Allocations Attributable to Contributed Property: Section 704(c)

• Pages: 123-152
• Author: James R. Repetti,William H. Lyons,Charlene D. Luke

123

Chapter Seven

ALLOCATIONS ATTRIBUTABLE TO

CONTRIBUTED PROPERTY:

SECTION 704(c)

A. Introduction

The previous two chapters discussed various tools Congress has

adopted to preve nt partnerships from abusing their great flexibility

to allocate tax items among partners. Chapter 5 explained that the

substantial economic effect test of § 704(b) requires that tax

allocations correspond to book allocations that increase or reduce a

partner’s capital account in order to prevent the disassociation of tax

effects from underlying economic ef fects. Chapter 6 discussed

application of the common law assignment-of-income doctrine to

partnerships in general, as well as some specific statutory rules

implementing that doctrine (e.g., § 704(e) and § 706(d)).

This chapter continues the discussion of the interaction of

partnership tax allocations and the assignment-of-income doctrine by

examining the special ized statutory and regulatory rules that

address situations in which the fair market value of property

contributed to a partnership differs from its tax basis. Can a partner,

who purchased property for $30,000 that has appreciated in value to

$40,000, shift the $10,000 built-in tax gain to other partners by

contributing the property to the partnership and having the

partnership sell it and then allocate all the tax gain to the other

partners? The short answer is no . If the partnership sells the

property for $40,000, § 704(c) and its regulations require that the

$10,000 built-in gain be allocated to the contributing partner.

Section 704(c) uses different rules depe nding on whether the

property contributed to the partnership has a built-in loss or a built-

in gain and whether the property is depreciable. We w ill first

examine the rules for co ntributions of non-depreciable and

depreciable property with built-in gains and then turn to the

treatment of contribu tions of prope rty with buil t-in losses. The

chapter then examines so-called “reverse” 704(c) allocations as well

as ru les intended to prevent taxpayers from using distributions to

avoid § 704(c).

124

Allocations Attributable to

Contributed Property: Section 704(c)

Ch. 7

B. Contributions of Non-Depreciable Property

with Built-in Gain

1. In General

The § 704(c) regulations prevent the shifting of built-in gain

among partners by focusing on the difference between the

contributed property’s book value and tax basis.

1

If property

contributed to a partnership in a transaction subject to § 721, § 722,

and § 723 has a tax basis that differs from its book value, the tax

consequences attributable to that difference must be borne by the

contributing partner. Suppose that a new partner contributes

unimproved land with a tax basis of $30,000 and a value of $40,000

in exchange for an interest in a partnership. The contributing

partner’s capital account is $40,000, and the partnership’s book value

for the asset is $40,000. The partnership later sells the land for

$44,000. The contributing partner should report all of the $10,000

tax gain that was “built in” at the time of the contribution. If the

partnership agreement could allocate that built-in gain to a different

partner (for example, one in a lower rate bracket than the

contributor), the partners would easily be able to circumvent the

assignment-of-income doctrine. Only the $4,0 00 increase in the

property’s v alue that occurred after the contribution (i.e., the boo k

gain of $4,000) corresponds to an increase in the partnership’s wealth

that should be shared among all the partners.

Section 704(c)(1)(A) mandates this result. It requires that

taxable income and deductions “with respect to property contributed

to the partnership by a partner shall be shared among the partners

so as to take account of” any difference between book value and basis

at the time of the contribution.

2

On the facts of the examp le in the

previous paragraph, § 704(c)(1)(A) requires that the $10,000 of built-

in gain be allocated and taxed to the contributing partner. The

partnership agreement cannot change this $10,000 tax allocation.

The partnership agreemen t is permitted, however, to allocate the

$4,000 book gain (which represents the post-contribution

appreciation) to all the partners, and the $4,000 of recognized tax

gain is then allocated in the same manner.

1

Reg. § 1.704–3(a)(3)(i) defines “§ 704(c) property” to which the re gulations

apply as “[p]roperty contributed to a partnership . . . if at the time of contribution its

book value differs from the contributing partner’s adjusted tax basis.” Book value is

determined as set forth in Reg. § 1.704–1(b). See Chapter 5 § B.2.

2

Reg. § 1.704–3(a)(1) makes an almost identical statement. A de minimis rule

allows p artnerships to ignore § 704(c) in cases involving small disparities between

book value and basis. Reg. § 1.704–3(e)(1). A “small disparity” exists if (1) the book

value of all the properties contributed by one partner during the year does not differ

from the tax basis by more than 15% of that basis, and (2) the “total gross disparity”

for all property contributed by that partner is $20,000 or less. Reg. § 1.704–3(e)(1)(ii).