Reverse sec. 704(c) allocations for securities partnerships.

• Author: Miller, Sarah Allen

Under Sec. 704(c), any unrealized gain or loss on property contributed to a partnership has to be allocated to all partners, to account for any variation between the property's adjusted basis and its fair market value (FMV) at the time of contribution. Similar rules apply when the property is revalued (e.g., on admission of a new partner) under Regs. Sec. 1.704-1(b)(2)(iv)(f)--a "reverse" Sec. 704(c) allocation.

Regs. Sec. 1.704-3(a)(2) generally requires Sec. 704(c) allocations to be made on a property-by-property basis. However, Regs. Sec. 1.7043(e)(3)(i) allows certain securities partnerships (as defined in Regs. Sec. 1.704-3(e)(3)(iii); see examples below for qualifications) to apply an aggregate Sec. 704(c) approach to "reverse" Sec. 704(c) allocations. Such approach can be used only on an allocation resulting from revaluations of partnership property, not from property contributions on partnership formation. This method requires the use of the partial netting approach of Regs. Sec. 1.7043(e)(3)(iv) or the full netting approach under Regs. Sec. 1.7043(e)(3)(v). In most cases, once an aggregate approach has been adopt ed, it has to be applied to all qualified financial assets for all tax years in which the partnership qualifies as a securities partnership.

Example 1: Various partners of Partnership P contribute cash at different times. These cash contributions are not pro rata by partner. The FMV of the underlying partnership assets is different each time a cash contribution is made.

First, it is necessary to analyze whether P qualifies as a securities partnership. Regs. Sec. 1,704-3(e)(3) (iii)(A) defines a securities partnership as a partnership that is either a management company or art investment partnership, and makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership).

"Investment partnership" is defined in Regs. Sec. 1.704-3(c)(3) (iii)(B)(2) as meeting the following criteria:

1. On the date of each capital account restatement, the partnership holds qualified financial assets that constitute at least 90% of the FMV of the partnership's noncash assets; and

2. The partnership reasonably expects, as of the end of the first tax year in which it adopts an aggregate approach under Regs. Sec. 1.7043(e)(3), to make revaluations at least annually.

   Under Regs. Sec...