Several options available for property contributed to a partnership.

As the globalization of the world economy continues, companies are increasingly turning to the corporate joint venture as a form to conduct new businesses. Corporate joint ventures provide instant access to technology, financing, new markets, and numerous other benefits that otherwise might take years for a company to obtain. The vehicle chosen to conduct these joint venture operations is frequently either a partnership or a limited liability company (LLC). An LLC provides limited liability for all of its owners and nearly all LLCs are taxed as partnerships for federal tax purposes.(1)

When forming a partnership or LLC, corporations must consider the tax effects of the specific provisions of the agreement. Recently, the Internal Revenue Service issued regulations under section 704(c) of the Internal Revenue Code governing the contribution of property to a partnership. Section 704(c) applies any time a partner contributes appreciated or depreciated property to a partnership or when a new partner is admitted to a partnership. The new regulations afford taxpayers substantial flexibility and tremendous tax planning opportunities. They also contain significant traps for the unwary.

Overview

General Rules and Principles

The Tax Reform Act of 1984(2) amended section 704(c) to require partnerships to take into account precontribution gain or loss on contributed property. Specifically, the statute now requires that income, gain, loss, and deduction with respect to property contributed to a partnership by a partner be shared among the partners to reflect any variance between the basis of the property to the partnership and its fair market value at the time of contribution. The 1984 Act granted broad regulatory authority to the Department of the Treasury and the IRS to determine how these allocations should be made. Both final and temporary regulations were published in the Federal Register on December 22, 1993, effective for contributions of property after December 20, 1993. Although the new regulations leave several questions unanswered, they represent an effort by the IRS to provide broad guidance that is relatively simple for both taxpayers to comply with and the IRS to administer.

The guiding principle of the regulations is that any precontribution gain (built-in gain) or precontribution loss (built-in loss) from property contributed to a partnership must be allocated to the contributing partner using a reasonable method.(3) The IRS did not attempt to prescribe an intricate allocation system that explicitly describes how section 704(c) allocations must be made but that would be over-burdensome for taxpayers to comply with. Rather, the regulations provide that the IRS will accept any reasonable method consistent with the purpose of section 704(c).(4) This has been described as an "overall reasonableness" standard that applies to all aspects of section 704(c) allocations. In addition to the reasonableness requirement, the regulations propound an anti-abuse rule.

The final regulations specifically describe two reasonable methods of making section 704(c) allocations: the Traditional Method,(5) and the Traditional Method with Curative Allocations.(6) The Remedial Allocation Method described in the temporary regulations represents a third reasonable method.(7) Partnerships may also use any other reasonable method that satisfies the purpose of the statute.(8) Partnerships may use different methods with respect to different items of section 704(c) property, as long as the partnership and the partners consistently apply a single reasonable method for each item of section 704(c) property.(9) Property is considered section 704(c) property if at the time of contribution to the partnership the fair market value of the property (book value) differs from the contributing partner's adjusted tax basis in the property.(10) The amount of the built-in gain or loss is reduced as the variance between the property's book value and the partnership's adjusted tax basis in the property decreases over the years.

Effective Dates

Both the final and temporary regulations are effective for property contributed to a partnership and to restatements pursuant to section 1.704-1(b)(2)(iv)(f) after December 20, 1992. Prior to December 21, 1993, the only expressly permitted method was the Traditional Method. Many partnerships, however, used various other methods. Allocation methods used before the effective date of the regulations probably will not be challenged by the IRS if they are deemed reasonable under the new regulations. In contrast, partnerships that used allocation methods that are not considered reasonable under the new regulations may face IRS scrutiny. For example, partnerships that began using the Deferred Sale Method--which was set forth in section 704(c) proposed regulations that were issued on December 24, 1994 but which is not included in the final regulations--may have trouble convincing the IRS to respect that method for any taxable year because the final regulations specifically describe it as an unreasonable method.

Reverse Section 704(c) Allocations

The partnership must also follow the principles of section 704(c) and the regulations when a partnership chooses to revalue partnership property under the provisions of section 704(b). For example, when a new partner is admitted to the partnership, any built-in gain or loss in the partnership assets at the time the new partner is admitted is allocated to the current partners and not to the new partner.(11) These types of allocations are known as "reverse section 704(c) allocations." The regulations provide considerable flexibility for reverse section 704(c) allocations. Partnerships are permitted to use different methods for allocations relating to reverse section 704(c) than for contributed section 704(c) property, even if at the time of revaluation the property is already subject to section 704(c).(12) Partnerships are also permitted to use different allocation methods each time the partnership revalues its property.(13) To the extent the regulations apply to built-in gain or loss on property contributed to a partnership, they also apply to reverse section 704(c) amounts resulting from a revaluation of partnership property.

Anti-abuse Rule

The IRS received numerous comments that the anti-abuse rule in the proposed regulations was both too broad and too vague. In response, the IRS attempted to clarify the meaning and scope of the anti-abuse rule. The final regulations provide that "[a]n 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."(14) The specific anti-abuse rule complements the more general "overall reasonableness" requirement that allocations must be consistent with the purposes of section 704(c). The temporary regulations provide that if an allocation method is found to be unreasonable, the IRS will not require the partnership to use the Remedial Allocation Method.(15)

The final regulations provide two examples of the operation of the anti-abuse rule: Example 2 of Treas. Reg. [sections] 1.704-3(b)(2), and Example 3 of Treas. Reg. [sections] 1.704-3(c)(4). Both examples illustrate that a section 704(c) allocation method cannot be chosen 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 in a relatively short period of time.

Reasonable Allocation Methods

The choice of a section 704(c) allocation method can have a considerable effect on the taxable income of each o the partners. Even when there will be no contributed property at the formation of the partnership, later contributions or a revaluation event resulting in reverse section 704(c) allocations make a choice of section 704(c) allocation method one of the critical issues to be resolved during formation. This decision can involve a lot of peering into the crystal ball for partners attempting to foresee how each allocation method will affect them. Appendix A provides a numerical example that compares the three reasonable methods defined in the regulations.

The regulations do not specify when an allocation method must be chosen. A reading of the entire statute suggest that an allocation method need not be chosen until an allocation subject to section 704(c) is actually made. Therefore, a partnership has until the due date of its partnership tax return for the year section 704(c) property is contributed to the partnership to select an allocation method. Once a method is chosen, the partnership and the partners must consistently use the method for that item of section 704(c) property.(16) In a major change from the proposed regulations, the final regulations specifically proscribe the used of the Deferred Sale Method.(17) The Remedial Allocation Method, however, while less complicated than the Deferred Sale Method, is intended to yield similar results.

The Traditional Method

The Traditional Method is the method described in section 1.704-1(c)(2) of the former regulations that were written when the currently mandatory section 704(c) was elective. The Traditional Method requires the partnership to make appropriate allocations of income, gain, loss, or deduction to avoid shifting the tax consequences of built-in gain or loss.(18) Generally, the partnership accomplishes these allocations in two ways. First, upon the disposition of contributed property, the partnership must allocate any gain or loss to the contributing partner, up to the amount of the remaining built-in gain or loss in the property (subject to the ceiling rule discussed in the next section). The remaining gain or loss of the partnership is then allocated according to the partnership agreement. Second, for property subject to depreciation or other cost recovery, the partnership must allocate to the noncontributing partners, if possible, the full cost-recovery deduction they are entitled to before making any allocation to the contributing partner. This means that the contributing partner will receive either a smaller deduction (for built-in gain property) or a larger deduction (for built-in loss property) than the partner would have received if it had not been section 704(c) property, thereby taking into account a portion of the precontribution gain or loss.

Example 1. Corp. T and Corp. K form 50-50 partnership

TK and agree to use the Traditional Method.

T contributes depreciable property with a tax

basis of $60,000 and a fair market value of

$100,000, and K contributes $100,000 cash. T has

a built-in gain of $40,000. The property is depreciated

using the straight-line method over a 10-year

useful life. Because the property depreciates at an

annual rate of 10 percent, K is entitled to a depreciation

deduction of $5,000 per year for both book

and tax purposes (50 percent of TK's $10,000 deduction).

Under the Traditional Method, the partnership's

$6,000 tax deduction is allocated $5,000

to K (the amount of K's book deduction) and the

remaining $1,000 to T. At the end of that year, TK

has an adjusted book basis for the property of

$90,000 ($100,000 less the $10,000 book depreciation

deduction), and an adjusted tax basis in the

property of $54,000 ($60,000 less the $6,000 tax

depreciation deduction). T's built-in gain with respect

to the property decreases to $36,000 ($90,000

book value less $54,000 tax basis). If TK sells the

property at the beginning of TK's second year for

$100,000, TK recognizes a tax gain of $46,000

($100,000, the amount realized, less the adjusted

basis of $54,000). Only $36,000 of gain must be

allocated to T to account for its built-in gain. The

remaining $10,000 of gain is allocated equally between

T and K in accordance with the partnership

agreement.

The Ceiling Rule

The final regulations retain the ceiling rule of the Traditional Method. The ceiling rule provides that the total cost-recovery deduction or gain or loss allocated to the partners with respect to an item of section 704(c) property cannot exceed the amount of the partnership's cost recovery or gain or loss with respect to that property.(19) The effect of the ceiling rule is to temporarily shift a portion of the built-in gain or built-in loss to the noncontributing partners; the distortion will not be corrected until the noncontributing partner sells the partnership interest or the partnership interest is redeemed.(20) The ceiling rule can also cause distortions in the character of particular tax items that will never be corrected.(21) A ceiling rule distortion created by the sale of the contributed property is illustrated in Example 2. A ceiling rule problem created by cost-recovery allocations is illustrated in Example 3.

Example 2. Corp. S and Corp. K form 50-50

partnership SK and agree to use the Traditional

Method. S contributes undeveloped real property

with a tax basis of $20,000 and a fair market value

of $100,000, and K contributes $100,000 cash. S

has a built-in gain of $80,000. SK later sells the

property for $90,000 and recognizes a tax gain of

$70,000. The entire gain is allocated to S. The

ceiling rule denies K any share of the $10,000

post-contribution loss from the property.

Example 3. Corp. F and Corp. B form 50-50

partnership FB and agree to use the Traditional

Method. F contributes depreciable property with a

tax basis of $20,000 and a fair market value of

$100,000, and B contributes $100,000 cash. F has

a built-in gain of $80,000. The property is depreciated

using the straight-line method over a 10-year

useful life. Because the property depreciates at an

annual rate of 10 percent, B would have been entitled

to a depreciation deduction of $5,000 per year

for both book and tax purposes but for the ceiling

rule limitation. Under the Traditional Method,

each year the $2,000 tax depreciation deduction is

allocated solely to B. Because of the ceiling rule, B

does not receive the remaining $3,000 of depreciation

deduction to which B is economically entitled.

After FB depreciates the property for 10 years,

and assuming no other economic activity, B has

$20,000 of tax depreciation deductions, reducing

its basis to $80,000. If the property is then worthless

and FB liquidates, F and B each receive

$50,000 (the $100,000 of cash remaining in the

partnership is distributed $50,000 each based on

their $50,000 book capital account balances). B

has a $30,000 capital loss. This will correct the

distortion created by the ceiling rule over the years

($3,000 depreciation deduction shortfall each year

for 10 years), but what would have been ordinary

deductions have been converted to a capital loss.

The final regulations contain a safe harbor providing that if a partnership has no property subject to the ceiling rule, the Traditional Method is always reasonable when used for all contributed property.(22) The other two reasonable methods described in the regulations avoid the income shifting engendered by the ceiling rule.

The Traditional Method with Curative Allocations

Curative allocations are special allocations of partnership items of income, gain, loss, or deduction that are intended to 'cure" ceiling rule distortions. The allocations are made for tax purposes only and not on the partnership's books because their purpose is to equalize the overall allocations of book and tax items to noncontributing partners.(23) Some taxpayers used curative allocations prior to the issuance of the final regulations because they provide an effective means of mitigating or eliminating the distortions caused by the ceiling rule.

A partnership has several options in utilizing curative allocations as long as the method chosen is consistent with respect to each item of contributed property from year to year.(24) A partnership may restrict curative allocations to a particular tax item, such as deductions, or even further, such as depreciation deductions from a particular item of partnership property.(25)

Example 4. Corp. X and Corp. Y form 50-50 partnership

XY and agree to use the Traditional Method

with Curative Allocations. X contributes Machine

A with a tax basis of $20,000, and a fair

market value of $100,000. X has a built-in gain of

$80,000. Y contributes Machine B with both a fair

market value and tax basis of $100,000. In XY's

first year, the proceeds generated by the machinery

exactly equal XY's operating expenses. Each

piece of equipment is depreciable using the

straight-line method over a 10-year life. Thus, each

year there is $10,000 of book depreciation for each

machine, and $2,000 of tax depreciation for Machine

A and $10,000 of tax depreciation for Machine

B. Under the Traditional Method, X and Y

are each allocated $10,000 of depreciation for book

(continued on page 296)

purposes. X and Y are also each allocated $5,000 of

depreciation for Machine B for tax purposes. Because

there is only $2,000 of depreciation for tax

purposes for Machine A, however, it all must be

allocated to Y. At the end of the first year, X's and

Y's book and tax capital account's are, as follows:

      Corp. X               Corp. Y
  Book        Tax       Book       Tax
$100,000    $20,000   $100,000   $100,000   Initial contribution
  (5,000)       (0)    (5,000)    (2,000)     Machine A
                                            depreciation
  (5,000)    (5,000)   (5,000)    (5,000)     Machine B
                                            depreciation
$90,000     $15,000    $90,000     $93,000

Under the Traditional Method with Curative Allocations, XY may allocate to Y an additional $3,000 of tax depreciation from Machine B, that otherwise would have been allocated to X, because the ceiling rule creates a $3,000 disparity between Y's book and tax capital accounts. This allocation results in capital accounts at the end of XY's first year, as follows:

    Corp. X                Corp. Y
  Book     Tax         Book       Tax

$100,000   $20,000   $100,000   $100,000   Initial contribution
  (5,000)      (0)    (5,000)    (2,000)      Machine A
                                           depreciation
  (5,000)  (2,000)    (5,000)    (8,000)      Machine B
                                           depreciation
$90,000    $18,000    $90,000    $90,000

Thus, the curative allocation has corrected the distortion caused by the ceiling rule.

Limitations on Curative Allocations

Curative allocations are subject to a number of limitations. First, curative allocations cannot exceed the amount necessary to offset the effect of the ceiling rule for the current taxable year.(26) For example, in Example 4, the curative allocation is limited to $3,000, because any larger curative allocation would create a new disparity in Y's capital accounts. The proposed regulations permitted "makeup" curative allocations for past years in which there were insufficient items to make complete curative allocations. The final regulations, in contrast, only permit make-up allocations upon disposition of the contributed property.(27)

Curative allocations are also limited to tax items that are expected to have substantially the same effect on each partner's tax liability as the tax items limited by the ceiling rule.(28) This "type" limitation not always be an easy test to apply depending on the type of partnership item from which the partnership intends to make the curative allocation. In order to comply with the type limitation, the overall effect of the allocation on all the partners must be examined. Hence, partnerships opting to use curative allocations must know some of the details about the overall tax status of its partners.(29) There are several factors involved in determining whether a partnership item meets the type limitation for a curative allocation. One concern is the difference between capital and ordinary items. For instance, in Example 4, without a curative allocation Y will receive only a $2,000 tax depreciation deduction when it has a book deduction of $5,000. Therefore, Y will have $3,000 of excess ordinary income. On the other hand, X will be allocated $3,000 too little of ordinary income. In order to meet the type limitation, Y must either receive a curative allocation of $3,000 of additional ordinary deductions or have $3,000 less of ordinary income allocated to it. Another concern is whether the partnership has any foreign partners. For example, a curative allocation to the contributing partner of foreign source income in a particular statutory grouping under section 904(d) will not be reasonable if the ceiling rule limits foreign source income from a different statutory grouping.(30)

The final regulations added a timing limitation to curative allocations. In some situations, making curative allocations over the remaining recovery period of the property will be unreasonable. In those cases, curative allocations may be made over the a reasonable period of time, such as over the property's economic life, if the allocations are provided for at the time of contribution.(31)

A final limitation on curative allocations is that they are subject to both the overall reasonableness standard and the anti-abuse rule. Accordingly, taxpayers must be wary even if a curative allocation passes all the other limitations.

The Remedial Allocation Method

The Remedial Allocation Method provides a second method to overcome the effect of the ceiling rule. Remedial allocations are artificial tax allocations of income and gain, offset by artificial tax allocations of loss and deduction, that have absolutely no effect on the partner's book capital accounts. Remedial allocations differ from curative allocations in that they are purely artificial tax allocations. Curative allocations, on the other hand, involve the reallocation of existing partnership tax items. Under the Remedial Allocation Method, if the ceiling rule results in a tax allocation to a noncontributing partner that differs from the corresponding book allocation, the partnership will make a remedial allocation of income, gain, loss, or deduction to the noncontributing partner equal to the full amount of the limitation caused by the ceiling rule, and a simultaneous, offsetting remedial allocation of deduction, loss, gain, or income to the contributing partner.(32)

Remedial allocations have a type limitation similar to that of curative allocations. Remedial allocations must have the same effect on each partner's tax liability as the tax item limited by the ceiling rule.(33) Because the allocation is artificial, partnerships must create allocations that will have the same effect as the item limited by the ceiling rule, rather than the "substantially similar" standard of curative allocations.

Example 5. Corp. A and Corp. J form 50-50 partnership

AJ and agree to use the Remedial Allocation

Method. A contributes undeveloped land,

Blackacre, with a basis of $50,000 and a fair market

value of $100,000. J contributes $100,000 cash.

Later AJ sells Blackacre for $80,000 resulting in a

tax gain of $30,000 and a book loss of $20,000. A

and J are each allocated $10,000 of book loss, and

A is allocated all $30,000 of tax gain. The ceiling

rule prohibits the allocation of a $10,000 tax loss

to J. AJ could, however, make a remedial tax allocation

of $10,000 of loss to J and a corresponding

remedial tax allocation of $10,000 of gain to A.

This $10,000 of gain to A, added to the $30,000 of

tax gain already allocated to A, equals A's original

$50,000 of precontribution gain in Blackacre less

A's $10,000 share of the postcontribution loss.

The final regulations provide that, if the item limited by the ceiling rule is depreciation, the offsetting remedial allocation of income to the contributing partner must be of the same type of income that the contributed property produces. This standard can be difficult to apply because it is not always easy to determine exactly what type of income a depreciable asset produces.(34)

The Remedial Allocation Method contains a special bifurcated method for recovering book depreciation. The portion of the partnership's book basis in the property equal to the tax basis at the time of contribution is recovered in the same manner the tax basis in the property is recovered. The new book basis in the property (the amount by which the partnership's book basis exceeds the tax basis) is recovered using any method available to the partnership for newly purchased property placed in service at the time of contribution.(35)

Example 6. Corp. S and Corp. M form 50-50 partnership

SM and agree to use the Remedial Allocation

Method. S contributes depreciable property

with a tax basis of $20,000 and a fair market value

of $100,000. M contributes undeveloped land with

both a tax basis and fair market value of $100,000.

In,all years, Sm's revenue exactly equals operating

expenses. The depreciable property has 4 years

of its 10-year useful life remaining and the partnership

uses the straight-line method of depreciation.

In years 1 through 4, the partnership has book

depreciation of $13,000 (one-fourth of the old

$20,000 basis plus one-tenth of the new $80,000

basis) and tax depreciation of $5,000 (one-fourth

of the $20,000 tax basis). S and M are each allocated

$6,500 of book depreciation. Because there is

only $5,000 of tax depreciation, however, it all

must be allocated to M. Because the ceiling rule

causes a disparity of $1,500 between M's book and

tax capital accounts, SM makes a remedial allocation

of $1,500 of depreciation to M and a corresponding

allocation of $1,500 of income to S. This

allocation results in capital accounts at the end of

SM's first year, as follows:

      Corp. S              Corp. M
  Book       Tax       Book       Tax
$100,000   $20,000   $100,000   $100,000   Initial contribution
 (6,500)       (0)    (6,500)    (5,000)     Depreciation
           (1,500)               (1,500)       Remedial
                                               Allocation
$93,500    $21,500    $93,500    $93,500   End of Year 1

The first four years of allocations will be, as follows:

    Corp. S                  Corp. M
  Book         Tax       Book       Tax
$100,000     $20,000   $100,000   $100,000   Initial contribution
  (26,000)       (0)   (26,000)   (20,000)     Depreciation
             (6,000)               (6,000)       Remedial
                                                 Allocation
$74,000      $26,000    $74,000    $74,000     End of Year 4

In each of years 5 through 10, the partnership has

book depreciation of $8,000 (one-tenth of the new

$80,000 basis) and tax depreciations of $0 (the tax

depreciation is used up in years one through four).

S and M are each allocated $4,000 of book depreciation

and $0 of tax depreciation. Because the ceiling

rule causes a disparity of $4,000 between M's

book and tax capital accounts, SM makes a remedial

allocation of $4,000 of depreciation to M and a

corresponding allocation of $4,000 of income to S.

This allocation results in capital accounts at the

end of SM's fifth year, as follows:

      Corp. S             Corp. M
  Book      Tax       Book       Tax
$74,000   $26,000   $74,000   $74,000    Beginning
                                          of year 5
(4,000)       (0)   (4,000)       (0)   Depreciation
            4,000             (4,000)     Remedial
                                          Allocation
$70,000   $30,000   $70,000   $70,000   End of Year 5

Allocations for years five through ten will be, as

follows:

    Corp. S              Corp. M
  Book      Tax       Book     Tax
$74,000   $26,000   $74,000   $74,000   Initial contribution
(24,000)      (0)  (24,000)       (0)     Depreciation
           24,000              24,000       Remedial
                                            Allocation
$50,000   $50,000   $50,000   $50,000   End of Year 10

Thus, the remedial allocation has corrected the distortion caused by the ceiling rule.

Special Rules

Transfer of a Partnership Interest

The final regulations clarify that when a partnership interest is transferred, built-in gain or loss must be allocated to the transferee as it would have been allocated to the transferor.(36) If only a portion of the interest is transferred, a proportionate share of the built-in gain or loss must be allocated to the transferee partner.(37)

Disposition of Property in a Nonrecognition Transaction

The final regulations provide that, if a partnership disposes of section 704(c) property in a nonrecognition transaction, the substituted basis property is treated as replacing the section 704(c) property.(38) The partnership must continue to use the same allocation method for the property received in the transaction. If gain or loss is recognized, appropriate adjustments must be made. The lack of a specific requirement for boot creates some uncertainty. It is unclear whether the boot should be allocated to the contributing partner on some type of proportionate basis or whether the boot should be first recognized by the contributing partner up to the amount of built-in gain.

A special tracking rule applies for contributions by a partnership under section 351. When section 704(c) property is contributed to a corporation under section 351, a specific block of stock is treated as being received for each item of section 704(c) property in order to preserve each property's built-in gain or loss amount.(39)

Tiered Partnerships

Tiered partnerships present one of the most difficult areas in applying section 704(c). The regulations provide that if a partnership contributes section 704(c) property to a second partnership (the lower-tier partnership), or if a partner that has contributed section 704(c) property to a partnership contributes that partnership interest to a second partnership (the upper-tier partnership), the upper-tier partnership must allocate its distributive share of lower-tier partnership items with respect to that section 704(c) property in a manner that takes into account the contributing partner's remaining built-in gain or loss.(40)

Example 7. Corp. A and Corp. B form 50-50 partnership

AB and agree to use the Traditional Method.

A contributes depreciable property with a tax

basis of $60,000 and a fair market value of

$100,000, and B contributes $100,000 cash. A has

built-in gain of $40,000. The property is depreciated

using the straight-line method over a 10-year

useful life. AB immediately contributes the property

to partnership ABJ for a 50-percent interest

therein. ABJ uses the traditional Method for all

its assets. J Corp. contributes to ABJ for the other

50-percent interest a building with both a tax basis

and fair market value of $100,000. The building

will be depreciated straight-line over the remaining

10 years of its useful life.

AB's interest in ABJ is treated as section 704(c)

property. At the end of ABJ's first taxable year, the

$10,000 tax and book depreciation deduction from

J's building, and the $10,000 book depreciation

deduction from Ks property, are allocated $5,000

each to J and AB. AB's allocation is then allocated

$2,500 each to A and B.

It is unclear how the $6,000 tax deduction attributable

to A's property is allocated under section 704(c).

Absent the ceiling rule, B would receive a tax depreciation

deduction of $2,500 and J would receive

a depreciation deduction of $5,000. Therefore, one

possibility is to divide ABJ's $6,000 tax depreciation

deduction pro rata between B and J (the noncontributing

partners) $2,000 to A and $4,000 to J.

Alternatively, the $6,000 tax depreciation deduction

could be allocated first at the ABJ level $5,000

to J (the amount of J's book depreciation deduction)

and $1,000 to AB. AB's $1,000 tax depreciation deduction

would then be allocated to B.

Small Disparities

A small disparity exists if the book value of all properties contributed by one partner during the partnership taxable year does not differ from the adjusted tax basis by more than 15 percent of that tax basis, and the total disparity does not exceed $20,000.(41) In this situation, a partnership may (i) use a reasonable section 704(c) method, (ii) disregard section 704(c), or (iii) apply section 704(c) only when the property is sold.(42) The final regulations significantly broadened the definition of small disparities contained in the proposed regulations. The 15-percent test now applies on an aggregate, rather than property-by-property, basis and the dollar amount has been raised from $10,000 to $20,000.

Aggregation

The final regulations generally do not permit the aggregation of items of contributed property for purposes of section 704(c) allocations.(43) Aggregation is permitted, however, for the following specific categories of assets:

* all property, other than real property, that is included

in the same general asset account of the

partner and the partnership under section 168,(44)

* all property, other than real property, with a basis

equal to zero,(45)

* each item of inventory, other than securities or

similar investments, for partnerships that do not

use a specific identification method of accounting,(46)

and

* types of property designated in guidance published

in either the Internal Revenue Bulletin or permitted

by the IRS in a private letter ruling.(47)

The temporary regulations also generally provide a special rule that, when making reverse section 704(c) allocations, a securities partnership may consistently aggregate all gains from securities and similar investments and separately aggregate all losses from securities and similar investments (as defined in section 1.704-1(b)(2)(iv)(f)(5)(iii) (i.e., gains must be aggregated separately from losses.(48)

Conclusion

The new section 704(c) regulations provide tremendous planning opportunities for corporations entering into joint ventures through the use of partnerships and LLCs. Corporations can meet the reasonableness requirement of the regulations while still electing to use the most beneficial allocation method. Of course, what is good for one partner is often bad for the others. Therefore, corporations must also pay close attention to the allocation method being proposed by their partners.

-Notes-

(1) LLCs are classified for federal tax purposes using Treas. Reg. [sections] 1.7701-2. In some states, the provisions of the LLC statute are such that all LLCs will be taxed as partnerships. In other states, depending upon the LLCs organizational documents, it may be possible for the LLC to be classified as a corporation. If LLC owners desire to be taxed as a regular corporation, there is little reason to form an LLC rather than a C corporation. (2) The Tax Reform Act of 1984, Division A of Deficit Reduction Act of 1984, Pub. L. No. 98-369, 98th Cong., 2d Sess. (July 18, 1984). (3) Treas. Reg. [sections] 1.704-3(a)(1). (4) Id. (5) Treas. Reg. [sections] 1.704-3(b). (6) Treas. Reg. [sections] 1.704-3(c). (7) Temp. Reg. [sections] 1.704-3T(d). (8) Treas. Reg. [sections] 1.704-3(a)(1). The Partnership Committee of the Section of Taxation of the American Bar Association has submitted comments on section 704(c) suggesting the use of a Disparity Offset Model (DOM). DOM contains elements of both the deferred sale method and curative allocations. The IRS has informally indicated that DOM is a reasonable method under the regulations. (9) Treas. Reg. [sections] 1.704-3(a)(2). (10) Treas. Reg. [sections] 1.704-3(a)(3). Partnerships are required to use a book value that reflects the fair market value of the property at the time of contribution and is subsequently adjusted for cost recovery and other recognition events under the principles of Treas. Reg. [sections] 1.704-1(b)(2)(iv). Partnerships that follow the capital account maintenance rules of Treas. Reg. [sections] 1.704-1(b)(2)(iv) are required to use the fair market value of property at contribution as its initial book value. Because not all partnerships adhere to the capital account maintenance rules, book value for purposes of the section 704(c) regulations is defined as the book value determined under Treas. Reg. [sections] 1.704-1(b) (i.e., a book value that reflects the fair market value upon contribution and is subsequently adjusted for cost recovery and other recognition events). (11) Treas. Reg. [sections][sections] 1.704-1(b)(2)(iv)(d), (e), (f), and (r). (12) Treas. Reg. [sections] 1.704-3(a)(6)(i). (13) Id. (14) Treas. Reg. [sections] 1.704-3(a)(10). (15) Temp. Reg. [sections] 1.704-3T(d)(4). (16) Treas. Reg. [sections] 1.704-3(a)(2). (17) Treas. Reg. [sections] 1.704-3(a)(1). (18) Id. (19) Id. (20) The ceiling rule problem will be corrected upon the sale of the partnership interest or upon redemption because there will be a disparity between the partner's basis in the partnership interest and the capital account balance that is attributable to the ceiling rule. The amount realized for the partnership interest in a sale or the value of partnership property received in a redemption will reflect this difference. This will trigger a gain or loss to reverse the effects of the ceiling rule. (21) For example, if the ceiling rule problem was created by insufficient cost recovery deductions being allocated to the noncontributing partner, then the noncontributing partner will report too much ordinary income. Upon sale of the interest or redemption the partner will have a capital loss (or a smaller capital gain) to correct the distortion. Therefore, the ceiling rule converts those ordinary deductions into capital losses. (22) Treas. Reg. [sections] 1.704-3(b)(1). (23) Treas. Reg. [sections] 1.704-3(c)(1). (24) Treas. Reg. [sections] 1.704-3(c)(2). (25) Treas. Reg. [sections] 1.704-3(c)(1). (26) Treas. Reg. [sections] 1. 104-3(c)(3)(i). (27) Id. (28) Treas. Reg. [sections] 1.704-3(c)(3)(iii). (29) The regulations do not address when differences for a partner subject to the alternative minimum tax must be taken into account. (30) Treas. Reg. [sections] 1.704-3(c)(3)(iii). The passive activity rules in section 469 also create difficulties under the type limitation, where the partners are closely held corporations, personal service corporations, individuals, partnerships, or S corporations. For example, a problem arises in Example 4 if the facts are the same, except that under section 469, X is closely held and is active as to the Machine A activity and passive as to the Machine B activity, and Y is closely held and is passive as to Machine A activity and active as to Machine B activity. Because of the ceiling rule, Y is allocated insufficient deductions from Machine A. These deductions would be passive losses to Y. In Example 4, X-Y allocated additional depreciation deductions from Machine B to Y. Deductions attributable to Machine B are active losses to Y. Therefore, the curative allocation in this example would fail the type limitation. (31) Treas. Reg. [sections] 1.704-3(c)(3)(ii). See also Teas. Reg. [sections] 1.704-3(c)(4), Example 3(ii)(c). (32) Temp. Reg. [sections] 1.704-3T(d)(1). (33) Temp. Reg. [sections] 1.704-3T(d)(3). (34). Id. (35) Temp. Reg. [sections] 1.704-3T(d)(2). (36) Treas. Reg. [sections] 1.704-3(a)(7). (37) Treas. Reg. [sections] 1.704-3(a)(8). (38) Treas. Reg. [sections] 1.704-3(a)(9). (39) Treas. Reg. [sections] 1.704-3(e)(1)(ii). (40) Treas. Reg. [sections] 1.704-3(e)(1)(i). (41) Treas. Reg. [sections] 1.704-3(a)(2). (42) Treas. Reg. [sections] 1.704-3(e)(2)(i). (42) Treas. Reg. [sections] 1.704-3(e)(2)(ii). (43) Treas. Reg. [sections] 1.704-3(e)(2)(iii). (44) Treas. Reg. [sections][sections] 1.704-3(e)(2)(iv) and (v). Temp. Reg. [sections] 1.704-3T(e)(3)(i). The scope of the securities aggregation rule in the temporary regulations is unclear. Many practitioners have requested that the rule be clarified when final regulations are issued.

DAVID EDQUIST is an attorney in the National Tax Consulting Group of Coopers & Lybrand located in Washington, D.C. He is a graduate of the North Carolina School of Law and received his LL.M. in Taxation from Georgetown Coopers & Lybrand, Mr. Edquist was with the IRS Office of Chief Counsel where he participated in the development of the section 704(c) regulations.