash contributions for additional units. Thus, P is an investment partnership. P makes all of its book allocations in proportion to the partners relative book capital accounts and, hence, it is a securities partnership. The de minimis exception does not apply.

As a result of P qualifying as a securities partnership, it is eligible under Regs. Sec. 1.704-3(e)(3) to aggregate gains and losses from the sale of stocks by any reasonable approach consistent with Sec. 704(c). Two potential methods are the partial netting approach (Regs. Sec. 1.704-3(e)(3)(iv)) and the full netting approach (Regs. Sec. 1.704-3(e)(3)(v)).

Partial netting approach: Under this approach, on the date of each capital account restatement, a partnership:

1. Nets its book gains and losses from qualified financial assets since the last capital account restatement, and allocates the net amount to its partners;

2. Separately aggregates all tax gains and losses from qualified financial assets since the last capital account restatement; and

3. Separately allocates the aggregate tax gain and loss to the partners in a manner that reduces the disparity between the book capital account balances and the tax capital account balances (book-tax disparities) of each partner.

Full netting approach: Under this approach, on the date of each capital account restatement, the partnership:

1. Nets its book gains and losses from qualified financial assets since the last capital account restatement and allocates the net amount to its partners;

2. Nets tax gains and losses from qualified financial assets since the last capital account restatement; and

3. Allocates the net tax gain (or loss) to the partners in a manner that reduces the book-tax disparities of each partner.

Once a partnership applies a method (partial or full netting), it should use that method consistently, going forward. Additional rules, contained in Regs. Sec. 1.704-3(e)(3)(vi), state that the allocated gain or loss has to:

1. Preserve the tax attributes of each item of gain or loss;

2. Be determined under an approach consistently applied; and

3. Not be determined with a view to reducing substantially the present value of the partners aggregate tax liability.

Example 3: The facts are the same as in Example 2 and P chooses the full netting approach. In the first year, P has four partners for the first half of the year, during which time there is $300,000 of appreciation in the partnerships portfolio, but no realized gains or losses. Halfway through the year, two new partners contribute cash. As a result of the new partners buying units at FMV, they are not allocated any of the $300,000 appreciation, which occurred before they joined the partnership. P realizes $300,000 of capital gains for the year; see the Exhibit below, which illustrates the results. P is not tracking reverse Sec. 704(c) on a security-by-security basis, because it is using the full netting approach; thus, it allocates the $300,000 only to partners who owned units when the appreciation occurred.

However, it is possible that the actual investments that had appreciated before the revaluation were not yet sold (other investments could have appreciated and then been sold, but nonetheless trigger the reverse Sec. 704(c) allocation).

Each time there is a revaluation, P will have to:

1. Book up or down to FMV, and then appropriately adjust the revaluation accounts of all other partners to reflect that change;

2. Allocate net gains to all positive revaluation accounts in accordance with each partners relative share of the total positive revaluation accounts, until such accounts reach zero.

3. Allocate the remaining gain pro-rata, based on units owned.

4. Allocate net losses to all negative revaluation accounts in accordance with each partners relative share of the total negative revaluation accounts, until such accounts reach zero.

5. Allocate the remaining loss pro-rata, based on units owned.

If all revaluation accounts are negative and the current year produces a net gain, there would be no special gain allocations (i.e., P would allocate the gain by units owned, in the same way it would all other items of income and deduction). The same result would occur if all revaluation accounts are positive and the current year produces a net loss. 

From Sarah Allen Miller, CPA, South Bend, IN