Several options available for property contributed to a partnership.

• Author: Edquist, David

As the globalization of the world economy continues, companies are increasingly turning to the corporate joint venture as a form to conduct new businesses. Corporate joint ventures provide instant access to technology, financing, new markets, and numerous other benefits that otherwise might take years for a company to obtain. The vehicle chosen to conduct these joint venture operations is frequently either a partnership or a limited liability company (LLC). An LLC provides limited liability for all of its owners and nearly all LLCs are taxed as partnerships for federal tax purposes.(1)

When forming a partnership or LLC, corporations must consider the tax effects of the specific provisions of the agreement. Recently, the Internal Revenue Service issued regulations under section 704(c) of the Internal Revenue Code governing the contribution of property to a partnership. Section 704(c) applies any time a partner contributes appreciated or depreciated property to a partnership or when a new partner is admitted to a partnership. The new regulations afford taxpayers substantial flexibility and tremendous tax planning opportunities. They also contain significant traps for the unwary.

Overview

General Rules and Principles

The Tax Reform Act of 1984(2) amended section 704(c) to require partnerships to take into account precontribution gain or loss on contributed property. Specifically, the statute now requires that income, gain, loss, and deduction with respect to property contributed to a partnership by a partner be shared among the partners to reflect any variance between the basis of the property to the partnership and its fair market value at the time of contribution. The 1984 Act granted broad regulatory authority to the Department of the Treasury and the IRS to determine how these allocations should be made. Both final and temporary regulations were published in the Federal Register on December 22, 1993, effective for contributions of property after December 20, 1993. Although the new regulations leave several questions unanswered, they represent an effort by the IRS to provide broad guidance that is relatively simple for both taxpayers to comply with and the IRS to administer.

The guiding principle of the regulations is that any precontribution gain (built-in gain) or precontribution loss (built-in loss) from property contributed to a partnership must be allocated to the contributing partner using a reasonable method.(3) The IRS did not attempt to prescribe an intricate allocation system that explicitly describes how section 704(c) allocations must be made but that would be over-burdensome for taxpayers to comply with. Rather, the regulations provide that the IRS will accept any reasonable method consistent with the purpose of section 704(c).(4) This has been described as an "overall reasonableness" standard that applies to all aspects of section 704(c) allocations. In addition to the reasonableness requirement, the regulations propound an anti-abuse rule.

The final regulations specifically describe two reasonable methods of making section 704(c) allocations: the Traditional Method,(5) and the Traditional Method with Curative Allocations.(6) The Remedial Allocation Method described in the temporary regulations represents a third reasonable method.(7) Partnerships may also use any other reasonable method that satisfies the purpose of the statute.(8) Partnerships may use different methods with respect to different items of section 704(c) property, as long as the partnership and the partners consistently apply a single reasonable method for each item of section 704(c) property.(9) Property is considered section 704(c) property if at the time of contribution to the partnership the fair market value of the property (book value) differs from the contributing partner's adjusted tax basis in the property.(10) The amount of the built-in gain or loss is reduced as the variance between the property's book value and the partnership's adjusted tax basis in the property decreases over the years.

Effective Dates

Both the final and temporary regulations are effective for property contributed to a partnership and to restatements pursuant to section 1.704-1(b)(2)(iv)(f) after December 20, 1992. Prior to December 21, 1993, the only expressly permitted method was the Traditional Method. Many partnerships, however, used various other methods. Allocation methods used before the effective date of the regulations probably will not be challenged by the IRS if they are deemed reasonable under the new regulations. In contrast, partnerships that used allocation methods that are not considered reasonable under the new regulations may face IRS scrutiny. For example, partnerships that began using the Deferred Sale Method--which was set forth in section 704(c) proposed regulations that were issued on December 24, 1994 but which is not included in the final regulations--may have trouble convincing the IRS to respect that method for any taxable year because the final regulations specifically describe it as an unreasonable method.

Reverse Section 704(c) Allocations

The partnership must also follow the principles of section 704(c) and the regulations when a partnership chooses to revalue partnership property under the provisions of section 704(b). For example, when a new partner is admitted to the partnership, any built-in gain or loss in the partnership assets at the time the new partner is admitted is allocated to the current partners and not to the new partner.(11) These types of allocations are known as "reverse section 704(c) allocations." The regulations provide considerable flexibility for reverse section 704(c) allocations. Partnerships are permitted to use different methods for allocations relating to reverse section 704(c) than for contributed section 704(c) property, even if at the time of revaluation the property is already subject to section 704(c).(12) Partnerships are also permitted to use different allocation methods each time the partnership revalues its property.(13) To the extent the regulations apply to built-in gain or loss on property contributed to a partnership, they also apply to reverse section 704(c) amounts resulting from a revaluation of partnership property.

Anti-abuse Rule

The IRS received numerous comments that the anti-abuse rule in the proposed regulations was both too broad and too vague. In response, the IRS attempted to clarify the meaning and scope of the anti-abuse rule. The final regulations provide that "[a]n allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse section 704(c) allocations) and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability."(14) The specific anti-abuse rule complements the more general "overall reasonableness" requirement that allocations must be consistent with the purposes of section 704(c). The temporary regulations provide that if an allocation method is found to be unreasonable, the IRS will not require the partnership to use the Remedial Allocation Method.(15)

The final regulations provide two examples of the operation of the anti-abuse rule: Example 2 of Treas. Reg. [sections] 1.704-3(b)(2), and Example 3 of Treas. Reg. [sections] 1.704-3(c)(4). Both examples illustrate that a section 704(c) allocation method cannot be chosen with a view to shifting a significant amount of taxable income to a partner with a low marginal tax rate and away from a partner with a high marginal tax rate in a relatively short period of time.

Reasonable Allocation Methods

The choice of a section 704(c) allocation method can have a considerable effect on the taxable income of each o the partners. Even when there will be no contributed property at the formation of the partnership, later contributions or a revaluation event resulting in reverse section 704(c) allocations make a choice of section 704(c) allocation method one of the critical issues to be resolved during formation. This decision can involve a lot of peering into the crystal ball for partners attempting to foresee how each allocation method will affect them. Appendix A provides a numerical example that compares the three reasonable methods defined in the regulations.

The regulations do not specify when an allocation method must be chosen. A reading of the entire statute suggest that an allocation method need not be chosen until an allocation subject to section 704(c) is actually made. Therefore, a partnership has until the due date of its partnership tax return for the year section 704(c) property is contributed to the partnership to select an allocation method. Once a method is chosen, the partnership and the partners must...