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

• Author: Walsh, Joseph G.
• Position: Part 1

When property with a fair market value (FMV) that differs from basis is contributed to a partnership, intricate rules under Sec. 704(c) come into play to deter mine how allocations of gain, loss, income or deduction on such property are to be made to partners. The goal is to ensure that the partner who contributed the property receives the benefits or burdens of built-in loss or gain on it and does not unreasonably shift the tax consequences to the other partners. The first part of this two-part article addresses Sec. 704(c)'s complexities, using numerous examples to illustrate the application of the rules. The second part, in the May issue, will examine tax planning strategies and pitfalls.

Contributions of Property to a Partnership

Sec. 721(a) allows partners to contribute appreciated or depreciated property to a partnership without recognizing gain or loss. The partnership's basis in the contributed property ("inside basis") under Sec. 723 is the property's basis in the contributing partner's hands. Thus, if the partner contributed appreciated property to the partnership, its FMV at the time of contribution ("book value") will be greater than its inside basis.

Under Sec. 722, the contributing partner's basis in his partnership interest ("outside basis") equals the basis of the property he contributed to the partnership. His capital account equals the book value of the property at the time of the contribution.(1)

* Sec. 704(c) property

Final regulations under Sec. 704(c), issued on Dec. 21, 1993, define "Sec. 704(c) property" as contributed partnership property with a book value that differs from inside basis.(2) The contributing partner's "built-in gain" on See. 704(c) property is the excess of the property's book value over its inside basis; the excess of property's inside basis over its book value is the contributing partner's "built-in loss."(3) The built-in gain or loss can change over time as the book value and inside tax basis of the Sec. 704(c) property are adjusted by factors such as tax depreciation or a revaluation of the assets.

* Partnership allocations

Generally under Sec. 704(a) and (b), partners can determine among themselves how to allocate partnership items of income, gain, loss or deduction, provided their allocations have substantial economic effect. However, Reg. Sec. 1.704-1(b)(1)(i) states that if the partners do not provide for such allocations in the partnership agreement, or if their allocations do not have substantial economic effect, the IRS will reallocate the partnership's items of income, gain, loss or deduction in accordance with the partners' interests in the partnership.

* Pre-DRA allocations of built-in gain or loss

Prior to the enactment of the Deficit Reduction Act of 1984 (DRA), allocations of depreciation, depletion, gain or loss with respect to contributed property were made as if the partnership had purchased the property(4) (i.e., depreciation and gain or loss on sale were allocated in accordance with the partners' profit or loss interests). The partnership could elect under Sec. 704(c)(2) to allocate the depreciation and the built-in gain or loss to take account of the variation between the partnership's basis in the property and its FMV at the time of contribution.(5)

* Current law

The DRA required partnerships to allocate built-in gain or loss to the contributing partner. Thus, allocations of built-in gain or loss cannot be made in accordance with the allocations provided in the partnership agreement, even if those allocations have substantial economic effect. Congress believed that special rules were necessary to "prevent an artificial shifting of tax consequences between partners with respect to pre-contribution gain or loss."(6) Congress was particularly concerned that partnerships would be used to shift built-in gain to a tax-exempt partner, a partner with a lower marginal rate than the contributing partner, or a partner with expiring net operating losses (NOLs).

Example 1: Allocating Gain to a Contributing Partner A and B form partnership AB. A contributes $10 cash and B contributes property with an adjusted basis of $60 and FMV of $90. The partnership agreement provides that A has a 10% interest in partnership profits, losses and capital, B has a 90% interest and the allocations have substantial economic effect.

A has a partnership interest with a basis and capital account of $10. B has a partnership interest with a capital account of $90 and an outside basis of $60. The basis to AB of the property that B contributed is $60. AB's tax and book balance sheets are as follows:

Partnership assets Partners' capital

Inside Outside tax Book tax Book basis value basis value

Cash $10 $ 10 A $10 $ 10 Property 60 90 B 60 90

Total $70 $100 $70 $100 AB is required to account for the $30 built-in gain on the Sec. 704(c) property contributed by B. If it does so properly, AB will also eliminate the $30 difference between B's capital account ($90) and his outside basis ($60).

Methods of Accounting for Book-Tax Differences

* Any reasonable method

According to Reg. Sec. 1.704-3(a)(1), a partnership may account for the built-in gain or loss on its Sec. 704(c) property through any reasonable method that is consistent with the purpose of Sec. 704(c). Sec. 704(c)'s purpose is to ensure that the contributing partner receives the tax burdens and benefits of any built-in gain or loss. Some methods recognized in the final regulations as being generally reasonable include (1) the "traditional method" of Regs. Sec. 1.704-3(b)(1), which combines allocations of book depreciation, tax depreciation and gain or loss on sale and (2) Regs. Sec. 1.704-3(c)'s "traditional method with curative allocations" of other partnership items of income, gain, loss or deduction. Curative allocations are used to ameliorate the effects of the "ceiling rule" (discussed below).

In addition, the Treasury issued final regulations on Dec. 27, 1994,(7) permitting the use of a new method to eliminate distortions caused by the ceiling rule - the "remedial allocation method." Remedial allocations are notational tax items of income, gain, loss or deduction created by the partnership and allocated to the noncontributing partner to compensate for the ceiling rule and are simultaneously offset by remedial allocations of deduction, loss, gain or income to the contributing partner.

Regs. Sec. 1.704-3(a)(2) provides that these methods of accounting for built-in gain are applied on a property-by-property basis. A partnership may use a different method for each item of Sec. 704(c) property, provided that such method is used consistently for each item of Sec. 704(c) property. However, the overall method (or combination of methods) must be reasonable based on the facts and circumstances - e.g., it may be unreasonable to use one method for properties with built-in gain and another method for properties with built-in loss.

* Related Code provisions

Other Code provisions require the recognition of built-in gain on (1) certain distributions of Sec. 704(c) property to noncontributing partners (Sec. 704(c)(1)(B)) or (2) distributions of other property to the contributing partner (Sec. 737). In either event, the built-in gain recognized must be allocated to the contributing partner (as discussed below). Proposed regulations were issued on Jan. 6, 1995.(8)

In addition, the Sec. 707(a)(2) disguised sale rules (a discussion of which is beyond the scope of this article) prevent taxpayers from using the Code provisions that allow tax-free contributions to and distributions from partnerships to avoid recognizing the built-in gain on the property.

* Allocation of gain on sale

The easiest way for a partnership to account for built-in gain on Sec. 704(c) property is simply to allocate to the contributing partner the tax gain recognized at the time of sale, up to the amount of the built-in gain.(9) Any gain in excess of this amount would be allocated among all of the partners in accordance with their profits interests in the partnership.(10) When combined with allocations of tax depreciation (discussed below), this is the traditional method of allocation.

Example 2: Allocating Gain to a Contributing Partner on Sale The facts are the same as in Example 1, and AB sells the contributed property for $90. There is no book gain on the sale ($90 sales price - $90 book basis), but there is $30 tax gain on the sale ($90 sales price - $60 tax basis). The $30 built-in gain must be allocated to B, the partner who contributed the property. After the sale, AB's balance sheets are as follows:

Partnership assets Partners' capital

Inside Outside tax Book tax Book basis value basis value

$ 90 $90 Cash 10...