Accounting for book-tax differences of property contributed to a partnership.

When property with a fair market value (FMV) that differs from basis is contributed to a partnership, intricate rules under Sec. 704(c) come into play to deter mine how allocations of gain, loss, income or deduction on such property are to be made to partners. The goal is to ensure that the partner who contributed the property receives the benefits or burdens of built-in loss or gain on it and does not unreasonably shift the tax consequences to the other partners. The first part of this two-part article addresses Sec. 704(c)'s complexities, using numerous examples to illustrate the application of the rules. The second part, in the May issue, will examine tax planning strategies and pitfalls.

Contributions of Property to a Partnership

Sec. 721(a) allows partners to contribute appreciated or depreciated property to a partnership without recognizing gain or loss. The partnership's basis in the contributed property ("inside basis") under Sec. 723 is the property's basis in the contributing partner's hands. Thus, if the partner contributed appreciated property to the partnership, its FMV at the time of contribution ("book value") will be greater than its inside basis.

Under Sec. 722, the contributing partner's basis in his partnership interest ("outside basis") equals the basis of the property he contributed to the partnership. His capital account equals the book value of the property at the time of the contribution.(1)

* Sec. 704(c) property

Final regulations under Sec. 704(c), issued on Dec. 21, 1993, define "Sec. 704(c) property" as contributed partnership property with a book value that differs from inside basis.(2) The contributing partner's "built-in gain" on See. 704(c) property is the excess of the property's book value over its inside basis; the excess of property's inside basis over its book value is the contributing partner's "built-in loss."(3) The built-in gain or loss can change over time as the book value and inside tax basis of the Sec. 704(c) property are adjusted by factors such as tax depreciation or a revaluation of the assets.

* Partnership allocations

Generally under Sec. 704(a) and (b), partners can determine among themselves how to allocate partnership items of income, gain, loss or deduction, provided their allocations have substantial economic effect. However, Reg. Sec. 1.704-1(b)(1)(i) states that if the partners do not provide for such allocations in the partnership agreement, or if their allocations do not have substantial economic effect, the IRS will reallocate the partnership's items of income, gain, loss or deduction in accordance with the partners' interests in the partnership.

* Pre-DRA allocations of built-in gain or loss

Prior to the enactment of the Deficit Reduction Act of 1984 (DRA), allocations of depreciation, depletion, gain or loss with respect to contributed property were made as if the partnership had purchased the property(4) (i.e., depreciation and gain or loss on sale were allocated in accordance with the partners' profit or loss interests). The partnership could elect under Sec. 704(c)(2) to allocate the depreciation and the built-in gain or loss to take account of the variation between the partnership's basis in the property and its FMV at the time of contribution.(5)

* Current law

The DRA required partnerships to allocate built-in gain or loss to the contributing partner. Thus, allocations of built-in gain or loss cannot be made in accordance with the allocations provided in the partnership agreement, even if those allocations have substantial economic effect. Congress believed that special rules were necessary to "prevent an artificial shifting of tax consequences between partners with respect to pre-contribution gain or loss."(6) Congress was particularly concerned that partnerships would be used to shift built-in gain to a tax-exempt partner, a partner with a lower marginal rate than the contributing partner, or a partner with expiring net operating losses (NOLs).

Example 1: Allocating Gain to a Contributing Partner A and B form partnership AB. A contributes $10 cash and B contributes property with an adjusted basis of $60 and FMV of $90. The partnership agreement provides that A has a 10% interest in partnership profits, losses and capital, B has a 90% interest and the allocations have substantial economic effect.

A has a partnership interest with a basis and capital account of $10. B has a partnership interest with a capital account of $90 and an outside basis of $60. The basis to AB of the property that B contributed is $60. AB's tax and book balance sheets are as follows:

       Partnership assets              Partners' capital

        Inside                        Outside
         tax         Book              tax        Book
         basis       value             basis      value

Cash      $10        $ 10       A       $10       $ 10
Property   60          90       B        60         90

Total     $70        $100               $70       $100

AB is required to account for the $30 built-in gain on the Sec. 704(c) property contributed by B. If it does so properly, AB will also eliminate the $30 difference between B's capital account ($90) and his outside basis ($60).

Methods of Accounting for Book-Tax Differences

* Any reasonable method

According to Reg. Sec. 1.704-3(a)(1), a partnership may account for the built-in gain or loss on its Sec. 704(c) property through any reasonable method that is consistent with the purpose of Sec. 704(c). Sec. 704(c)'s purpose is to ensure that the contributing partner receives the tax burdens and benefits of any built-in gain or loss. Some methods recognized in the final regulations as being generally reasonable include (1) the "traditional method" of Regs. Sec. 1.704-3(b)(1), which combines allocations of book depreciation, tax depreciation and gain or loss on sale and (2) Regs. Sec. 1.704-3(c)'s "traditional method with curative allocations" of other partnership items of income, gain, loss or deduction. Curative allocations are used to ameliorate the effects of the "ceiling rule" (discussed below).

In addition, the Treasury issued final regulations on Dec. 27, 1994,(7) permitting the use of a new method to eliminate distortions caused by the ceiling rule - the "remedial allocation method." Remedial allocations are notational tax items of income, gain, loss or deduction created by the partnership and allocated to the noncontributing partner to compensate for the ceiling rule and are simultaneously offset by remedial allocations of deduction, loss, gain or income to the contributing partner.

Regs. Sec. 1.704-3(a)(2) provides that these methods of accounting for built-in gain are applied on a property-by-property basis. A partnership may use a different method for each item of Sec. 704(c) property, provided that such method is used consistently for each item of Sec. 704(c) property. However, the overall method (or combination of methods) must be reasonable based on the facts and circumstances - e.g., it may be unreasonable to use one method for properties with built-in gain and another method for properties with built-in loss.

* Related Code provisions

Other Code provisions require the recognition of built-in gain on (1) certain distributions of Sec. 704(c) property to noncontributing partners (Sec. 704(c)(1)(B)) or (2) distributions of other property to the contributing partner (Sec. 737). In either event, the built-in gain recognized must be allocated to the contributing partner (as discussed below). Proposed regulations were issued on Jan. 6, 1995.(8)

In addition, the Sec. 707(a)(2) disguised sale rules (a discussion of which is beyond the scope of this article) prevent taxpayers from using the Code provisions that allow tax-free contributions to and distributions from partnerships to avoid recognizing the built-in gain on the property.

* Allocation of gain on sale

The easiest way for a partnership to account for built-in gain on Sec. 704(c) property is simply to allocate to the contributing partner the tax gain recognized at the time of sale, up to the amount of the built-in gain.(9) Any gain in excess of this amount would be allocated among all of the partners in accordance with their profits interests in the partnership.(10) When combined with allocations of tax depreciation (discussed below), this is the traditional method of allocation.

Example 2: Allocating Gain to a Contributing Partner on Sale The facts are the same as in Example 1, and AB sells the contributed property for $90. There is no book gain on the sale ($90 sales price - $90 book basis), but there is $30 tax gain on the sale ($90 sales price - $60 tax basis). The $30 built-in gain must be allocated to B, the partner who contributed the property. After the sale, AB's balance sheets are as follows:

              Partnership assets              Partners' capital

              Inside                         Outside
               tax          Book               tax         Book
              basis         value              basis       value

      $ 90           $90
Cash    10    $100    10    $100     A        $ 10         $ 10

                                         $60          $90
Property        -              -     B    30    90      0    90

Total         $100          $100              $100         $100

The $30 built-in gain from the sale has been allocated to B, the contributing partner, as required by Sec. 704(c].

The best indication that the $30 built-in gain was properly accounted for is that the allocation of the entire gain to B eliminated the $30 difference between his capital account [$90) and his outside basis ($60). If AB liquidates, B will receive his entire capital account, $90, and will not recognize any gain or loss on receipt of the liquidating distribution (Sec. 7311.

In addition, the equality between A's outside basis and his capital account has been maintained. If AB liquidates, A will receive $10 and will not realize any gain or loss (Sec. 731).

If Sec. 704(c) did not require that all of the built-in gain be allocated to B, t*he gain would have been allocated pursuant to the provisions of the partnership agreement and $3 ($30 x 10%) gain would have been incorrectly allocated to A.

Regs. Sec. 1.704-3(e)(1) provides that, if the Sec. 704(c) property is depreciable property, the partnership must account for the built-in gain by proper allocation of both the tax depreciation and the gain on sale, unless the built-in gain constitutes only a small disparity. A "small disparity" exists under Regs. Sec. 1.704-3(e)(1)(ii) when the difference between the book value of all properties contributed by one partner does not differ from the adjusted tax basis by more than 15%, and the total gross disparity does not exceed $20,000. In the case of a small disparity, taxpayers may account for the built-in gain or loss solely on the sale of Sec. 704(c) property, even in the case of depreciable property.(11)

* Allocation of depreciation

For depreciable property, Regs. Sec. 1.704-3(b)(2), Example 1, provides that the built-in gain on Sec. 704(c) property may also be accounted for through a reasonable allocation of both book and tax depreciation. Allocations of depreciation, combined with allocations of built-in gain or loss on a sale, are referred to as the "traditional method."

Under Sec. 168(i)(7), the tax depreciation that a partnership may claim for depreciable Sec. 704(c) assets is the same amount that the contributing partner could have claimed had the asset not been contributed to the partnership. Thus, the partnership "steps into the shoes" of the contributing partner for purposes of computing the tax depreciation on contributed property.

The book depreciation for a period is the amount that bears the same relationship to the book value of the property as the tax depreciation for the period bears to the adjusted inside tax basis of such property.(12)

The partnership accounts for book and tax depreciation by first allocating book depreciation between the partners in accordance with their deduction or loss-sharing percentage, as provided in the partnership agreement.(13) Then, under Regs. Sec. 1.704-3(b)(1), the partnership allocates tax depreciation to the noncontributing partner equal to the book depreciation previously allocated to him. Finally, the partnership allocates the balance of the tax depreciation to the contributing partner.(14)

Except for when the ceiling rule (discussed below) applies, this allocation procedure will preserve the equality between the noncontributing partner's outside tax basis and his capital account. It will also eventually eliminate both the built-in gain and the difference between the contributing partner's capital account and outside basis.

This allocation formula makes the noncontributing partner indifferent for tax purposes whether the partnership purchases the property or the property is contributed by another partner. In either event, except when the ceiling rule applies, the noncontributing partner will be allocated the same amount of tax depreciation.

Example 3: Using the Traditional Method - Allocating Book and Tax Depreciation The facts are the same as in Example 1, except that B contributed depreciable property with a cost recovery period of five years. B had originally purchased the property for $100 and had taken two years' worth of straight-line cost recovery deductions of $20 each prior to contributing the property to AB.

AB is allowed a $20 cost recovery deduction for its first year because AB steps into B's shoes with respect to the property. AB's book depreciation for the year is $30 ($90 book value / 3-year remaining life).

The $30 of book depreciation is allocated between A and B based on their interests in partnership losses. A is allocated $3 book depreciation ($30 book depreciation x 10% loss interest); B is allocated $27 book depreciation [$30 book depreciation x 90% loss interest).

AB's tax depreciation is allocated first to A equal to the book depreciation allocated to him ($3). The balance of the tax depreciation, $17 ($20 tax depreciation - $3 allocated to A) is allocated to B. After the allocations, AB's balance sheets are as follows:

               Partnership assets            Partners' capital

                Inside                       Outside
                tax          Book             tax         Book
                basis        value            basis       value

                                        $10          $10
Cash           $10           $10   A    - 3    $ 7   - 3   $ 7

           $60        $90                 60          90
Property  - 20  40    -30     60   B    - 17    43    27    63

Total          $50           $70               $50         $70

The allocations of book depreciation and cost recovery tax between A and B have the following consequences: * The equality between A's (the noncontributing partner's) adjusted outside basis and his capital account has been preserved. * The difference between the inside tax basis and the book value of the contributed property has been reduced from $30 ($90 - $60) to $20 $60 - $40). * The difference between B's (the contributing partner's) basis and his capital account has been reduced from $30 ($90 - $60) to $20 ($63 - $43).

If AB depreciated the property for two more years and allocated the depreciation between A and B in the same manner, its balance sheets at the end of the third year would be as follows:

               Partnership assets                Partners' capital

               Inside                            Outside
                tax          Book                 tax        Book
               basis         value              basis        value
                                          $ 7          $ 7

Cash            $10           $10    A    - 6    $ 1   - 6   $ 1

         $40          $60                  43           63
Property -40      0  - 60       0    B    -34      9   -54     9

Total           $10           $10                $10         $10

At the end of the cost recovery period of the contributed property, the built-in gain has been eliminated. The difference between B's outside basis and his capital account has also been eliminated.

If AB were to distribute its $10 cash in liquidation, A would receive $1 (the amount of his capital account) and recognize no gain or loss (Sec. 73 1). B would receive $9 and recognize no gain or loss.

Solely through the proper allocation of both book and tax depreciation,. AB has met the Sec. 704(c) requirement that it "take account of the variation" between the adjusted basis and the book value of the contributed property.

* Allocation of depreciation and gain on sale

Partnerships can account for the built-in gain on depreciable Sec. 704(c) property through reasonable allocations of tax depreciation and gain on sale.(15)

Under the traditional method, book and tax depreciation are allocated as illustrated in Example 3. Except when the ceiling rule applies, the gain on sale is allocated in a manner similar to the way in which depreciation is allocated. The book gain on the sale is allocated between the partners in accordance with their profits interest in the partnership, as set forth in the partnership agreement. The tax gain is then allocated to the noncontributing partner in an amount equal to his share of book gain. Finally, the balance of the tax gain is allocated to the contributing partner.(16)

Example 4: Allocating Tax Depreciation and Gain on Sale The facts are the same as in Example 3, except that AB sells the contributed property for $70 at the end of its first tax year, when the property's book value is $60 and its tax basis is $40. Book gain is $10 ($70 sales price - $60 book value) and tax gain is $30 ($70 sales price - $40 tax basis).

Book gain is allocated $1 to A ($10 book gain x 10% profits interest) and $9 to B ($10 book gain x 90% profits interest). Tax gain is first allocated to A in an amount equal to his book gain, $1. The balance of the tax gain, $29 ($30 tax gain - $1 allocated to A), is allocated to B, the contributing partner.

After the sale, AB's balance sheets are as follows:

                Partnership assets              Partners' capital

               Inside                           Outside
                 tax          Book                tax         Book
               basis          value              basis        value

         $10            $10                 $ 7          $ 7
Cash      70     $80     70    $80    A       1   $ 8      1   $ 8

                                            43            63
Property          -             -     B     29     72      9    72

Total            $80           $80                $80          $80

As a result of the allocations of book and tax depreciation and gain, equality between A's outside basis and capital account is maintained. B's outside basis and capital account are also equalized. If AB were to liquidate, neither A nor B would recognize gain or loss.

* The ceiling rule

Under the ceiling rule, the total tax income, gain, loss or deduction to be allocated to the partners with respect to a property cannot exceed the amount of such items realized for tax purposes by the partnership with respect to that property.(17) The ceiling rule causes book-tax distortions when a tax item is less than the comparable book item allocated to the noncontributing partner.

The ceiling rule applies to property with built-in gain when the tax depreciation for the period is less than the noncontributing partner's share of book depreciation for the period. The ceiling rule is also likely to apply when Sec. 704(c) property with built-in gain later declines in value.

Example 5: Applying the Ceiling Rule The facts are the same as in Example 4, except that the property declined in value and AB sold it for $50. AB has a book loss of $10 ($50 sales price - $60 book value) and a tax gain of $10 ($50 sales price - $40 tax basis).

AB must allocate the book loss in accordance with the partners' loss interests as set forth in the partnership agreement (10% to A and 90% to B). Due to the ceiling rule, there is no tax loss to allocate to A, the noncontributing partner. Thus, AB must allocate all of the tax gain to B. AB's balance sheets will be as follows:

               Partnership assets                 Partners' capital

               Inside                              Outside
                tax           Book                  tax        Book
               basis          value                basis       value

         $10            $10                 $ 7           $ 7
Cash      50   $60       50   $60      A      0    $ 7    - 1   $ 6

                                               43          63
Property        -               -      B       10   53    - 9    54

Total          $60            $60                  $60           $60

As a result of these allocations, A's capital account will no longer equal A's outside basis, and B's capital account will not equal B's outside basis. If AB liquidates, B will receive $54 and have a capital gain of $1 (Sec. 731(a)(1)); A will receive $6 and have a capital loss of $1 (Sec. 731(a)(2)).

The ceiling rule prevents A from deducting a tax loss at the time of sale of the Sec. 704(c) property, even though A suffered a $1 economic loss ($10 decline in value x A's 10% loss interest) and the sale of property is an event that usually gives rise to the recognition of tax loss (Sec. 1212(4)). Instead, the ceiling rule postpones recognition of A's $1 tax loss until AB is liquidated.

The ceiling rule also postpones recognition of the remaining $1 of B's gain until AB's liquidation. Therefore, B's original $30 built-in gain will be accounted for by his $10 of tax depreciation (see Example 3), his $9 share ($10 x 90%) of the property's decline in value, his $10 tax gain recognized on the sale of the property and the $1 tax gain he will recognize on the liquidation of his partnership interest.

* Reasonable curative allocations

In situations in which the ceiling rule has caused distortions, Regs. Sec. 1.704-3(c)(1) allows the partnership to make reasonable curative allocations of other partnership items. Curative allocations for tax purposes differ from allocations of items for book purposes. Under Regs. Sec. 1.704-3(c)(3), a reasonable curative allocation to the noncontributing partner is limited to the amount necessary to offset that partner's book-tax difference caused by the ceiling rule for the current tax year. A curative allocation of a tax item to the noncontributing partner reduces the allocation of such item to the contributing partner by the same amount.

The combined effect of the ceiling rule and curative allocations is that equal allocations of book and tax items are made to noncontributing partners. Curative allocations allow the noncontributing partner the current tax benefit of items, such as losses, that (as illustrated in Example 5) would otherwise be postponed until the liquidation of the partner's interest in the partnership.

Example 6: Cumulative Effects of the Ceiling Rule and Curative Allocations The facts are the same as in Example 5. AB's balance sheets are as follows:

              Partnership assets                 Partners' capital
               Inside                             Outside
               tax         Book                    tax      Book
               basis       value                   basis    value

Cash           $60          $60         A          $ 7       $ 6
Property         -            -         B           53        54

Total          $60          $60                    $60       $60

The ceiling rule prevented AB from allocating to A any tax loss on the sale, even though A had suffered a $1 economic loss.

Now assume that (1) the sold Sec. 704(c) property was a capital asset in AB's hands, (2) instead of liquidating, AB bought another capital asset for $60 and (3) the new asset is not depreciable and declines in value to ($50.

If AB sells the new asset for $50, it will have a $10 ($50 - $60) book loss and a $10 ($50 - $60) tax loss. A's share of both the book loss and the tax loss on the sale is $1 ($10 loss x A's 10% loss interest). In addition, AB may make a curative allocation to A of $1 capital loss for tax purposes, but not for book purposes. This reduces the tax loss allocated to B, but not the book loss allocated to B. After these allocations, AB's balance sheets are as follows:

             Partnership assets            Partners' capital

             Inside                        Outside
              tax     Book                  tax         Book
             basis    value                basis        value

                                    $ 7            $ 6
                                    - 1            - 1
Cash        $50       $50      A    - 1     $ 5           $ 5

                                     53             54
Property     -          -      B    - 8      45    - 9     45

Total       $50       $50                   $50           $50

As a result of the curative allocation, A's and B's capital accounts equal their outside bases. If AB were liquidated, A would receive S-5 and B would receive $45 (their capital accounts); neither would recognize gain or loss on the liquidation. More importantly, from A's perspective, through the curative allocation A was able to take the $1 loss he suffered on the Sec. 704(c) property into account for tax purposes before AB was liquidated.

* The ceiling rule and depreciation

The ceiling rule can produce interesting effects when book depreciation exceeds tax depreciation by a large margin.

Example 7: The Ceiling Rule and Depreciation The facts are the same as in Example 1, except that, instead of a $60 basis at the time of contribution, the property contributed by B had only a $6 basis. After the contribution, AB's balance sheets are as follows:

          Partnership assets                Partners' capital

          Inside                            Outside
           tax          Book                 tax        Book
          basis         value               basis       value

Cash     $10            $ 10        A       $10          $10
Property   6              90        B         6           90

Total    $16            $100                $16          $100

If the property still had three years remaining on its original five-year cost recovery period, tax depreciation for the first year would be $2 ($6 / 3 years). Total book depreciation for the year would be $30 ($90 / 3 years).

A's share of the book depreciation is $3 ($30 book depreciation x 10% partnership interest). However, there is only $2 of tax depreciation available because of the ceiling rule. All of the $2 tax depreciation is allocated to A. After the allocations, AB's balance sheets are as follows:

               Partnership assets               Partners' capital

              Inside                           Outside
                 tax          Book                 tax       Book
               basis          value              basis       value

                                           $10           $10
Cash            $10            $10  A      - 2   $ 8     - 3   $ 7

           $6          $90                    6           90
Property   - 2     4   -30      60    B     - 0     6   - 27     63
Total            $14           $70                $14           $70

As a result of the ceiling rule, A's capital account no longer equals his outside basis.

* Curative allocations and depreciation

Generally under Regs. Sec. 1.704-3(c)(3), to be reasonable, curative allocations must be of the same amount and have substantially the same effect on the partners' tax liability (i.e., the same character) as the item limited by the ceiling rule. Moreover, the curative allocations must be made in the same year in which the ceiling rule limitations occur. Thus under Regs. Sec. 1.704-3(c)(1), a limitation on tax depreciation on one item of partnership property may generally be offset in that same year by a curative allocation of tax depreciation on another item of partnership property. If no other tax depreciation is available, Regs. Sec. 1.704-3(c)(3)(iii)(a) provides that the partnership may make a curative allocation of some other item of partnership income or deduction that is expected to have substantially the same effect on each partner's tax liability as the depreciation limited by the ceiling rule.

An exception under Regs. Sec. 1.704-3[c)(3)(iii)(B) provides that, if the item limited by the ceiling rule is tax depreciation, the curative allocation may be made of the tax gain on the sale of the property, if the partnership agreement in effect for the year of contribution properly so provides. This exception applies even if the gain would be of a different character than the tax depreciation and would occur in a different tax period.

Example 8: Offsetting the Ceiling Rule - Curative Allocations of Tax Depreciation The facts are the same as in Example 7, except that the Sec. 704(c) property was rented and the rental income equals the sum of all partnership expenses except tax depreciation (i.e., AB incurs a tax loss each year in the amount of its tax depreciation). AB properly elects to use curative allocations t() offset the effects of the ceiling rule. Since AB does not have any other items of depreciable property, it cannot make a curative allocation of tax depreciation. However, AB may make a curative allocation of partnership rental income, since it is ordinary income and can be expected to have the same effect as an allocation of depreciation. In such case, AB would allocate $1 less rental income to A, the noncontributing partner affected by the ceiling rule. AB would also make an allocation of $1 additional rental income to B, the contributing partner. AB's balance sheets would be as follows:

               Partnership assets                Partners' capital

               Inside                            Outside
               tax         Book                  tax         Book
               basis      value                  basis       value

                                           $ 8
Cash           $10           10     A       -1   $ 7         $ 7

                                             6
Property          4          60     B        1     7          63
Total           $14         $70                  $14         $70

After two more years of allocations of book and tax depreciation and curative allocations, AB's balance sheets would be as follows:

              Partnership assets                Partners' capital

               Inside                            Outside
               tax           Book                tax         Book
               basis         value               basis       value

                                           $7           $ 7
                                           -2           - 3
                                           -1(*)
                                           -2           - 3
Cash             $10         $10      A    -1(*)   $ 1         $ 1

                                            7            63
                                                        -27
            $4           $60                1(*)
           - 2          - 30                            -27
Property   - 2       0  - 30     0     B     1(*)     9           9
Total              $10         $10                  $10         $10

(*) Curative allocation of $1 less revenue to A and $1 more revenue to B.

At the end of the Sec. 704(c) property's useful life, despite the ceiling rule, A's book-tax equality has been maintained and B's has been established. If AB were to liquidate, neither A nor B would recognize gain or loss.

* Unreasonable allocations

The allocation of tax depreciation or any other item will not be respected by the Service unless it is reasonable. Regs. Sec. 1.704-3(a)(10) states that an allocation method is not reasonable if the contribution of property and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability.

Example 9: Unreasonable Allocations The facts are the same as in Example 7, except that the property contributed by B with a $6 basis has only one year left on its cost recovery schedule, even though it has a substantially longer economic life. B wants to contribute it to a partnership to shift the built-in gain to another taxpayer.

Thus, instead of forming a partnership with A, B enlists C as a partner. C has a large NOL, which he anticipates would otherwise expire unused. C contributes $90 cash to BC and becomes a 50% partner. After the formation of BC, its balance sheet would be as follows:

                 Partnership assets             Partners' capital
                 Inside                         Outside
                 tax        Book                   tax      Book
                 basis      value                 basis     value

Cash             $90        $ 90           B     $ 6        $ 90
Property           6          90           C      90          90
Total            $96        $180                  $96       $180

During its first tax year, BC must allocate the entire $90 book depreciation between the partners. Since B and C are equal partners, each is allocated $45 of book depreciation. Next, C is allocated tax depreciation equal to book depreciation, or $45. However, the ceiling rule limits C's depreciation to $6. After the allocations, BC's balance sheets are as follows:

                 Partnership assets             Partners' capital
                 Inside                         Outside
                 tax        Book                    tax        Book
                 basis      value                 basis        value

                                             $ 6          $90
Cash              $90        $90       B     - 0   $ 6    -45    $45

              $6        $90                   90           90
Property     - 6    0    90     0       C     -6    84     45     45
Total             $90         $90                   $90          $90

If BC sold the property contributed by B for $90, it would have a $90 book gain and a $90 tax gain. If BC were to allocate $45 ($90 x 50%) of the gain to B and $45 $90 x 50%) to C, as provided in the partnership agreement, B would have shifted taxation on half of the original built-in gain to C, who is indifferent to the additional income because of his expiring NOL. After the sale, BC's balance sheets would be as follows:

          Partnership assets                    Partners' capital

           Inside                              Outside
            tax          Book                    tax         Book
           basis         value                  basis        value

      $90          $90                   $ 6          $45
Cash   90   $180    90   $180     B       45  $ 51     45   $ 90

                                          84           45
Property                          C       45   129     45     90
Total       $180         $180           $180         $180

Use of the traditional method is not reasonable here, because the contribution of property is made, and the traditional method is used, with a view to shifting significant taxable income away from a partner in a high tax bracket to a partner in a low tax bracket, despite the fact that B and C will have compensating gain or loss on liquidation of BC. At that time, B will have a $39 gain ($90 distribution - $51 basis) and C will have a $39 loss ($90 distribution - $129 basis).

The traditional method would be reasonable in this situation if B and C provided in the partnership agreement that any tax gain from the sale of the property would always lie allocated first to B to the extent of the remaining built-in gain.

* Remedial allocations

The remedial allocation method is a third reasonable method of accounting for book-tax differences permitted under the final regulations. Under this method, when the ceiling rule limits the amount of a tax allocation (e.g., tax depreciation) to the noncontributing partner, the partnership can make a remedial tax allocation (e.g., additional ordinary deduction) to that partner equal to the limitation caused by the ceiling rule. At the same time, the partnership makes an offsetting remedial allocation e.g., ordinary income) to the noncontributing partner. Because the partnership does not realize these additional amounts of deduction and offsetting income, but uses them merely to counteract the ceiling rule, the remedial allocation method effectively repeals the ceiling rule.

Regs. Sec. 1.704-3[d)(4)(i) and (ii) provide that remedial allocations are notational tax items created by the partnership solely for tax purposes and do not affect the partnership's computation of its taxable income; further, they have no effect on the partnership's tax basis in assets or the partners' capital accounts. However, they have the same effect as actual tax items on a partner's tax liability and the partner's outside basis.

Regs. Sec. 1.704-3(d)(3) requires that remedial allocations to the noncontributing partner have the same tax attributes as the tax item limited by the ceiling rule. The tax attributes of offsetting remedial allocations to the contributing partner are determined by reference to the item limited by the ceiling rule. Thus, if the ceiling rule limits a loss on the sale of a capital asset, the noncontributing partner would receive a remedial allocation of a capital loss and the contributing partner would receive an offsetting remedial allocation of capital gain.

Any partner-level tax attributes are determined at the partner level. Thus, if the ceiling rule-limited item is tax depreciation on a rental unit, the remedial allocation to the contributing partner will be of rental income, and each partner will then apply the Sec. 469 passive loss rules to the remedial allocations as appropriate.

The book depreciation for a tax period under the remedial allocation method differs from book depreciation under the traditional method. Under Regs. Sec. 1.704-3(d)(2), the portion of the book value equal to the tax basis of the Sec. 704(c) property at the time of contribution is recovered in the same manner as is the adjusted tax basis (i.e., for that portion of the book value, book depreciation will equal tax depreciation).

Book depreciation on the balance of the book value (equal to the built-in gain) is computed using any applicable recovery period and depreciation method available to the partnership for newly purchased property (of the same type as the contributed property) placed in service at the time of contribution.

Example 10: Using the Remedial Allocation Method The facts are the same as in Example 7, except that AB decides to use the remedial allocation method and properly so provides in its partnership agreement.

The book value of the property, $90, is comprised of two components: the first component is $6, the tax basis of the property. This component is depreciated in the same manner as the tax basis is depreciated for tax depreciation purposes, or $2 per year ($6 basis / 3-year life, using straight-line depreciation).

The second component is $84, the difference between the book value of the property ($90) and its tax basis ($6). This component is depreciated using any applicable recovery period and depreciation method available. Assuming that AB elects to depreciate this component straight-line over five years, the book depreciation on this component would be $16.8 per year ($84 / 5 years).

For the first year of the partnership, book depreciation would be $18.8 ($16.8 + $2). (In Example 3, the book depreciation for the first year was $30.) Tax depreciation would be $2 ($6 / 3 years).

Book depreciation of $18.8 is allocated $1.9 to A ($18.8 x 10%) and $16.9 to B ($18.8 x 90%). Tax depreciation is allocated $1.9 to A (equal to book depreciation) and $0.1 to B ($2 - $1.9 to A). After these allocations, AB's balance sheets are as follows:

[TABULAR DATA OMITTED]

After two more years, AB's balance sheets are as follows:

[TABULAR DATA OMITTED]

At the end of the third tax year, through the tax depreciation of $2 per year, the original inside tax basis of the property, $6, has been reduced to zero. By virtue of the ceiling rule, no more tax depreciation is available to AB.

In AB's fourth year, only $16.8 book depreciation ($84 basis / 5 years) is available. There is no tax depreciation. The book depreciation would be allocated $1.7 to A ($16.8 x 10% interest) and $15.1 to B ($16.8 x 90% interest). After the allocation, AB's balance sheets are as follows:

[TABULAR DATA OMITTED]

Since A's book depreciation ($1.7) exceeded A's tax depreciation zero), A's capital account ($2.6) no longer equals his outside basis ($4.3).

AB can make a remedial allocation of a $1.7 deduction to A and an offsetting allocation of $1.7 of ordinary income to B. There would be no allocation of book items. After these allocations, AB's balance sheets would be as follows:

           Partnership assets          Partners' capital

           Inside                      Outside
             tax    Book                 tax     Book
            basis   value               basis    value

                                $4.3
Cash        $10.0   $10.0   A   -1.7   $ 2.6     $ 2.6

                                 5.7
Property      0.0    16.8   B    1.7     7.4       24.2
Total       $10.0   $26.8              $10.0      $26.8

For year 5, AB again incurs $16.8 book depreciation and no tax depreciation. The book depreciation is allocated $1.7 to A and $15.1 to B.

To compensate A for the $1.7 tax depreciation he did not receive for the year due to the ceiling rule, AB makes a remedial allocation of a $1.7 deduction to A and an offsetting remedial allocation of $1.7 of ordinary income to B. AB allocates the $1.7 deduction to A even though AB did not realize that amount of deduction in year 5. There are no parallel allocations to book amounts. After the allocations of book and tax depreciation and the remedial allocations, AB's balance sheets are as follows:

[TABULAR DATA OMITTED]

The allocations of book and tax depreciation, combined with remedial allocations, have eliminated the property's built-in gain and made B's capital account equal to his outside basis. If AB were to liquidate, neither A nor B would realize gain or loss on the liquidation.

(1) Regs. Sec. 1.704-1(b)(2)(iv)(b). (2) TD 8500 (12/21/93); Regs. Sec. 1.704-3(a)(3)(i). (3) Regs. Sec 1.704-3(a)(3)(iii). (4) Staff of the Joint Committee Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 211 (1984) (hereinafter, the "Blue Book"). (5) Pre-DRA Regs. Sec. 1.704-1(c)(2) (superseded by Regs. Sec. 1.704-3). (6) Blue Book, note 4, at 212. (7) TD 8585 (12/27/94); Regs. Sec. 1.704-3(d)(1). (8) PS-76-92 and PS-51-93 (both 1/6/95). (9) Regs. Sec. 1.704-3(b)(2), Example 1(iii). See also Regs. Sec. 1.704-1(b)(5), Example 18(iii), which provides that such allocations of gain cannot have economic effect because the gain cannot be properly reflected in the partners' capital accounts. (10) Regs. Sec. 1.704-1(b)(5), Example 13(i). (11) Regs. Sec. 1.704-3(e)(1)(ii). To limit the recordkeeping burden, the DRA legislative history provides that the relatively simple method of accounting for the built-in gain solely by allocating the gain on sale (and not by allocating the tax depreciation) is allowable - when the partnership is a small operating partnership; - when no tax avoidance potential exists; and - if this simplifed method is "not likely to result in the contributing partner avoiding the effect of the allocation of [Sec. 704(c)] gain . . . (such as when the property is expected to be held by the partnership until it has little, if any, fair market value)." Blue Book, note 4, at 214.

Therefore, it would seem that, under the final regulations, accounting for the Sec. 704(c) gain solely by allocating gain on sale should be considered a reasonable method in more cases than when the amount of the built-in gain constitutes only a small disparity. (12) Regs. Sec. 1-704-1(b)(2)(iv)(g)(3). See also Regs. Sec. 1.704-1(b)(5), Example 18(ii) and (vii). (13) Regs. Secs. 1.704-1(b)(5), Example 18(vii); 1.704-3(b)(1); 1.704-3(b)(2), Example 1(ii). See also McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners (Warren, Gorham & Lamont, 2d ed., 1977), at [paragraph]10.04[1]. (14) Regs. Sec. 1.704-3(b)(2), Example 1(ii). (15) See Regs. Sec. 1.704-3(b)(2), Example 1. (16) McKee, note 13, at [paragraph]10.04[1], provides that the tax gain allocated to the contributing partner under Sec. 704(c) equals the excess of the property's book value at the time of sale by the partnership (initial book value less accumulated book depreciation) over the tax basis of the property at that time (initial tax basis less accumulated tax depreciation). An alternative way of allocating the tax gain on the sale is to allocate any remaining built-in gain (as reduced by prior allocations of book and tax depreciation) to the contributing partner. Any tax gain in excess of this amount is then allocated among the partners in accordance with their partnership profits interests. (17) Regs. Secs. 1.704-3(b)(1). See also McKee, note 13, at [paragraph]10.04[2].