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Reverse 704(c) Allocations: Partnership Revaluations, Triggering Events, and Recent IRS Guidance JANUARY 10, 2018 Jennifer A. O'Leary, Partner Pepper Hamilton, Philadelphia olearyj@pepperlaw.com David Stauber, Of Counsel Pepper Hamilton, New York stauberd@pepperlaw.com Robert Ricketts, Ph.D., Director of School of Accounting Texas Tech University, Lubbock, Tex. robert.ricketts@ttu.edu
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Section 704(c) Introduction and Overview
Introduction and Overview Purpose of 704(b) - Ensures that the alloation of partnership income corresponds to the economic arrangement of the partners - Deals with book allocations, rather than tax allocations Incorporates elements of fair market value Purpose of 704(c) - Causes the allocation of taxable income to take into account the variation between the basis of contributed property and its fair market value at contribution prevents the shifting of pre-contribution built-in gain or loss between partners 6
Introduction and Overview What are 704(b) allocations? - Allocations are the tracking mechanism for the partners economic interests in the partnership over time. - They provide the governing rules for how profit/loss is allocated among the partners. What are 704(b) capital accounts? - Book capital accounts based on Treasury Reg 704(b) accounting rules, start with FMV of partnership assets. - Tax capital accounts based on tax basis of partnership assets; follows book. - GAAP capital accounts prepared in accordance with GAAP. How do book and tax allocation provisions relate to each other? - Generally, book items are allocated first (which adjusts the book capital accounts of the partners) and then the allocation of tax items follows the allocation of book items (which adjusts the tax capital accounts of the partners) 7
Introduction and Overview For nondepreciable assets, the partnership will allocate builtin gain or loss to contributing partner upon disposition of the asset For depreciable assets: - built-in gain can be gradually eliminated by allocating tax depreciation away from the contributing partner and to the noncontributing partner (so that the noncontributing partner s tax depreciation will follow its book depreciation). - If the asset has built-in loss, then 704(c)(1)(C) requires that the allocations to the noncontributing partner be determined as if the tax basis = FMV, while the allocations to the contributing partner take into account the built-in loss. 8
Introduction and Overview: nondepreciable property Example 1 (nondepreciable property): - A and B form AB LLC A contributes $100 in cash B contributes inventory worth $100 with a basis of $60 - Since B s contribution of inventory to AB LLC is a tax-free contribution to capital, the partnership takes a carryover basis in the inventory - A and B will each have 50% interests in the LLC Assets Basis Book Cash $100 $100 Inventory $60 $100 $160 $200 Liabilities and Capital Tax Book A $100 $100 B $60 $100 $160 $200 9
Introduction and Overview: nondepreciable property After the first year, AB LLC sells the inventory for $200 Book gain = $200 $100 = $100 Tax gain = $200 $60 = $140 Book gain will be shared among the partners 50/50; if tax gain were to be split 50/50, then B would have shifted $20 of precontribution gain to A - A would eventually be made whole by realizing a capital loss upon liquidation the partnership or of its partnership interest Assets Basis Book Cash $300 $300 $300 $300 Liabilities and Capital Tax Book A $170 $150 B $130 $150 $300 $300 10
Introduction and Overview: depreciable property Example 2 (depreciable property): - Partner A contributes Equipment to Partnership, with a value of $100 and tax basis of $50 - Partner B contributes cash of $100 - For book purposes, the depreciation is generally calculated based on the fair market value of Equipment - However, depreciation for tax purposes is calculated by reference to basis 11
Introduction and Overview: depreciable property Assets Tax Book Equipment 50 100 Cash 100 100 Capital Accounts A 50 100 B 100 100 Assume Equipment depreciates straight-line over 10 years book depreciation of $10/year tax depreciation of $5/year 12
Introduction and Overview: Three Methods The regulations bless three alternative allocation methods as generally being reasonable - These are known as the traditional method, traditional method with curative allocations, and the remedial method (to be discussed in the next segment). - But any reasonable allocation method may be used; these three are examples of what may be reasonable. The IRS can challenge any allocation method used in a particular circumstance. The anti-abuse rules give an indication of what is not consistent with the purposes of subchapter K. 13
Introduction and Overview: Operating Rules 704(c) allocations are determined on an asset-by-asset basis; no aggregation of properties. Permissible to use different methods for different properties. New methods can be selected after technical termination. Purchaser of LLC interest steps into shoes of seller for 704(c). Nonrecognition exchanges of 704(c) property preserve 704(c) attributes. Reverse 704(c) items can use different method than the original 704(c) items or other reverse 704(c) layers. - Treas. Reg. 1.704-3(a)(6)(i):. A partnership that makes allocations with respect to revalued property must use a reasonable method that is consistent with the purposes of section 704(b) and (c). 14
The Three Reasonable Methods
Traditional Method: The General Rule 1. The book items for contributed and all other property are allocated in accordance with the partnership agreement; the overall economic deal governs 2. Noncontributing partners get allocated their tax items as close as possible to the book items 3. Contributing partner is allocated remaining tax income, gain, loss or deduction to the extent of built-in gain or loss 16
Traditional Method Allocation of depreciation, amortization, depletion or other cost recovery items attributable to 704(c) property have to take into account the built-in gain or loss on the contributed property Allocations of such items to non-contributing partners should equal their share of the book items 17
Traditional Method: Nondepreciable Property A and B form AB LLC - A contributes $100 in cash - B contributes inventory worth $100 with a basis of $60 Since B s contribution of inventory to AB LLC is a tax-free contribution to capital, the partnership takes a carryover basis in the inventory Assets Basis Book Cash $100 $100 Inventory $60 $100 $160 $200 Liabilities and Capital Tax Book A $100 $100 B $60 $100 $160 $200 LLC later sells the inventory for $110 18
Traditional Method: nondepreciable property Calculate tax and book gain at the partnership level Book Tax Amt Real 110 110 Basis 100 60 Gain/Loss 10 50 Allocate book gain - $5 to each of A (NC) and B (C) Allocate tax gain to noncontributor (A) A (NC) B (C) Book gain $5 $5 Tax Gain to NC $5 Allocate remaining tax gain to contributor (B) A (NC) B (C) Book gain $5 $5 Tax Gain to NC $5 Tax Gain to Contributor $45 19
Traditional Method: depreciable property Both 704(b) book and tax depreciation must be calculated - Book depreciation is based on 704(b) book basis - Tax depreciation is based on tax basis (calculated normally and not impacted by 704(c) considerations) Noncontributing partners are allocated the same amouint of tax depreciation as their shares of the 704(b) book depreciation, per the partnership agreement The contributing partner is allocated the remaining amount of tax depreciation 20
Traditional Method: Depreciable Property Partner A contributes Equipment (value of $100 and tax basis of $50). Partner B contributes cash of $100 Assume Equipment depreciates straight-line over 10 years book depreciation of $10/year tax depreciation of $5/year Assets Tax Book Equipment 50 100 Cash 100 100 Capital Accounts A 50 100 B 100 100 21
Traditional Method: depreciable property Allocate book depreciation A (C) B (NC) Book Depr $5 $5 Allocate tax depreciation to noncontributor (B) A (C) B (NC) Book Depr $5 $5 Tax Depr to NC $5 Allocate remaining tax depreciation to contributor (A) A (NC) B (C) Book gain $5 $5 Tax Depr to NC $5 Tax Depr to Contributor $0 22
Traditional Method-Ceiling Rule Traditional Method is limited by amount of income or loss available with respect to that property Thus, non-contributing partner may not get full allocations of income or loss or deduction that they should The ceiling rule limitation applies when a disparity exists between 704(b) book and available tax allocations to the noncontributing partners 23
Traditional Method: ceiling rule example Assets Tax Book Equipment 10 100 Cash 100 100 Capital Accounts A 10 100 B 100 100 Assume Equipment has a tax basis of $10 instead of $50 Depreciates straight-line over 10 years book depreciation of $10/year tax depreciation of $1/year 24
Traditional Method: ceiling rule example Allocate book depreciation A (C) B (NC) Book Depr $5 $5 Allocate tax depreciation to noncontributor (B) A (C) B (NC) Book Depr $5 $5 Tax Depr to NC $5? Even though B should be entitled to $5 of tax depreciation, there is only $1 of tax depreciation to allocate. B s allocation is ceiling-limited. 25
Traditional Method with Curative Allocation Used to correct the distortions created by the Ceiling Rule Allocates other partnership tax items of income, gain, deduction or loss to reduce or eliminate the distortion - Made for tax purposes only, not for 704(b) book purposes Attempts to make noncontributing partners whole Curative allocations must be: - reasonable curative allocations are not reasonable to the extent they exceed amount necessary to offset the effect of the ceiling rule for the current taxable year or, if there is a disposition of the property, for prior taxable years - of the same character as limited item - consistent from year to year in application of curative allocations 26
Curative Allocations So, to rectify the ($400) shortfall of depreciation allocations for B with respect to Equipment #1, if AB owned Equipment #2 (purchased with the cash), AB may allocate ($400) of depreciation from Equipment #2 away from A and to B, in order to make B whole. Curative allocations: A (C) B (NC) Book Depr $5 $5 Tax Depr to NC $1 Tax Depr to C $0 Curative Allocations ($4) $4 Total Tax Allocations ($4) $5 27
Curative Allocations The effect of curative allocation must be expected to be substantially the same as the item limited by the ceiling rule to be reasonable - expectation has to exist when property is contributed - test the reasonableness when allocation is made - if cost recovery deductions are limited by ceiling rule, general limitation on character does not apply to income from disposition, but only if properly provided for in partnership agreement in effect when property was contributed 28
Remedial Allocations Remedial Allocations eliminate distortions caused by the ceiling rule by creating remedial items and allocating those items to its partners - no need for partnership to have actual tax items of a specific character to make remedial allocations Partnership determines book items and allocates for book purposes Partnership then allocates the corresponding tax items recognized by the partnership, just like in Traditional Method - If the ceiling rule causes book allocations of an item to noncontributing partner to differ from tax allocations, partnership creates remedial items - created tax items are allocated to noncontributing partners, with offsetting created tax items allocated to contributing partners 29
Remedial Allocations Section 704(b) book basis is split into two components - Amount of 704(b) book basis equal to tax basis is recovered over remaining tax-recovery period - Excess of 704(b) book basis over tax basis is treated as new asset and depreciated over applicable tax-recovery period (using method that would apply if new property of same type was placed in service by partnership at that time) Distortions caused by Ceiling Rule cured over new depreciable life of property Has the effect of lengthening the recovery period as compared to curative or traditional method 30
Remedial Method Allocation Example Assets Tax Book Equipment 10 100 Cash 100 100 Capital Accounts A 10 100 B 100 100 Assume Equipment has one year remaining in its useful life (Yr 1 tax depreciation = $10), but would be depreciated straight-line over 2 years if it was newly purchased. AB uses the remedial method 31
Remedial Method Example Calculate tax and book depreciation Yr 1 Yr 2 Total Book Tax Book Tax Book Tax Base 10 10 0 0 10 10 Forward 45 0 45 0 90 0 Total 55 10 45 0 100 10 Allocate book and tax depreciation Yr 1 Yr 2 Total A (C) B (NC) A (C) B (NC) A (C) B (NC) Book Depr 27.5 27.5 22.5 22.5 50 50 Tax Depr NC 0 10 0 0 0 0 Tax Depr C 0 0 0 0 0 0 Make Remedial Allocations Yr 1 Yr 2 Total A (C) B (NC) A (C) B (NC) A (C) B (NC) Book Depr 27.5 27.5 22.5 22.5 50 50 Tax Depr NC 0 10 0 0 0 10 Tax Depr C 0 0 0 0 0 0 Remedial Allocation (17.5) 17.5 (22.5) 22.5 (40) 40 Total Tax Allocations (17.5) 27.5 (22.5) 22.5 (40) 50 32
Revaluations and Reverse 704(c) Allocations
Revaluations and Reverse 704(c) Allocations Pre-contribution or Forward 704(c) allocations - Sec. 704(c) applies to contributed property to the extent that its 704(b) book basis is different than its tax basis at the time of contribution. Revaluations or Reverse 704(c) allocations - Sec. 704(b) capital accounts may be revalued at certain times authorized by the Regulations when the partners interest in the partnership changes - Unrealized gain or loss is locked in at the time of the revaluation resulting in reverse Section 704(c) allocations 35
Revaluations A revaluation is the adjustment of capital accounts to reflect a revaluation of partnership property on the partnership s books The existing partners are considered contributing partners to the extent of unrealized gain in the partnership's property Revaluations are optional; however, the failure to revalue may create a taxable capital shift - The regulations provide that if the capital accounts are not adjusted to reflect the FMV of partnership property and the principals of Section 704(c) applied, potential tax consequences may arise. See Treas. Reg. 1.704-1(b)(2)(f)(5). 36
Revaluations and Reverse 704(c) Allocations The principles of Section 704(c) 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. Treas. Reg. 1.704-3(a)(6). - The regulations refer to such allocations as reverse section 704(c) allocations - Practitioners generally refer to the subsequently locked-in amounts of section 704(c) built-gain or loss as section 704(c) layers Partnerships are not required to use the same allocation method for reverse allocations as for contributed property, even if at the time of revaluation the property is already subject to section 704(c). - In addition, partnerships are not required to use the same allocation method for reverse allocations each time the partnership revalues its property. 37
Revaluations When? Capital account revaluations must be made principally for a substantial non-tax business purpose, in connection with: - a contribution of money or other property to the partnership by a new or existing partner as consideration for an interest in the partnership; - the liquidation of the partnership or a distribution of money or other property by the partnership to a retiring or continuing partner as consideration for an interest in the partnership; - the grant of an interest in the partnership as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner; or - the issuance by the partnership of a noncompensatory option De minimis issuance exceptions apply to each of the foregoing Capital account revaluations may also be made under generally accepted industry practice (GAAP) for investment partnership (hedge funds) 38
Revaluations - Requirements Capital account revaluations must: - Be based on the fair market value of partnership on the date of adjustment; and - Reflect the manner in which the unrealized income, gain, loss, or deduction inherent in such property (that has not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for such fair market value on that date The partnership agreement must require that: - the partners capital accounts be adjusted for allocations to them of depreciation, depletion, amortization, and gain or loss, as computed for book purposes, with respect to such property; and - the partners distributive shares of depreciation, depletion, amortization, and gain or loss, as computed for tax purposes, with respect to such property be determined so as to take account of the variation between the adjusted tax basis and book value of such property in the same manner as under section 704(c). Treas. Reg. 1.704-1(b)(2)(iv)(f)(1)-(4) 39
Section 704(c) Revaluations: Securities Partnerships Special rules for tracking section 704(c) revaluations apply with respect to securities partnerships Securities partnerships may aggregate gains and losses from qualified financial assets (generally, actively traded personal property) in making reverse allocations. Treas. Reg. 1.704-3(e)(3) - Regulations prescribe partial & full netting approaches to gains and losses - Securities partnerships are management companies registered under the Investment Company Act of 1940 and investment partnerships (i.e., a partnership 90% of whose assets are qualified financial assets and that expects to make revaluations at least annually) IRS determined that frequency of capital account restatements & number of assets may make it impractical to make reverse allocations on an asset-byasset basis Once a partnership adopts an aggregate approach, that partnership must apply the same aggregate approach to all of its qualified financial assets for all taxable years in which the partnership qualifies as a securities partnership Management companies can use the aggregation exception for certain nonactively traded financial instruments 40
Revaluations - Methodology Deem that the partnership sells all its assets at FMV immediately before the revaluation event Allocate the resulting gains and losses to the partners in accordance with the partnership agreement. Resulting capital accounts will be the partners new Section 704(b) capital accounts Calculate the Section 704(b) and tax depreciation and allocate to the partners taking into account the disparities using Section 704(c) 41
Section 704(c) Revaluations: Example A and B form equal partnership AB. - Each contribute $70, and AB buys land for $140. When the land is worth $200, AB admits new partner C as an equal partner for $100. Formation by A & B C later joins the ABC Partnership A 1/2 Cash B 1/2 A B C 1/3 1/3 1/3 AB Partnership ABC Partnership Land Value = $200 Basis - $140 Cash = $100 42
Section 704(c) Revaluations: Example ABC sells the land for $230 How should the gain be allocated? A B C ABC Partnership Proceeds $230 Basis $140 Gain $ 90 $230 Land Buyer 43
Revaluations: Capital Accounts Without Revaluation Beginning Capital Revaluation Gain A B C $70 $70 $0 $0 $0 C s Contribution $100 Gain on Sale $30 $30 $30 Ending Capital $100 $100 $130 Taxable Gain $30 $30 $30 44
Revaluations: Capital Accounts (Cont.) With Revaluation Beginning Capital Revaluation Gain A B C $70 $70 $30 $30 $0 C s Contribution $100 Gain on Sale $10 $10 $10 Ending Capital $110 $110 $110 Taxable Gain $40 $40 $10 45
Section 704(c) Revaluations: Overlapping Layers The Regulations are unclear how to treat multiple Section 704(c) layers - Reg. Sec. 1.704-3(a)(3)(ii) seems to imply that a netting approach be used at least in the case of opposite side revaluations - Reg. Sec. 1.704-3(a)(6) arguably supports a layering approach. - In practice, different practitioners adopt different methodologies. - The IRS implicitly acknowledge the lack of guidance in issuing Notice 2009-70 requesting public comments on how to treat multiple Section 704(c) layers. Under proposed regulations published in 2014, netting would not be permitted and instead each revaluation would create a separate section 704(c) layer - For instance, one section 704(c) layer with respect to a particular property may be of built-in gain, and another section 704(c) layer with respect to the same property may be of built-in loss. Prop. Treas. Reg. 1.704-3(a)(6)(i). - The proposed regulations would be effective when finalized. Proposed regulations also clarify that section 704(c)(1)(C) does not apply to revaluations 46
Multiple 704(c) Layers Initial Balance Sheet A B 50% 50% Property A Basis = $ 4,000 Value = $10,000 $10,000 AB Property A Property AB Tax Basis $ 4,000 $ 10,000 704(b) $ 10,000 $ 10,000 Layer 1 $ 6,000 $ 0 AB buys property AB for $10,000 47
Multiple 704(c) Layers (Cont.) Assumptions $400 tax depreciation on Property A $1,000 tax depreciation on Property AB Traditional method is used Total Depreciation B s share A s Share Tax Basis 704(b) Tax 704(b) Tax 704(b) Tax 704(b) Property A 4,000 10,000 400 1,000 400 500 0 500 Property AB 10,000 10,000 1,000 1,000 500 500 500 500 48
Multiple 704(c) Layers (cont.) After 1 Year A B 50% 50% AB Property A Property AB Tax Basis $ 3,600 $ 9,000 704(b) $ 9,000 $ 9,000 Layer 1 $ 5,400 $ 0 49
Multiple 704(c) Layers (cont.) Year 2 A B The actual values of properties A and AB increase to $12,000 and $18,000. C is admitted as a 50% partner for $30,000. AB Buys property ABC for $30,000. Properties A, AB and ABC have tax depreciation of $400, $1,000 and $3,000 respectively. 25% 25% AB 50% $30,000 C Property A Property AB Property ABC Tax Basis $ 3,600 $ 9,000 $ 30,000 704(b) $ 12,000 $ 18,000 $ 30,000 Layer 1 $ 5,400 $ 0 $ 0 Layer 2 $ 3,000 $ 9,000 $ 0 50
Layering Method A B 50% 50% $10,000 Separate Layer Approach AB C Property A Property AB Tax Basis $ 3,600 $ 9,000 704(b) $ 12,000 $ 18,000 50% 50% $30,000 ABC 51
Layering Method (cont.) ABC Partnership Total Depreciation C s share AB s Share Tax 704(b) Tax 704(b) Tax 704(b) Tax 704(b) Property A 3,600 12,000 400 1,333 400 667 0 667 Property AB 9,000 18,000 1,000 2,000 1,000 1,000 0 1,000 Property ABC 30,000 30,000 3,000 3,000 1,500 1,500 1,500 1,500 AB Partnership Total Depreciation B s share A s Share Tax Basis 704(b) Tax 704(b) Tax 704(b) Tax 704(b) Property A 3,600 12,000 0 667 0 334 0 334 Property AB 9,000 18,000 0 1,000 0 500 0 500 Property ABC 30,000 30,000 1,500 1,500 750 750 750 750 52
Netting Method A B 25% 25% C 50% Collapsed Layer Approach ABC Share of 704(b)/Tax Disparity Property A Property AB Property ABC Basis $ 3,600 $ 9,000 $ 30,000 704(b) $ 12,000 $ 18,000 $ 30,000 Ptr A $ 6,900 $ 4,500 $ 0 Ptr B $ 1,500 $ 4,500 $ 0 Ptr C $ 0 $ 0 $ 0 53
Netting Method (cont.) Property A Depreciation A B Total Original 704(c) 5,400-5,400 Revaluation 1,500 1,500 3,000 Total Basis Disparity 6,900 1,500 8,400 CY Depreciation Disparity 767 167 933 A B C Total 704(b) Depreciation 333 333 667 1,333 Less: CY Disparity (767) (167) - (933) Before Ceiling Rule (433) 167 667 400 Ceiling Rule Limitation 433 (87) (346) - Tax Depreciation (0) 80 320 400 54
Choosing Among 704(c) Methods Generally, the traditional method is best for contributing partner - maximizes deferral for contributing partner The traditional method with curative allocations is generally most likely to get noncontributing partner to all depreciation deductions but depends on specifics Remedial method extends period over which depreciation is taken into effect - contributing partner typically wouldn t want Remedial 55
To Book or Not to Book When should a partnership book-up or revalue its assets? - To avoid a potentially taxable capital shift among the partners. - To preserve unrealized gain/loss for existing partners so that a new partner is not receiving the benefit of a preexisting loss or bearing the burden of a preexisting gain. When would a partnership not want to book-up or revalue its assets? - The valuation of all partnership property, including intangibles, could be burdensome and expensive. - Existing partners don t want to be allocated less depreciation (assuming they aren t confronted with the collateral consequences of not booking-up). Consider whether these considerations can be addressed by special allocations, which are permitted if they accomplish the same end result. - See Treas. Reg. Section 1.704-1(b)(5) Example 14(iv) 56
Revaluations and Reverse 704(c) Allocations: LLC Agreements When will revaluations be permitted and/or required? Who has the authority to elect which allocation method to use? - Majority member? Manager? All members? Contributing member? - Is any method prohibited or required? Will the contributing member have the right to approve the timing of when contributed property is sold? Will tax distributions cover 704(c) and reverse 704(c) items? In the case of a purchase of partnership interests, consider whether a 754 election should be made. 57
Anti-Abuse Rules
Section 704(c) anti-mixing bowl rule If any section 704(c) property (i.e., built-in gain or built-in loss) contributed is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed, the contributing partner is treated as recognizing gain or loss (as the case may be) from the sale of such property in an amount equal to the gain or loss which would have been allocated to such partner by reason of section 704(c) if the property had been sold at its fair market value at the time of the distribution. Section 704(c)(1)(B). - Character of such gain or loss is determined by reference to the character of the gain or loss which would have resulted if such property had been sold by the partnership to the distributee - Appropriate adjustments are made to the adjusted basis of the contributing partner's interest in the partnership and to the adjusted basis of the property distributed to reflect any gain or loss recognized. 60
Section 704(c) anti-mixing bowl rule (cont.) There are several notable regulatory exceptions to the application of section 704(c)(1)(B): - Property contributed to the partnership on or before 10/3/1989 - Certain liquidating distributions in which the contributing partner receives only an interest in the section 704(c) property contributed by that partner and the built-in gain or loss in such interest, determined immediately after the distribution, is equal to or greater than the built-in gain or loss on the property that would have been allocated to the contributing partner under section 704(c)(1)(A) on a sale of the contributed property to an unrelated party immediately before the distribution - Deemed distribution of interests in a new partnership caused by the termination of a partnership under section 708(b)(1)(B) - Transfers of all of a partnership s assets and liabilities to a second partnership (transferee partnership) in a section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement - Certain partnership incorporations - Distributions of an undivided interest in property to the extent that the undivided interest does not exceed the undivided interest, if any, contributed by the distributee partner in the same property - See generally Treas. Reg. 1.704-4(c) 61
Section 704(c)(1)(B): Example On 1/1/15, A, B, and C form partnership ABC as equal partners. A contributes $10,000 cash and Property A, nondepreciable real property with a fair market value of $10,000 and an adjusted tax basis of $4,000. B contributes $10,000 cash and Property B, nondepreciable real property with a fair market value and adjusted tax basis of $10,000. C contributes $20,000 cash. On 12/31/18, Property A and Property B are distributed to C in complete liquidation of C s interest in the partnership. A would have recognized $6,000 of gain under section 704(c)(1)(A) on the sale of Property A at the time of the distribution ($10,000 fair market value less $4,000 adjusted tax basis). As a result, A must recognize $6,000 of gain on the distribution of Property A to C. B would not have recognized any gain or loss under section 704(c)(1)(A) on the sale of Property B at the time of distribution because Property B was not section 704(c) property. As a result, B does not recognize any gain or loss on the distribution of Property B. See Treas. Reg. 1.704-4(a)(5) Ex. 1. Formation: 1/1/15 A B C 1/3 1/3 Property B & cash 1/3 Distribution: 12/31/18 A B C 1/3 1/3 1/3 ABC Partnership ABC Partnership 62
Section 704(c) anti-mixing bowl rule: Section 737 Section 737 applies a back-stop to section 704(c)(1)(B) in the event the contributing partner receives certain distributions of non-contributed property during the 7-year period - Section 704(c)(1)(B) would not otherwise apply in this situation because the section 704(c) property has not itself been distributed, but the end result may be economically similar Section 737 requires recognition of gain equal to the lesser of (i) the excess (if any) of (A) the fair market value of property (other than money) received in the distribution over (B) the adjusted basis of such partner's interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or (ii) the net precontribution gain of the partner - Net precontribution gain is the hypothetical section 704(c)(1)(B) gain that would have been allocated to the contributing partner were all the contributed section 704(c) property still held by the partnership distributed to non-contributing partners 63
Section 737 example On 1/1/15, A, B, and C form partnership ABC as equal partners. A contributes Property A, depreciable real property with a fair market value of $30,000 and an adjusted tax basis of $20,000. B contributes Property B, nondepreciable real property with a fair market value and adjusted tax basis of $30,000. C contributes $30,000 cash. Property A has 10 years remaining on its cost recovery schedule and is depreciated using the straight-line method. The partnership uses the traditional method. See Treas. Reg. 1.737-1(e) Ex. 1. At the end of 1997, the book value of Property A is $21,000 ($30,000 initial book value less $9,000 aggregate book depreciation) and its adjusted tax basis is $14,000 ($20,000 initial tax basis less $6,000 aggregate tax depreciation). On 12/31/17, Property B is distributed to A in complete liquidation of A's partnership interest. The adjusted tax basis of A's partnership interest at that time is $20,000. The amount of the excess distribution is $10,000, the difference between the fair market value of the distributed Property B ($30,000) and A's adjusted tax basis in A's partnership interest ($20,000). A's net precontribution gain is $7,000, the difference between the book value of Property A ($21,000) and its adjusted tax basis at the time of the distribution ($14,000). A recognizes gain of $7,000 on the distribution, the lesser of the excess distribution and the net precontribution gain. A Formation: 1/1/15 1/3 Property B B 1/3 1/3 C Distribution: 12/31/17 A B C 1/3 1/3 1/3 ABC Partnership ABC Partnership 64
Section 704(c)(1)(A) anti-abuse rule An allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse section 704(c) allocations) and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the (direct or indirect) partners in a manner that substantially reduces the present value of the (direct or indirect) partners aggregate tax liability. Treas. Reg. 1.704-3(a)(10). An indirect partner is any direct or indirect owner of a partnership, S corporation, or controlled foreign corporation (generally, to the extent allocations enter into section 951(a) inclusions), or direct or indirect beneficiary of a trust or estate, that is a partner in the partnership, and any consolidated group of which the partner in the partnership is a member. In exercising its authority under the anti-abuse rule, the IRS will not require a partnership to use the remedial allocation method or any other method involving the creation of notional tax items 65
Section 704(c)(1)(A) anti-abuse rule example C and D form partnership CD, allocate all partnership items 50-50 and elect the traditional method. C contributes equipment with an adjusted tax basis of $1,000 and a book value of $10,000, with a view to taking advantage of the fact that the equipment has only one year remaining on its cost recovery schedule although its remaining economic life is significantly longer. D contributes $10,000 of cash, which CD uses to buy securities. D has substantial net operating loss carryforwards that D anticipates will otherwise expire unused. Under 1.704-1(b)(2)(iv)(g)(3), the partnership must allocate the $10,000 of book depreciation to the partners in the first year of the partnership. Thus, there is $10,000 of book depreciation and $1,000 of tax depreciation in the partnership's first year. CD sells the equipment during the second year for $10,000 and recognizes a $10,000 gain, which is allocated $5,000 each to C and D. The traditional method is not reasonable because the contribution of property is made, and the traditional method is used, with a view to shifting a significant amount of taxable income to a partner with a low marginal tax rate and away from a partner with a high marginal tax rate. If the partnership agreement in effect for the year of contribution had provided that tax gain from the sale of the property (if any) would always be allocated first to C to offset the effect of the ceiling rule limitation, the allocation method would not violate the anti-abuse rule. Treas. Reg. 1.704-3(b)(2) Ex. 2. 66
Section 704(c)(1)(B) anti-abuse rule If a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of section 704(c)(1)(B), the Commissioner can recast the transaction for federal tax purposes as appropriate to achieve tax results that are consistent with the purpose of section 704(c)(1)(B) and this section. Whether a tax result is inconsistent with the purpose of section 704(c)(1)(B) and this section must be determined based on all the facts and circumstances. See Treas. Reg. 1.704-4(f). Section 737 has an analogous anti-abuse rules. See Treas. Reg. 1.737-4 67
Section 704(c)(1)(B) anti-abuse rule example On 1/1/95, A, B, and C form partnership ABC as equal partners. A contributes Property A, nondepreciable real property with a fair market value of $10,000 and an adjusted tax basis of $1,000. B and C each contributes $10,000 cash. On 12/31/98, the partners desire to distribute Property A to B in complete liquidation of B's interest in the partnership (which would otherwise trigger $9,000 of gain to A under section 704(c)(1)(B)). On becoming aware of this potential gain recognition, and with a principal purpose of avoiding such gain, the partners amend the partnership agreement on 12/31/98, and take any other steps necessary to provide that substantially all of the economic risks and benefits of Property A are borne by B as of 12/31/98, and that substantially all of the economic risks and benefits of all other partnership property are borne by A and C. The partnership holds Property A until 1/5/02, at which time it is distributed to B in complete liquidation of B's interest in the partnership. The steps taken by the partnership on 12/31/98 are the functional equivalent of an actual distribution of Property A to B in complete liquidation of B s interest in the partnership as of that date. Section 704(c)(1)(B) requires recognition of gain when contributed section 704(c) property is in substance distributed to another partner within seven years of its contribution to the partnership; treating the transaction in accordance with its form would undermine the purpose of section 704(c)(1)(B). See Treas. Reg. 1.704-4(f)(2) Ex. 1. 68
REVERSE 704(C) ALLOCATIONS Robert Ricketts, Ph.D., Director of School of Accounting Texas Tech University
Reverse 704(c) Allocations for Securities Partnerships General Rule 1.704-3(a)(2) provides that Sec. 704(c) allocations must be made on a property-by property basis. Exception 1.704-3(e)(3) provides that securities partnerships may aggregate built-in gains and losses resulting from revaluation transactions for purposes of making reverse Sec. 704(c) allocations. PLRs 201710007 and 201710008 allowed aggregation of built-in gains and losses on qualified financial assets for purposes of making a forward Sec. 704(c) allocation upon the merger of 3 securities partnerships. 70
Use of Aggregate Approach to Apply 704(c) in Merger of Multiple Securities Partnerships Both PLRs involved the merger of multiple securities partnerships owned by identical or related parties; Mergers were structured as assets-over transactions in which terminating partnerships transferred their assets to the surviving partnership in a Sec. 721 transaction before distributing their interest in the surviving partnership to their partners in liquidation; One issue was whether built-in gains and losses could be netted in making forward Sec. 704(c) allocations with respect to the transfers by the terminating partnerships of their security portfolios to the surviving partnership; Service determined that aggregation would be allowed. 71
Requirements to Qualify for Aggregation Rev. Proc. 2001-36 (2001-1 CB 1326) provides automatic permission for Qualified Master-Feeder Structures to aggregate built-in gains and losses from contributed securities for purposes of making both forward and reverse 704(c) allocations. The Revenue Procedure also provides that other securities partnerships could apply for permission to aggregate gains and losses for purposes of making forward and reverse Sec. 704(c) allocations, so long as such partnerships meet the following requirements: Revaluations will occur at least annually; The burden of making separate Sec. 704(c) allocations is substantial; and The partnership s contributions, revaluations and corresponding allocations are not made with a view toward tax avoidance. 72
Partial vs. Full Netting 1.704-3(e)(3) Partial Netting: Upon restatement of book capital accounts, the partnership nets all book gains and losses since last restatement and allocates the net gain or loss to partners; As securities are subsequently sold, tax gains and losses are separately aggregated; and Aggregated tax gains and tax losses are each allocated in a manner that reduces the differences between the partners book and tax capital accounts. Full netting same as partial netting except that tax gains and losses are also netted before making special allocations of net gain or loss to partners under Sec. 704(c). 73
Example Assume the following facts: X and Y form equal securities partnership P with cash contributions at time t 1 ; Z joins partnership P at time t 2 as a one-third partner in exchange for a cash contribution; Partnership P revalues its properties at time t 2 ; Partnership P sells securities at time t 3, realizing both gains and losses for tax purposes. Aggregate tax gains total $2,000 Aggregate tax losses total $4,000 Net book gains at date of revaluation equal $3,000 (including securities not sold) 74
Example (cont): Adjustments to Book Capital and Revaluation Accounts at Revaluation Dates Partner X Partner Y Partner Z Book Tax Reval (B-T) Book Tax Reval (B-T) Book Tax Reval (B-T) Beginning Capital 150,000 150,000 0 150,000 150,000 0 - - - Revaluation, t 1 -t 2 2,500-2,500 2,500 2,500 - - - Z joins at time t 2 152,500 152,500 0 Balances at t 2 152,500 150,000 2,500 152,500 150,000 2,500 152,500 152,500 0 Revaluation, t 2 -t 3 (1,000) - (1,000) (1,000) - (1,000) (1,000) - (1,000) Balances at t 3 151,500 150,000 1,500 151,500 150,000 1,500 151,500 152,500 (1,000) 75
Example (cont): Allocation of Tax Gains/Losses Partial Netting Partner X Partner Y Partner Z Book Tax Reval (B-T) Book Tax Reval (B-T) Book Tax Reval (B-T) Balances at t 3 151,500 150,000 1,500 151,500 150,000 1,500 151,500 152,500 (1,000) Allocation of Tax Gains ($2,000) - 1,000 (1,000) - 1,000 (1,000) - 0 0 Allocation of Tax Losses ($4,000): - 1 st 1,000 - Remainder - - 0 (1,000) 0 1,000 - - 0 (1,000) 0 1,000 - - (1,000) (1,000) 1,000 1,000 Balances 151,500 150,000 1,500 151,500 150,000 1,500 151,500 150,500 1,000 76
Example (cont): Allocation of Tax Gains/Losses Full Netting Book Partner X Partner Y Partner Z Tax Reval (B-T) Book Tax Reval (B-T) Book Tax Balances at t 3 151,500 150,000 1,500 151,500 150,000 1,500 151,500 152,500 (1,000) Allocation of Net Tax Loss ($2,000): - 1 st 1,000 - Remainder - - 0 (333) 0 333 - - 0 (333) 0 333 - - (1,000) (333) Balances 151,500 149,167 1,833 151,500 149,667 1,833 151,500 151,167 333 Reval (B-T) 1,000 333 77