Sec. 704(c)'s anti-abuse rule: a practitioner's guide.

• Author: Drew, Walter R.

Sec. 704(c)'s purpose is to prevent shifting of tax consequences among partners that can occur when property is contributed to a partnership with a fair market value that differs from its tax basis. Sec. 704(c)'s principles also apply to partnership property revaluations under Sec. 704(b). Allocations resulting from those revaluations are usually referred to as "reverse Sec. 704(c) allocations."

The regulations provide that Sec. 704(c) allocations can be made using the (1) traditional, (2) traditional with curative allocations and (3) remedial methods. (For additional discussion of these methods, see Walsh, "Accounting for Book-Tax Differences of Property Contributed to a Partnership," TTA, Apr. 1995, and May 1995.)

The traditional method provides that tax allocations of cost recovery deductions generally must follow book allocations for noncontributing partners. Regs. Sec. 1.704-3(b)(1) provides a safe harbor from the anti-abuse rule when it states,"If a partnership has no property the allocations from which are limited by the ceiling rule, the traditional method is reasonable when used for all contributed property." A ceiling: rule applies when the partnership's total tax deduction for cost recovery is less than the noncontributing partners' book allocations of cost recovery. This rule causes a temporary distortion by allocating a portion of the precontribution gain or loss to noncontributing partners. The ceiling rule distortion is reversed when the contributing partner and the noncontributing partners exit the partnership in a taxable transaction.

The anti-abuse rule is contained in Regs. Sec. 1.704-3(a)(10), which provides:

An 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.

The present value of the partners' aggregate tax liability can be reduced only when the contributing and non-contributing partners are in different tax brackets and the ceiling rule applies to the allocations. Therefore, a practitioner's first guideline is that the anti-abuse rule cannot apply if the contributing and noncontributing partners are in the same tax bracket. The second guideline...