Revisiting sec. 704(c).

• Author: Mahoney, Peter C.
• Position: Partnerships and limited liability companies

Partnerships and limited liability companies (LLCs) (collectively, partnerships) have become an increasingly popular operating form for owners of small and mid sized businesses. Given their flowthrough tax treatment and overall flexibility (both economic and managerial), the increase in popularity is easily understood.

Most small businesses operating in partnership form have a straightforward economic relationship between the partners. A contribution of appreciated or depreciated property, however, may cause unexpected tax complexity for the partners, due to the application of Sec. 704(c).This section contains a sophisticated set of tax allocation rules which, if ignored, can distort the partners' economic arrangement. This item revisits Sec. 704(c), so as to provide increased awareness and understanding of these rules.

Overview

Property is appreciated or depreciated for tax purposes when its fair market value (FMV) does not equal its tax basis. When such property is contributed to a partnership, it is called "Sec. 704(c) property." Certain tax items (e.g., taxable gain or loss and tax depreciation or amortization) generated by Sec. 704(c) property are subject to that provision's mandatory allocation rules. The policy objective is to prevent shifting of tax consequences among partners for pre-contribution gain or loss; see Regs. Sec. 1.704-3(a); see Example 1 above.

Example 1: On Jan. 1, 2004, A and B form partnership AB. A contributes land with a $1,000 FMV and a $500 adjusted basis; B contributes $9,000. The AB partnership agreement provides for a 10%/90% split between A and B, respectively. Immediately after AB's formation, A and B have the following capital accounts: Event Book Tax A's contribution $1,000 $500 B's contribution $9,000 $9,000 Shortly after formation, AB sells the land for $1,000. For book purposes, AB would recognize no gain or loss on the land sale, because there was no post-contribution appreciation or depreciation. For tax purposes, however, AB would recognize a $500 gain: In the absence of Sec. 704(c), this gain would presumably be allocated 10% to A and 90% to B, resulting in the following capital accounts: Event Book (A) Tax (A) Book (B) Tax (B) Contribution $1,000 $500 $9,000 $9,000 Gain on sale 0 50 0 450 $1,000 $550 $9,000 $9,450 Thus, in the absence of Sec. 704(c) adjustments, AB's land sale would result in 90% of the land's pre-contribution tax gain being shifted from A to B. The pre-contribution gain shifted to B would not be offset until B's interest in AB is either sold or liquidated, which could be many years later. On sale...