704(c) Allocation Methods -...

Partners Share For Contributed

Property

Chapter 8

704(c)Allocation Methods

Three Methods

• Traditional Method

• The Curative Method

• The Remedial Method

8-4

Example 1(not in Text)

704(c)Traditional

Method

ABC Partnership

AliceBill

Blackacre FMV $1,000,000Adj. Basis: $100,000

30%50%

Carol$600,000

$400,000

20%

Assets:704(b)

Book BasisCash $1,000,000Blackacre $1,000,000

Total $2,000,000Capital:

Alice 50% $1,000,000Bill 30% $600,000Carol 20% $400,000

Debt + Capital $2,000,000

Balance Sheet After Formation

Assets: Tax Basis704(b)

Book BasisCash $1,000,000 $1,000,000Blackacre $100,000 $1,000,000

Total $1,100,000 $2,000,000Capital:

Alice 50% $100,000 $1,000,000Bill 30% $600,000 $600,000Carol 20% 400,000 400,000

Debt + Capital $1,100,000 $2,000,000

Balance Sheet After Formation

Blackacre(an ordinary asset)

declines in value and is sold by ABCfor $800,000

at the end of Year 1

No other income or loss in Year 1

<$200,000> Book Loss

($800,000 (sale price)-$1,000,000

(inside book basis))

Divided 50/30/20

Book Capital Accounts(In Thousands)

Alice(50%)

Bill(30%)

Carol(20%)

Beg. 1,000 600 400Loss on Sale -100 -60 -40

Balance 900 540 360

Economic loss to Partners: <$100,000> Alice< $60,000> Bill< $40,00O> Carol

$700,000 of ordinary tax

gain ($800,000 (Sales Price) - $100,000

(inside basis))

How is the tax gain allocated?• Traditional Method• Remedial Method• Traditional with

Curative Allocation

Traditional method of

allocating IRC sec. 704(c) gain

Tax Basis Capital Accounts(In Thousands)

Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700

Balance 800 600 400

Alice’s K-1

$700,000

Bill’s K-1

$0

Carol’s K-1

$0

Ceiling rule prevents Bill and

Carol from claiming ordinary

tax loss for economic loss.


Book BasisCash $1,800,000 $1,800,000

Capital:Alice 50% $800,000 $900,000Bill 30% $600,000 $540,000Carol 20% $400,000 $360,000

Debt + Capital $1,800,000 $1,800,000

Balance Sheet Following Sale

If, following the sale of Blackacre, the

partnership is liquidated

Do not liquidate in accordance with tax basis capital

accounts!!(Malpractice)


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700

Balance 800 600 400


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700

Balance 800 600 400Book Capital Accounts (Detail Below):

900 540 360

Liquidate in Accordance with

Book Capital Accounts

Per Partnership Agreement

The ultimate importance of

maintaining book basis capital

accounts


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 1,000 600 400Loss on Sale -100 -60 -40

Balance 900 540 360


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 1,000 600 400Loss on Sale -100 -60 -40

Balance 900 540 360LiquidatingDistribution

-900 -540 -360

End. Balance 0 0 0

Tax basis capital accounts and outside basis influence tax

consequences


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700

Balance 800 600 400


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700

Balance 800 600 400Liquidating Distribution

-900 -540 - 360


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700


-900 -540 - 360

End. Bal. -100 60 40

Tax consequence of liquidation (sec. 731):

$100,000 Alice Cap. Gain

<$60,000> Bill’s Cap. Loss<$40,000> Carol’s Cap. Loss

Resist adjusting ending tax basis

capital accounts to zero on K-1 on

liquidation.

Bill and Carol’s economic loss in the

year of sale was delayed and converted

to a capital loss

The traditional method clearly favored Alice

Example 2(not in text)

Same as Ex. 1 but use the RemedialMethod

Blackacre (ordinary asset) declines in value and

is sold by ABCfor $800,000

at the end of Year 1

No other income or loss in Year 1


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 1,000 600 400Loss on Sale -100 -60 -40

Balance 900 540 360


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700

Balance 800 600 400

Traditional Method


Book BasisCash $1,800,000 $1,800,000


Debt + Capital $1,800,000 $1,800,000

Balance Sheet Before Remedial Alloc.

With the traditional method the

disparity between tax and book

capital accounts is preserved

Remedial allocations:

1) Correct the disparity, and

2) Enable Bill and Carol (noncontributing partners) to claim ordinary tax loss on sale equal to economic loss.

Remedial Allocations following Blackacre sale:

$100,000 K-1 Alice’s Ord. Inc.

<$60,000> K-1 Bill’s Ord. Loss

<$40,000> K-1 Bill’s Ord. Loss


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700RemedialAllocation

100 -60 -40

Balance 900 540 360

The remedial allocations are not

shown in book capital accounts

(nothing to remedy)

The remedial method favors Bill

and Carol


Book BasisCash $1,800,000 $1,800,000


Debt + Capital $1,800,000 $1,800,000

Balance Sheet After Remedial Allocation

No tax consequences on

liquidation


Alice(50%)

Bill(30%)

Carol(20%)

Beg. 100 600 400Sale Gain 700RemedialAllocation

100 -60 -40


-900 -540 - 360

End. Bal. 0 0 0


Same as Ex. 2 but use Traditional

Method with Curative

Allocations (TMCA)

Blackacre (ordinary asset) declines in value and

is sold by ABCfor $800,000

at the end of Year 1But…

Assume an additional

ordinary income of $200,000 (and cash)

The traditional with curative

allocation also favors Bill and

Carol


Book BasisCash $2,000,000 $2,000,000

Capital:Alice 50% $900,000 $1,000,000Bill 30% $660,000 $600,000Carol 20% $440,000 $400,000

Debt + Capital $2,000,000 $2,000,000

Balance Sheet Following SaleBut Without Curative Allocation

Traditional with curative accomplishes

the same thing as remedial method but with other income or

deduction items

For tax purposes, allocate all

$200,000 of the additional ordinary

income to Alice.

(For Book purposes $100,000 to Alice)

No Change to Book Capital

Accounts


Book BasisCash $2,000,000 $2,000,000

Capital:Alice 50% $900,000 $1,000,000Bill 30% $660,000 $600,000Carol 20% $440,000 $400,000

Debt + Capital $2,000,000 $2,000,000

Traditional MethodBefore Curative Allocation


Book BasisCash

Capital:Alice $100,000Bill 60,000Carol 40,000

Debt + Capital

Curative Allocation of Ordinary Income for Tax Purposes

DebitCredit

Debit


Book BasisCash $2,000,000 $2,000,000

Capital:Alice 50% $1,000,000 $1,000,000Bill 30% $600,000 $600,000Carol 20% $400,000 $400,000

Debt + Capital $2,000,000 $2,000,000

Balance Sheet Following Curative Allocation


Reverse 704(c)

The BC Partnership has existed for decades and is a

real estate dealer.All assets were purchased by

BC.

Assets: Tax Basis

704(b)Book Basis

FMV OutsideBasis

Blackacre $100 $100 $1,000

Capital:Bill 60% $60 $60 $600 $60Carol 40% 40 40 $400 $40

Cap. $100 $100 $1,000

Current Balance Sheet Numbers are in Thousands

• Alice contributes $1,000,000 for a 50% interest in BC.

• Per the partnership agreement, book capital accounts are adjusted to reflect current FMV at the time Alice becomes a partner.

Events Warranting Revaluation:• Contribution of money,

property, or services as consideration for partnership interest.

• Distribution of money or property as consideration for partnership interest.

Reg. 1.704-1(b)2)(iv)(f)(5)(i) – (iii)

Assets: Tax Basis

704(b)Book Basis

CashBlackacre $900

TotalCapital:Alice 50%Bill 30% 540Carol 20% 360

Cap.

Revaluation of Book Basis

Debit

CreditCredit

Blackacre (land)--held for sale --

is sold for $1,000,000

Ordinary Gain $900,000(1,000,000 – 100,000)

No other income or loss.

IRC sec. 704(c), in reverse,

forces all $900K of the tax gain to Bill

and Carol

Zero Book Gain

Assets: Tax Basis

704(b)Book Basis

FMV OutsideBasis

Cash $2,000 $2,000 $2,000Capital:Alice 50% $1,000 $1,000 $1,000 $1,000Bill 30% $600 $600 $600 $600Carol 20% 400 400 $400 $400

Cap. $2,000 $2,000 $2,000

Balance Sheet After Sale Numbers are in Thousands


Blackacre is distributed to Alice

Sec. 704(c)(1)(B)?

Mixing Bowl Issue

Same as Ex. 4 but Blackacre is not sold.

Instead 3 years later, when still worth $1 mil.,

Blackacre is distributed to Alice in liquidation of her

interest

Assets: Tax Basis

704(b)Book Basis

FMV OutsideBasis

Blackacre $100 $100 $1,000


Cap. $100 $100 $1,000

Balance Sheet Before Alice Joins Numbers are in Thousands

• Alice contributes $1,000,000 for a 50% interest in BC.

• Book capital accounts are adjusted.

Assets: Tax Basis

704(b)Book Basis

FMV OutsideBasis

Cash $1,000 $1,000 $1,000Blackacre $100 $1,000 1,000

Total $1,100 $2,000 $2,000Capital:Alice 50% $1,000 $1,000 $1,000 $1,000Bill 30% $60 $600 $600 $60Carol 20% 40 400 $400 $40

Cap. $1,100 $2,000 $2,000

Before Liquidation of Alice Numbers are in Thousands

Does the distribution trigger gain to Bill and

Carol per section 704(c)(1)(B)?

No, sec. 704(c)(1)(B) does not apply to a reverse sec. 704(c)(gain)

Alice’s Basis in Blackacre is $1,000,000,

matching Alice’s O.B.

(partnership inside basis was $100,000)

Assume the partnership purchases

Whiteacre(held for sale)

for $1,000,000 with the money from Alice.

Even without a section 754 election, section 734

forces a partnership inside basis step-down of

$900,000 to Whiteacre(section 734(d)(1)

(Adj. exceeds $250,000)

Assets: Tax Basis

704(b)Book Basis

FMV OutsideBasis

Whiteacre $100 $1,000 1,000Total $100 $2,000 $2,000


Cap. $100 $2,000 $2,000

Balance Sheet After Numbers are in Thousands

Why wait three years before the liquidating distribution?

If distributed within 2 years, a presumed disguised sale

of Blackacre to Alice: Partnership recognizes gain

of $900,000

Would still need to be wary of

disguised sale treatment.

Traditional MethodWith Non-depreciable

Property

Example 8-1 FactsAdam contributes raw land:$50,000 FMV$10,000 Basis

Melvin contributes $50,000 cash.

8-3

Same as tax basis except for: FMV of contributed property

FMV of distributed property(adjust all partners’ book capital accounts as if the distributed property is first sold by the partnership)

Capital Accounts (“Book”)

84

Beginning Balance Sheet

ContributingPartner Adam

NoncontributingPartner Melvin

Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Partnership sells the land for $50,000

Sale for $50,000



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land Sale$50K

0 0

End. Bal. 50,000 50,000

Partnership Book Gain of $0

Sale for $50,000



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land Sale$50K

40,000 0 0 0

End Bal. 50,000 50,000 50,000 50,000

Partnership Tax Gain of $40,000

Ex. 8-1 Variation



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Partnership sells the land for $100,000

8-3

Sale for $100,000



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land Sale 25,000 25,000

End Bal. 75,000 75,000

Partnership Book Gain of $50,000

Sale for $100,000



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land Sale 65,000 25,000 25,000 25,000

End Bal. 75,000 75,000 75,000 75,000

Partnership Tax Gain of $90,000($100,000 - $10,000)

Three Methods

• Traditional Method

• The Curative Method

• The Remedial Method

8-4

The Ceiling Rule

The total income or loss allocated to the partners cannot exceed the partnership income or loss.

Ex. 8-2Sale for $30,000



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land Sale -10,000 -10,000

End Bal. 40,000 40,000

Partnership Book Loss of $20,000

8-4

Ex. 8-2Sale for $30,000



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land Sale 20,000 -10,000 0 -10,000

End Bal. 30,000 40,000 50,000 40,000

Partnership Tax Gain of $20,000($30,000 - $10,000)

The ceiling rule prevents Melvin from being allocated a <$10,000> tax loss to match his book loss

8-6Example 8-3(Continuation of 8-2)

• The Example 8-2 partnership makes an $80,000 liquidating distribution to Adam and Melvin ($40,000 each).

• Melvin recognizes his ($10,000) loss.

• Melvin’s $10,000 (50% x of ($20,000)) economic loss (book loss) on the land sale is preserved in his outside basis which reflects his unreduced $50,000.

Ex. 8-3Liquidation--$40K Each($80,000 total assets)

ContributingPartnerAdam

NoncontributingPartnerMelvin

Outside Basis $30,000 $50,000

Cash Distributed -$40,000 -$40,000

Sec. 731 Gain $10,000

Outside Basis $10,000

Sec. 731 Loss ($10,000)

8-5

The Curative MethodCurative allocations are allocations of other partnership tax items of income or loss , that “cure” the disparity caused by the ceiling rule.

May be mandated in the partnership agreement.

Ex. 8-4 -- Sale for $30K(Variation on Ex. 8-2)

8-7

• Assume that the partnership, in the same tax year as the land sale, incurred a ($20,000) capital loss on stock previously purchased by the partnership with the cash contributed by Melvin.

• Absent a curative allocation, the ($20,000) capital loss on the stock sale would be allocated 50/50 for book and tax purposes.

Ex. 8-4 -- Sale for $30KTraditional Method



Tax Book Tax Book

Initial Bal. 10,000 50,000 50,000 50,000

Land Sale 20,000 -10,000 0 -10,000

Balance 30,000 40,000 50,000 40,000

Stock Sale -10,000 -10,000 -10,000 -10,000

Balance 20,000 30,000 40,000 30,000

Ex. 8-4 -- Sale for $30K(Variation on Ex. 8-2)

8-7

Under the traditional method with curative allocation, the entire ($20,000) capital loss, for tax purposes, is allocated to Melvin (though split 50-50 for book purposes).

Ex. 8-4Trad. With Curative Method



Tax Book Tax Book

Initial Bal. 10,000 50,000 50,000 50,000

Land Sale 20,000 -10,000 0 -10,000

Balance $30,000 $40,000 $50,000 $40,000

Stock Sale Bk -10,000 -10,000

Stock Sale Tax

-20,000

Ending Bal. 30,000 30,000 30,000 30,000

The Remedial Method

Offsetting Allocations remedythe distortions caused by the ceiling rule.

May be mandated in the partnership agreement.

Ex. 8-5 -- Sale for $30K(Same facts as Ex. 8-2) 8-8

• In Example 8-2, Melvin has a ($10,000) book and economic loss, but with no accompanying tax loss under the traditional method (due to the ceiling rule).

• Under the remedial allocation method, the partnership makes a remedial allocation of tax loss of ($10,000) for Melvin and a tax gain of $10,000 for Adam.

Ex. 8-5 -- Sale for $30KRemedial Method



Tax Book Tax Book

Beg. Bal. 10,000 50,000 50,000 50,000

Land SaleTrad. Alloc.

20,000 -10,000 0 -10,000

Balance 30,000 40,000 50,000 40,000

Remedial Allocation

10,000 -10,000

End. Bal. 40,000 40,000 40,000 40,000

8-8

Reverse Sec. 704(c)Allocations

8-9

Reg. sec. 1.704-3(a)(6)(i):

“Revaluations under section 704(b). The principles of [reg. sec. 1.704-(3)] apply to allocations with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues partnership property pursuant to reg. sec. 1.704-1(b)(2)(iv)(f) (reverse section 704(c) allocations). …”

Contributions of property or services for a partnership interest.

Distributions in consideration for a partnership interest.

Optional Revaluation of AllCapital Accounts on All

Partnership Property

108

Example 8-6 FactsAdam and Melvin each contribute $60,000

The AM Partnership immediately purchases land for $120,000 cash.

8-9

Ex. 8-6

Adam Melvin Alice

Tax Book Tax Book Tax Book

Beg. 60,000 60,00060,000 60,000

Five years later, the land has appreciated to $180,000.

Alice contributes $90,000 for a one-third partnership interest.

Adam and Melvin’s capital accounts are optionally revalued (per agreement) to $90,000 each.

8-9Additional Facts

Alice Contributes $90,000Before Revaluation

Adam Melvin Alice


Beg. 60,000 60,00060,000 60,000

Alice’s$90K

90,000 90,000

Revaluation of Capital Accts

Adam Melvin Alice


Beg. 60,000 90,00060,000 90,000

Alice’s$90K

90,000 90,000

Land is sold for $180,000.

Partnership tax gain of $60,000 ($180,000 - $120,000)

How is the gain allocated?

Reverse IRC sec. 704(c), all to Adam and Melvin (50/50).

Sale of Land for $180,000

Adam Melvin Alice


Beg. 60,000 90,00060,000 90,000

Alice’s$90K

90,000 90,000

Sale Gain

$0 $0 $0

Bal. 90,000 90,000 90,000

Partnership Book Gain of $0


Adam Melvin Alice


Beg. 60,000 90,00060,000 90,000

Alice’s$90K

90,000 90,000

Sale Gain

30,000 $0 30,000 $0 $0

Bal. 90,000 90,00090,000 90,000 90,000 90,000

Reverse Sec. 704(c)

Partnership Tax Gain of $60,000

What if, after Alice joins, instead of a land sale, the land declines in value from 180K to $45K (tax basis is $120K) and is distributed to Adam in liquidation of his partnership interest.

No tax consequence to Adam, but his basis in the land is $60,000 (his outside basis).

Mandatory Book Cap Acct Adjustment for Distributed Land

Adam Melvin Alice


Beg. 60,000 90,00060,000 90,000 90,000 90,000RevalueLoss

-45,000 -45,000 -45,000

Bal. 60,000 45,000 60,000 45,000 90,000 45,000

Dist. -60,000 -45,000

Bal. 0 0

Book Loss of <$135,000> (45K – 180K)

If the partnership has an IRC sec. 754 election in effect, and

it continued, then the partnership would make a

$60,000 upward adjustment to partnership capital gain

property when it is acquired.

What if Melvin and Alice subsequently were liquidated for cash of $45K each?

Melvin AliceTax Book Tax Book

Beg. 60,000 90,000 90,000 90,000

RevalueLoss -45,000 -45,000

Bal. 60,000 45,000 90,000 45,000Dist. -45,000 -45,000-45,000 -45,000Bal. 15,000 $0 45,000 $0731(b) Cap.Loss

-15,000 -45,000

Melvin and Alice’s ending tax basis capital account

balances, if tax basis is used on the K-1, tips off the partner

that they have a loss on liquidation.

Ex. 8-7W/O Capital Account

Revaluation butWith Special

allocation of Built-in Gain

8-10

Ex. 8-7 8-10

Adam Melvin Alice


Beg. 60,000 60,000 60,000 60,000

Alice’s$90K

90,000 90,000

Sale Gain

30,000 30,000 30,000 30,000

Bal. 90,000 90,000 90,000 90,000 90,000 90,000

Meets Sec. 704(b)Per 704(b) Regs.


Ex. 8-8W/O Capital AccountRevaluation and W/Oa Special allocation of Built-in Gain to Adam

and Melvin

8-11

Ex. 8-: No Revaluation and No Special Allocation of Built-in Gain

8-11

• Same facts as Example 8-7, the partnership does NOT opt to revalue the capital accounts of the existing partners (Adam and Melvin), when Alice joins the partnership.

• Unlike Example 8-7, the partnership agreement is NOT modified to provide that the first $60,000 of taxable gain is allocated to Adam and Melvin. After Alice’s joins the partnership, all income, gains, losses, and deductions are allocated equally among Adam, Melvin, and Alice (1/3 each).

8-11

• When the land is sold for $180,000, the $60,000 ($180,000 - $120,000) tax and book gain is allocated equally to the three partners, $20,000 each.

• Does this allocation satisfy the IRC sec. 704(c) and IRC sec. 704(b)?


Adam Melvin Alice


Beg. 60,000 60,000 60,000 60,000

Alice’s$90K

90,000 90,000

Sale Gain

20,000 20,000 20,000

Bal. 80,000 80,000 110,000

Partnership Book Gain of $60,000


Adam Melvin Alice


Beg. 60,000 60,000 60,000 60,000

Alice’s$90K

90,000 90,000

Sale Gain

20,000 20,000 20,000 20,000 20,000 20,000

Bal. 80,000 80,000 80,000 80,000 110,000 110,000

Partnership Book/Tax Gain of $60,000

SEE if, per the partnership agreement, each partner gets his/her capital account balance on liquidation.

8-11

• With this deal, Adam and Melvin are shifting $20,000 of capital to Alice:

1) Is it a gift?2) Is it compensation for services?

8-11

But what if Alice is allocated $20,000 of income, but she is only entitled to $90,000 on liquidation?

The substantial economic effect (SEE) test in the IRC sec. 704(b) regulations is failed. The $20,000 is reallocated to Adam and Melvin per the PIP test.


Adam Melvin Alice


Beg. 60,000 60,000 60,000 60,000

Alice’s$90K

90,000 90,000

Sale Gain

20,000 20,000 20,000 20,000 20,000 20,000

Bal. 80,000 80,000 80,000 80,000 110,000 110,000

Partnership Book/Tax Gain of $60,000

No IRC sec. 704(b) SEE if each partner will get $90,000 on liquidation?

Example 8-9 Forward 704(c) w/o revaluation

Adam contributes raw land:$90,000 FMV$30,000 Basis

Melvin contributes $90,000 cash.

8-12

Five years later Alice contributes $90,000 for a one-third partnership interest.

Adam and Melvin’s capital accounts are not revalued.

The land is sold for $90,000

How is the gain of $60,000 allocated?

Adam Melvin Alice Tax Book Tax Book Tax Book

Beg. Cap. Accts. 30,000 90,000 90,000 90,000 Alice’s $90,000 Contribution

90,000 90,000

Sale for $180,000 60,000 0 0 0 0 0 Cap. Acct. Bal. 90,000 90,000 90,000 90,000 90,000 90,000

Allocation of all $60,000 to Adam is mandatory; this is forward IRC sec. 704(c) gain.

Traditional MethodWith Depreciable

Property

Example 8-12 FactsAssume that IRC Sec. 704(c) is not in the IRC. Al contributes equipment:$100 FMV$ 40 Basis

10 Year MACRS Property with 5 Years Remaining

Betty contributes $100

8-15

Ex. 8-12

Al Betty

Tax Book Tax Book

Capital Account 40 100 100 100

Ex. 8-12 First Year

Al Betty

Tax Book Tax Book


Depreciation Deduction -4 -10 -4 -10

Adjusted Cap. Accounts 36 90 96 90

Ignoring Sec. 704(c)

Betty gets $20 ($4 x 5 years) of total tax depreciation despite paying $50 for her share of the asset.

Ceiling RuleWith

DepreciableProperty

8-16

Ex. 8-13 Depreciation with Traditional Method 8-16

• Al contributes equipment with a FMV of $100 and an adjusted basis of $40.

• The equipment is 10-year depreciable property with a 5-year remaining life (straight-line for simplicity).

• Betty contributes $100 cash.

• Al and Betty are equal partners.

Ex. 8-13 8-16• The partnership’s book value in the equipment

equals the FMV of the property at contribution, $100.

• Under the traditional method, book depreciation is calculated using the same method as tax depreciation: 5 years straight-line, the remaining useful life of the asset.

• In Year 1, the equipment generates book depreciation of $20 and tax depreciation of $8.

• The partnership’s capital accounts are as follows:

Ex. 8-13 – Year 1

Al Betty

Tax Book Tax Book




Traditional Method 8-18

The ceiling rule prevents Betty from being allocated

any more than $8 of depreciation each year

Ex. 8-13 – After 5 Years

Al Betty

Tax Book Tax Book




Traditional Method

After 5 years, Betty gets $40 ($8 x 5 years) of total tax depreciation (ceiling rule) despite paying $50 for her share of the asset.

8-18

Example 8-14Curative Allocation 8-19

•Assume the same facts as in Example 8-13, except that the partnership has $4 of ordinary income to be allocated every year for five years (total $20).

8-18

• The partnership’s book value in the equipment equals the FMV of the property at contribution, $100.

• The partnership’s tax basis in the equipment equals the contributing partner’s tax basis at the time of contribution, $40.

• In Year 1, the equipment generates book depreciation of $20 and tax depreciation of $8.

8-18

• The partnership opts to cure the ceiling rule distortion, with the curative allocation method, by allocating the $4 of ordinary income to Al (the contributing partner), for tax purposes, despite the fact that the $4 will be divided equally between the partners for book purposes.

8-18

• The curative allocation of an extra $2 of taxable income (relative to Book) to Al causes the same result to Betty as an allocation of an extra $2 tax depreciation to her each year for five years.

Ex. 8-14Capital Acct for Five Years

Al Betty

Tax Book Tax Book

Yr. 1 Beg. Cap. Acct 40 100 100 100

Traditional Depreciation

0 -50 -40 -50

Balance 40 50 60 50

Curative Inc. Alloc. 20 10 0 10

End of Yr. 5 60 60 60 60

After five years, Betty gets $40 ($8 x 5 years) of total tax depreciation and $10 ($2 x 5) less taxable income thus curing the ceiling rule distortion.

8-18

•The answer would be the same if the asset (with the same depreciable basis) were a commercial building with five years remaining in its MACRS life.

Ex. 8-15Remedial Method

8-19

Example 8-15 FactsAl contributes equipment:

$100 FMV$ 20 Basis

10 Year MACRS Property with 5 Years Remaining

Betty contributes $100 8-20

Remedial Method Annual Depreciation for 1st Five Years

Equipment

Annual First 5 Years: Tax Book

Book = Tax ($20) over 5 years 4 4

Book > Tax ($80), over 10 years 0 8

Annual Depreciation First 5 Years 4 12

After five years, the book depreciation drops to $8 per year

and tax dep. drops to zero.

Remedial Method Book Depreciation Year One

Al Betty

Year 1: Tax Book Tax Book


Remedial Book Depreciation -6 -6

Traditional Tax Depreciation

Balance

Remedial Tax Allocation

Adjusted Capital Accounts 94 94

Remedial Method Tax Depreciation Year One

Al Betty

Year 1: Tax Book Tax Book


Remedial Book Depreciation -6 -6

Traditional Tax Depreciation -0 -4

Balance 20 96

Remedial Tax Allocation 2 -2

Adjusted Capital Accounts 22 94 94 94

First Five Year Totals

Al Betty

Tax Book Tax Book

Beg. Capital Account 20 100 100 100

Remedial Book Depreciation--$60 total

-30 -30


-0 -20

Balance 20 0 80 0


End of Yr. 5 Capital Accounts

30 70 70 70

Years 6 through 10Al Betty

Tax Book Tax Book

Yr. 6 Beg. Capital Account 30 70 70 70

Remedial Book Depreciation--$40 total

-20 -20


-0 -0

Balance 30 0 70 0


End of Yr. 10 Capital Accounts

50 50 50 50

After ten years, Betty is, in effect, allocated

$50 of total tax depreciation thus

remedying the ceiling rule distortion.

If you are Betty, which method

Traditional with Curative allocationsor

Remedial Allocation method

would you prefer?

Traditional with curative allocation cures

the distortion in five yearscompared to 10 years with

the remedial method

Traditional Method with Curative Allocation

Al Betty

Tax Book Tax Book

Beg. Capital Account 40 100 100 100

Traditional Depreciation

0 -50 -40 -50

Balance 40 50 60 50

Curative Inc. Alloc. 20 10 0 10

Adjusted Cap.Accounts

60 60 60 60

Note, if the asset were a commercial building (with 5 years MACRS

life remaining), it would take Betty 39 years to remedy the ceiling rule with the

remedial method.

Ex. 8-16

Sale ofDepreciable

Property

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Example 8-16 8-21

Example 8-16 FactsA contributes depreciable property:$10,000 FMV

$4,000 Basis(10 Year recovery period)B contributes:$10,000 cash.

8-21

Capital Accounts: A B

Tax Book Tax Book

Beg. Cap. Acct. 4,000 10,000 10,000 10,000

Year 1 Deprec. -0 -500 -400 -500

Balance 4,000 9,500 9,600 9,500

Tax Basis Book Basis

Sec. 704(c) Built-In

Gain

Property 4,000 10,000 $6,000

Year 1 Deprec. - 400 -1,000 -600

Adjusted Basis $3,600 9,000 $5,400

Traditional Method

Partnership sells the land for $9,000 at the beginning of Year 2.

Zero Book Gain or Loss ($9,000 - $9,000)

8-22

How is the tax gain of $5,400 ($9,000 - $3,600) allocated?

8-22

A’s Built In Tax Gain:

6,000 Beg.

- 600 Year 1

= 5,400 Year End

8-22

Beginning Of Year 2:

Sell for the proprety for $9,000:A B

Tax Book Tax Book

Yr. 2 Bal. 4,000 9,500 9,600 9,500

Sale Gain 5,400 0 0

Balance 9,400 9,500 9,600 9,500

Tax Basis Book Basis

Sec. 704(c) Built-In

Gain

Property 4,000 10,000 $6,000

Year 1 Deprec. - 400 -1,000 -600

Adjusted Basis $3,600 9,000 $5,400

Partnership sells the land for $10,000 at the beginning of Year 2.

How is the tax gain of $6,400 ($10,000 - $3,600) allocated?

Traditional Method

How much of $6,400 to A?$5,400 + 500 (50% x 1,000)

Sell for $10,000 at Beg. of Yr. 2 (Traditional Method)

Capital Accounts: A B

Tax Book Tax Book

Yr. 1 Beg. Cap. Acct.

4,000 10,000 10,000 10,000

Yr 1 Loss. -0 -500 -400 -500

Yr. 1 End. Balance 4,000 9,500 9,600 9,500

Yr. 2 Sale Gain 5,900 500 500 500

Yr. 2 End. Cap. Acct.

9,900 10,000 10,100 10,000

Example 8-17Reverse

Section 704(c)

All gain on sale mustgo to ABCD

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• Alice, Bill, Carol and Dinah each contributed $120,000 to form the ABCD calendar year general partnership on January 1, Year 1.

• ABCD uses the proceeds to purchase a commercial building (on leased land).

• For simplicity, assume that the building is depreciated for tax purposes over 10 years (no conventions)..

Underlying Facts

• ABCD incurs a net loss of $48,000 each year for ten years.

• The loss is allocated equally among the four partners, $12,000 each, over the entire ten years.

Facts

Balance Sheet – End of Year 10

• At the end of Year 10, Lewis becomes a 20% partner in the ABCD general partnership by contributing $90,000 of capital in exchange for a 20% partnership interest.

• The following day, the partnership sells the building for $360,000.

Facts

ReverseSection 704(c)

Book Up theCapital Accounts

Restated Cap Accounts

Allocation of $360,000 Sale Gain

Partners: K-1 Gain

Lewis $0

Alice $90,000

Bill $90,000

Carol $90,000

Dinah $90,000

After Sale of Building

Example 8-18Reverse

Section 704(c) With Depreciation

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• Same facts as example 8-17, but the partnership does not sell the building.

• Instead, it continues to rent the building.

• Recall, at the end of Year 10, Lewis becomes a 20% partner in the ABCD general partnership by contributing $90,000 of capital in exchange for a 20% partnership interest.

Facts

ReverseSection 704(c)

Book Up theCapital Accounts

Restated Cap Accounts

Lewis’ Depreciation

Traditional Method: zero

Remedial Allocation Method: $7,200($7,200 = 20% x 360,000 ÷ 10)

Traditional with Curative: $72,000?($72,000 = 20% x 360,000)

Section 704(c) With Intangibles

8-39

Example 8-23

Post-1993Goodwill

8-41

8-41

Ken Jose

Tax Book Tax Book

Beg. Cap. 300,000 1,000,000 1,000,000 1,000,000

Amortization

Jose can receive curative or remedial allocations of amortization. Remedial:

$700,000/2 = $350,000$350,000/15 = $23,333

Example 8-24

Pre-1993Goodwill

Remedial Allocations Only (longer life)

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704(c) Allocation Methods -...

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