I Want In Selected Tax Considerations in Entering a ...I Want In – Selected Tax Considerations in...

I Want In –

Selected Tax Considerations

in Entering a Partnership

Alabama Federal Tax Clinic

November 16, 2012

John J. Rooney

KPMG LLP

Washington, DC

(c) 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of

independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity, All

rights reserved.

Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT

INTENDED OR WRITTEN BY KPMG TO BE USED, AND

CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON

OR ENTITY FOR THE PURPOSE OF (i) AVOIDING

PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER

OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO

ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without

limitation, the tax treatment or tax structure, or both, of any transaction described in the associated

materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax

analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are subject to

change. Applicability of the information to specific situations should be determined through

consultation with your tax adviser.

1 (c) 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent

member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity, All rights reserved.

Topics

• Basic Section 721 rules

– Exceptions to non-recognition treatment

• Basic Section 704(c) rules



Basic Section 721 Rules



Section 721

• General Rule

– A transfer of property to a partnership in exchange for

a partnership interest is generally nontaxable for both

the partner and the partnership under Section 721(a).

• No Section 351(a) control requirement.



Section 721 - Property

• Definition of property – Generally includes money and any other property

– Property that qualifies for Section 351(a) should also qualify for Section 721(a)

• Property? – Services

– Accounts Receivable

– Partner’s Note

– ”DuPont Issue” • Partner contributes non-exclusive right to use property

– Section 752(c) • Property subject to nonrecourse debt > FMV of property



Section 721 – Basis

• Partnership’s basis in contributed property

– Carry-over basis

• Partner’s basis in partnership interest

– Carry-over basis of contributed assets

– Plus partner’s share of partnership liabilities

– Minus partner’s debt transferred to partnership



Section 721 – Holding Periods

• Partnership’s holding period in assets

– Carry-over/tacking of partner’s holding period

• Partner’s holding period in partnership interest

– Carry-over holding period

• Section 1231 assets and capital assets

– New holding period

• Cash, inventory, and non-section 1231 assets

– Possible split holding period



Section 721 – Rev. Rul. 99-5

A

SMLLC

DE

B purchases a 50% interest in LLC from A.

A retains the sale proceeds.

A and B operate the business of LLC as co-owners.

B

50% interest Situation 1



Transaction treated as if:

(1) B purchased 50% of the LLC’s assets from A

(2) A and B each contributed 50% of the assets and formed LLC as a

partnership.

A

DE

B

50% assets

A B

LLC

Situation 1

50%

assets

50%

assets





• Can the owner choose to “cherry-pick” the

assets of the LLC that are deemed sold in

Situation 1?

– Sale is treated as a sale of a portion of all assets

– Not a sale of selected assets

A

DE

B

50% of all assets



A

DE

B contributes $10,000 to DE for a 50% interest.

DE keeps the cash.

B

Situation 2

$




Transaction treated as a contribution of assets by A and a

contribution of cash by B in formation of a partnership.

Situation 2

Assets

A B

LLC

$





• What if A had previously loaned money to LLC?

– Loan is disregarded prior to contribution by B, BUT

loan is a regarded loan after the contribution.

– As a result, A may be treated as having sold a portion

of the assets to LLC in exchange for the new note.

– Consider repaying the note prior to formation.

B

Assets &

N/P to A

A

LLC

$



Section 721 - Exceptions



Section 721 - Exceptions

• Disguised Sales

• Liability Shifts in Excess of Basis

• Investment Company Exception

• Partnership Interest for Services

• Deferred Intercompany Transactions

• Overall Foreign Loss

• 481(a) Adjustments

• Acceleration of Advance Payments

• Section 337(d) (“May Co. Exception”)



Section 721 – Exceptions

Disguised Sales



Disguised Sale

• Section 707(a)(2)(B)

– A transfer to a partnership is a taxable sale if:

• There is a transfer of property to a partnership by a

partner;

• There is a transfer of money or property by the

partnership to the partner; and

• The two transfers, when viewed together, are

“properly characterized as a sale or exchange of

property.”



Disguised Sale

• Treas. Reg. §1.707-3(b)(1)

– A contribution is treated as a disguised sale if:

• The partner transfers property to the partnership;

• The partnership transfers money or other property to the

partner (including the assumption of a liability of the partner);

• The transfer to the partner would not have been made “but

for” the contribution by the partner; and

• If the transfer to the partner is not simultaneous with the

contribution, the transfer by the partnership is “not dependent

on the entrepreneurial risks of partnership operations.”



Disguised Sale

• A disguised sale is treated as a sale for all

purposes of the Code.

• A disguised sale is treated as occurring on the

date of the contribution by the partner – not on

the date the partnership transfers property to the

partner.

– If the transfer by the partnership occurs after the

contribution by the partner, the partnership is treated

as having issued an installment note to the partner on

the date of contribution. Reg. §1.707-3(a)(2).



Disguised Sale

• Cherry-Picking

– If there is a disguised sale, can the seller designate

which assets were sold to the partnership?

• Relevant authorities:

– Proposed 707 regulations. Prop. Reg. §1.707-3(e).

– Brown, 27 TC 27 (1956)

– Collins, 48 TC 45 (1966)

– Rev. Rul. 68-55; Rev. Rul 68-13

– TAM 200540010; TAM 200512020

– TAM 200701032; TAM 200650017



Disguised Sale

• Factors for determining a disguised sale:

– Timing/amount of distribution are reasonably determinable;

– Partner has a legally enforceable right to the distribution;

– Partner’s right to distribution is secured in any manner;

– Partner’s distribution is funded by:

• Other partner’s loan or future capital commitment

• Partnership’s asset or future borrowing;

– Partnership terms are “designed to effect an exchange of the

benefits and burdens of ownership of property”;

– Distribution is “disproportionately large” in relation to distributee

partner’s continuing interest; and

– Partner has no obligation to return or repay the distribution.



Disguised Sale

• Simplified Factors:

– Type of property contributed

– Type and amount of debt contributed

– Economic terms of the interest received by partner

– Amount of cash or property expected to be distributed

– Amount of time the contributor will be a partner



Disguised Sale

• Rebuttable presumption for a sale

– A transfer of property and a distribution of property to

the partner within a two-year period is presumed to

be a disguised sale unless the facts and

circumstances “clearly establish” that the transfers

are not a sale. Reg. §1.707-3(c).

• If the partner takes the position that there is no sale on a

distribution within two years, disclosure to IRS is required

unless the distribution is a guaranteed payment for capital, a

reasonable preferred return, or an operating cash flow

distribution.



Disguised Sale

• Rebuttable presumption for no sale

– A transfer of property and a distribution of property to

the partner that are more than two years apart is

presumed not to be a disguised sale unless the facts

and circumstances “clearly establish” that the

transfers are a sale. Reg. §1.707-3(d).



Disguised Sale

• Contribution of a liability to the partnership

– If a partner contributes a liability to a partnership, the

contributing partner is generally deemed to receive

cash in a disguised sale to the extent, if any, that a

portion of the contributed liability is allocated to other

partners under section 752. Reg. §1.707-5(a)(1).



Disguised Sale

Property X $50 Cash

FMV: 150

Recourse Debt: 100

Basis: 80

Liability Shift

Amount of recourse debt assumed 100

A’s share of recourse debt 50

Potential amount of disguised sale 50

A B

50% 50%



Disguised Sale

• Contributing partner’s share of contributed debt

– Contributing partner’s share of recourse debt is

determined under Reg. 1.752-2.

– Contributing partner’s share of non-recourse debt is

determined under the third-tier allocation rules of Reg.

1.752-3(a)(3) EXCEPT the rules for “excess 704(c)

debt” do not apply



Disguised Sale

• Contributing partner’s share of contributed debt

– Multiple liabilities contributed by more than one

partner

• A contributing partner’s share of its contributed debt equals

the partner’s combined share of ALL debt contributed as part

of the same transaction (except for the contributing partner’s

share of its own qualified liabilities).

• Rule does not apply to any liability assumed with a principal

purpose of reducing amount of consideration.



Disguised Sale

• Time for determining contributing partner’s share

of debt

– Partner’s share of the liability is determined

immediately after the contribution of the liability

– BUT the partner’s share is reduced for any

“anticipated reductions” in the partner’s share of

liability. Reg. §1.707-5(a)(3).



Disguised Sale

Property X $50 Cash

FMV: 150

Debt: 100

Basis: 80

Liability Shift

Amount of debt assumed 100

A’s share of debt assumed 50

Potential disguised sale 50

Partner A can avoid a disguised sale by preventing $50 of the liability

from being allocated to B. This might be achieved by having Partner A

guarantee the debt and/or indemnify Partner B.

A B

50% 50%




Disguised Sales Exceptions



Disguised Sale - Exceptions

• Qualified liabilities

• Reimbursements of preformation expenses

• Debt-financed distributions

• Distributions of operating cash flow

• “Reasonable” guaranteed payments

• “Reasonable” preferred returns



Disguised Sale – Exceptions

• Qualified Liability Exception

– The contribution of a “qualified liability” is not treated

as a disguised sale unless there is another transfer

that triggers a disguised sale. Reg. §1.707-5(a)(5).



Disguised Sale – Exceptions

• Qualified Liability Exception

– If there is another transfer that triggers a disguised

sale, the contribution of the qualified liability is treated

as a disguised sale to the extent of the lesser of:

• the amount of the qualified liability that is allocated to the

non-contributing partners or

• the amount of the qualified debt multiplied by the partner’s

“net equity percentage”.




• Definition of Qualified Liabilities – Reg. §1.707-5(a)(6)

– “Old and Cold” Debt

• Incurred more than two years before contribution

• Must have “encumbered” contributed property for two-year period

– “Not Old and Cold” Debt

• Incurred less than two years before contribution

• Must disclose to IRS if treat this type of debt as a qualified liability

• Must have “encumbered” contributed property for the entire period

– Debt allocable to capital expenditures with respect to contributed

property under Reg. §1.163-8T

– Ordinary trade or business debt

• Incurred in the ordinary course of a trade or business

• All “material” assets of the trade or business are contributed




• “Old and Cold” Qualified Liabilities

– Liability must have “encumbered” the contributed

property for the two-year period prior to contribution

• Meaning of “encumbered”

– Perfected security interest required?




A borrows 25 and distributes it to SH prior to contribution.

Bank liability is NOT a qualified trade or business liability - even if all of

the assets of A’s trade or business are contributed to the partnership –

because the liability was incurred to finance a distribution to SH and

was not incurred in the “ordinary course” of A’s trade or business.

Trade or Business Liability

SH

$25

B

Bank $25

50% 50%

A



Disguised Sales - Exceptions

• Reimbursement of Preformation Expenses

– A transfer of money to a partner is not treated as part

of a disguised sale to the extent that the transfer was

made to reimburse the partner for capital

expenditures that

• Were incurred during the two-year period prior to the

contribution and

• Were incurred by the partner with respect to the contributed

property or to partnership organization or syndication costs.





– Subject to FMV cap.

– If the contributed property has appreciated by more

than 20%, the amount of reimbursement is limited to

20% of the FMV of the property at the time of

contribution. Reg. §1.707-4(d)(2)(ii).

– How is the FMV cap applied if a partner contributes

multiple properties?




Property Cash

Properties Contributed by A

Basis FMV Gain Acquired

Prop A: 0 100 100 2000

Prop B: 100 150 50 2012

Prop C: 100 100 0 2012

200 350 150

A B

50% 50%




• Possible ways to apply FMV cap and exception

– Apply FMV cap to all properties whenever acquired

• 20% FMV cap applies (200 basis and 150 gain)

– Apply FMV cap to all properties acquired in last two years

• 20% FMV cap applies (200 basis and 50 gain)

– Apply FMV and the exception on property-by-property basis

• Exception does not apply to Prop A (acquired > 2 years ago)

• 20% FMV cap applies to Prop B (100 basis and 50 gain)

• 20% FMV cap does not apply to Prop C (100 basis; 0 gain)





– Double dip potential?




• Reg. §1.707-5(a)(5)

– If a partner contributes property subject to a liability

the proceeds of which were used to acquire or

improve the contributed asset, the liability is a

qualified liability, and a shift in the sharing of that

liability will not give rise to a disguised sale.

• Reg. §1.707-4(d)

– A partner may receive a distribution of cash in

reimbursement for capitalized expenditures incurred

within the two-year period prior to contribution,

subject to certain limitations. 43 (c) 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent



Property Cash

+ Liability

Properties Contributed by A

Basis FMV Gain Acquired

Prop A: 0 100 100 2000

Prop B: 50 50 0 2012

Partner A borrowed 50 to buy property B.

Can A receive a 50 distribution as preformation reimbursement?

If so, A has been reimbursed even though it never actually paid the 50.

A B

50% 50%




• Debt-financed distribution:

– If a partnership borrows money and the proceeds are

allocable under Reg. §1.163-8T to a distribution of

money to the contributing partner, the distribution is

treated as a disguised sale only to the extent that the

distribution exceeds the partner’s allocable share of

the partnership liability. Reg. §1.707-5(b)(1).




• Debt-financed distribution:

– A partner’s share of the partnership liability for

purposes of this exception is equal to the partner’s

allocable share of the liability under Section 752

multiplied by a fraction:

• The numerator is the portion of the liability that is allocable to

the money transferred to the partner.

• The denominator is the total amount of the liability.




Property X $100 Cash

FMV: 100 $25

Basis: 10 $50 Bank

Partnership borrows $50 and distributes $25 to A. A’s

share of the debt under section 752 is $25.

Distribution of $25 to Partner A is treated as a partial

disguised sale (with an amount realized of $12.50) even

through Partner A is allocated $25 of the $50 Bank debt.

A B

50% 50%




Property X $100 Cash

FMV: 100 $25

Basis: 10 $50 Bank

Under the fraction rule for the exception, A’s allocable

share of the debt is $12.50:

$25 share of total debt x 25

50

A B

50% 50%




• Distributions of Operating Cash Flow

– A distribution of operating cash flow is presumed not to be part of

a disguised sale unless the facts and circumstances clearly

establish otherwise. Reg. §1.707-4(b)(1).

– Partner’s share of operating cash flow is the lesser of

• Partner’s share of overall profits for the year of distribution or

• Partner’s percentage interest in overall partnership profits for the life

of the partnership.

– Notice that definition of operating cash flow is NOT the same as

the partner’s share of net profit for the year or GAAP cash flow.




• Reasonable Guaranteed Payments

– A “reasonable” guaranteed payment for the use of capital under

section 707(c) is presumed not to be part of a disguised sale

unless the facts and circumstanced clearly establish otherwise.

Reg. §1.707-4(a)(1)(ii).

– A guaranteed payment is reasonable if it does not exceed the

safe harbor rate.

– Safe harbor rate is generally 150% of the highest AFR in effect

at any time after the right to the guaranteed payment is

established.




• Reasonable Preferred Returns

– A “reasonable” preferred return for the use of capital is presumed

not to be part of a disguised sale unless the facts and

circumstanced clearly establish otherwise. Reg. §1.707-4(a)(2).

– A preferred return is reasonable if it does not exceed the safe

harbor rate.

– Safe harbor rate is generally 150% of the highest AFR in effect

at any time after the right to the preferred return is established.




Liability Shifts in Excess of Basis




• Section 731(a):

– a partner recognizes gain to the extent a distribution

of cash exceeds partner’s basis.

• Section 752(a):

– a partner’s basis in its interest includes the partner’s

share of partnership liabilities.

• Section 752(b):

– a contribution of a liability to a partnership is treated

as a distribution of cash by the partnership to the

contributing partner.




Property X $50 Cash

FMV: 150

Debt: 100

Basis: 40

Liability Shift

A’s starting basis in pship: 40

Amount of debt assumed: (100)

A’s share of debt assumed: 50

Gain/Difference: (10)

A’s ending basis in pship: 0

A B

50% 50%




Investment Company Exception




• Section 721(a) does not apply to a transfer to a partnership that would be an investment company if it were a corporation.

• A transfer to an investment company occurs if: – the transfer results in diversification of the transferor’s

interests, and

– the transferee is either:

• a RIC or a REIT, or

• any corporation more than 80 percent of the value of whose assets are held for investment and consist of “stocks or securities.”




• Diversification

– Any transfer of non-identical assets to a newly formed

entity “ordinarily” results in diversification

• Exceptions:

– Single transferor to a Newco

– Two or more transferors

• Each transferor transfers identical assets, unless non-

identical assets are insignificant, or

• Each transferor transfers a diversified portfolio of stock and

securities (as defined in section 368(a)(2)(F)(ii))

– Transfers to pre-existing companies?




• “Stocks and Securities” include:

– cash,

– options, forwards, notional principal contracts, derivatives, or futures contracts,

– debt,

– foreign currency,

– stock in corporations (but look-thru if >50%)

– interests in RICs, REITS, publicly-traded p’ships, or common trust funds (or other interests readily convertible into these interests),

– interests in precious metals (unless used or held in an active trade or business)

• Note that Reg. §1.351-1(c) definition of “stocks and securities” is out-of-date.



Investment Company - Rev. Rul. 87-9

Newco

Google stock Cash

Diversification

For 89 percent of

Newco

For 11 percent of

Newco



Investment Company - Reg. 1.351-1(c)(6)

Newco

Diversified portfolio (utilities)

Reg. 1.368(a)(2)(F)(ii)

No diversification

Diversified portfolio (high tech)

Reg. 1.368(a)(2)(F)(ii)



Rev. Rul. 87-9 and Reg. 1.351-1(c)(6)

Newco

Diversified portfolio

Reg. 1.368(a)(2)(F)(ii) Cash

Arguably no diversification as cash is the ultimate

diversified asset 61 (c) 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent


Investment Company - All-or-Nothing

Newco

Google stock Diversified portfolio

Notwithstanding diversification of only one transferor, rules appear to

require gain recognition by both transferors



Investment Company - Pre-existing Transferee

Newco

B: transfers shares of IBM for

80 percent of X stock

Shareholder A

Should result in diversification to B; any effect on A?

Regulations and rulings address only transfers to Newco

Owns only

Google stock




Partnership Interests for Services



Partnership Interest for Services

• Rev. Proc. 93-27

– Receipt of a profits interest for services provided “to

or for the benefit” of a partnership is not a taxable

event unless:

• Profits interest relates to a substantially certain and

predictable stream of income (such as high-quality debt

securities);

• Partner “disposes” of interest within 2 years of receipt; or

• Profits interest is an interest in a publicly traded partnership.



Partnership Interest for Services

• Definitions

– A “capital interest” is any interest that would give the

holder a share of proceeds upon liquidation of the

partnership.

– A “profits interest” is any interest other than a capital

interest.

• To ensure service partner receives only a profits

interest, “book-up” the capital accounts of the

other partners prior to admission of the service

partner




• Rev. Proc. 2001-43

– Time for testing whether an interest is a “profits interest” is at

time of grant – even if the interest is non-vested.

• As a result, there is no tax effect when the interest vests.

– Requirements:

• Partnership and service provider treat the service provider as the

owner of the interest from the date of grant;

• Service provider includes its share of partnership income;

• No deduction is taken (either by partnership or a partner) upon the

grant or the vesting of the interest; and

• All other conditions of Rev. Proc. 93-27 are satisfied.

– Section 83(b) election:

• No election needed if Rev. Proc. 2001-43 applies.




• Proposed Section 721 Regulations

– Receipt of a vested or unvested profits interest is a taxable event

to the employee under Section 83

– BUT: a valuation safe harbor allows the employee/partner to

treat the profits interest as having a FMV of $0.

– Partner must make a Section 83(b) election.

– Special “forfeiture” allocations of loss to the employee are

required if an unvested profits interest does not vest.

– Partnership does not recognize any gain on transfer of a

compensatory profits interest.




Deferred Intercompany Transactions




• Transactions between members of a consolidated group

of corporations are generally disregarded for federal

income tax purposes. Reg. §1.1504-13(c).

– For example, gain or loss is not recognized on a sale of property

between members of the same consolidated group.

– Any gain or loss on the sale is deferred until the property is no

longer held by a member of the consolidated group. Reg.

§1.1502-13(d)(1).

– A contribution of the property to a partnership will trigger the

deferred gain or loss.




P

S

Asset X

FMV 100

Basis 75

Asset X

FMV 200

Basis 75

Parent sells Asset X to Sub for 100 in Year 1. No gain recognized by Parent.

Sub subsequently contributes Asset X to Sub in Year 2.

Parent recognizes deferred gain of $25 in Year 2.




Overall Foreign Losses



Overall Foreign Losses

• When a taxpayer “disposes” of property used

predominately outside the US, the taxpayer is deemed to

have foreign source income in an amount equal to the

lesser of

– The gain/loss in the property or

– The remaining amount of overall foreign losses of the taxpayer

• “Disposition” includes a tax-free contribution to a

partnership. Section 904(f)(3)(B)(i).




Section 481 Accounting Method

Adjustment



§481 Accounting Method Adjustments

• If a taxpayer with a net Section 481(a) accounting

method adjustment ceases to engage in the trade or

business to which the net adjustment relates, the

balance of the net adjustment not previously taken into

account is taken into account in the taxable year of the

cessation. Rev. Proc. 2011-14, §5.04(3)(c)(i).

• The contribution of trade or business assets to a

partnership is treated as a cessation of that trade or

business for this purpose. Rev. Proc. 2011-14

§5.04(3)(c)(ii)(E).




Acceleration of Advance Payments



Acceleration of Advance Payments

• Qualifying taxpayers may generally defer to the next

taxable year the inclusion of advance payments for

goods or services to the extent the advance payments

are not recognized in revenues in the taxable year of

receipt. Rev. Proc. 2004-34.

• This deferral ends if the taxpayer's obligation with

respect to the advance payments is satisfied or

otherwise ends other than in-

– A transaction to which Section 381(a) applies, or

– Certain Section 351(a) transfers. Rev. Proc. 2004-34,

§5.02(5)(b).




Section 337(d) Transactions




• Proposed §337(d) regulations address the tax

consequences that can occur when a

partnership, directly or indirectly, owns, acquires,

or distributes the stock of a partner. Prop. Reg.

§1.337(d)-3(a).




• Deemed Redemption Rule:

– A partner recognizes gain when the partner increases

its interest in its own stock in exchange for

appreciated property.

• Distribution Rule:

– A partner is treated as redeeming its stock for a

portion of its partnership interest (and recognizes

gain, if any) if the partnership distributes stock of the

partner to the partner.



Section 337(d) – Deemed Redemption

As a result of the contribution, X has economically exchanged

50% of Property Z for 50% of Y’s cash.

X is treated for tax purposes as exchanging:

$50 of Property Z for $50 of X stock.

X recognizes $45 of gain:

$50 FMV of Property Z - $5 basis in Property Z

Property Z $100 of X Stock

FMV: 100

Basis: 10

X Y

50% 50%



Section 337(d) – Distribution Rule

X Y

$200 of X stock

X’s interest has $200 FMV and $50 basis

X receives $200 of X stock in liquidation of its interest

X recognizes $150 of gain:

$200 FMV of X stock - $50 basis in X’s interest



Basic Section 704(c) Rules



Section 704(c)

• Statute:

– “Income, gain, loss, and deduction with respect to

property contributed to the partnership by a partner

shall be shared among the partners so as to take

account of the variation between the basis of the

property to the partnership and its fair market value at

the time of contribution.”

• Reality:

– “You break it – you bought it.”



Section 704(c) – Example 1

A B

50% 50%

Asset A $100

FMV: $100

Basis: $ 60

Partner A contributes Asset A with $40 of pre-contribution built-in

gain.

Section 704(c) is intended to ensure that Partner A continues to

bear the tax consequences of the $40 built-in gain (BIG) in

Asset A.



Section 704(c)

• Section 704(c) achieves this result by allocating

– MORE tax gain to Partner A

– LESS tax depreciation to Partner A



Section 704(c)

• This result can create serious confusion for both

taxpayers and tax professionals.

– Partners will normally expect tax gain and tax

depreciation to be allocated according to their

economic agreement.

– Tax professionals must deal with both §704(c) “tax”

items and §704(b) “book” items in making allocations.

– This can be accomplished through a simple 4-step

process.



Section 704(c)

• Four Simple Steps

– Calculate tax gain or tax depreciation

– Calculate book gain or book depreciation

– Allocate book items to partners according to their

partnership agreement

– Allocate tax items to partners:

• Non-contributing partner: allocated tax items = book items

• Contributing partner: allocated the remaining tax items



Section 704(c) – Example 1

A B

50% 50%

Asset A $100

FMV: $100

Basis: $ 60

Partner A contributes Asset A with $40 of built-in gain.

Property has two years of remaining straight-line

depreciation.



Section 704(c)

• Example 1(a): Partnership sells Assets A for $110

– Calculate tax gain: $50 ($110 sale - $60 tax basis)

– Calculate book gain: $10 ($110 sale - $100 book basis)

– Allocate book items 50-50 to partners: $5 to A; 5 to B

– Allocate tax items to partners:

• $ 5 to B (tax gain = book gain for non-contributing partner)

• $45 to A (remaining $45 of tax gain to contributing partner)



Section 704(c)

• Example 1(b): Partnership depreciates Asset A

– Calculate tax depreciation

• $30 ($60 tax basis ÷ 2) (2-year straight line property)

– Calculate book depreciation

• $50 ($100 book basis ÷ 2)

– Allocate book items to partners (50-50 agreement)

• $25 to A

• $25 to B

– Allocate tax items to partners

• $25 to B (tax depreciation = book depreciation)

• $ 5 to A (remaining $5 of tax depreciation)



Section 704(c)

• “Step 5”: The Ceiling Rule

– In Step 4, the non-contributing partner is allocated tax

items = book items.

– This works well as long as the partnership has enough

tax items.

– What happens if there are not enough tax items to

allocate to the non-contributing partner?

• For example, what would happen in Example 1 if Asset A had

only $20 of total tax depreciation in Year 1?

– This “shortage” of tax items is referred to as the

“ceiling rule.”



Section 704(c)

• Three Options for Dealing with Ceiling Rule:

– Traditional: “never fix it”

– Curative: “try to fix it” with other tax items

– Remedial: “always fix it” with notional tax items



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