Chapter 2
ALLOCATIONS WITH RESPECT TO CONTRIBUTED PROPERTY: SECTION 704(C)(1)(A)
LEARNING OBJECTIVES
After completing this chapter, you should be able to do the following:
• Distinguish between “book” allocations required under Section 704(b) and “tax” allocations required under Section 704(c).
• Identify the potential tax consequences when a partner or LLC member makes a contribution of appreciated or depreciated property to the entity.
• Distinguish between the various methods prescribed by the regulations to make required special allocations with respect to contributed property.
• Recognize the three methods described in the Section 704(c) regulations to make special allocations with respect to contributed property.
• Determine when a non-contributing partner or LLC member will or will not be protected by required allocations under Section 704(c).
INTRODUCTION
26 CFR Section 704(b), requiring allocations to have substantial economic effect, has as its primary purpose the prevention of tax avoidance by the use of economically meaningless allocations of partnership or LLC income or loss. Partners and LLC members can reduce their tax liabilities by use of special partnership allocations, but only if those allocations are associated with real economic costs. Section 704(c), on the other hand, requires special allocations that do not cause the partner to suffer nontax economic costs, in order to prevent the use of partnerships and LLCs as tax avoidance vehicles.
Example 2-1
A contributes land to AB, Ltd., a limited liability company opting to be taxed as a partnership for federal income tax purposes. A and B each own 50 percent of AB. The tax basis of the land at the date of contribution is $100,000 and its fair market value is $250,000. If the land is sold, Section 704(c) will require the first $150,000 of gain to be allocated to A. If not for Section 704(c), the partners would share the gain equally and A would have effectively shifted $75,000 of gain to B.
Section 704(c) applies whenever an investor contributes property to a partnership or LLC with a fair market value that differs from its tax basis. In such a case, tax gains and losses, and depreciation and depletion with respect to the contributed property, differ from the amounts recorded for “book” purposes under Section 704(b). To the extent of these differences, the tax consequences of a partnership or LLC allocation do not reflect the economic cost or benefit associated with that allocation. Accordingly, Section 704(b) cannot, by itself, prevent investors from using partnerships or LLCs to manipulate their tax liabilities when there is a contribution of appreciated or depreciated property.
KNOWLEDGE CHECK
1. Bill contributed non-depreciable property with a tax basis of $15,000 and a fair market value of $32,000 to the BG Partnership in exchange for a 50 percent interest therein. If the property is subsequently sold (two years later) for $40,000, how much of the resulting $25,000 gain must be allocated to Bill?
a. $12,500.
b. $25,000.
c. $17,000.
d. $21,000.
When it was first enacted, Section 704(c) was an elective provision designed to protect the other investors in a partnership when a partner contributed appreciated property. Thus, where a partner contributed depreciable property with a basis less than its fair market value, the partnership could elect to allocate tax gain from the subsequent disposition of such property to the contributing partner to the extent of the original difference between the value and basis. Similarly, tax depreciation during the period prior to disposition could be allocated away from the contributing partner in a like amount. In this way, the other partners would not be affected by any difference between fair market value (Section 704(b) book value) and tax basis at the date of contribution. Only the contributing partner would receive allocations of tax gain or loss unaccompanied by economic consequence under Section 704(b).
The Tax Reform Act of 1984 changed Section 704(c) from an elective provision to a mandatory one. Special allocations are now required when property is contributed to a partnership or LLC with a tax basis different from its fair market value.
Between 1993 and 1995, the IRS issued new regulations under Section 704(c)(1)(A).1 The regulations require partnerships and LLCs to take into account built-in gains and losses inherent in contributed properties when making allocations among partners or members. They allow partnerships or LLCs to allocate items of tax depreciation, depletion, gain, or loss with respect to contributed property using any reasonable method, as long as the method is consistently applied. The regulations further identify three reasonable methods: the “traditional” method, the traditional method with curative allocations, and the remedial allocations method. Note that the latter method replaces the deferred sale method originally countenanced by the proposed regulations. Other reasonable methods are presumably allowable, and a partnership or LLC may use different methods with respect to different properties, but once a method has been selected for a given property, it must be consistently applied.
KNOWLEDGE CHECK
2. Ellen contributed land with a tax basis of $23,000 and a fair market value of $35,000 to the Barking Dog Partnership. In return, she received a one-half interest in the partnership. The partnership agreement provides that all items of income, gain, loss, or deduction are to be allocated one-half to Ellen and one-half to her other partner. The partnership subsequently sold the land for $41,000, recognizing a taxable gain of $18,000 ($41,000 sales price less $23,000 tax basis). How much of this gain will be allocated to the other partner?
a. $0.
b. $3,000.
c. $6,000.
d. $9,000.
3. Clara contributed property with a tax basis of $150,000 and a fair market value of $230,000 to a newly-formed partnership in exchange for a one-fourth interest in partnership capital, profits, and losses. The partnership subsequently sold the property for $310,000, recognizing a $160,000 taxable gain. What portion of the gain will be reported to Clara on her Schedule K-1?
a. $40,000.
b. $80,000.
c. $100,000.
d. $160,000.
The Traditional Method
The traditional method sanctioned by the regulations corresponds with the method outlined in the regulations under Section 704(b). Those regulations require the special allocation of partnership or LLC tax items associated with contributed property on the occurrence of either of two events: (1) disposition by the entity of the contributed asset(s); or (2) depreciation, or other cost recovery, by the partnership or LLC of the tax basis of the contributed property.
ALLOCATIONS OF TAX GAIN OR LOSS
With regard to special allocations of gain or loss on the disposition of contributed property by a partnership or LLC, use of the traditional method is relatively straightforward. Any tax gain or loss recognized by the entity is first allocated to the contributing partner or LLC member to the extent of the remaining built-in gain or loss inherent in the property at the date of the sale. The remainder (equivalent to the Section 704(b) “book” gain on disposition of the property) is then allocated among all the partners or members, including the original contributor, in accordance with the partnership or LLC agreement.
Example 2-2
J contributed land to JD, Ltd., a limited liability company opting to be taxed as a partnership for federal income tax purposes. The tax basis of the land at the date of contribution was $15,000 and its fair market value was $20,000. D contributed $20,000 cash. The LLC agreement allocates all items of profit and loss equally between the partners. Two years later, the LLC sold the land contributed by J for $25,000, recognizing a tax gain of $10,000. Under Section 704(c), applying the traditional method, the first $5,000 of this gain (the built-in gain of $5,000, measured as the difference between the property's $15,000 tax basis and its $20,000 Section 704(b) “book” value) must be allocated to J. The remaining $5,000 gain is allocated equally between J and D under Section 704(b). Thus, the two investors will receive the following allocations of gain on sale of the property contributed by J:
| J | D | ||
| Section 704(c) gain (in other words, "built-in" gain) | $ |
$ 5,000 |
— |
| Remaining gain (equal to "book" gain) | 2,500 |
2,500 |
|
| Total gain reported to each member on K-1 | $ 7,500 |
$ 2,500 |
|
| Original basis in JD | 15,000 |
20,000 |
|
| Ending basis in JD | $ 22,500 |
$ 22,500 |
|
| Ending capital account (20,000 + 2,500) | $ 22,500 |
$ 22,500 |
As indicated above, the required Section 704(c) allocation will tend to make the tax basis capital account (that is, basis without the effect of partnership liabilities) closer in value to the Section 704(b) “book” capital account.
KNOWLEDGE CHECK
4. Q contributed land to the QL partnership with a tax basis of $350 and a fair market value of $500. L contributed $500 cash. The partnership agreement allocates all items of profit and loss equally between the partners. Two years after formation, the partnership sells the land contributed by Q for $700, recognizing a tax gain of $350. How much of this gain must be allocated to Q?
a. $150.
b. $175.
c. $250.
d. $350.
COST RECOVERY DEDUCTIONS
The allocation of tax depreciation and/or other cost recovery deductions using the traditional method is slightly more complex. With regard to these items, the Section 704(c) allocations are determined in two steps. First, to the extent possible, investors other than the contributor (that is, the non-contributing investors) are allocated tax deductions equal to their shares of the book depreciation (or other cost recovery deduction) with respect to the contributed property under Section 704(b). Any remaining tax deduction is then allocated to the contributing investor.
Example 2-3
A, B, and C form the ABC partnership with contributions as follows. A contributes depreciable personal property with a basis of $33 and a fair market value of $45. The property is subject to a $15 debt. B and C each contribute $30 cash. The partnership agreement provides that all items of partnership gain, loss, income, and deduction will be shared equally by the three partners. The property has a remaining depreciable life of 3 years and is depreciated using the straight-line method.
Depreciation expense in the partnership's first year of operations will be $15 for book and $11 for tax. It will be allocated among the partners as follows:
| A | B | C | ||||
| Book | Tax | Book | Tax | Book | Tax | |
| Year 1: | ||||||
| Book depreciation | $ 5 |
$ 5 |
$ 5 |
|||
| Tax depreciation | $1 |
$ 5 |
$ 5 |
|||
| Year 2: | ||||||
| Book depreciation | $ 5 |
$ 5 |
$ 5 |
|||
| Tax depreciation | $1 |
$ 5 |
$ 5 |
|||
| Year 3: | ||||||
| Book depreciation | $ 5 |
$ 5 |
$ 5 |
|||
| Tax depreciation | $1 |
$ 5 |
$ 5 |
|||
| Total allocations | $15 |
$3 |
$15 |
$15 |
$15 |
$15 |
Under Section 704(b), each partner will be allocated $5 of book depreciation. Under Section 704(c), the non-contributing partners (B and C), will be allocated $5 tax depreciation, the same amounts as they are allocated for book purposes. The remaining tax depreciation of $1 will be allocated to A. Thus, A alone bears the tax burden associated with the $12 gain inherent in the property at the date of contribution. Over the remaining 3-year depreciable life of the asset, A will recognize the entire $12 tax gain in the form of reduced deductions for tax depreciation.
KNOWLEDGE CHECK
5. X, Y, and Z form the XYZ partnership with the following contributions. X contributes depreciable personal property with a basis of $90 and a fair market value of $108. The property is subject to a $48 debt. Y and Z each contribute $60 cash. The partnership agreement provides that all items of partnership gain, loss, income, and deduction will be shared equally by the three partners. The property has current tax and book depreciation of $30 and $36, respectively. How much tax depreciation will be allocated to X in the year of formation?
a. $12.
b. $10.
c. $6.
d. $16.
Tax Planning Point—Relationship between Sections 704(b) and 704(c): As is apparent in the above examples, the application of Section 704(c) is heavily dependent on the allocations prescribed in Section 704(b). Under Section 704(c), the tax allocations to non-contributing partners or members follow the book allocations to those partners or members under Section 704(b). As a result, some observers maintain that partnerships or LLCs that want to avoid the provisions of Section 704(c) can sometimes do so by making special allocations of depreciation or other cost recovery deductions under Section 704(b).
Example 2-4
Assume the same facts as example 2-2. A, B, and C form partnership ABC, with A contributing depreciable property and B and C each contributing cash. In this case, however, assume that the partnership agreement allocates the first two years' depreciation expense entirely to Β and C, with the third year's depreciation expense allocable entirely to A. Further assume that these allocations have substantial economic effect.2 Over the three-year period, the partners would now receive allocations as follows:
| A | B | C | ||||
| Book | Tax | Book | Tax | Book | Tax | |
| Year 1: | ||||||
| Book depreciation | $— |
$7.5 |
$7.5 |
|||
| Tax depreciation | $— |
$5.5 |
$5.5 |
|||
| Year 2: | ||||||
| Book depreciation | $— |
$7.5 |
$7.5 |
|||
| Tax depreciation | $— |
$5.5 |
$5.5 |
|||
| Year 3: | ||||||
| Book depreciation | $15 |
$— |
$— |
|||
| Tax depreciation | $11 |
$— |
$— |
|||
| Total allocations | $15 |
$11 |
$15 |
$11 |
$15 |
$11 |
Because B and C are allocated all the book depreciation in years 1 and 2, they receive all the tax depreciation that year also. Moreover, because neither of them is the contributing partner with respect to the depreciable property, no special allocation of tax depreciation is available under Section 704(c) for those years. In year 3, A is allocated all the partnership's depreciation expense for book, and thus will be allocated all $11 tax depreciation in that year as well. As a result, over the three-year period constituting the asset's remaining depreciable life, each partner will be allocated 1/3 of the total tax depreciation taken by the partnership. Even though A was the contributing partner with respect to the depreciable asset, the built-in gain with respect to that asset is not subjected to the provisions of Section 704(c). If this is allowed, the special allocation under Section 704(b) has effectively allowed A to avoid the limitations of Section 704(c).
KNOWLEDGE CHECK
6. A, B, and C form the ABC partnership with the following contributions. A contributes depreciable personal property with a basis of $54,000 and a fair market value of $72,000. B and C each contribute $72,000 cash. The partnership agreement provides that all items of partnership gain, loss, income, and deduction will be shared equally by the three partners. The property contributed by A has total current book and tax depreciation of $24,000 and $18,000, respectively. The partnership opts to use the traditional method to make allocations under Section 704(c). How much depreciation expense will be allocated to partner A for tax purposes in the partnership's first year of operations?
a. $0.
b. $8,000.
c. $6,000.
d. $2,000.
7. Ann contributed five-year depreciable property to the AB partnership with a basis of $54,000 and a fair market value of $162,000. The property, which has been depreciated using the straight-line method, has current tax and book depreciation of $18,000 and $54,000. The partnership agreement allocates all items equally between Ann and the other partner. The partnership uses the traditional method to make tax allocations under Section 704(c). How much tax depreciation will be allocated to Ann in the partnership's first year of operations?
a. ($9,000) negative share of depreciation.
b. $0.
c. $9,000 positive share of depreciation.
d. $27,000 positive share of depreciation.
DEPRECIATION METHODS
In order to ensure that partnerships or LLCs do not attempt to avoid Section 704(c) by choosing different accounting methods or different useful lives for book and tax, the regulations under Section 704(b) require that book depreciation and other cost recovery deductions be calculated at the same rate used in the tax computations of those items.3 Thus, where a depreciable asset has three years remaining in its depreciable life for tax purposes, it must be depreciated over three years for book purposes as well. Furthermore, if the percentage rate at which tax depreciation is calculated differs for one or more of the asset's remaining depreciable years, this difference must be reflected in the Section 704(b) depreciation computation as well.
Example 2-5
A contributes five-year depreciable property to a limited liability partnership in January, year three. The property was purchased in January, year one for $20,000. Its value at the date of contribution is $15,000. Its remaining tax basis is $9,600 ($20,000 original cost – $4,000 depreciation in year one -$6,400 depreciation in year two). The property will be depreciated over another four years for tax purposes (remaining three-year useful life + ½ year depreciation in sixth year). Tax depreciation in the partnership's first taxable year will be $3,840 ($20,000 × 19.20 percent).
Thus, book depreciation under Section 704(b) will be $6,000 ([3,840/9,600] × 15,000). In the partnership's second year, tax depreciation will be $2,304 ($20,000 × 11.52 percent). Section 704(b) book depreciation will be $3,600 ([2,304/9,600] × 15,000).
KNOWLEDGE CHECK
8. Kim contributed five-year depreciable property to a partnership in January, Y3. The property was purchased in January, Y1 for $80,000. Its value at the date of contribution was $60,000. Its remaining tax basis was $38,400 ($80,000 original cost – $16,000 depreciation in year 1 – $25,600 year 2 depreciation). Tax depreciation in year 3 will be $15,360. How much book depreciation will the partnership record under Section 704(b) for Y3, the year of contribution to the partnership?
a. $15,360.
b. $20,000.
c. $24,000.
d. $32,000.
ANTI-ABUSE PROVISION
The regulations impose an additional barrier to manipulation, adopting an anti-abuse rule under which an allocation method is not reasonable if the contribution of property and the allocation of tax items are made “in a manner that substantially reduces the present value of the partners' aggregate tax liability.”4 The regulations make clear that the traditional method cannot be used if it violates this anti-abuse provision.5 Thus, it is not clear how much room is available for avoiding one's Section 704(c) gains (or losses) via special allocations of book items under Section 704(b).
THE CEILING RULE
The regulations retain the ceiling rule of old Regulations Section 1.704-1(c).6 Under the ceiling rule, special allocations of tax depreciation, depletion, gain, or loss cannot exceed the actual amounts of those items recognized by the partnership or LLC. The ceiling rule will generally come into play when a contributing partner's percent ownership is less than the percent the contributed property has appreciated. Thus, where a 50 percent partner or LLC member contributes depreciable property to the partnership or LLC with a basis less than half its fair market value, special allocations of depreciation under Section 704(c) will not be sufficient to prevent the shifting of at least some of the pre-contribution gain to the other partners or members. This shifting will occur in the form of reduced depreciation deductions because under the ceiling rule depreciation can be allocated to partners or LLC members only to the extent of the total amount allowed at the partnership or LLC level.
Example 2-6
A contributes 5-year depreciable property to AB, Ltd., a limited liability company choosing to be taxed as a partnership for federal income tax purposes. The property contributed by A has a tax basis of $9,000 and a fair market value of $27,000. The property, which has been depreciated using the straight-line method, has a remaining depreciable life of 3 years. The LLC agreement allocates all items equally among the members.
For each of the next three years, Section 704(b) book depreciation for the contributed property will be $9,000, of which $4,500 will be allocated to A and $4,500 to B. Tax depreciation each year will total only $3,000, however. Although this is all allocated to B under Section 704(c), it is not enough to match the decrease in his capital account. Thus, A is shifting $1,500 of the built-in gain in the contributed property to B each year. This shift cannot be prevented. Even upon the sale of the asset at the end of its depreciable life, Section 704(c) will provide no further relief to B because the remaining book-tax disparity with respect to the contributed property is zero. (Being fully depreciated, the property has both a book value and tax basis of zero.)
Similarly, tax gain or loss can be specially allocated among the partners only to the extent of the actual amount realized by the partnership. As a result, post-contribution depreciation in the value of a contributed asset will allow the contributor to shift some of the built-in gain at the date of contribution to his partners who will not be allowed to deduct the economic losses they have realized since the date of contribution.
Example 2-7
G contributes land with a tax basis of $50,000, and a fair market value of $90,000, to the GH limited partnership. H contributes $90,000 cash. The partners agree to share all items of partnership gain and loss equally. If the property contributed by G is subsequently sold for $75,000, the partnership realizes a ($15,000) economic (and book) loss, of which ($7,500) is attributable to H. H is not allowed to deduct this loss, however, because for tax purposes, the partnership realizes a $25,000 gain. This gain will be allocated entirely to G under Section 704(c), but this allocation does not prevent G from shifting $7,500 of the pre-contribution built-in gain to H.
KNOWLEDGE CHECK
9. A contributes five-year depreciable property to the AB partnership in exchange for a 50 percent interest therein. The property has a basis of $27,000 and a fair market value of $81,000. The property has current tax and book depreciation of $9,000 and $27,000, respectively. B contributed cash for the remaining 50 percent interest. The partnership agreement allocates all items equally among the partners. The partnership uses the traditional method to make tax allocations under Section 704(c). How much tax depreciation will be allocated to A in the partnership's first year of operations?
a. $0.
b. $4,500.
c. $9,000.
d. $13,500.
10. M contributes land with a tax basis of $150,000, and a fair market value of $190,000, to the MP partnership. P contributes $190,000 cash. The partners agree to share all items of partnership gain and loss equally. The property contributed by M is subsequently sold for $165,000. How much gain will P be allocated for tax purposes from the sale? Assume the partnership uses the traditional method to make allocations under Section 704(c).
a. $0.
b. $7,500.
c. $15,000.
d. $40,000.
NONTAXABLE DISPOSITIONS
When a partnership or LLC disposes of Section 704(c) property in a nontaxable exchange (for example, a like-kind exchange under Section 1031, contribution to a corporation under Section 351, and the like), the disposition does not trigger recognition of built-in gain or loss under Section 704(c) using the traditional method. Property received in the exchange, however, becomes Section 704(c) property so that any built-in gain or loss will be subject to Section 704(c) when it is subsequently sold (or otherwise disposed of). Also note that any gain or loss recognized on the exchange itself (that is, upon receipt of boot) is subject to Section 704(c) to the extent of the built-in gain or loss inherent in the property at the date of the exchange.7
Example 2-8
A transfers land with a tax basis of $40,000 to the AB limited liability company in exchange for a 50 percent interest therein. At the date of the contribution, the FMV of the land is $75,000. B transfers $75,000 cash. The LLC opts to use the traditional method to allocate gains and losses under Section 704(c). Two years later, AB exchanges the land for like-kind property with a fair market value of $75,000. No boot is received in the exchange and AB recognizes no gain. Thus, A (the contributor-member) will not recognize any gain under Section 704(c) on the exchange. The “new” property, however, retains the Section 704(c) “taint,” so that when it is sold in a taxable transaction, the first $35,000 of gain recognized must be allocated entirely to A under Section 704(c).
Example 2-9
Assume the same facts as in example 2-8, except that AB exchanged the property contributed by A for like-kind property worth $55,000, and $20,000 cash. Under Section 1031, AB must recognize a $20,000 gain on the exchange (because it received $20,000 boot), and will take a $40,000 basis in the like-kind property received. This $20,000 gain is allocable entirely to A pursuant to Section 704(c). Moreover, the like-kind property received is again treated as Section 704(c) property, but the built-in gain in such property is reduced to $15,000 (FMV of $55,000 less $40,000 basis). Thus, a subsequent sale of the substitute property for $60,000 would result in a $20,000 gain to AB, of which $17,500 would be allocated to A (first $15,000 plus half of remaining $5,000) and $2,500 to B.
The Traditional Method With Curative Allocations
The second reasonable method sanctioned by the regulations is the traditional method described above, with curative allocations to alleviate distortions caused by the ceiling rule. Curative allocations, first sanctioned in the Committee Reports accompanying the 1984 amendment of Section 704(c), use special allocations of other items of income or loss to make up for any distortions caused by the ceiling rule. Thus, where the ceiling rule limits the allocation of depreciation or depletion from one property to noncontributing partners or members, this limitation can be avoided by specially allocating depreciation or depletion from another property to those non-contributors to the extent of the shortfall. Similarly, where a post-contribution change in the value of contributed property leads to ceiling rule limitations on the allocation of tax gain or loss from the sale of such property, other partnership or LLC gain or loss can be specially allocated to cure the ceiling rule distortion. These curative allocations equalize the book and tax allocations to the noncontributing partners or members, thereby preventing the contributor(s) from shifting built-in gain or loss to non-contributors.
Example 2-10
A and B form the AB partnership with the following contributions.
A contributes 5-year property (P1) valued at $15,000, with a tax basis of $5,000. The property has a two-year remaining depreciable life.
B contributes 5-year property (P2) with a tax basis of $12,000, and a fair market value of $15,000. The property has three years remaining in its depreciable life. Both properties are depreciated using the straight-line method.
The ceiling rule applies here, and will prevent B from being allocated her full share of depreciation with respect to property 1 (contributed by A). Depreciation allocations to the two partners will be as follows:
| A | B | |||
| Book | Tax | Book | Tax | |
| Depreciation, property 1 | $ 3,750 |
$ — |
$ 3,750 |
$ 2,500 |
| Depreciation, property 2 | 2,500 |
2,500 |
2,500 |
1,500 |
| Total, w/out curative allocations | $ 6,250 |
$ 2,500 |
$ 6,250 |
$ 4,000 |
Book depreciation on P1, $7,500, is allocated equally between the two partners under Section 704(b). Using the traditional method to make allocations under Section 704(c), tax depreciation is allocated first to B, the non-contributor, to the extent of her share of book depreciation, or $3,750.
The ceiling rule, however, allows only $2,500 tax depreciation to be allocated to B with respect to P1 (because there is only $2,500 tax depreciation from this property). Thus, using the traditional method, the ceiling rule causes B to recognize, indirectly, $1,250 of the built-in gain inherent in the property contributed by A. If the partnership opts to use curative allocations, this distortion could be cured by re-allocating $1,250 depreciation on P2 away from A and over to B. Thus, total allocations would be as follows:
| A | B | |||
| Book | Tax | Book | Tax | |
| Depr, P1: book | $ 3,750 |
$ 3,750 |
||
| Depr, P1: tax | $ — |
$ 2,500 |
||
| Depr, P2: book | 2,500 |
2,500 |
||
| Depr, P2: tax | 2,500 |
1,500 |
||
| Curative Allocation: | ||||
| Depr, P2 | — |
(1,250) |
1,250 |
|
| Total depreciation | $ 6,250 |
$ 1,250 |
$ 6,250 |
$ 5,250 |
Note that the difference between book and tax depreciation for A is $5,000, or one-half the built-in gain inherent in property 1 at the date of contribution. Effectively, the built-in gain in this property is being amortized over the two years remaining in its useful life. Similarly, the difference between book and tax depreciation for partner B is $1,000, or one-third of the built-in gain inherent in property 2, which has three years remaining of its depreciable life.
Of course, for curative allocations to be effective, the partnership must have sufficient amounts of other income or deductions to cure the ceiling rule distortions. The regulations allow ceiling rule limitations on depreciation allocations to be cured with special allocations of items other than depreciation.8 For example, a ceiling rule limitation of depreciation allocated to a noncontributing partner or member can be cured by allocating additional interest expense to such partner or member (and away from the contributor), or by allocating ordinary income away from the noncontributing partner or member (and to the contributor). Either of the above special allocations will correct the ceiling rule distortion.
The only case in which curative allocations will not be sufficient to cure ceiling rule distortions is when the partnership or LLC has insufficient amounts of other income or deductions of the same character to fully cure the ceiling rule distortion. The regulations clearly prohibit using tax items that would have a different tax effect to the partners to cure ceiling rule distortions. The regulations do provide, however, that shortages in one tax year can be corrected with curative allocations in a subsequent year.9 The regulations indicate that the correction should be made within a reasonable time, such as over the economic life of the property.
Example 2-11
X is a member of the XY limited liability company. In year 1, X's share of book depreciation on a property contributed by Y (the other member of the LLC) exceeded her share of tax depreciation due to the ceiling rule. The LLC had no other depreciable property. Its only other items of taxable income or deduction consisted of a long-term capital gain and a small amount of foreign source income. Because neither of these items have the same tax character as depreciation, X's ceiling rule distortion cannot be cured in year 1. X may, however, be entitled to a special allocation of domestic ordinary income (a negative allocation) or additional depreciation deductions, and the like, in year 2 to cure the ceiling rule distortion caused in year 1.
The Remedial Allocations Method
The third reasonable method of making Section 704(c) allocations that is countenanced by the regulations is the remedial allocations method. The remedial allocations method is designed to allow the partnership or LLC to eliminate ceiling rule distortions by creating remedial accounts, and allocating the amounts in these accounts to the partners or members affected by the ceiling rule. In essence, the entity creates two offsetting remedial accounts—one an expense (or loss) account, and the other an income (or gain) account. Because these two accounts offset one another, they have no effect on the entity's net taxable income or loss, though they do affect the allocation of taxable income or loss among the partners or members.
MECHANICS
The remedial allocations method is really quite simple. Just as under the traditional method, the partnership or LLC computes book depreciation, depletion, gain, or loss with regard to contributed property and allocates these amounts among the partners or members in accordance with the partnership or LLC agreement. Tax depreciation, depletion, gain, or loss with respect to a particular piece of property is then allocated to non-contributors in an amount equal to their book allocations of these items. Any remaining balance, after allocation to the non-contributors, is then allocated to the contributing partner or member.
If there is insufficient amount of tax depreciation, depletion, gain, or loss to support the allocations to the non-contributors, the ceiling rule applies, creating book-tax distortions in the capital balances for these partners or members. Under the remedial allocations method, these distortions are eliminated by creating a remedial account (for example, a remedial depreciation account) in the amount of the deficiency, and allocating the balance in this account to the non-contributors.10 In effect, the ceiling rule limitation is simply ignored.
To offset the above “remedial” account, a second account is created in a like amount for the contributing partner or member. Where the first remedial account had a debit balance (for example, depreciation expense), the offsetting account must have a credit balance (for example, ordinary income). The balance in this account is allocated entirely to the contributor, thus shifting the entire burden of the pre-contribution built-in gain (or loss) with respect to the contributed property onto the shoulders of the contributor-partner(s) or member(s).
Example 2-12
A contributes depreciable property to the AB limited partnership with a tax basis of $3,000, and a fair market value of $10,000. B contributes $10,000 cash. Assume that book depreciation for the partnership's first year of operations with respect to the property contributed by A is $5,000, and that this depreciation is allocable 50 percent to each partner. Tax depreciation with respect to this property is $1,500. Finally, assume the partnership breaks even before depreciation expense.
Under Section 704(c), the first $2,500 of tax depreciation must be allocated to partner B, with any remainder allocable to A. Applying the ceiling rule, however, B can only be allocated $1,500 of tax depreciation, creating a $1,000 book-tax disparity in B's capital account.
Under the remedial allocations method, this ceiling rule distortion can be eliminated by creating $1,000 in “remedial” depreciation expense, allocable to B, and offsetting this allocation by creating $1,000 “remedial” income to be allocated to A. The effects on the partners' capital accounts would be as follows:
| A | B | |||
| Book | Tax | Book | Tax | |
| Initial contribution | $ 10,000 |
$ 3,000 |
$ 10,000 |
$ 10,000 |
| Depreciation | (2,500) |
— |
(2,500) |
(1,500) |
| Remedial depreciation | (1,000) |
|||
| Remedial income | 1,000 |
|||
| Ending balances | $ 7,500 |
$ 4,000 |
$ 7,500 |
$ 7,500 |
The only restriction the regulations place on the creation of these remedial accounts is that they be the same in character.11 Thus, where the first remedial account is depreciation expense, as in the example above, the offsetting account must be ordinary income. Note that the regulations do not require that the partnership or LLC wait to make the offsetting allocation until sufficient income or deductions of the same character occur. For example, the $1,000 of “remedial income” allocated to A in the above example could be negative depreciation. Moreover, if the depreciable property is used in a partnership rental activity, the offsetting allocation to the contributor-partner must be ordinary income from that rental activity. Where the initial remedial account creates loss from the disposition of the contributed property, the offsetting account must be characterized as gain from the sale of that property.
Example 2-13
N and P form a limited liability company, NP. N contributes property with a tax basis of $3,000 and a fair market value of $10,000 in exchange for her one-half interest in the LLC. P contributes $10,000 cash. At the end of NP's first year of operations, it sells the property contributed by Ν to an unrelated buyer for $2,000. It has zero net taxable income before considering the loss on the sale. The LLC agreement allocates all items of income, deduction, gain, or loss equally between N and P.
Sale of the property triggers an ($8,000) book loss, which is allocated equally between the two investors. The tax loss, however, is only ($1,000) [$3,000 tax basis less $2,000 sales proceeds]. This loss is allocable entirely to P under Section 704(c). If the LLC uses the remedial allocations method, P will also be allocated an additional ($3,000) remedial loss on the sale, offset by a remedial allocation to N of $3,000 gain from the sale:
| N | P | Total | ||||
| Book | Tax | Book | Tax | Book | Tax | |
| Initial contribution | $ 10,000 |
$ 3,000 |
$ 10,000 |
$ 10,000 |
$ 20,000 |
$ 13,000 |
| Loss on sale | (4,000) |
— |
(4,000) |
(1,000) |
(8,000) |
(1,000) |
| Remedial loss | (3,000) |
(3,000) |
||||
| Remedial gain | 3,000 |
3,000 |
||||
| Ending balances | $ 6,000 |
$ 6,000 |
$ 6,000 |
$ 6,000 |
$ 12,000 |
$ 12,000 |
KNOWLEDGE CHECK
11. M contributes land with a tax basis of $150,000 and a fair market value of $190,000 to the MP Partnership. P contributes $190,000 cash. The partners agree to share all items of partnership gain and loss equally. The property contributed by M is subsequently sold for $165,000. How much gain or loss will P be allocated for tax purposes from the sale? Assume the partnership uses the remedial allocations method to make allocations under Section 704(c).
a. $0.
b. $7,500.
c. ($12,500) loss.
d. $15,000.
COMPUTATION OF BOOK ITEMS
The regulations contain a minor departure from the principles of Section 704(b) concerning the computation of book depreciation and depletion with respect to contributed property. Solely for purposes of determining the amounts involved in remedial allocations, the regulations require that book depreciation and depletion be computed as if the contributed property consisted of two assets. To the extent of the tax basis of the property, book depreciation or depletion is computed over the remaining depreciable life of the property (for tax purposes) at the same rates used for tax purposes. Thus, book depreciation will equal tax depreciation for this portion of the asset. Any excess of the book value (fair market value) of the contributed property over its tax basis will be treated as a new asset acquisition for purposes of computing book depreciation or depletion.12
Example 2-14
L and M formed the equal LLC LM, making the following contributions. L contributed depreciable property with a tax basis of $6,000 and a fair market value of $15,000. M contributed $15,000 cash. The property contributed by L has four years remaining in its depreciable life. Under current rules, it is classified as 10-year property. The LLC, like L, opts to use the straight-line method to compute depreciation. For sake of simplicity, the first-year conventions of Section 168 are ignored in the following computations.
Book depreciation of the property contributed by L will be $2,400 for each of the LLC's first four years of operations [($6,000 ÷ 4) + ($9,000 ÷ 10)]. With regard to the first $6,000 book value of this property, book depreciation will equal tax depreciation [straight-line over remaining 4-year useful life]. The remaining $9,000 book value will be recovered using the straight-line method over the 10-year depreciable life of a new asset from this class. Thus, in years one through four, the LLC will make no remedial allocations because tax depreciation will be sufficient to cover M's share of the entity's book depreciation:
| L | M | |||
| Book | Tax | Book | Tax | |
| Initial contribution | $ 15,000 |
$ 6,000 |
$ 15,000 |
$ 15,000 |
| Depreciation, Y1-Y4 | (4,800) |
(1,200) |
(4,800) |
(4,800) |
| Ending balances | $ 10,200 |
$ 4,800 |
$ 10,200 |
$ 10,200 |
Beginning in year five, however, remedial allocations of $450 of tax depreciation must be made to M (offset by remedial allocations of $450 ordinary income to L):
| L | M | |||
Book |
Tax |
Book |
Tax |
|
| Balance, beg. Y5 | $ 10,200 |
$ 4,800 |
$ 10,200 |
$ 10,200 |
| Depreciation | (450) |
— |
(450) |
— |
| Remedial depreciation | (450) |
|||
| Remedial income | 450 |
|||
| Ending balances | $ 9,750 |
$ 5,250 |
$ 9,750 |
$ 9,750 |
These remedial allocations will continue over the remaining 6-year life of the property (years 5-10), so that at the end of year 10, the book and tax capital accounts of both members will be equal. In effect the LLC will have amortized L's $9,000 built-in gain over the 10-year useful life of the property she contributed. As is clear from an analysis of the above capital accounts, L recognizes $900 more income (less loss) from the LLC than M in each of the entity's first 10 years of operations.
Special Rules
SECTION 704(B) REVALUATIONS
The regulations require that the principles of Section 704(c) be applied when partnerships or LLCs revalue property under Regulations Section 1.704-1(b)(2)(iv)(f).13 Under this provision, partnerships and LLCs are allowed to revalue all entity assets at fair market value upon the admission of a new partner or member, the liquidation of all or part of an existing partner's or member's interest, or in connection with the grant of a partnership interest after May 5, 2004, in exchange for services to the partnership.14 In such cases, all partners or members whose Section 704(b) capital accounts are altered are treated as contributors from that point on,15 and future tax allocations must reflect the differences between the book and tax values of partnership or LLC assets resulting from the revaluation.
Example 2-15
A and B are equal partners in the AB partnership. On January 1, the partnership had the following balance sheets:
| Book and Tax | ||
| Basis | FMV | |
| Land | $ 500,000 |
$ 800,000 |
| Capital, A | $ 250,000 |
$ 400,000 |
| Capital, B | 250,000 |
400,000 |
$ 500,000 |
$ 800,000 |
|
At that date, the partnership admits new partner C as a one-third partner in exchange for a $400,000 cash contribution. To ensure that the partners' book capital accounts reflect the true sharing arrangements between the partners, the partnership elects to “book up” its sole asset (land) to its fair market value of $800,000 at the date of C's admission.
This revaluation causes A's and B's book capital accounts to be increased to $400,000 each, so that the new partnership balance sheets are as follows:
| Tax Basis | Book Value | |
| Cash | $ 400,000 |
$ 400,000 |
| Land | 500,000 |
800,000 |
$ 900,000 |
$ 1,200,000 |
|
| Capital, A | $ 250,000 |
$ 400,000 |
| Capital, B | 250,000 |
400,000 |
| Capital, C | 400,000 |
400,000 |
$ 900,000 |
$ 1,200,000 |
For purposes of Section 704(c), the land is now treated as contributed property (contributed by partners A and Β to “new” partnership ABC).16 Accordingly, upon a subsequent sale of the property for $950,000, partners A and B will each be required to recognize their $150,000 shares of the built-in gain inherent in the property before C's admission to the partnership, plus their one-third shares ($50,000) of the post-admission gain.
SMALL DISPARITIES
The regulations allow partnerships and LLCs to ignore Section 704(c) when the disparity between the book and tax values of contributed property is less than 15 percent of the adjusted basis of such property.17 In order for this exception to apply, the aggregate disparity between book and tax basis for all properties contributed by a contributor-partner or member during the same tax year cannot exceed $20,000. Alternatively, the partnership or LLC can elect to apply Section 704(c), but only upon disposition of the property (that is, it can choose to defer special allocations until it sells or exchanges the contributed property).
AGGREGATION OF PROPERTIES
An additional simplification provision allows a partnership or LLC to aggregate all properties contributed by an individual partner or member that are included in the same general asset account for depreciation purposes, and treat them as a single asset when making Section 704(c) allocations. This aggregation provision does not apply to real estate.18
TIERED PARTNERSHIPS
Finally, the regulations provide that tiered partnerships cannot be used to avoid the requirements of Section 704(c). Where one partnership or LLC contributes Section 704(c) property to a lower tier entity, it must allocate its distributive share of depreciation, gain, loss, and the like, allocated from that entity with respect to that property in such a way as to take into account the original contributor's built-in gain or loss.19
Summary
The regulations under Section 704(c) provide substantial guidance with respect to special allocations of gains and losses, including cost recovery deductions recognized on items of contributed property. In general, the regulations are quite favorable to taxpayers. Not only do they allow the use of any reasonable method of making such allocations, they also allow the use of different methods by the same partnership or LLC for different properties. The only restriction is that partnerships or LLCs are not allowed to use methods expressly designed to reduce the aggregate tax liabilities of their partners or members.