Small business tax solutions.

This series is based on questions from AICPA tax certificate of educational achievement (CEA) courses.

When appreciated depreciable property is contributed to a partnership in exchange for a partnership interest, there may not be sufficient tax depreciation to allocate to noncontributing partners based on book (market) value. How can this situation be handled?

A. Until recently, the "ceiling rule" that causes this problem could not be avoided. Treasury regulations section 1.704-3--proposed in 1993 and finalized in 1995--provides three optional accounting methods for the effects of the ceiling rule:

1. Traditional method.

2. Traditional method with curative allocations.

3. Remedial allocation method.

ILLUSTRATION

The three methods can be best explained with an example. Assume Z contributes depreciable real estate to the XYZ partnership in exchange for a one-third interest in partnership capital, profits and losses. The property has an adjusted basis of $150,000 with a remaining recovery period of 10 years and a market value of $450,000 with a remaining economic life of 15 years.

Straight-line depreciation applies and tax depreciation is $15,000 per year. Book depreciation is $30,000, and partners X and Y (each with a one-third interest) expect to receive a $10,000 depreciation allocation each even though total tax depreciation is limited to $15,000.

Before Internal Revenue Code section 704 was amended in 1984, to add section 704(c) (1) (A), the partnership could have allocated $5,000 of tax depreciation to each partner and ignored the expectations of the noncontributing partners. The partners could have agreed among themselves to recognize the noncontributing partners' expectations, except the ceiling rule would have limited the allocations to X and Y to $7,500 each with nothing left to allocate to Z. Such an agreement became mandatory beginning with the Deficit Reduction Act of 1984.

Traditional method. This method has the same effect as the ceiling rule, depriving both X and Y of $2,500 of annual depreciation deductions.

Traditional method with curative allocations. This method requires tax and book depreciation to be computed proportionally. Thus, over a 10-year life, book depreciation (under the section 704(b) regulations) would be $45,000 per year--S15,000 to each partner.

Tax depreciation of $15,000 would be split evenly between X and Y. Then, to ameliorate the effect of the ceiling rule, the partnership would make a special allocation of a $7,500 ordinary loss each to X and Y with an offsetting special allocation of $15,000 of ordinary income to Z. Thus, both X and Y would receive tax deductions equal to their shares of book depreciation. The traditional method with curative allocations must be elected in the partnership agreement.

Remedial allocation method. This method generally accomplishes the same net result, over time, as the traditional method with curative allocations. However, book depreciation is computed using the property's remaining economic life. In the example, book depreciation is $30,000 for 15 years, allocated $10,000 to each partner. The exhibit below shows the results. The remedial allocation method (and the traditional method) does not have to be provided for in the partnership agreement.

COMMENTS AND CAVEATS

The ceiling rule and the three methods of accounting for it apply in all cases where depreciation and gain or loss on contributed property differ for tax and book purposes.

To make such a curative allocation under the traditional method with curative allocations, the partnership must have other items of the same character as the item limited under the ceiling rule. However, under the remedial allocation method, no other similar items are required. Notional items are used giving each noncontributing partner an allocation of a hypothetical item having the same tax characteristic as the item limited by the ceding rule; the contributing partner is given a corresponding allocation of an item with the same characteristics.

For example, assume a contributed capital asset is sold at a tax gain but at a book loss and the partnership has no other capital losses for the year. Under the traditional method with curative allocations, no such allocation could be made for the year to give the noncontributing partners their expected capital loss; there is, however, a carryover of the potential curative allocation until the partnership has other capital losses sufficient to cover it. Under the remedial allocation method, however, an offsetting notional item of a hypothetical capital loss can give the noncontributing partners their expected capital loss allocations. The offsetting notional item would allocate a capital gain equal to the notional capital loss to the contributing partner.

Any of the three methods may be used for each item of contributed property.

The choice of a particular method might have ancillary effects, such as the allocation of liabilities under IRC section 752, the recognition of gain under section 704(c)(1)(B) on a distribution of previously contributed property to a noncontributing partner or the recognition of gain under IRC section 737 to a partner who previously contributed appreciated property, and received other property in a distribution.

  REMEDIAL ALLOCATION METHOD
                           X       Y       Z          Total

First 10 years:

 Tax depreciation     $ 7,500   $ 7,500   $      0    $15,000

 Remedial allocation    2,500     2,500     (5,000)         0
 Reduction (increase)
 in taxable income     $10000    $10000   $ (5,000)   $15,000

Next 5 years:
Tax depreciation      $     0   $     0   $      0          0
Remedial allocation    10,000    10,000    (20,000)         0

 Reduction (increase)
 in taxable income     $10000   $10,000   $(20,000)         0

JULIAN R. SAYRE, CPA, JD, PhD, is retired from Clifton Gunderson LLC in Tuscon, Arizona. ROBERT L. WEITZNER, CPA, JD, LLM, is an assistant director of federal tax research, planning and policy with AT&T in Morristown, New Jersey. Both are authors in the AICPA tax CEA series.