Partnership capital account revaluations: an in-depth look at sec. 704(c) allocations.

• Author: Greenwell, James M.

Under Sec. 704(a), a partner's distributive share of income, gain, loss, or credit is determined, except as otherwise provided in subchapter K, in the partnership agreement. This flexibility allows partnership agreements to reflect any economic arrangement of the partners. This flexibility, however, also opened the door for taxpayers to abuse the provision. In response, Congress enacted Sec. 704(b) to prevent the shifting of tax items among partners through special allocations. (1)

Sec. 704(b) generally requires allocations to have "substantial economic effect" or to be in accordance with the "partner's interest in the partnership." No matter the test met, the regulations require that partnership allocations follow the partners' true economic arrangement. (2)

The Need for Sec. 704(b) Capital Accounts

The regulations generally require partnerships to maintain a Sec. 704(b) book capital account for each partner to reflect the partner's economic interest in the partnership. (3) To pass the substantial economic effect safe harbor, the partnership agreement must require these capital accounts to be maintained in accordance with the subchapter K regulations. (4) If capital accounts are not maintained properly throughout the partnership's full term, allocations will be deemed to lack substantial economic effect. By and large, capital accounts are determined to be in accordance with the Sec. 704(b) regulations if adjusted as required by Regs. Sec. 1.704-1(b)(2)(iv)(b).

The flexibility of subchapter K is limited further by rules in the regulations, such as the anti-abuse rule (5) and other rules regarding allocations attributable to nonrecourse liabilities, (6) mixing bowl transactions, (7) and allocations in connection with contributed (8) and distributed9 property. These rules were included in the regulations with the intent of ensuring that book, and consequently tax, allocations are made in accordance with the partners (9) economic arrangement.

Contributions of Property: Forward Sec. 704(c) Allocations

Sec. 704(c) limits the flexibility partnerships have to make special allocations for contributed property. When a partner contributes property to a partnership (including liabilities identified in Regs. Sec. 1.752-7) with a fair market value (FMV) different from its tax basis, there is a gain or loss inherent in the property that originated while the partner owned the property outside the partnership. To prevent the shifting of tax items among partners for the appreciated or depreciated property, Congress enacted Sec. 704(c). (10) Sec. 704(c) prevents the assignment of income by allocating the built-in gain or loss that arose prior to the contribution to the contributing partner. Separate from Sec. 704(b), which allows partners to allocate Sec. 704(b) book items in any manner they desire so long as certain requirements are met (i.e., substantial economic effect safe harbor, partner's interest in the partnership, anti-abuse requirements, Regs. Sec. 1.704-2 nonrecourse liabilities), items subject to Sec. 704(c) must be allocated so as to recognize the built-in gain or loss at the time of contribution. (11) These allocations are generally known as "forward" Sec. 704(c) allocations.

Built-in loss property is taken into account only in determining the value of items allocated to the contributor. When determining the value of items allocated to the noncontributing partners, the partnership's basis in the contributed property is treated as being equal to its FMV at the time of contribution. This ensures the partner who contributed the built-in loss property cannot transfer the loss to another partner through the transfer of the partner's interest. (12)

The allocation of tax items relating to property contributed with a built-in gain or loss must be made using a reasonable method. (13) Regs. Sec. 1.704-3 identifies three methods that are generally permissible: traditional, traditional with curative allocations, and remedial. A partnership may use a different method for each contributed property so long as (1) it consistently uses a single reasonable method for each contributed property, and (2) the overall combination of methods is reasonable. (14) Partnership agreements usually identify one method to be used for all contributed property, unless the partners agree otherwise. Although partnerships have the flexibility to use different methods for different assets, they must be cautious to select a reasonable method since the IRS has the authority to reconstruct the contribution to avoid tax results it deems are inconsistent with the intent of subchapter K. (15)

Traditional Method

The traditional method requires a partnership to allocate its income, deductions, gains, or losses directly associated with Sec. 704(c) property to avoid shifting income tax consequences among its partners. Tax allocations to noncontributing partners for Sec. 704(c) property must generally, to the extent possible, equal their Sec. 704(b) book allocations. However, the total allocation cannot exceed the partnership's total income, deductions, gains, or losses from the property in that tax year. This is known as the "ceiling rule." (16)

Example 1, Scenario 1: On Jan. 1, 2012, A and B formed Partnership. A contributed equipment worth $500 with a tax basis of $300 to Partnership in exchange for a 50% interest in its capital, profits, and losses. B contributed $500 for the same interest. At the time of A's contribution, the equipment had a built-in gain of $200 ($500 FMV less $300 tax basis). Partnership uses the traditional method for all of its Sec. 704(c) property. The equipment is depreciated straight-line over 14 years with 10 years remaining. For 2012, Partnership would receive Sec. 704(b) book and tax depreciation of $50 ($500 10) and $30 ($300 10), respectively. Generally, for the traditional method, there are five key steps to correctly allocate Sec. 704(b) book and tax depreciation:

1. Compute tax depreciation.

2. Compute Sec. 704(b) book depreciation.

3. Allocate Sec. 704(b) book depreciation.

4. Allocate tax depreciation to the noncontributing partners up to the amount of their allocation of Sec. 704( b) book depreciation. If any tax depreciation remains to be allocated, move on to step S.

5. Allocate remaining tax depreciation to the contributing partner.

   Exhibit 1 shows the allocations of depreciation for Sec. 704( b) book and tax purposes. Steps 1 and 2 were completed above.

   Exhibit 1: Depreciation allocation in Example 1, Scenario 1 A B Partnership 704(b) Tax 704(b) Tax 704(b) Tax Capital account, 500 300 500 500 1,000 800 1/1/12 Step 3: Allocate (25) (25) (50) book depreciation according to Sec. 704(b) Step 4: Allocate tax (25) (25) depreciation to noncontributing partners Step 5: Allocate (5) (5) tax depreciation to contributing partners Capital account, 12/31/12 475 295 475 475 950 770 Note: The allocation of tax depreciation first to the noncontributing partners has two primary effects. First, it ensures the noncontributing partner, .8, does not have a disparity between his Sec. 704(b) book and tax capital accounts. B's Sec. 704( b) and tax capital accounts were equal at the time of his contribution and are equal after the allocation of depreciation. Second, the contributing partner, A, recognizes the built-in gain over the remaining depreciable life of the contributed asset. A's built-in gain at the time of his contribution was $200, but is now decreased by $20, the excess of his Sec. 704(b) book depreciation over his tax depreciation. These two effects would be limited if the ceiling rule applied.

   Example 1, Scenario 2: The facts are the same as Scenario 1, except when A contributed the equipment, it had a tax basis of $200. The 2012 depreciation for Sec. 704(b) book and tax would be $50 ($500 / 10) and $20 ($200 10), respectively. Due to the ceiling rule, the allocation of tax depreciation to B is limited to the partnership's total depreciation related to the equipment. This causes a $5 distortion between the allocation of Sec. 704(b) book and tax depreciation to the noncontributing partner. Thus, under the traditional method, the ceiling rule can cause a noncontributing partner to incur an economic loss without an equal loss for tax purposes. Exhibit 2 shows the allocations of depreciation for Sec. 704(b) book and tax purposes.

   Exhibit 2: Depreciation allocation in Example 1, Scenario 2 A B Partner ship 704(b) Tax 704(b)...