Joint Report on IRC Section 1031
Open Issues Involving Partnerships
February 8, 2001

Contents | Introduction | I | II | III | IV | V

Discussion of Partnership Section 1031 Open Issues: Questions and Answers

Q-3: In connection with a Section 1031 exchange can a partnership make special allocations of the “boot” gain recognized pursuant to Section 1031(b) exchange, including historical precontribution gain governed by Section 704(c)?

A-3:

Part One- Section 704(b) Issue

We believe that gain recognized by a partnership in a partially tax deferred exchange governed by Section 1031(b) may be specially allocated to one or more partners under Section 704(b), if such recognized gain is appropriately reflected in the partners’ respective capital accounts and such allocation has substantial economic effect.

The most appropriate application of Section 704(b) is illustrated in the following examples, which illustrate circumstances where a Section 704(b) allocation should be recognized. However, not all attempted allocations of "boot" gain should be recognized, as noted in the last example in this portion of the Report.

Example No. 3(a)

ABC limited liability company ("LLC") was formed in 199X by individuals A, B and C, each of whom contributed $100,000 in cash in exchange for a one-third interest in the profits, losses and capital of LLC. ABC is treated as a partnership.

The operating agreement for LLC provides that allocations of income, gain, loss and deduction are reflected in the member’s respective capital accounts, and liquidating distributions, including in complete retirement or redemption of a member’s interest would be made in accordance with the member’s capital account balances.

LLC purchased Whiteacre, a rental office building, for $300,000 in cash.

In 200X, the adjusted basis of Whiteacre has been reduced to $200,000 through straight line depreciation deductions and the fair market value of Whiteacre had increased to $600,000. At that time, A agrees with B and C that A’s one-third interest in LLC should be fully retired and liquidated for the amount of $200,000, representing one-third of the fair market value of the assets of LLC.

LLC enters into a contract to exchange Whiteacre for Blackacre, which has a fair market value of $400,000, plus $200,000 in cash. Immediately before the exchange, the capital account of each of A, B and C is $66,667. The LLC has no other significant assets and no liabilities at that time.

Immediately prior to the closing of the exchange, A, B and C agree to modify their operating agreement for LLC such that $133,333 of the "boot" gain recognized in the exchange for Blackacre and $200,000 in cash is specially allocated to A, thereby increasing her capital account to $200,000. (In the Section 1031(b) exchange, LLC will realize $400,000 of gain, of which $200,000 will be recognized.) The remaining $66,667 of "boot" gain is allocated equally to B and C. A also agrees to accept a cash distribution of $200,000 from LLC in complete retirement of A’s interest in the LLC. B and C agree to continue the LLC indefinitely as equal members, and B and C intend that the LLC will hold Blackacre for productive use in LLC’s trade or business.

The disproportionate allocation of $133,333 of gain to A and $66,667 to B and C should be recognized as a valid Section 704(b) allocation because the allocation has substantial economic effect and is consistent with the respective partner interests of A, B and C under two alternative tax analyses.

(i) Value Equals Basis Analysis

The economic effect of the disproportionate allocation of boot gain to A is substantial because the second to the last sentence in Treas. Reg. § 1.704-1(b)(2)(iii)(c)(i.e., the so-called "value-equals-basis rule") provides that "for purposes of § 1.704-1(b)(2)(iii), the adjusted basis of partnership property...will be presumed to be the fair market value of such property, and adjustments to the adjusted basis of such property will be presumed to be matched by corresponding changes in such property’s fair market value. Thus, there can not be a strong likelihood that the economic effect of an allocation (or allocations) will be largely offset by gain or loss from the disposition of property." Accordingly, because at the time of the special gain allocation, it is assumed that the fair market value and adjusted basis of Blackacre are $200,000 and neither the IRS nor ABC could presume the existence of $200,000 of gain inherent in Blackacre to "charge back" to B and C. Thus, B and C are deemed to bear the burden of the disproportionate gain allocation to A in the form of a relatively smaller increase in the capital account balances of B and C. Objective facts indicating that Blackacre actually retained its fair market of $400,000 are, therefore, ignored under the value-equals-basis analysis.

(ii) Alternative Economic Analysis

Alternatively, the special allocations to A, B and C have "substantial economic effect," within the meaning of Treas. Reg. §1.704-1(b)(2)(i), because the allocations will be reflected in the capital accounts of A, B and C, and A’s adjusted capital account balance of $200,000 will determine the liquidating distributions made to A. Treas. Reg. §1.704-(B)(2)(ii)(b)(2).

The economic effect of the allocation made to A is " substantial" because, as an objective economic matter, A will not participate in the future economic profits or losses attributable to Blackacre after his interest in LLC is retired.

Under Treas. Reg. §1.704-1(b)(2)(iii)(a), the economic effect of an allocation is "substantial" if there is a "reasonable possibility" that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. There is more than a "reasonable possibility" that the special allocation to A will affect the dollar amount received by A because B and C, as the remaining partners, will incur all of the economic risk and potential profit associated with Blackacre, the replacement property.

Treas. Reg. §1.704-1(b)(2)(iii)(b) and (c) describe two types of special allocations that are not recognized as "substantial." The first type is referred to as a "shifting tax consequence" allocation. (For example, allocating all taxable interest income to one partner and all tax-exempt interest income to another partner in the same dollar amount.) Such allocations fail because they result in net increases and decreases in capital accounts that do not differ substantially from the net increase and decrease that would occur in the absence of the special allocation. See Treas. Reg. §1.704-1(b)(5) example (6), (7)(ii), (iii) and (10)(ii).

The second type of "insubstantial allocation" is the so-called "transitory allocation," where the original allocation will be largely offset by one or more offsetting allocations. (For example, an allocation of tax loss in one year to a partner combined with a promise that an offsetting allocation of taxable income will be made in the following year.) The allocation of gain to A attributable to $133,333 of the cash boot is neither a prohibited "transitory allocation" nor a "shifting tax consequence" allocation.

Finally, Treas. Reg. §1.704-1(b)(2)(iii) establishes a "catchall" prohibition against any allocation if "…at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequence of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocations were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequence of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement." Example (5) and Example (9) of Treas. Reg. §1.704-1(b)(5) illustrate the application of the "catchall" prohibition. Neither of these examples suggest that a special allocation of gain to a retiring partner should be barred by the "catchall" prohibition.

The application of this "catchall" prohibition is unclear in the context of a retiring partner; however, a pragmatic approach would not apply the prohibition in this instance, where there is a strong likelihood that the after-tax economic consequences to A, as a former partner of LLC, will be substantially diminished by the special allocation to A because A will no longer participate in the partnership’s future gains or losses attributable to its replacement property investment in Blackacre. Permitting a special allocation of gain in this situation also will simplify the application of Section 704(b) in the context of the retirement of a partner who does not wish to participate in a partnership’s continuing investment in a Partnership’s Section 1031 replacement property. Thus, under the alternative analysis, the special allocation to A also should be recognized.

Example No. 3(b)

Assume the same facts in example 3(a), but assume that ABC amended its operating agreement before the exchange in order to allocate all of the $200,000 "boot" gain to A, increasing her capital account to $266,667. However, upon liquidation and retirement of A’s interest, she receives only $200,000 in cash. The purported special allocation of the entire $200,000 of boot gain to A would not be recognized, and only $133,333 of such disproportionate allocation to A would be recognized, which would increase her capital account balance to $200,000.

Part Two - Section 704(c) Issue

If property contributed to a partnership has a basis to the contributing partner (a "Section 704(c) Partner") that is more or less than its fair market value, the property has a built in gain or loss and such property is referred to as "Section 704(c) property." Treas. Reg. §1.704-3(a)(3). ⁷

A partnership that disposes of property with a built in gain or loss is required to allocate any remaining built in gain or loss to the 704(c) Partner in order to prevent the shifting of tax consequences among partners with respect to such built in gain or loss. Section 704(c)(1)(A).

Treas. Reg. §1.704-3 permits the adoption of various methods to allocate for built in gain or loss, including the traditional method and so-called curative methods.

If a partnership disposes of Section 704(c) property in a Section 1031 nonrecognition transaction in which no gain or loss is recognized, Treas. Reg. §1.704-3(a)(8) requires that the replacement property be treated as Section 704(c) property. If gain or loss is recognized in such an exchange, Treas. Reg. §1.704-3(a)(8) states that "appropriate adjustments" are required. The regulations do not state how such appropriate adjustments should be determined.

The appropriate adjustments contemplated by Section 704(c) should include (i) treating any gain allocated to the Section 704(c) Partner as Section 704(b) gain to the extent there is book gain recognized in the Section 1031 exchange and (ii) treating any taxable gain in excess of the book gain as Section 704(c) gain allocated to the Section 704(c) Partner in order to reduce book and tax disparities. These principles can be illustrated as follows:

Example No. 3(c)

As the Section 704(c) Partner, A contributes nondepreciable property with an adjusted basis of zero and a fair market value of $1,000 and B and C each contribute cash in the amount of $1,000 to the ABC Partnership ("ABC"). A, B and C are equal one-third partners. The $2,000 in cash is expended by ABC to pay costs that are required to be capitalized and which increase the adjusted basis of the Section 704(c) property owned by the ABC to $2,000. After the expenditures, the fair market value of the Section 704(c) property is $5,000.

ABC is using the traditional method under Treas. Reg. §1.704-3(b)(1).

ABC decides to dispose of the Section 704(c) property in a Section 1031 exchange for like kind replacement property in a transaction in which no book or tax gain or loss is recognized. Under such circumstances, the replacement property with a fair market value of $5,000 and adjusted basis of $2,000 will be treated as Section 704(c) property and A will continue as the Section 704(c) Partner with respect to the $1,000 of built in gain.

If, alternatively, ABC disposes of the Section 704(c) property in a partially taxable exchange for replacement property with a fair market value of $3,000 and cash of $2,000, $2,000 of book gain and an equal amount of taxable gain would be recognized by ABC as follows: The book gain recognized on the exchange is $2,000 ( i.e., the lesser of the book gain realized $2,000 (amount realized of $5,000 minus book basis of $3,000) or the boot received which is $2,000), and the tax gain recognized is $2,000 ( i.e., the lesser of the tax gain realized $3,000 (amount realized of $5,000 minus tax basis of $2,000) or the boot received $2,000). Since the book gain recognized and the tax gain recognized are equal, the entire $2,000 of tax gain must be allocated under Section 704(b) in the same manner that the book gain is allocated. Because there is no difference between the tax and book gain recognized, this is not an appropriate occasion to take into account any of the book/tax disparity attributable to A. The adjusted basis of the replacement property would be $2,000, and the full $1,000 of potential Section 704(c) gain would be preserved.

Example 3(d)

A and B form a "50-50" partnership ("AB"). A contributes business property with an adjusted basis of $4,000 and a fair market value of $10,000 reflecting built in gain of $6,000. The property’s book value to the partnership following the contribution is thus $10,000. B contributes cash in the amount of $10,000. AB adopts the traditional method. The Section 704(c) property depreciates for book purposes at an annual rate of 10% ($1,000 per year), and all of the tax depreciation ( i.e., $400) is allocated to B. AB disposes of the Section 704(c) property contributed by A at the beginning of the second year of AB (when the adjusted basis in the property is $3,600) in a cash sale for $10,000, and AB thereby realizes taxable gain of $6,400 and book gain of $1,000. $5,400 of the tax gain must be allocated to A to account for A’s built-in gain. The remaining $1,000 of gain is allocated equally between A and B. Treas. Reg. §1.704-3(b)(2) example (1)(iii).

If the sale had been for cash of $9,000, there would have been no book gain and all of the $5,400 tax gain would be allocated to A.

In contrast, assume AB disposes of the Section 704(c) property in a Section 1031 exchange at the beginning of its second year when its value is $9,000, and AB receives replacement property with a value of $8,000 and cash in the amount of $1,000. AB realizes and recognizes $1,000 of taxable gain in the exchange, and no book gain is recognized ( i.e., the value of the consideration received in the exchange is equal to the book value of the relinquished property of $9,000). The replacement property has an adjusted basis of $3,600. After the exchange, the excess of the fair market value of the replacement property over its adjusted basis is sufficient to account for all of A’s remaining "built in gain." However, the $1,000 of taxable gain must be allocated solely to A because such allocation reduces A’s book/tax capital account disparity. After such an allocation, the book capital accounts of A and B would continue to be $9,500 each ( i.e., original $10,000 less 50% of $1,000 book depreciation). The tax capital account of A would be increased from $4,000 to $5,000. The tax capital account of B would be $9,600 ( i.e., $10,000 decreased by $400 of depreciation).

Contents | Introduction | I | II | III | IV | V