Is sec. 704(c) or sale treatment better for a contributing partner?

Sec. 723's carryover basis rules provide that a partnership's basis for property contributed by a partner is the property's basis in the contributing partner's hands. If the contributed property's basis differs from its fair market value (FMV) at the time of the contribution, income, gain, loss and deductions with respect to the contributed property are allocated among the partners under Sec. 704(c) and the regulations thereunder, to take account of the variation between the property's basis to the partnership and its FMV at the time of the contribution. The purpose of this special allocation of precontribution gain or loss is to prevent artificial shifting of tax consequences among partners.

If property contributed to a partnership is nondepreciable, nondepletable and nonamortizable, this special allocation is made when the partnership disposes of the property. On the other hand, property subject to any type of cost recovery requires a current Sec. 704(c) allocation.

The general rule for depreciation of contributed property by a partnership is that the partnership continues the contributing partner's depreciation. It retains that partner's depreciation elections and whatever life and method the contributing partner used. However, for contributed property, a special allocation of depreciation deductions may be made to the noncontributing partner(s). Depreciation deductions allocated to the noncontributing partner(s) must equal the amount that would be allowed if the partner purchased a direct interest in the contributed property.

Regs. Sec. 1.704-3 provides taxpayers with the following alternative methods for allocating cost recovery deductions for contributed property:

[] The traditional method.

[] The traditional method with curative allocations.

[] The remedial method.

(See the immediately preceding Tax Clinic item,"Sec. 704(c)'s Anti-Abuse Rule: A Practitioner's Guide.")

The most commonly used methods are the traditional and curative allocation methods. Under the traditional method, the total tax allocations to the noncontributing partner(s) of cost recovery deductions must, to the extent possible, equal "book" depreciation allocated to those partners. Book depreciation is the cost recovery of the property's FMV. However, the total deductions allocated to the partners for a tax year cannot exceed the partnership's deduction for that property. Therefore, noncontributing partners do not benefit from their full book deduction if the property's tax basis is substantially less than its FMV at the contribution date. This is referred to in the regulations as the "ceiling rule" because the ceiling placed on the specially allocated book depreciation is the actual tax depreciation.

The traditional method with curative allocations is a method that allows allocations to offset the negative impact of the ceiling rule on noncontributing partners. Under the curative allocation method, sufficient income or deductions may be reallocated among the partners to give noncontributing partners the benefit of book depreciation. Therefore, if substantial built-in gain exists at the contribution date, the curative allocation method may be detrimental to the contributing partner and beneficial to the noncontributing partners, who receive depreciation deductions as if they had purchased the property for full value.

Since Sec. 704(c)'s provisions are mandatory for contributed property, a partner may want to analyze whether he should contribute property to a partnership or whether he should sell property to the partnership, so that Sec. 704(c) would not apply. See the comprehensive example.

There are many variables that go into this analysis, including the contributed property's built-in gain, its remaining tax life, the contributing partner's ordinary income and capital gains tax rates, and the achievable rate of return on deferred tax dollars. Nonetheless, a proactive tax adviser should always analyze the options of a partner contemplating the contribution of appreciated property to a partnership. An event that triggers sale or exchange treatment (and, consequently, escapes Sec. 704(c)'s mandatory rules) may be advantageous for that partner.

RELATED ARTICLE: Example: Alternative Allocation Methods for the Contributing Partner

A and B form a partnership; each will be allocated a 50% share of all partnership items. A contributes $100,000 in cash and B contributes depreciable property with a $40,000 adjusted tax basis and a $100,000 FMV;. therefore, the property has a $60,000 built-in gain. The asset has a five-year remaining tax life and the partners agree that at the end of year 5, the property will be sold, at which time the gain will be split 50/50 according to the partnership agreement. For simplicity's sake, assume that the property's FMV does not change during this time.

The partnership agreement also allows for the use of either the traditional method or the curative allocation method under Sec. 704(c). B decides to analyze whether he should contribute the property or whether he should sell it to the partnership at its inception. Thus, B sells the property to the partnership for $100,000 cash, recognizes $60,000 of capital yarn, and then recontributes the $100,000 back to the partnership.

Observation: To accomplish the sale approach for persons who wish to form a partnership, they must first form the partnership. On the other hand, this approach could be used if there is an existing partnership or a one-member limited liability company (LLC) treated as a partnership when the second member joins the LLC.

The chart below outlines the stream of taxable gain and tax costs under the following scenarios: (1) contribution with traditional method; (2) contribution with curative allocation method; and (3) sale of the property to the partnership.

Note: Assume a 28% capital gains rate and a 39% (instead of 39.6%, for simplicity) ordinary income tax rate for B.

         Traditional method          Curative method

         Income        Tax benefit   Income       Tax benefit
         (deduction)   (burden)      (deduction)  (burden)

Year 1   $     0       $      0       $ 2,000       $   (780)

Year 2         0              0         2,000           (780)
Year 3         0              0         2,000           (780)
Year 4         0              0         2,000           (780)
Year 5         0              0         2,000           (780)
Sale      60,000     CG (16,800)        50,000    CG (14,000)
Total    $60,000       $(16,800)       $60,000$      (17,900)

         Sale treatment

         Income       Tax benefit
         (deduction)   (burden)

Year 1    $60,000        $(16,800)
                 (10,000)         3,900
Year 2    (10,000)          3,900
Year 3    (10,000)          3,900
Year 4    (10,000)          3,900
Year 5    (10,000)          3,900
Sale       50,000      CG (14,000)
Total     $60,000        $(11,300)

All income and losses are ordinary unless marked "CG" (capital gain).

B's total tax liability is lowest using the sale treatment. The second best option is the traditional method; the worst option for the contributing partner is the curative method. Under the sale method, B pays capital gains tax of $16,800 initially, but then recognizes depreciation deductions over the asset's five-year life. B would not be entitled to these deductions if he contributed the property to the partnership; all depreciation deductions would be allocated to the noncontributing partner(s) under Sec. 704(c). Since depreciation deductions generate a 39% tax benefit to B, the cumulative tax cost is less.

The net present value concept must be considered, as most of B's tax burden is borne by him in year 1. The chart below applies net present value calculations to the three methods using internal interest rates of 6%,8%,10%,12% and 14%. It is only when B can achieve a 14% rate of return on deferred tax liabilities that sale treatment is not the optimal solution.

           Present value of tax burden

Interest   Traditional   Curative       Sale        Lowest
rate       method        method         treatment   tax burden
 6%        $(11,843)    $(13,155)       $(9,290)    Sale
 8%         (10,587)     (11,937)        (8,860)    Sale
10%          (9,483)     (10,859)        (8,391)    Sale
12%          (8,511)      (9,905)        (8,034)    Sale
14%          (7,654)      (9,056)        (7,726)    Traditional