Sec. 704(c)'s anti-abuse rule: a practitioner's guide.

Sec. 704(c)'s purpose is to prevent shifting of tax consequences among partners that can occur when property is contributed to a partnership with a fair market value that differs from its tax basis. Sec. 704(c)'s principles also apply to partnership property revaluations under Sec. 704(b). Allocations resulting from those revaluations are usually referred to as "reverse Sec. 704(c) allocations."

The regulations provide that Sec. 704(c) allocations can be made using the (1) traditional, (2) traditional with curative allocations and (3) remedial methods. (For additional discussion of these methods, see Walsh, "Accounting for Book-Tax Differences of Property Contributed to a Partnership," TTA, Apr. 1995, and May 1995.)

The traditional method provides that tax allocations of cost recovery deductions generally must follow book allocations for noncontributing partners. Regs. Sec. 1.704-3(b)(1) provides a safe harbor from the anti-abuse rule when it states,"If a partnership has no property the allocations from which are limited by the ceiling rule, the traditional method is reasonable when used for all contributed property." A ceiling: rule applies when the partnership's total tax deduction for cost recovery is less than the noncontributing partners' book allocations of cost recovery. This rule causes a temporary distortion by allocating a portion of the precontribution gain or loss to noncontributing partners. The ceiling rule distortion is reversed when the contributing partner and the noncontributing partners exit the partnership in a taxable transaction.

The anti-abuse rule is contained in Regs. Sec. 1.704-3(a)(10), which provides:

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 partners in a manner that substantially reduces the present value of the partners' aggregate tax liability.

The present value of the partners' aggregate tax liability can be reduced only when the contributing and non-contributing partners are in different tax brackets and the ceiling rule applies to the allocations. Therefore, a practitioner's first guideline is that the anti-abuse rule cannot apply if the contributing and noncontributing partners are in the same tax bracket. The second guideline is that the anti-abuse rule cannot apply unless the allocation of tax items has been limited by the ceiling rule.

Two factors must always be present before the anti-abuse rule applies. The contribution of property to the partnership and the selection of the Sec. 704(c) allocation method must have been made with a view to shifting the tax consequences in a manner that substantially reduced the present value of the partners' aggregate tax liability. The third guideline is that the anti-abuse rule cannot apply unless the contribution of property arid the selection of the Sec. 704(c) allocation method were made with a view to reducing the present value of the partners' aggregate tax liability. This guideline should give practitioners a great deal of comfort. Because of the "view to" requirement, it would appear to be impossible to "stumble" into an abusive situation.

Regs. Sec. 1.704-3(b) (2), Example (2), demonstrates an unreasonable use of the traditional method, as follows:

(i) Facts.

C and D form partnership CD and agree that each will be allocated a 50 percent share of all partnership items and that CD will make allocations under section 704(c) using 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. At the time of contribution, C has a built-in gain of $9,000 and the equipment is section 704(c) property. 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 [sections] 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 to the partners in the first year of the partnership. CD sells the equipment during the second year for $10,000 and recognizes a $10,000 gain ($10,000, the amount realized, less the adjusted tax basis of $0).

(ii) Unreasonable use of method. (A) At the beginning of the second year, both the book value and adjusted tax basis of the equipment are $0. Therefore, there is no remaining built-in gain. The $10,000 gain on the sale of the equipment in the second year is allocated $5,000 each to C and D. The interaction of the partnership's one-year write-off of the entire book value of the equipment and the use of the traditional method results in a shift of $4,000 of the precontribution gain in the equipment from C to D (D's $5,000 share of CD's $10,000 gain, less the $1,000 tax depreciation deduction previously allocated to D).

(B) 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 with a low marginal tax rate and away from a partner with a high marginal tax rate.

(C) Under these facts, 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 .... Under other facts (for example, if the partnership holds multiple section 704(c) properties and either uses multiple allocation methods or uses a single allocation method where one or more of the properties are subject to the ceiling rule), the allocation to C may not be reasonable.

This gives rise to another guideline: The anti-abuse rule will apply when, in addition to all other requirements, the timing of the ceiling rule distortion is accelerated.

However, an unanswered question is posed by this example. Would the use of the traditional method with the ceiling rule have been abusive if the property had not been sold (presumably within a prearranged time) at the beginning of the second year? If the answer to the question is yes, why was the sale included in the facts?

If the IRS intends to apply the anti-abuse rule in situations in which the timing of the ceiling rule distortion is not accelerated, it could have more effectively communicated its intent. First, the transaction in Example (2) could have been described without the property's sale at the beginning of year 2. This example would then demonstrate that the property was contributed and the traditional allocation method selected with a view to reduce the present value of the partners' aggregate tax liability. In such an example, the guidance for practitioners would have been clearer.

The regulations do not require tax-payers to select the Sec. 704(c) allocation method that results in the highest possible tax liability. Regs. Sec. 1.704-3 (a)(1) pertinently provides that"[a]n allocation method is not necessarily unreasonable merely because another allocation method would result in a higher aggregate tax liability."

Presumably, this general principle would allow taxpayers to calculate the aggregate tax liabilities before entering into a transaction and to select the allocation method that results in the least amount of aggregate tax liability. How, then, are practitioners to reconcile the conflicting statements in the Sec. 704(c) regulations?

The Sec. 704(c) anti-abuse provisions appear to be at odds with this general principle when there is a contribution of property and the selection of the traditional method yields a lower aggregate tax liability than another allocation method. Interpreting Example (2) as applying only when the timing of the ceiling rule distortion has been accelerated would reconcile the apparent conflict between this general principle and the anti-abuse rule.

There can be many transactions in which there is no clear guideline for applying the anti-abuse rule. Example (2) indicates that a gain chargeback provision would have made the traditional method reasonable under those facts. However, in nontax shelter situations, if taxpayers intend to hold the contributed property for most or all of its economic useful life (and not sell the property in the second year), a gain chargeback provision may provide a "reasonable basis" (within the meaning of Sec. 6662) for using the traditional method. Of course, appropriate disclosure of this position should be considered.

On the other hand, when taxpayers require absolute certainty of result when holding the property throughout its economic life, practitioners may need to recommend the traditional method with curative allocations. A curative allocation is an allocation of income, gun, loss or deduction for tax purposes that differs from the partnership's allocation of the corresponding book item.

If the contributed property is to be sold by the partnership fairly soon after the contribution (as in Example (2)), a gain chargeback provision should be sufficient to ensure that the traditional method is reasonable.

In other cases, it may be possible to use an S corporation instead of a partnership. Because there is no S corporation equivalent to Sec. 704(c), the results from contributing appreciated or depreciated property to an S corporation can differ dramatically from the results under the partnership rules.