The Tax Lawyer

“Partnership Revaluations: Book-ups are Your Friends (Usually)” Planning with Revaluations and their Interplay with Section 704(c)

by Daniel S. Goldberg

Abstract

The procedure provided in the section 704(b) regulations known as “Revaluation and Book-up” (and sometimes called simply “Book-up”) of a partnership’s assets and capital accounts is available and often used when a new partner enters an existing partnership and acquires a partnership interest in exchange for cash or property. The procedure is also available for use when the new partner obtains his partnership interest for services and when an existing partner’s interest is reduced by a non-proportionate distribution or increased by a non-proportionate contribution.

Section 704(b) and the regulations thereunder create a process of allocation by which the tax consequences of the allocation of a partnership’s income and losses are forced to follow the economic consequences of those allocations. In partnership accounting designed to comply with section 704(b), the economic consequences of a partnership are tracked by means of “book” capital accounts.

On the other hand, tax consequences are determined by tax basis of the partnership’s assets and partner tax capital accounts. The underlying concepts and principles embedded in section 704(c) tie these two measurements, book and tax, together. That section and the regulations thereunder seek to prevent or regulate the partnership from being used to facilitate a partner’s pre-entry unrealized tax gain (or loss) in property contributed to a partnership from being shifted to other partners when the partnership realizes that income. Similar shifting of income (or loss), sometimes categorized as “assignments of income,” can arise during the operation of existing partnerships, such as upon the entry of a new partner into an existing partnership that owns appreciated property. While it is possible for a partnership to address this issue through section 704(b) special allocations, as I will discuss later in this article, it can generally be more easily controlled by using the principles of section 704(c). Revaluations and Book-ups make use of these Section 704(c) principles and the regulations under that section to create a process by which allocations of “built-in” gains (or losses), i.e., gains (or losses) that have arisen but have not yet been realized by the partnership prior to the entry of the new partner (or other transaction that gives rise to the book-up), are allocated automatically to the existing partners (in a case involving a newly admitted partner) when realized by the partnership in the amount of the built-in gain (or loss). 

The revaluation and book-up process, like section 704(c), the foundation upon which it is built, seeks to avoid the possibility and danger of a shift in the tax incidence when a partnership sells property acquired before the event giving rise to the book-up opportunity and, often more important, the inadvertent shift in economic benefits among partners when a new partner enters a partnership whose allocations are governed by the substantial economic effect safe harbor provisions that are common in modern partnership agreements. Application of the principles of Section 704(c) seeks to prevent the use of a partnership to facilitate the shifting of unrealized tax gain (or loss), that arose prior to the entry of the new partner, from the existing partners to the new partner. This goal is consistent with the tax law in general and Subchapter K in particular, which seek to preclude these types of assignments of income upon creation of a partnership through contributions to the partnership of appreciated property.

The regulations governing book-ups, as the next sections of this article explain more fully and illustrate through examples, accomplish these goals by intervening in the partnership’s normal allocations governing book income that are set forth in the partnership agreement, and preventing the shifting of allocations of tax income attributable to built-in gain to the new partner from the existing partners, as measured immediately before the contributions of the new partner. Book-ups create an automatic tax allocation mechanism through the application of the principles of Section 704(c) to the existing partners upon sale of the assets that were owned by the partnership at the time of entry of the new partner, in general, allocating gain in the amount of the built-in gain in those assets to the pre-existing partners. That is why allocations after a book-up are sometimes referred to as “reverse Section 704(c) allocations.” The automatic nature of tax allocations after a book-up is what is appealing about them. However, book-ups create their own set of complications. In addition, the regulations make them optional rather than mandatory in most situations.

The article will deal with the book-up procedure generally, its consequences, planning involving book-ups, alternatives to book-ups and of using other allocation procedures, including the Target Method of allocation, in lieu of the book-up procedure. The Target Method for special allocations is a “distribution driven” system of allocating income, gain and losses that does not rely on the Section 704(b) “substantial economic effect” safe harbor and require that liquidation distributions be made in accordance with capital account balances. Rather, it seeks to comply with the “in accordance with the partners’ interest in the partnership” (“PIP”) standard directly, which is the basic test of the regulations interpreting and carrying out Section 704(b).

Part I of this article deals extensively with Section 704(c), because Section 704(c) provides the foundation for book-ups. It then deals with that section’s relationship with special allocations, as further background for when the issues discussed later in the article arise. The treatment of built-in losses seeks to achieve a similar result but is handled somewhat differently, as is more fully discussed later in this article.

Part II embarks on a discussion of book-ups themselves, and, for ease of explication, discusses book-ups generally in the context of a new partner entering an existing partnership that owns appreciated property. Part III discusses the special situation of real estate partnerships whose property is financed with nonrecourse liabilities and the interaction between book-ups and Minimum Gain in that context, particularly the interplay of the Minimum Gain Chargeback with Section 704(c). Part IV discusses another book-up situation, involving entry of a new partner for services rather than cash or property, giving particular attention to these transactions in the special situation of real estate partnerships financed with nonrecourse liabilities. Part V deals with book-ups in the context of a reduction of a partner’s partnership interest upon the liquidation of all or a portion of that partner’s interest in a partnership. It also deals in this context with the special situation of a partnership that owns ordinary income assets and therefore confronts issues of section 751(b). Part VI deals with book-ups that are required upon exercise of non-compensatory stock options, and Part VII concludes with policy recommendations.

This article provides a guide to understanding and planning in this complicated area and, based on the discussions in the article, makes policy suggestions to achieve more certainty and predictability to partners and less revenue loss to the Treasury through unjustified manipulation.