Accounting for book-tax differences of property contributed to a partnership.

• Author: Walsh, Joseph G.
• Position: Part 2

The contribution to a partnership of property with a fair market value (FMV) that differs from basis triggers the application of complicated rules under Sec. 704(c) to determine how allocations of gain, loss, income or deduction on such property are to be made to partners. These rules ensure that the partner who contributed the property receives the benefits or burdens of built-in loss or gain in it, without unreasonably shifting them to the other partners. The first part of this two-part article addressed Sec. 704(c)'s complexities, using numerous examples to illustrate the application of the rules. The second part, below, examines tax planning strategies and pitfalls, and some related provisions.

Ceiling Rule Planning Obstacles

and Opportunities

When the ceiling rule applies, partners can choose among the traditional method, the traditional method with curative allocations, or remedial allocations. In making this decision, the partners are likely to be at arm's length because, if they are in the same marginal tax bracket, a reasonable allocation method that is advantageous to one partner generally will be disadvantageous to another.

Comparison of methods

In Example 7 in Part I of this article, B, a 90% partner, contributed property with a $6 basis and a $90 book value. The ceiling rule applied to the Sec. 704(c) property, so that the partners would have increased (or decreased) income as follows:(18)

Partner A:

Traditional Curative Remedial Year method allocations allocations

1 $-2 $-3 $-1.9 2 -2 -3 -1.9 3 -2 -3 -1.9 4 0 0 -1.7 5 0 0 -1.7

Total $-6 $-9 $-9.0(*)

Partner B: Traditional Curative Remedial Year method allocations allocations

1 $0 $1 $-0.1 2 0 1 -0.1 3 0 1 -0.1 4 0 0 1.7 5 0 0 1.7

Total $0 $3 $ 3.0(*)

(*)Reflects rounding. * Noncontributing partner

Curative allocations are likely to be more advantageous than remedial allocations to the noncontributing partner if the Sec. 704(c) property has built-in gain. Curative allocations will provide the noncontributing partner with his full share of the tax depreciation deductions (in this case, $9) over the remaining useful life of the Sec. 704(c) property's inside tax basis.(19)

Remedial allocations will provide the noncontributing partner with the same total depreciation deduction ($9) as provided by the curative allocation method. However, since the built-in gain will be depreciated over a new useful life that begins at the time of contribution, the deduction will be spread over a greater number of years.

The traditional method provides the noncontributing partner with the least amount of depreciation, because the ceiling rule limits the partnership's total depreciation deductions to the depreciation to which the contributing partner would have been entitled (here, $6) had he not contributed the property to the partnership.

* Contributing partner

The traditional method is most advantageous to the contributing partner because no additional income is allocated to him to offset the effects of the ceiling rule. Remedial allocations are likely to be more advantageous than curative allocations to the contributing partner if the property has built-in gain. Both curative and remedial allocations will increase the contributing partner's taxable income by the amount necessary to offset the effects of the ceiling rule; however, with remedial allocations, at least some of the additional income will be allocated to the contributing partner over the new useful life of the Sec. 704(c) property's built-in gain (in this case, five years). Curative allocations will be taken into account over the balance of the remaining useful life of the Sec. 704(c) property at the time of contribution (here, three years).

* Time and manner for electing method

Regs. Sec. 1.704-3(c)(3)(iii)(A) indicates that the partnership agreement should provide, in the year of contribution, the allocation method the partnership will use for each item of Sec. 704(c) property; if it does, the reasonableness of the method will be determined as of the time of contribution. If the partnership agreement is not sufficiently specific as to the precise manner in which allocations are to be made with respect to such property, the reasonableness of the allocation will be tested when it is actually made.

It is generally easier to meet the reasonableness standard at the time of contribution than when allocations are actually made, because the partners' relative tax brackets or other tax attributes may change over time. Therefore, a tax adviser should, at the time of contribution, determine whether the ceiling rule applies and, if so, explain the advantages and disadvantages of the alternatives to the partners. The tax adviser should then specify the selected method in the partnership agreement in the year of the contribution. If one partner does not agree to the method preferred by the others, the tax practitioner should aid the partners in reaching an agreement by advising them to change some other term of the partnership agreement to compensate the objecting partner for the tax disadvantage suffered.

Obstacles in the Absence of the Ceiling Rule

Even if the partners are in the same relative tax bracket and the ceiling rule does not apply, the tax adviser must properly allocate the effects of built-in gain or loss among the partners. If the partners are in the same tax bracket, the IRS will probably not care to whom the Sec. 704(c) gain or related depreciation is allocated, but the partners will.

In Example 3 in Part I of this article, A contributed $10 cash for a 10% interest and B contributed property with an adjusted basis of $60 and a book value of $90 for a 90% interest. B had depreciated the property $20 a year for two prior years. Sec. 168(i)(7) limited the partnership to $20 tax depreciation per year, and the ceiling rule did not apply.

A tax practitioner unaware of Sec. 704(c)'s requirements might allocate the depreciation the same as any other partnership tax item, so that A would receive $2 of depreciation ($20 x 10%). However, as illustrated in Example 3 of Part I, A is entitled to $3 of depreciation. If A learns that he was allocated too little depreciation, A might request the tax adviser to file amended returns for all open tax years, and sue the adviser for malpractice for the closed years. B might have to pay additional taxes (and perhaps, interest and penalties) for all open tax years on the excess depreciation taken.

Reverse Sec. 704(c) Allocations

Regs. Sec. 1.704-3(a)(6)(i) requires partnerships to apply Sec. 704(c) principles when revaluing assets in accordance with the Sec. 704(b) substantial economic effect regulations. One such situation occurs, under Regs. Sec. 1.704-1(b)(2)(iv)(f)(5)(i), when a new partner...