The procedure provided in the section 704(b) regulations known as “revaluation and book-up” (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 a partnership interest for services and when an existing partner’s interest is reduced by a nonproportionate distribution or increased by a nonproportionate contribution.
The revaluation and book-up process 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. Revaluations and book-ups 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 when realized by the partnership in the amount of the built-in gain (or loss).
This Article deals with the book-up procedure generally, its consequences, planning involving book-ups, alternatives to book-ups, and other allocation procedures in lieu of the book-up procedure. The Article deals extensively with section 704(c) because section 704(c) provides the foundation for book-ups. It then discusses book-ups in a number of situations involving a new partner entering an existing partnership as well as 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. The Article concludes with a number of policy recommendations.
The procedure provided in the section 704(b) regulations known as “revaluation and book-up” (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 a partnership interest for services and when an existing partner’s interest is reduced by a nonproportionate distribution or increased by a nonproportionate 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. Section 704(c) 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 a partnership may address this issue through section 704(b) special allocations, the principles of section 704(c) generally provide a more easily applied approach. Revaluations and book-ups make use of these section 704(c) principles and the regulations thereunder 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 tax law in general and Subchapter K in particular; that is, both 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 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 makes their use so appealing. Nevertheless, book-ups create their own set of complications. In addition, the regulations make them optional rather than mandatory in most situations.
This Article deals with the book-up procedure generally, its consequences, planning involving book-ups, alternatives to book-ups, and 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 requiring that liquidation distributions be made in accordance with capital account balances. Rather, the Target Method 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 implementing section 704(b).
Part II deals extensively with section 704(c) because section 704(c) provides the foundation for book-ups. It then deals with section 704(c)’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 III 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 IV discusses the special situation of real estate partnerships that hold property 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 V discusses another book-up situation that involves entry of a new partner for services rather than cash or property, giving particular attention to transactions in the special situation of real estate partnerships financed with nonrecourse liabilities. Part VI 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 under section 751(b). Part VII deals with book-ups that are required upon exercise of noncompensatory stock options. Part VIII concludes with a number of policy recommendations.
A discussion of book-ups and the regulations providing for and governing them must begin with a discussion of section 704(c), a section on which they depend and out of which the rules governing them are derived. This task is best achieved by starting with a brief review of the basic accounting principles on which Subchapter K relies and the special allocation regulations under section 704(b).
When two partners each contribute cash to form a partnership, the partnership’s opening balance sheet shows the cash as the partnership’s sole asset and two equal capital accounts (often referred to as “book” capital accounts), one for each partner. If the partnership agreement follows the “substantial economic effect” (SEE) rules, these two capital accounts determine what each partner will receive when the partnership liquidates. In other words, the book capital accounts determine the ultimate economic sharing of partnership property or proceeds from its sale.
For purposes of computing each partner’s gain or loss when a partner leaves the partnership or the partnership liquidates, the partners will each have what the regulations refer to as a “tax capital account.” In this simple example, if we assume no liabilities are involved, each partner will have a beginning tax capital account in the partner’s partnership interest equal to the cash contributed. As noted above, each partner will also have a beginning book capital account equal to the cash contributed.
If, however, one partner contributes cash and the other partner contributes appreciated or depreciated property of equal value, things become a bit more complicated. The partnership would assign the contributed property a “book” basis equal to its value but a tax basis equal to its tax basis in the hands of the contributor. Further, both partners will have a book capital account equal to the cash or value of the property contributed (here, both equal), but the property contributor will have a tax capital account equal to the basis of the contributed property instead of its value.
Thus, the book balance sheet diverges from the tax balance sheet on the asset side by the difference between the value of the contributed property at the time of its contribution to the partnership and its tax basis. This difference is sometimes referred to as “built-in gain” or “built-in loss.” That same difference is also reflected in the property contributor’s capital account portion of the balance sheets as the difference between the property contributor’s book capital account and tax capital account.
Example 1. Assume Y and Z enter into a partnership in which Y contributes $10,000 in cash and Z contributes securities of P Corporation, which have an adjusted basis of $3,000 and a fair market value of $10,000. Y and Z are equal partners, and the partnership agreement contains allocation and distribution provisions that satisfy the SEE safe harbor. As such, Y will have a book capital account of $10,000 and a tax capital account of $10,000. Z will also have a book capital account of $10,000 but will have a tax capital account of $3,000.
Another relevant concept is “outside basis,” a tax concept. Outside basis is a partner’s tax basis in her partnership interest. Tax capital account derives from, and is therefore closely related to, outside basis. They differ only in their treatment of liabilities which affects outside basis but not tax capital account. The tax capital account of a partner is an accounting concept that measures a partner’s equity in the partnership, computed by subtracting the partner’s share of liabilities from the sum of the amount of money and the tax basis of partnership assets contributed by the partner. Thus, the outside basis at the inception of a partnership is equal to a partner’s tax capital account, increased by the partner’s share of partnership liabilities (treated as “deemed” cash contributions under section 752 and the regulations thereunder). During the operation of the partnership, both the partner’s tax capital account and outside basis are adjusted upward by both taxable and tax exempt income and gain allocations and downward by partnership distributions, the partner’s loss allocations, and nondeductible and noncapitalizable expenditures. Outside basis and tax capital account remain separated only by the inclusion of liability allocation in outside basis but not in tax capital account.
Tax basis for assets and tax capital accounts generally appear on the balance sheet section of a partnership’s tax return. In contrast, book basis and book capital accounts are maintained by the partnership’s accountants on a separate balance sheet in order to compute and track allocations of gain or loss, since those “book” items are provided for in the SEE compliant partnership agreement and are the accounting items upon which the allocation of income and loss in the partnership agreement operate and which those allocations affect. A partner’s outside basis can be determined from the tax balance sheet by adding a partner’s share of liabilities to the partner’s tax capital account, which is set forth on the tax return.
During the operation of the partnership, the tax capital account and outside basis of a partner both increase by allocations to the partner of gain and income (as set forth above) and decrease by distributions and allocations to the partner of deductions and loss (as also set forth above), all measured on a tax basis. Book capital accounts also increase or decrease in that manner from allocations and distributions, but only as measured for book purposes using book basis values.
To summarize, there are two distinctions between “tax” and “book.” The first arises when appreciated (or depreciated) property is contributed to the partnership by at least one of the partners. In that event, the property must be reflected on the partnership’s book balance sheet for book purposes at its fair market value at the time of contribution. In contrast, the property is reflected on the partnership’s tax balance sheet at its tax basis. The difference between the contributed property’s tax basis and book basis is equal to the difference in the property contributor’s tax and book capital accounts. As a result, the partner’s outside basis computation will also reflect that difference because it is based on tax basis instead of book basis.
The second distinction between “tax” and “book” involves liabilities. If the partnership borrows money, the amount of the loan is reflected on the book balance sheet as a liability and the borrowed cash as an asset. Similarly, those amounts are also reflected in the partnership’s tax balance sheet, using tax basis for assets and capital accounts rather than book basis. For purposes of computing a partner’s outside basis, however, a partner’s share of partnership liabilities is added to the partner’s tax capital account. The sharing of the liability between or among the partners for outside tax basis purposes is determined under the section 752 regulations and depends on the type of liability (recourse or nonrecourse) and the profit and loss sharing provided in the partnership agreement.
If the appreciated property that had been contributed by one of the partners is subsequently sold by the partnership at an amount equal to its book basis to the partnership, there will be no book gain to allocate to the partners. There would, however, be tax gain that will need to be allocated.
Section 704(c) responds to the difference between book gain and tax gain by ensuring that the built-in tax gain cannot be shifted to the cash-contributing partner by means of clever partnership allocations. Rather, section 704(c) requires that the tax gain be allocated to the partner who contributed the appreciated property to the extent of the built-in tax gain at the time of contribution of the property to the partnership. Thus, section 704(c) guards against the built-in gain being assigned to another partner to achieve a more desirable tax result.
Section 704(c) accomplishes this allocation of tax gain to the property-contributing partner by causing the allocation of tax gain to the cash-contributing partner (or partners) to follow or conform to that partner’s (or partners’) allocation of book gain. This result is often contracted into the phrase “tax follows book” for the cash-contributing partner. Thus, if the property is sold for a book gain, then the tax gain equal in amount to the book gain is allocated between the partners in the manner in which the book gain has been allocated in the partnership agreement. The book gain is attributable to post-contribution appreciation, and if the partnership agreement provides that this gain is to be divided equally between the partners, then the tax gain up to the extent of the book gain must be divided equally as well. The remaining tax gain, which was built-in gain when the property-contributing partner contributed it to the partnership, will be allocated entirely to the property-contributing partner under section 704(c).
Example 1 (cont.). If the securities in Example 1 are subsequently sold by the partnership for $10,000 (i.e., without any book gain), the $7,000 of tax gain will be allocated to Z as built-in gain per section 704(c), and thus none of the tax gain will be allocated to Y. Because there is no book gain realized, the entire tax gain is allocated to the property-contributing partner, Z.
But, if there is tax gain in excess of the built-in gain, it would be allocated in the same manner as the book gain, that is, allocated between partners Y and Z in accordance with their sharing ratio set forth in the partnership agreement.
Example 2. Returning to the facts of Example 1, if the securities are sold for $12,000, the partnership will have book gain of $2,000 ($12,000 – $10,000) but tax gain of $9,000 ($12,000 – $3,000). The book gain of $2,000 will be divided as provided for in the partnership agreement, $1,000 to each of Y and Z, and the tax gain of $2,000 will be allocated in that manner as well. In addition, the built-in tax gain of $7,000 (reflecting the property’s appreciation at the time of its contribution) will be allocated solely to Z, the property’s contributor, under section 704(c).
This method of dealing with the divergence of book gain and tax gain of contributed property is known as the “Traditional Method.” The Traditional Method is required (unless its use is deemed “abusive”) as long as there is sufficient tax gain to be allocated to the cash-contributing partner to equal that partner’s book gain.
A corresponding rule operates with respect to the allocation of partnership depreciation in connection with contributed property. When one partner contributes appreciated depreciable property (e.g., a building) to the partnership and the other partner contributes cash, the allocation of depreciation tax deductions is also governed by section 704(c). Depreciation deductions are computed on both a tax and book basis. In situations involving the contribution of appreciated depreciable property, the recovery period for both computations will be the same, both based upon tax depreciation. As a result, book depreciation will exceed tax depreciation. The shortfall in tax basis from book basis in the case of property contributed with built-in gain, as explained above, will be reflected in a lesser amount of overall (and therefore annual) depreciation of the contributed property for tax purposes than for book purposes. The regulations provide a “tax follows book” methodology, under which the cash-contributing partner is allocated tax depreciation equal to that partner’s share of book depreciation, leaving the remainder of the tax depreciation (if any) to be allocated to the property-contributing partner.
Thus, with regard to the allocation of depreciation deductions, the mechanics work differently, but consistently with the method of determining and allocating tax and book gain or loss from the sale of appreciated property discussed above. If the contributed property is depreciable and is worth more than its basis at the time of contribution, the section 704(c) Traditional Method provides that the cash-contributing partner’s share of the partnership’s book depreciation determines the tax depreciation that is allocated to the cash-contributing partner. Thus, the cash-contributing partner’s allocation of tax depreciation will be equal to his share of book depreciation. The partnership’s remaining tax depreciation, which would be less than the property-contributing partner’s share of book depreciation, will be allocated to the property-contributing partner. The differing amounts of tax and book depreciation must be allocated and tracked throughout the life of the partnership until the difference between the tax basis and book basis disappears (which could occur for depreciable property). These principles are illustrated in Example 3(a), below.
Example 3(a). A and B form partnership AB. Under the partnership agreement, each partner will be allocated 50% of all partnership items, and AB will make allocations under section 704(c) using the Traditional Method, if applicable. A contributes depreciable property with an adjusted tax basis of $6,000 and a fair market value of $10,000, and therefore a built-in gain of $4,000; B contributes $10,000 cash.
Assume the property will be depreciated using the straight-line method over a ten-year recovery period (ignoring depreciation conventions if applicable). As such, each partner will be allocated $500 of the annual $1,000 of book depreciation.
In Year 1, tax depreciation will be $600 (ten percent of $6,000) even though book depreciation will be $1,000 (ten percent of $10,000). Of that tax depreciation, $500 will be allocated to B, which is an amount equal to B’s book depreciation, and $100 will be allocated to A.
The implicit judgment made in these situations by application of the “tax follows book” rule under the regulations is that the property-contributing partner has already benefitted from some or all, as the case may be, of his share of the tax depreciation from the property. Thus, the cash-contributing partner should also be entitled to his share. This share will come from the partnership’s tax depreciation after formation.
These section 704(c) rules regarding the allocation of both gain and depreciation are mandatory and operate in the case of the partnership’s sale of the property if the partnership’s tax gain exceeds its book gain and, in the case of depreciation, if the book depreciation exceeds the tax depreciation. Both situations, however, are subject to the Ceiling Rule, discussed below.
Returning to the facts of Example 2 above, in which Y contributes $10,000 in cash and Z contributes appreciated securities with a value of $10,000 and a basis of $3,000, assume that after the contribution the securities decline in value and the partnership sells them for more than their tax basis but less than their book basis. The sale thereby generates a book loss but a tax gain. In that situation, the tax gain realized by the partnership is greater than the property contributor’s share of book gain, of which there is none. Absent more, the property-contributing partner’s built-in allocated tax gain is less than that partner’s original built-in gain, but that tax gain is nevertheless allocated to the property-contributing partner in that lesser amount.
The cash-contributing partner, on the other hand, though suffering a book loss, has no allocation of tax loss because the lower sale price merely reduces the partnership’s tax gain but does not produce an allocable tax loss. This result is referred to in the regulations as the “Ceiling Rule.” The effect of the Ceiling Rule is that a portion of the property contributor’s built-in tax gain is shifted in the foregoing situation to the cash-contributing partner in the form of the elimination of that partner’s potential tax loss, as reflected by her actual book loss. Thus, this situation threatens to allow an assignment of income in the form of shifting tax gain from the property-contributing partner to the cash-contributing partner by offsetting the latter partner’s potential tax loss that would match her economic loss.
Applying the Ceiling Rule using the Traditional Method limits the total amount of tax gain, deduction, or loss that the partnership can allocate to the partners to the actual tax gain, deduction, or loss recognized for tax purposes by the partnership. Thus, the Ceiling Rule provides an exception to the “tax follows book” rule for the cash-contributing partner. Because the tax gain on the sale of securities is less than the pre-contribution built-in gain, the partnership must allocate all tax gain to the property-contributing partner up to the amount under the Traditional Method.
Further, there is no tax loss to be allocated to match the cash-contributing partner’s book loss, which results in the cash-contributing partner being unfairly deprived of the tax loss to match the corresponding suffered book loss. Nevertheless, that is the result under the Traditional Method; the Ceiling Rule precludes creating a (curative or remedial) tax loss allocation to the cash-contributing partner, even when such loss would be balanced by a tax gain allocation to the property-contributing partner.
Example 3(b). Returning to the facts in Example 3(a), assume that the tax basis of the property contributed to the AB partnership by A is only $6,000, but that the property was nondepreciable, and was subsequently sold by the partnership for $6,000, so that no taxable gain or loss is realized by the partnership. In that event, each partner will suffer a book loss of $2,000, but neither partner will have an allocation of tax gain or loss under the Ceiling Rule because there is no tax gain or loss to allocate.
The Ceiling Rule can also adversely impact the cash-contributing partner when the other partner contributes depreciable property. This adverse effect can occur if the amount of the partnership’s tax basis in the property gives rise to less total annual tax depreciation than the amount of book depreciation allocable to the cash-contributing partner. Example 3(c) illustrates this problem.
Example 3(c). Returning to the facts in Example 3(a), assume that the tax basis of the property contributed to the AB partnership by A is only $4,000. As a result, the tax depreciation available to the partnership is only $400 per year when the book depreciation is $1,000, $500 per partner. Under the Traditional Method, B will be allocated that entire $400 of tax depreciation. This tax depreciation allocation is limited under the Traditional Method by the application of the “Ceiling Rule” and creates a book-tax imbalance between the partners’ capital accounts.
As Examples 3(b) and 3(c) demonstrate, the Ceiling Rule can perpetuate book-tax imbalances despite section 704(c)’s stated purpose of eliminating such imbalances. This problem is temporary because the deductions limited by the Ceiling Rule are preserved in the outside basis of B, the cash contributor. In Example 3(b), if the partnership liquidates immediately after the sale of the property, A and B will each have book capital accounts of $8,000 and will each receive liquidating distributions of $8,000. Because A’s outside basis will be $6,000, A will have a $2,000 tax gain. Because B’s outside basis will be $10,000, B will have a $2,000 tax loss. In Example 3(c), if the partnership fully depreciates the property and then liquidates, A and B will each have book capital accounts of $5,000. Because A’s outside basis will be $4,000 and B’s outside basis will be $6,000, A will have a $1,000 tax gain and B will have a $1,000 tax loss. Thus, the book-tax imbalance created by the Ceiling Rule will eventually be eliminated, albeit not without temporary under-taxation of A and temporary over-taxation of B. The Ceiling Rule can also change the character of a deduction. In Examples 3(b) and 3(c), B’s ultimate deduction at liquidation will be a capital loss. The loss on the sale of the property in Example 3(b) might have been capital or ordinary depending on the character of the property sold. The depreciation deductions in Example 3(c) would have been ordinary deductions.
Thus far, the discussion of tax and book allocations and capital accounts has centered on situations involving built-in gain. Similar to built-in gain, “built-in loss” would arise when the fair market value of the contributed property at the time of contribution is less than its tax basis. Built-in loss, however, is treated somewhat differently than built-in gain. In situations involving contributions of property with built-in loss, section 704(c)(1)(C) treats the contributed property as having a basis equal to its value. The excess of the property’s basis over its value at the time of contribution is treated as a zero value “tax-only” intangible property to the partnership that has been contributed by the contributing partner. All attributes arising from this tax-only basis item are allocated to the property-contributing partner. Thus, if a partner contributes depreciable property with a value of $10,000 and an adjusted basis of $14,000, the depreciation taken by the partnership attributable to the $4,000 of tax-only basis will be allocated entirely to the contributing partner.
In many situations, the Ceiling Rule under section 704(c) upsets the otherwise smooth workings of allocations when a book-tax disparity exists. When the Ceiling Rule does not apply because all of the built-in gain in a property is recognized and allocated in full to the property-contributing partner, any book-tax disparity will only be eliminated when the property is sold. Similarly, if the contributed property is depreciable and the cash-contributing partner is allocated tax depreciation in an amount at least equal to the partner’s corresponding book depreciation and the property is ultimately sold for no less than its book basis, only then will section 704(c) operate to eliminate the book-tax disparity completely.
To illustrate, return to Example 3(a) above and assume that the property is sold by the partnership after two years, when its book basis (reduced by book depreciation of $2,000) is $8,000 and its tax basis (reduced by tax depreciation of $1,200) is $4,800. If the sale price is $8,000, there will be no book gain on the sale, but there will be tax gain on the sale of $3,200 ($8,000 – $4,800), which will all be allocable to the property-contributing partner as the remaining amount of the property contributor’s section 704(c) gain.
A partnership confronted by a Ceiling Rule situation may, however, be able to use other alternative and reasonable methods in lieu of the Traditional Method to deal with a partner’s shortfall in the partner’s allocation of tax loss or tax depreciation. Allowable alternative methods explicitly provided in the regulations that can be used in lieu of the Traditional Method are the “Curative Method” and the “Remedial Method.” Importantly and perhaps curiously, these alternative rules, which serve to correct misallocation situations, are elective rather than mandatory, at least in situations that are not considered tax abusive.
The Curative Method permits the use of a so-called “curative allocation,” which is an allocation of income, gain, loss, or deduction for tax purposes that differs from the partnership’s allocation of the corresponding book item. Significantly, a partnership can only use an actual tax item of the same character as the Ceiling Rule item to make a curative allocation. Under the Remedial Method, the partnership creates an item of income, gain, loss, or deduction out of whole cloth (sometimes referred to as a “notional tax item”), which is then used as needed to offset the misallocation caused by the limitations of the Traditional Method. The process is straight forward when the need for a remedial allocation arises from the sale of the property. The rules for allocating deprecation under the Remedial Method, however, can be quite complex.
In essence, the cash-contributing partner is allocated tax depreciation equal to his book depreciation, but the computation and timing of those depreciation deductions is divided into two components and time periods:
The use of one of these alternative allocation methods (i.e., curative or remedial) is generally optional to the partnership under the regulations as long as the Traditional Method is not considered “abusive” under the circumstances. The regulations illustrate what would be considered “abusive” under the Traditional Method. For example, they describe a situation in which the Traditional Method is used for the sale of low tax basis depreciable property which, under the Ceiling Rule, would benefit the property-contributing partner. Because the gain on the sale of the property was both foreseeable and planned in order to take advantage of the cash-contributing partner’s lower marginal tax rate, the regulation requires that the gain be allocated equally between the partners. Presumably, if the property were not to be sold, or if there were no current plan to sell the property, the anti-abuse rule precluding the use of the Traditional Method would not apply. Furthermore, the regulations provide that “the Internal Revenue Service will not require a partnership to use the remedial allocation method . . . or any other method involving the creation of notional tax items.”
Partnerships are not restricted to straight percentage allocations of gain or loss proportional to the capital contributed by the partners. Indeed, more complicated allocation schemes, referred to as “special allocations,” are commonplace and allowable as long as they have “substantial economic effect.” Allocations have substantial economic effect under the regulations if they reflect the true economic sharing of income and loss. The allocations must not be mere artificial tax-saving maneuvers by the partnership to affect annual allocations in types or sources of income that are offsetting or in the timing of income that affect only the years in which the income is allocated, all in a manner that saves taxes for one partner without costing the other partner(s) any additional tax.
In more technical terms, section 704(b) allows special allocations to the extent they are in accordance with each “partner’s interest in the partnership” (PIP). Section 704(b) and the regulations thereunder provide a safe harbor in this regard, the previously mentioned SEE standard. The regulations were issued in the early 1980s and amended several times since then.
Drafters of partnership agreements that contain partnership special allocations of profits, gains, deductions, or losses (i.e., allocations that are not proportional to the partners’ capital contributions) in the past have generally attempted to satisfy the Treasury’s requirement that the allocations have substantial economic effect by satisfying the SEE safe harbor rules set forth in the regulations, although more recently Target Method distribution-driven allocations have apparently become more popular with drafters. There are two parts to the SEE requirement, the (1) “economic effect” part and (2) the “substantiality” part. The “economic effect” part is the heart of the requirement and requires satisfaction of three rules, which are sometimes referred to as the “Big Three.” Satisfaction of that test assures that, if the “substantial” aspect of the test is satisfied, the allocations provided in the partnership agreement will be respected; that is, they will be considered to actually govern the tax consequences provided by the partnership agreement draftsman because they are in accordance with “the partner[s’] interest in the partnership.”
The SEE “Big Three” are, generally speaking, (1) the requirement that capital accounts be maintained in accordance with the regulations, (2) the requirement that liquidating distributions be made in accordance with capital accounts in all events, and (3) the requirement that, upon liquidation of the partnership, the partners have an unlimited obligation to restore any deficits in their capital accounts—a “deficit restoration obligation” (DRO). As an alternative to the foregoing third requirement (sometimes referred to as the alternative requirement No. 3 of the “Alternate Big Three”), the regulations permit the inclusion in the agreement of a “qualified income offset” (QIO) provision, so that if a partner’s capital account drops below zero because of an “unexpected distribution” (or certain other specified events, none of which involves allocations of losses and deductions), the partner who experiences this circumstance will be allocated a sufficient amount of the partnership’s gross income as quickly as possible to raise her capital account to zero (or to the negative amount that she has an obligation to restore if she has a limited DRO). Satisfaction of the Big Three or Alternative Big Three under the section 704(b) regulations ensures that the allocations will comply with the “economic effect” part of the safe harbor of the regulations. Thus, the SEE portion of the regulation’s safe harbor requirements requires drafters to write allocation sections of partnership agreements that record all contribution, distribution, income, gain, and loss events (and some others) in the partners’ capital accounts (Big Three Requirement No. 1), and then provide that liquidation distributions from the partnership will be made in accordance with the capital account balances (Big Three Requirement No. 2). (Hereinafter, this approach will be referred to as the “Treasury Capital Account Method” of allocation or the “Treasury Method.”)
In complying with these regulations, practitioners often draft allocation provisions that govern economic sharing of income and losses to conform to the Treasury Method by satisfying the Big Three Requirements. Under that method of allocation, capital accounts govern ultimate liquidation distributions. (Big Three Requirement No. 2)
Sometimes, and increasingly more commonly however, the allocations are provided in a manner to cause capital accounts to conform to the explicit order and priority of distributions that are provided in the distribution section of the partnership agreement, which ultimately govern liquidation distributions. (This allocation system will be referred to as the “Target Method.”) Under the Target Method, distributions in liquidation of the partnership need not be made in accordance with capital accounts as they are under the Treasury Method, the method sanctioned under the section 704(b) regulations as coming within a safe harbor for “substantial economic effect.” Rather, under the Target Method, liquidating distributions are provided separately in the partnership agreement without regard to the partners’ respective capital accounts. Nevertheless, the focus of the Target Method is to ensure that the partners receive their agreed amounts and priorities in distributions, at the latest when the partnership is liquidated, and to allocate income and losses during the operation of the partnership in such a manner, and to the extent possible, to match each partner’s capital account with the amount of cash that partner would receive under the partnership agreement if the partnership were liquidated immediately after the allocations. If the matching of capital accounts with the agreed distributions in the partnership agreement is not possible, the partners nevertheless receive the distributions provided in the partnership agreement instead of their capital account balances.
In many cases, the liquidating distributions will match the partners’ respective capital account balances. Under some circumstances, however, they will not. This potential mismatch of distributions and partner capital accounts upon liquidation of the partnership would result in a gain or loss, as the case may be, to some of the partners.
Allocations that require the partnership to maintain capital accounts as provided in the regulations and to ultimately make liquidation distributions in accordance with the partners’ positive capital accounts (and require either a DRO or a QIO provision), the “Treasury Method,” are “safe-harbored” under the “substantial economic effect” safe harbor in the section 704(b) special allocation regulations. In contrast, the Target Method is not formally safe-harbored. The regulations, however, do allow for allocation methods other that the Treasury Method if they provide the same ultimate result as SEE compliant allocations and are therefore their “economic equivalent.” Thus, the Target Method for special allocations, although not safe-harbored, may, and in many cases will, provide the same result as SEE compliant allocations. If that is the case, they will be considered to have “economic effect equivalence” (i.e., to have the economic equivalent effect as the safe harbor result) and thereby will be deemed to be in accordance with the “partner[s’] interest in the partnership,” which is the ultimate test.
Allocation provisions in partnership agreements employing either of the foregoing methods are drafted under the guiding principle of the regulations providing that the ultimate receipts by the partners will reflect their true economic sharing of economic income and loss. As a result, both methods allocate book income and losses rather than tax income and losses. The agreements then rely on section 704(c) to deal with the tax gains and losses that differ from the book gains and losses.
Ultimately, the importance of a 704(c) allocation generally (both in practice and theory) involves timing and character of income rather than the amount of income. For that reason, considering possible transactions that might occur after the contribution provides insight into the important purpose of section 704(c). For example, consider the allocation of depreciation deductions from appreciated depreciable real property contributed by one of the partners to a partnership. The shortfall in the property-contributing partner’s allocation of depreciation deductions, which would have reduced that partner’s ordinary income for tax purposes, would be matched by, and therefore balanced against, (1) the eventual reduction of that partner’s capital gain upon the partnership’s sale of the property if the partner had not been allocated the depreciation or (2) upon liquidation of his partnership interest because the partner’s outside basis would not have been reduced by the pass-through of the ordinary deduction from the depreciation deduction that was not allocated to that partner.
Nevertheless, allocation provisions are often heavily negotiated and the subject of important tax planning because the timing and character benefits at stake may be, and often are, significant. Deferring the income of the partner upon contribution of the property to the partnership could involve a large immediate tax benefit in the form of nonrecognition of gain, particularly if the deferral of gain were for a long period of time. On the other hand, the character of the partner’s income may involve a change from ordinary income to capital gain, as in the situation described above in which the property-contributing partner traded off gain nonrecognition for lesser depreciation deductions under the section 704(c) depreciation allocation rule.
Moreover, again in general, when the partnership ends, or at least the partner’s interest in the partnership ends, a reckoning will occur. Without the allocation of the built-in gain to the property-contributing partner during the partner’s tenure as a partner, the partner’s outside basis will not be increased by the amount of that unrecognized income that was neither included in the contributing partner’s income at the time of contribution, or thereafter, but rather remained potentially includible under section 704(c) if the property had been sold by the partnership. As a result, that partner’s final distribution, if in cash, will result in more gain (or less loss) to the partner than if the section 704(c) tax allocation amount had been recognized during the tenure of the partner in the partnership. Also, in the case of a distribution of property, the lower outside basis in the absence of a section 704(c) allocation will be reflected in a lower basis to the partner in the distributed property.
Thus, an under-allocation of tax income to a partner during the operation of the partnership will be offset, generally, by an over-allocation of gain to that partner upon liquidation of the partnership, and vice versa, although there may be a character change. All of these offsetting effects, however, depend upon the partner being alive at the time of final distribution. If the partner does not survive to the end of his partnership interest, the partner’s estate will take a basis in the partnership interest equal to its fair market value at the partner’s death, so that any unrecognized income by virtue of the absence of a section 704(c) allocation will never have the offsetting effect described above (even if sold by the partnership while the partnership interest is still owned by the estate if the partnership makes a section 754 election). In those cases, all of the situations described above will result in complete avoidance of the section 704(c) income and the tax liability derived therefrom. Short of the death of the partner, however, the section 704(c) rule results in deferral and possible character change.
It is important to note that if section 704(c) were not part of the Code, the deferred income (or loss) to the property-contributing partner upon contribution of the property would not mean deferred income or loss to the partnership. Rather, the income that was not allocated to the property-contributing partner would be shifted to the other partners when recognized (but with the resulting increase in their respective outside bases). Thus, the remaining partners would be on the opposite side of the income deferral (i.e., their realization of taxable income would be accelerated). Further, upon the death of any remaining partner, that partner would forfeit any potential loss resulting from his higher outside basis, and upon that partner’s death, if he still owns the partnership interest at that time, some of the benefits to his estate of the date-of-death basis step-up rule would be lost.
Nevertheless, partners’ tax situations differ and a shift of income from one to another could reduce their combined income tax liability. For example, one partner could be in a loss carryover situation or in a low tax bracket and another in a high tax bracket, so that a shift of income from the latter partner to the former partner could reduce their combined tax liability, which would thereby reduce tax revenue. Accordingly, the regulations promulgated under section 704(c) seek to limit this potential tax arbitrage by taking priority over even special allocations under section 704(b).
Similar issues involving the diversion of tax and book income among partners, discussed in Part II in connection with partnership formations, arise when a new partner enters into an existing partnership that has property whose value is greater than (or less than) the partnership’s tax basis in the property. For example, assume that a new partner enters into an existing partnership that owns appreciated property by making a cash contribution to the partnership in an amount that reflects that appreciation, and the new partner receives a capital account equal to her cash contribution. If the partnership agreement follows the Treasury Method SEE safe harbor allocation provisions, liquidation distributions will be made in accordance with the partners’ positive book capital accounts. Under that scenario, the pre-existing partners’ book capital accounts would not accurately reflect the value of their interests used to determine the new partner’s interest or contribution of capital. Their rights to distributions would not accurately reflect their business deal with the new partner (i.e., they would not have received the benefit of the pre-entry appreciation in the value of the partnership because that pre-entry unrealized appreciation was not yet reflected in their capital accounts). Under Treasury Method allocation provisions in the partnership agreement, book capital accounts determine the amounts to be distributed on liquidation of the partnership, thereby failing to accurately reflect the partners’ business sharing arrangement (at least in the absence of a special allocation in the partnership agreement to address this problem).
To remedy this situation, the regulations recognize the entry of the new partner as an event that allows the partnership to revalue its assets in order to restate the book value of the partnership’s assets at their current fair market values and to adjust all of the partners’ book capital accounts to reflect the new fair market values of the partnership and its assets, including goodwill. The process is often referred to as a “book-up of the partnership assets and capital accounts,” or simply as a “book-up.” The book-up will re-determine the partners’ capital accounts as if the partnership had sold its assets for their fair market value with the resulting gains (and losses) allocated to the pre-existing partners under the terms of the partnership agreement. The amount of restatement on the asset side of the balance sheet by virtue of the revaluation of the partnership’s assets is thereby reflected in the pre-existing partners’ respective book capital accounts. This revaluation procedure of the assets and the pre-existing partners’ capital accounts aligns the partners’ book capital accounts with the economics of their “post-entry” business deal regarding the sharing of profits, gains, losses, and ultimately liquidating distributions of the partnership.
A book-up is used so that the partners’ respective book capital accounts will reflect the value of their partnership interests at the time of the entry of the new partner. In that manner, a partnership agreement that complies with the SEE safe harbor and provides that upon liquidation of the partnership the partners will each receive distributions in the amount in their respective (book) capital accounts will ensure that the distributions by the partnership upon liquidation will take that appreciation into account and carry out the economic deal of the partners.
Moreover, a book-up preserves the pre-existing appreciation of the pre-existing partners as built-in gain in the existing partnership assets as if those pre-existing partners had contributed those assets to the partnership. Thus, the amount of the book-up in each asset is treated as a section 704(c) amount, to be allocated, when recognized, to the existing partners following the principles of section 704(c). Practitioners refer to these allocations as “reverse section 704(c) allocations” because section 704(c) allocations are usually “forward” allocations made to property contributors and “reverse” section 704(c) allocation are made only to the pre-existing partners. A reverse section 704(c) allocation is a tax allocation, not a book allocation, and occurs only when the partnership recognizes the tax gain.
This reverse section 704(c) allocation operates only for tax purposes and at the time that the tax gain is recognized by the partnership. Following the book-up, the allocation provisions of the partnership agreement operate on book income, gain, deduction, or loss so that allocations of these book amounts increase or decrease, as the case may be, the new book capital accounts, which ultimately determine distributions in liquidation of the partnership. Tax allocations that are not reflected in book allocations are handled “under the principles of section 704(c).” An illustration of a book-up would be helpful at this point.
Example 4. Assume an existing equal four-partner partnership, ABCD Partnership, whose partnership agreement contains allocation and distribution provisions satisfying the SEE safe harbor, and that owns appreciated property with a tax basis of $4,000 and a value of $10,000. E enters into the partnership as a 20% partner by contributing $2,500 cash, so that the assets of the partnership after E’s entry are worth $12,500 in the aggregate.
If the partnership elects to book-up its assets, the partnership will increase the book value of its property to its fair market value of $10,000, which will then become the book basis of the property (the tax basis of $4,000 remaining unchanged), and increase each pre-existing partner’s book capital account by $1,500 (each partner’s share of the $6,000 appreciation) to $2,500, for an aggregate increase in the partners’ book capital accounts to $10,000. When E becomes a partner, E will also have a book capital account of $2,500. If the partnership were to thereupon sell its property for $10,000 and thus recognize $6,000 of tax gain (but no book gain), the entire tax gain would be allocated to partners A, B, C, and D under the “reverse section 704(c) allocation.”
Conceptually, such a revaluation raises the same issues relating to book-tax disparities that arise under section 704(c): the creation of a partnership with contributions of appreciated property, including built-in gain (or loss, as the case may be) and allocation of depreciation. In the event of a book-up, the regulations under section 704(b) allow the partnership to treat the built-in gain resulting from the book-up in the existing partnership property in a manner similar to the manner in which section 704(c) treats built-in gain arising from a contribution of appreciated property. In contrast, the allocation of built-in gain and depreciation for a new partner to a partnership that owns existing appreciated property is the reverse of what occurs when a partner contributes appreciated property in the formation of a partnership.
Regulation section 1.704-1(b)(2)(iv)(f) sets forth the “rules of the road” for revaluations (i.e., increases the book basis (not tax basis) of assets and book capital accounts (not tax capital accounts) to fair market value (as illustrated in Example 4 above)). Five of these rules of the road seek to prevent the misuse of a book-up as a tax abuse device. First, the adjustments to the book basis of the partnership’s properties and book capital accounts are based on the fair market value of the partnership property. Second, the increases (or the decreases) of the respective partners’ capital accounts reflect the way in which gain (or loss) would be allocated to the partners if those properties were sold for their fair market values. Third, book capital accounts are to be maintained in accordance with normal capital accounting rules, including book depreciation. Fourth, the principles of section 704(c) shall be applied to account for the variation between the adjusted tax basis and book basis of such properties in the same manner as under section 704(c). Fifth, the adjustments that are made in the revaluation must be made principally for substantial nontax business purposes.
Regulation section 1.704-1(b)(2)(iv)(g) provides that various normal accounting principles and adjustments, such as depreciation, must be adhered to in connection with the revalued book basis of the property and capital accounts. In this connection, the “tax accounting” of the partnership will determine the “book accounting” so that tax depreciation as a percentage of the remaining tax basis will determine book depreciation as a percentage of book basis if there is any remaining tax basis in the property. In essence, the book depreciation will be taken over the same number of years as the property’s remaining recovery period for tax depreciation.
Finally, Regulation section 1.704-1(b)(2)(iv)(h)(1) provides the rules to determine the fair market value of properties that are revalued and relies on the parties’ determination of value if the agreements relating to values are at arm’s length and the parties have sufficiently adverse interests. The partnership is permitted to revalue its assets for book purposes only to the fair market value of those assets.
Regulation section 1.704-3(a)(6) refers to the book-tax disparity issue that arises when partnership property is revalued and instructs that the “principles” of section 704(c) apply. The regulations do not, however, expressly incorporate all of the rules of the section 704(c) regulations and, further, provide that reverse section 704(c) allocations do not have to be consistent with other section 704(c) allocations of the partnership even if relating to the revalued property itself.
A special situation arises if the partnership has built-in gain property that is depreciable and the depreciation is allocated among the partners. In that situation, the foregoing rules are applied generally but with the significant exception relating to the depreciation life of the property, which is discussed more fully below. The economics of this transaction are equivalent to the result that would occur if the partnership had liquidated and its partners had contributed its property to a new partnership at the same time that the newly entering partner had contributed cash to that new partnership. Each pre-existing partner would be allocated, and be responsible for, the tax on that partner’s share of the section 704(c) gain when realized by the new partnership. Allocation of depreciation deductions would likewise follow the section 704(c) model.
An example will be helpful to make the foregoing rules relating to depreciation more understandable.
Example 5. Returning to the facts in Example 4, assume that an existing equal four-partner partnership, ABCD Partnership, whose partnership agreement contains allocation and distribution provisions satisfying the SEE safe harbor, owns appreciated property, but unlike the facts in Example 4, the property is depreciable property with ten years remaining from its original 20-year recovery period and has a depreciable tax basis of $4,000 and a value of $10,000. E enters into the partnership as a 20% partner by contributing $2,500 cash, so that the assets of the partnership (now comprised of the property worth $10,000 and cash of $2,500) are worth $12,500 in the aggregate.
As in Example 4, to ensure that E’s economic interest in the partnership is limited to the agreed upon 20%, the partnership elects to revalue and book up its asset to its fair market value (here, $10,000) and the pre-existing partners’ book capital accounts to $2,500 each, for an aggregate adjustment for the four pre-existing partners of $10,000. As in Example 4, an immediate sale of the property for its $10,000 value, and thereafter liquidation of the partnership, will result in distributions to the partners in accordance with their respective (book) capital accounts (i.e., a distribution of $2,500 to each of the five partners, which accomplishes the agreed upon economic deal). Application of the principles of section 704(c) will ensure that the gain of $6,000 resulting from the immediate sale of the partnership’s property would be allocated equally among the four pre-existing partners, $1,500 to each, with no gain allocated to the new partner.
Now assume, as would be expected, that the partnership does not liquidate but rather continues to operate as before and to depreciate its property. The depreciable property of the partnership retains its tax basis of $4,000, generating $400 of tax depreciation each year. A book-up essentially treats the partners for book purposes as if the new partner were entering into a partnership (the ABCDE partnership), which thereupon purchased at fair market value all of the property of the existing partnership (the ABCD partnership). In that circumstance, the partnership’s depreciation (as well as its income and its other deductions) will be allocated as provided in the ABCDE partnership agreement. Recall that the partners agreed to share their items on a straight percentage basis, and that new partner E contributed an amount equal to 20% of the after-contribution value of the partnership for a 20% interest in income, gains, and losses (determined on a “book basis”). After the book-up to fair market value of the book basis of the partnership’s assets and capital accounts, including the new partner’s capital account, the new partner will have a 20% interest in the partnership’s capital accounts.
As a result, under the section 704(c) rules, the partnership will continue to depreciate its properties under its previous depreciation schedule for the remainder of the property’s recovery period for both tax and book purposes. Thus, the tax depreciation schedule of the partnership continues as before the new partner’s entry, generating $400 of tax depreciation each year for the ensuing ten years. In contrast, the partnership’s book depreciation is computed on the basis of the property’s updated fair market value (i.e., the partnership computes its book depreciation using the booked-up value of each depreciable property, but it uses the remaining tax recovery period instead of a new recovery period for determining the annual depreciation of each depreciable property). In this example, the partnership’s book depreciation would be $1,000 per year, and E’s share will be $200 per year.
So, the partnership’s annual book depreciation over that longer, 20-year period, which would have been $500 per year and new partner E’s annual book depreciation for the next ten years would have been $100 per year (20% of $500), will be greater in each of the next ten years than it would have been in those ten years if the recovery period had begun anew. The foregoing ten-year recovery-period schedule will be the case until the remaining tax recovery period of the property is completed.
Allocating depreciation to a new partner when there is a book-up works the same as allocations of depreciation on property contributed on formation of a partnership. The new partner (like the cash partner in the earlier section 704(c) examples) will be allocated tax depreciation equal to her book depreciation amount, and the pre-existing partners will be allocated the remaining tax depreciation. Thus, the new partner in the example will be allocated $200 (20% of $1,000) book depreciation each year and $200 of tax depreciation in accordance with the section 704(c) principle that “tax follows book.” The other four partners will share the remaining annual tax depreciation of $200 ($400-$200) in accordance with their percentage interests, $50 each in this example. Interestingly, the new partner will be allocated greater tax depreciation (annual depreciation of $200 during each of the ensuing ten years) than if she had entered a new partnership that purchased the property. In the latter case, new partner E would have been entitled to annual depreciation of $100, albeit over each of the ensuing 20 years, because tax depreciation would be computed over the new, longer, 20-year recovery period of the new property rather than the remaining, shorter, recovery period of the existing property. As explained above, this annual tax depreciation to new partner E in the amount of $200 will be shifted from the existing partners A, B, C, and D ($50 from each per year) who, after new partner E’s entry, will be allocated substantially less than 80% of the tax depreciation from the partnership’s property each year. This last effect may come as a tax surprise to the existing partners.
A partial offset for the existing partners may occur if the partnership has the ability to purchase additional depreciable property with the new partner’s cash contribution, in which all of the partners, including partner E, share proportionately (i.e., equally in this example). The partnership would compute and allocate the depreciation deductions on the new property under the partnership agreement (20% to each partner). The fact that the new partner contributed the cash used to acquire the new property rather than the property itself would preclude application of section 704(c). Nevertheless, the four existing partners’ annual tax deductions from the partnership’s existing property would be substantially reduced, as explained above, and would not be offset by their respective shares of depreciation from the new property.
In the abstract, a new partner’s tax benefits from depreciation resulting from a book-up are offset by the pre-existing partners’ tax detriments from that same amount of reduced depreciation deductions. Because the partners may not all be in the same tax brackets (or one or more of them may be in a loss position), however, they may be able to derive an advantage from the system through tax arbitrage to the detriment of the Treasury.
The economic incentive for the existing partners to accept the book-up, even with this unfortunate tax depreciation side effect, is to preserve their amount and priority of distributions in a partnership that satisfies the SEE safe harbor by obtaining a book capital account based on the value of the partnership’s properties rather than their tax basis. The book-up accomplishes this objective.
In the absence of a book-up, if the partnership agreement provides that liquidation proceeds are distributed to the partners in accordance with their positive capital accounts (the provision that is included in a partnership agreement seeking to qualify for the SEE safe harbor allocation), then the pre-existing partners will retain their old book capital accounts and those capital accounts will govern the economic sharing arrangement upon liquidation of the partnership. Such a result would short-change the pre-existing partners of the economic fruits of their partnership interests because their book capital accounts governing liquidation distributions would not include the amount of their respective unrealized built-in gain at the time of entry of the new partner.
On the other hand, in the absence of a book-up, the existing partners will share their tax depreciation on a percentage basis with the new partner, an 80–20 split in this example. This seems to be a poor trade-off for the existing partners and one that they would unlikely make in most circumstances, at least if the partnership agreement requires the distribution of partnership assets to the partners upon liquidation of the partnership in the amounts of the partners’ respective capital accounts as prescribed under the SEE safe harbor.
In adopting the principles of section 704(c), the revaluation regulations implicitly adopt the section 704(c) “Traditional Method” and incorporate the Ceiling Rule and its modifications. The book-up situation, therefore, becomes more complicated when the Ceiling Rule applies under the Traditional Method. In that event, the choice to use either the Curative or the Remedial Method is, again, up for negotiation if both sides are aware of the issues in advance. Either of these modifications, if applicable, may be adopted without special permission from the Treasury.
Example 6. Returning to the facts of Example 5, assume that the partnership had a remaining tax basis in the depreciable property of $1,000, so that tax depreciation for each of the ensuing ten years (i.e., the property’s remaining recovery period) is only $100 (rather than the $400 in the previous example). Book depreciation for those years remains at $1,000 per year as in the previous example. While one might surmise that the Remedial Method would also allocate the additional $100 annual tax depreciation to the new partner over the remaining ten-year recovery period using offsetting income item(s) of like amount allocated to the existing partners for those years, the regulations provide otherwise. Rather, in that situation, although the new partner’s tax depreciation for each of those ten years would be limited to $100 under the Ceiling Rule of the Traditional Method ($1,000 in the aggregate) rather than her $200 share of book depreciation, the remaining $1,000 of tax depreciation would be spread over the remaining book recovery period of the property commencing after the tax recovery period had expired, which, in this example, is over the ensuing ten years (i.e., Years 11 through 20, with offsetting income allocated to the other partners during those ten years). Thus, under the Remedial Method, an aggregate of $2,000 of deductions could be allocated to the new partner during her post-entry years of the partnership, as described above, so that the new partner’s aggregate tax depreciation deductions equaled the amount of her aggregate book depreciation ($2,000), but the $2,000 would not have been fully recovered until the hypothetical new property recovery period had been completed.
Application of the Remedial Method, however, would entail allocating ordinary income to the original four partners in the amount of $100 per year in Years 11 through 20 and in that aggregate amount of $1,000 over the remaining book life of the property to be allocated among the original four partners amounting to $250 to each over that term of years. The book-up tax consequence described in the previous example (in other words, each of the four original partners losing $200 of depreciation deductions in the aggregate and substituting $100 of ordinary income in Years 11 through 20) may be considered unfortunate by the original partners, and they might object to it because of its tax consequences.
The Remedial Method, however, is not mandatory and, indeed, the Service cannot force the partnership to use it. Accordingly, the matter is one of negotiation among the partners and, of course, pricing the new partner’s partnership interest.
Thus, book-up situations may involve a straight-forward application of the rules governing reverse section 704(c) allocations, which are triggered automatically by a book-up decision, or an additional decision whether to choose the Curative or the Remedial Methods if the reverse section 704(c) allocation generates a Ceiling Rule issue. Regardless of which of the foregoing situations obtain, all sides need to be aware of the choices and the tax consequences to ensure that the economic deal can be set accordingly.
Book-ups also have practical detriments. They may involve costly appraisals of partnership assets or disagreements among the pre-existing partners and the new partner regarding the assets’ values. In addition, as noted above, following entry of the new partner and a book-up, depreciation of the depreciable assets of the partnership will have to be allocated among the partners following the principles of section 704(c), which can be a potentially costly undertaking of record-keeping. Further, if another new partner enters after further appreciation (or depreciation) of the partnership’s properties, layers of reverse section 704(c) allocations will need to be undertaken, adding to the woes of the partnership’s accountant (but likely offset by the accountant’s additional fees).
The partners may balk at electing the book-up and incurring these extra expenses. Or, they may just be unaware of the problem. Importantly, because book-ups are not mandatory under the regulations, the partners who are aware of the availability of a book-up may have divergent views on whether to make the election and may not be able to reach agreement without completing the necessary tax projections, if at all. Bear in mind that it is not the amount of the partnerships’ aggregate depreciation tax deductions that is at stake, which is fixed by the existing tax bases of the partnership’s properties, but rather how the tax benefit of those deductions will be shared among the partners.
Alternatives are available to the booking up of assets and book capital accounts in order to avoid the disadvantages to the partners regarding unexpected distributions in liquidation of the partnership and unfair allocations of taxable income. The alternatives, however, involve complications, may entail other tax disadvantages, and may not completely avoid the economic disadvantages to the pre-existing partners that book-ups are intended to avoid.
The first alternative to a book-up involves amending the partnership agreement by providing (and therefore drafting) special allocation provisions relating to the pre-entry assets of the partnership. The new provision would provide for the special allocation of the assets’ tax and book gain or loss when the assets are disposed of by the partnership. The special allocation regulations permit this procedure, but the drafting can be complex, and the mechanics of the allocations essentially mirror the computations under the book-up and reverse section 704(c) allocation approach. In addition, the complexities heighten the risk of a drafting error. If not done with great care, the use of section 704(b) allocations can easily cause the pre-entry partners’ book capital accounts to diverge from the partners’ expectations of the economic sharing arrangement. In that event, a liquidation “in accordance with the partners’ positive capital account balances,” an essential requirement under the SEE safe harbor regulations to achieve coverage in the SEE safe harbor, could cause liquidating distributions to diverge from the partners’ economic deal, thereby creating a result that is unexpected and unfair for the partners.
Moreover, if the appreciated assets in the partnership at the time of the new partner’s entry subsequently decline in value more quickly than the tax basis, the special allocations of gain would cause the book capital accounts to fall short of those needed to accomplish the agreed upon sharing arrangement at liquidation under the SEE allocation safe harbor. Because the expected allocation to the existing partners of the pre-entry built-in gain would never materialize in such a situation, the gain could not be allocated to the pre-existing partners to build up their capital accounts sufficiently. In that event, the tax capital accounts (i.e., the book capital accounts in the absence of a book-up) will diverge from what would have been the booked-up book capital accounts had a book-up been made. Under a SEE safe harbor-compliant partnership agreement, however, the capital accounts will nevertheless govern the liquidating distributions even though producing a result inconsistent with the partners’ economic deal.
This situation may be ameliorated to a large extent in a real estate partnership involving nonrecourse liabilities and the forced allocation to the pre-existing partners of “minimum gain” that arose prior to the entry of the new partner. Part IV of this Article deals with that situation.
A second alternative is to amend a SEE safe harbor-compliant agreement with one that uses the Target Method of allocation. The Target Method, in essence, makes allocations that conform the capital accounts to the order and priority of distributions and decouples capital accounts from determining the amount of those distributions, although as discussed earlier, the Target Method seeks to attain an equivalence to SEE compliant allocation provisions if possible under the circumstances of the deal. Thus, capital account balances will not be the determinant of the distributions that will be made in final liquidation of the partnership. Rather, the priority of liquidating distributions is explicitly provided in the partnership agreement.
Under the Target Method, however, one would hope to achieve equivalence to SEE compliant allocations. On the other hand, even if the partnership agreement is amended to switch to the Target Method of allocation, the Target Method, absent a book-up, may not solve the pre-existing partners’ tax problems (although with a book-up, the result would be acceptable to all of the partners by achieving the correct economic outcome). There will be a need under the Target Method to build up the pre-existing partners’ capital accounts quickly, which could cause adverse tax consequences to those pre-existing partners, who would likely prefer to await the sale of the partnership’s appreciated properties.
If no book-up is made, then the partnership’s book basis of properties and the pre-existing partners’ book capital accounts remain unchanged upon entry of the new partner. Thus, forgoing the book-up technique to realign the book capital accounts in favor of reliance on the Target Method to ensure that future allocations are sufficient to cause the capital accounts to mirror the distribution priorities of the partners will entail business risks for the pre-existing partners.
In contrast, a book-up creates items that will be “treated” as section 704(c) gains for tax purposes, leaving the allocation provisions to operate on the new book basis of properties and the partners’ capital accounts so that the purely tax allocations do not affect the ultimate distributions. Accordingly, if the partnership starts with the SEE compliant allocation system, a book-up will provide substantially more assurance that the partnership will retain an SEE compliant system, which is not a trivial consideration given the underlying complexities.
As noted above, the Target Method of allocation seeks to allocate income and loss in a manner that will cause the partners’ book capital accounts to conform to the amounts of final liquidating distribution priorities although such allocations may be insufficient to fully resolve the problems. Fortunately, additional routes are available that may better achieve this goal. For one, special allocations may be made of gross income and separately of losses and deductions, or items thereof, as the method that would “most quickly” align the book capital accounts to the partners’ respective entitlements to liquidation proceeds. Further, “[t]he effect of a retroactive allocation may apparently be achieved through the use of disproportionate special allocations of post-admission income or losses (or items thereof) under § 704(b).” Even if such special allocations are adopted by the partnership, as with the Target Method, the pre-existing partners may prefer the timing of gain allocations afforded by the application of section 704(c) to the booked-up property to this extreme allocation of gross income or losses or deductions from operations.
Moreover, the allocation of gross income in some situations may be regarded as creating (or resulting in) “retroactive allocations” in contravention of section 706(d) by allocating tax deductions to the new partner that, in substance, are deductions and losses arising at a time prior to the entry of the new partner that should have been allocated to the pre-existing partners in previous years, or the period of the year at issue, before the entry of the new partner under section 706(d). The tax deductions are effectively reallocated to the new partner through allocations of gross income to the existing partners without the associated deductions. If, however, sufficient deductions in the post-new-partner portion of the year are available to be allocated to the new partner (even to the extent of all of the deductions in that portion of the year), then a compelling argument can be made to allow the allocation of those deductions in their entirety to the existing partners under the authority of section 704(b). Yet, if the post-entry deductions are not sufficient, then section 706(d) would appear to preclude the retroactive allocation, so that only deductions in future years could be available to make these adjustments. Thus, under some circumstances, the allocation of gross income to the pre-existing partners and deductions to existing partners may be insufficient to cause the capital accounts of the partners to fully reflect the partners’ distribution expectations under their negotiated arrangement.
Following the entry of the new partner, the partners could decide to continue to make allocations among the existing partners in the same manner as before the entry of the new partner. This choice would ultimately cause capital accounts to no longer affect the liquidation priorities of the business deal, but those capital accounts would give way to the saving provisions commonly found in partnership agreements (generally intended to deal with, and allow for, correction or adjustment for accounting errors in years previous to liquidation), permitting the partnership’s accountants to ignore the capital accounts in favor of accomplishing the clear intent of the partners with regard to ultimate liquidation distributions of the partnership. (And, how often are partnership tax returns audited anyway?)
Moreover, ignoring the capital accounts on liquidation of the partnership in the face of a SEE compliant partnership agreement that clearly provides for liquidation distributions to be made in accordance with the partners’ positive capital accounts would raise the issue of whether the existing partners, who received an amount on liquidation that was greater than their respective capital accounts (the amounts to which they were entitled under the partnership agreement without regard to a savings provision), might be regarded as receiving disguised compensation or some other kind of ordinary income. Both foregoing risks likely entail serious tax, and therefore economic, consequences that, if identified in advance, should be avoided.
A fifth alternative would be to abandon capital accounts altogether as a measure of sharing any distributions from the partnership at the time of the partnership’s liquidation and thereby forgo the relative certainty that allocations of partnership income and loss will comply with the SEE safe harbor henceforth. Under this plan, the partnership would adopt a different liquidation distribution formula. The partners may very likely find this alternative undesirable because of an understandable reluctance to sail out of a well-known safe harbor and into uncertain seas infested with penalty risks. They would then presumably make all allocations in a manner to eventually align capital accounts with their liquidation priorities.
Making book-ups optional rather than mandatory (i.e., not including them as a requirement to satisfy the SEE safe harbor allocation requirement in the regulations and as a significant factor in determining a partner’s interest in a partnership (PIP)) can lead to substantial taxpayer abuse. So far, we have looked at the no-book-up choice as a problem for the partners because, in the absence of a book-up, the alignment of partner capital accounts may never be achieved and the pre-entry partners will not have been properly allocated their respective partnership profits or gains. From the government’s point of view, these choices of allocation methods without a book-up could offer taxpayers significant opportunities for tax abuse, particularly if the partners entered into a “side agreement” to assure the desired financial result would be imposed at the time of liquidation to override the “liquation in accordance with capital accounts” provision in the partnership agreement. The often-present “savings clause” may be viewed as such a side agreement within the partnership agreement.
Making book-ups a mandatory part of the SEE regulations and relying on the principles of section 704(c) to deal with pre-entry appreciation or subsequent depreciation of partnership assets would preclude the foregoing choices of allocation opportunities with their attendant opportunities for abuse, as discussed above. Indeed, this possibility presents a clean solution to an otherwise messy administrative problem dealing with substantial economic effect and the partners’ interest in the partnership. Thus, even if the Target Method is chosen as the allocation method, book-ups upon entry of a new partner and reliance on the principles of section 704(c) would be required for SEE.
The regulations already recognize the potential problems in this area and contain an anti-abuse rule to deal with the foregoing possibilities. The “anti-abuse rule” provides as follows:
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 of 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.
Query, does this statement in the regulations require a book-up? Clearly not, as optional is optional, but perhaps this regulation does strongly suggest a book-up in certain situations? Without specifying those situations, however, it does not appear to do much good or give much guidance.
Other regulations warn that in the absence of a revaluation and book-up upon the entry of a new partner, the arrangement will be reviewed, and if a failure to elect a book-up alters the economic arrangement among the partners, then the consequences of those alterations will be enforced on those partners. In particular, the last sentence of the hanging paragraph of Regulation section 1.704-1(b)(2)(iv)(f)(5) provides that the failure to adhere to the “principles of section 704(c)” could trigger other tax consequences, and it further references “paragraphs (b)(1)(iii) and (b)(1)(iv) [of Regulation section 1.704-1],” which in turn reference sections 61 and 83 of the Code, as well as some others. These latter sections, which one might characterize as general tax principles, suggest some possibilities but still do not offer more than general guidance. A clear statement in the regulations mandating a book-up in these situations would be preferable to the allusion to unforeseen and potentially dire tax consequences as currently suggested in the regulations.
Ultimately, regardless of the allocations provided in the partnership agreement, if they do not adhere to the SEE safe harbor, or otherwise comply with the PIP standard, the allocations will be redone by the Service and courts in accordance with the PIP standard. Although lacking complete specificity, this likely means that the Service and courts will seek to determine which partners stand to benefit from an allocation of gain or suffer from an allocation of loss. And, the ultimate yardstick is the method by which the proceeds of a liquidation of the partnership would be divided among the partners.
From a tax policy point of view, book-ups are a better alternative than either of the two foregoing alternatives because book-ups lock in the agreed business deal and the tax incidence of that deal through application of the principles of section 704(c) regarding the value of the partnership’s assets at the time of a new partner’s entry. Yet, on the tax allocation side, section 704(c) reliance could subsequently be impacted by the Ceiling Rule. Nevertheless, any complexity or imperfection in tax allocations that results from the Ceiling Rule, as applied without modification of the Curative or the Remedial Method, will not alter the economic sharing arrangement of the partners because the book capital accounts of the partners will reflect their business arrangement. Thus, book-ups achieve economic correctness with potential tax correctness, albeit with the risk of some tax misallocations by virtue of the application of the Traditional Method subject to the Ceiling Rule.
On the other hand, there are times when the partners may desire to achieve a “nontax-policy optimal” result and prefer a shift in the tax consequences that section 704(c) under the Ceiling Rule can create while still ensuring the agreed economic result on liquidation. For example, the new partner may be a taxpayer in a no-tax position or a low tax bracket (perhaps because of losses from other ventures or a net operating loss carryover position). In that situation, a shift to the new partner of some of the unrealized gains that accrued before that partner’s entry into the partnership could shift the tax on future gain from currently unrealized appreciation of the partnership to the new partner and away from the pre-existing partners when that gain is realized. Obtaining the timing and potential character benefits without upsetting the economic arrangement among the partners could be very desirable to the pre-existing partners. Indeed, a new partner may be able to negotiate a favorable entry contribution amount on that basis, effectively taking on the tax cost of the pre-existing partners with no immediate tax cost to himself or herself, thereby monetizing the new partner’s tax attributes at a cost to the Treasury. Thus, the elective rather than mandatory application of book-ups can allow a substantial amount of tax arbitrage and sale of tax benefits among partners.
Interestingly, this is precisely the kind of assignment of income abuse that section 704(c) was intended to preclude in the case of a newly formed partnership. Yet, by making book-ups, and therefore the application of section 704(c), optional in the situation of the entry of a new partner into a pre-existing partnership with appreciated assets, the regulations create a substantial opportunity for serious manipulation by the partners. Although a potential solution from a policy perspective is to make book-ups mandatory for a partnership in this situation, that approach would be relevant only if book capital accounts governed liquidation distributions. Thus, one might suggest that book-ups be added to the “Big Three” as a requirement under SEE if a new partner enters a partnership during its life. Arguments in favor of such a policy suggestion are set forth in the last part of this Article.
The foregoing analysis of the alternatives to book-ups and the potential consequences of allowing those alternatives to persist lead one to conclude that taxpayer choice should be limited and book-ups should be required or, at the least, heavily encouraged. The Treasury could, for example, amend the section 704(b) regulations to require book-ups to satisfy the SEE safe harbor and, where applicable, to determine whether a partnership’s allocations are in accordance with each “partner’s interest in the partnership” (PIP). Indeed, Treasury likely has the authority to implement the abovementioned suggestions based upon its previous decisions to require book-ups in other situations, as more fully discussed below.
The preceding part of this Article illustrates the multiple difficulties involving partnership allocations when a potential book-up situation arises but no book-up is made. Any partnership agreement that seeks to tie liquidation distributions to partner capital account balances (i.e., the SEE safe harbor) or to force allocations to cause capital accounts to conform to ultimate liquidating distributions among the partners (i.e., the Target Method, which should be safe-harbored) should include a book-up when the failure to do so would cause a distortion between capital accounts and liquidating distribution priorities. The failure to include such a provision in a partnership agreement should cause the partnership agreement to fail to satisfy the safe harbor for PIP. Currently under the regulations in all of those situations, book-ups are merely permissible, not mandatory. Any contrary rule invites uncertainty, as the previous section demonstrates, making capital accounts unreliable determinants of liquidating distributions. When this happens, allocations of income and deductions affecting capital accounts will cease to have economic effect.
In general, a minimum gain chargeback ensures that the partners who receive nonrecourse deductions will eventually be allocated gain in the same amount as those deductions. It also ensures that a partner who receives partnership distributions that are financed by nonrecourse liabilities, typically in a refinancing, will be allocated gain in the amount of that distribution when the minimum gain chargeback occurs.
Section 704(c), as discussed earlier, similarly seeks to ensure that any built-in gain, which is not taxable at the time of creation of the partnership, is allocated to the contributing partner during the life of the partnership either (1) when the property is sold and the built-in gain is allocated to the contributing partner under section 704(c) or (2) if the property is depreciable, through the allocation of depreciation deductions to the nonproperty-contributing partner as provided in the regulations under that section. Both outcomes, however, are subject to the important Ceiling Rule, which can thwart the satisfaction of those objectives of compensating for the tax-free nature of a contribution of appreciated property to the partnership. And, even in circumstances covered by the Ceiling Rule, the allocations of gain can be rescued from the Ceiling Rule by the correcting alternatives of “Curative” and “Remedial” allocations, which are optional.
A book-up relies on the principles of section 704(c) by increasing the amount of the book basis of the partnership’s existing appreciated property to an amount above its tax basis. The property is thereby subjected to the mechanics of section 704(c)’s built-in-gain sale or depreciation rules described earlier.
When the book-up occurs in the context of a typical real estate partnership that has minimum gain before the book-up, the book-up to a value that equals the nonrecourse liability does not trigger the minimum gain chargeback to the partners that have a share of that minimum gain. Rather, the book-up has the effect of replacing that minimum gain with section 704(c) gain. Booked-up value in excess of that amount generates additional section 704(c) gain. After the book-up, tax depreciation deductions are governed by section 704(c) rules rather than the sharing percentages of the book depreciation. This shift in regimes, from depreciation sharing under the terms of the partnership agreement (both nonrecourse deductions and recourse deductions) to depreciation sharing under the principles of section 704(c), creates tax planning opportunities for real estate partnerships because the book-up decision is optional.
More specifically, in a situation involving a partnership holding depreciable real estate financed with nonrecourse liabilities, the allocation of partnership minimum gain among the partners to whom the nonrecourse deductions were allocated would ensure, by virtue of the partnership’s “obligatory” minimum gain chargeback provision, that the nonrecourse deductions will be offset by the eventual allocation of minimum gain. As a result, the partners’ capital accounts that govern liquidation shares will ultimately be unaffected by the combination of both the deduction and gain chargeback allocations. By the time the partnership is liquidated, the book capital accounts of those partners will be increased by the minimum gain allocation because the property would have been sold and the gain allocated at or before this time. A book-up would further ensure this result by substituting the section 704(c) allocation for the minimum gain chargeback. An example will illustrate this point.
Example 7. Assume that the ABCD partnership holds real estate (its only asset) with a fair market value of $60 and a remaining tax basis (after depreciation) of $20, subject to a nonrecourse mortgage of $60. As a result, the property has a partnership minimum gain of $40. New partner E is admitted into the partnership without any immediate capital contribution as an equal 20% participant in future profits in return for the performance of future services in an equivalent manner as the existing partners. E receives no current interest in the partnership’s capital.
In the absence of a book-up, the four original partners, A, B, C, and D, retain their negative capital accounts and new partner E has a capital account of zero. All the ultimate gain upon a hypothetical foreclosure of the property by the lender would be allocated through the minimum gain chargeback provision to the four original partners, and none would be allocated to E. Any additional gain would be allocated in accordance with their equal sharing percentage interests, as would future depreciation if the partnership agreement so provided.
A book-up of the book basis of the property to $60, its fair market value, would cause the four original partners to replace their negative book capital accounts with book capital accounts of zero. The book-up would not change the tax consequences when the property is sold other than that section 704(c) would determine the allocation rather than the minimum gain chargeback rules. The amount that would have been allocated among the four original partners would be allocated to them under section 704(c) rather than under the minimum gain chargeback. Any subsequent appreciation, when recognized as gain, would be allocated equally among all five partners.
Book-ups, however, can serve an important additional function when the value of the partnership’s property at the time the new partner enters the partnership exceeds the amount of the nonrecourse liability to which the property is subject. That is because any gain attributable to the value of the property above the amount of the nonrecourse liability should take into account the excess of the value of the property at the time of entry of the new partner over the nonrecourse liability secured by the property. Any gain realized from a sale of the property for an amount in excess of the nonrecourse liability secured by the property would be allocated under the gain allocation provisions of the partnership agreement without regard to the minimum gain chargeback provision, as indicated above. In the foregoing example, this excess gain would be allocated equally among all five partners; this allocation comports with the partners’ deal because, at the time of E’s entry, the property’s value did not exceed the nonrecourse liability.
Alternatively, assume that the property’s value at the time of E’s entry into the partnership exceeded the liability. In that case, E should share only in any gain in excess of that value. A book-up to the value of the property at the time of E’s entry would accomplish this result because E would share only in the gain in excess of the new book value of the property rather than the greater amount equal to the excess of the sale price over the amount of the nonrecourse liability. The latter approach would have been the result in the absence of a book-up or special allocation of that extra gain. An extension of the example above will illustrate this point.
Example 8. Returning to the facts of Example 7, assume that the property has a fair market value of $100 and a basis of $20 at the time of E’s entry into the partnership. In the absence of a book-up when the new partner enters the partnership, a danger exists that a liquidating distribution, determined at book value of the partners’ respective capital accounts after the sale of the property and operation of the minimum gain chargeback, would not conform to the economic deal and expectations of the partners. If the property were sold by the partnership for its value at the time of E’s entry, the sharing of the proceeds of sale would distort the partners’ economic deal. That is because new partner E would be entitled to a share of gain upon sale of the property for the amount in excess of the partnership’s minimum gain from the sale of the property. Thus, of the gain of $80, after the allocation of minimum gain of $40, an allocable gain of $40 ($80 – $40) remains. Indeed, in this example, each of the five partners would share the $40 gain in accordance with the partners’ profit-sharing percentages (i.e., equally, amounting to $8 each). Thus, upon sale for $100 and a gain of $80, the minimum gain of $40 would be allocated among the four original partners at $10 each, and the gain of $40 ($100 – $60) above that amount would be allocated equally among all of the five partners at $8 each. E’s capital account would increase by $8, which E would thereby receive upon liquidation of the partnership at that time even though the partnership experienced no appreciation in its property after the time of E’s entry. This result occurs because of the absence of a book-up upon E’s entry, which caused him to have a disproportionately high book capital account relative to the pre-existing partners even after adjusting the capital accounts upward to account for the amount of partnership minimum gain that would be allocated to the partners after his entry into the partnership.
Alternatively, if the partnership booked up the property to the amount it would realize upon sale of the property at the time of E’s entry, $100, the subsequent sale of the property for $100 would yield $80 of tax gain ($40 of which replaced minimum gain and $40 attributed to other appreciation before E’s entry), all of which would be allocated to the original four partners as section 704(c) gain, leaving no gain to E, which is a result that mirrors the partners’ economic deal. E would share in only the gain from appreciation in excess of $80 after E’s entry into the partnership, which was their economic deal.
The examples above were not dependent upon E entering the partnership as a service partner who made no capital contribution. Returning to the facts of Example 8, assume that E contributed $10 (one-fifth of the value of the partnership after the contribution, which is $50) for his 20% interest in the partnership and that upon E’s entry into the partnership, the property is booked up to $100, its fair market value. Then, as a result, the partnership minimum gain would be eliminated but potential new section 704(c) gain for A, B, C, and D, which in the aggregate would become $80 ($100 – $20), would arise. Upon sale of the property for $100 (i.e., no further appreciation), the partnership’s tax gain would be allocated as $20 each to only A, B, C, and D (and not to E) per section 704(c). After payment of the liability of $60, there would be $50 of cash in the partnership remaining from the $100 sale price for distribution, which would be divided among the five partners at $10 each.
Extending Example 8 to involve deprecation, assume that the remaining depreciable life of the real estate is ten years and ignore depreciation conventions for simplicity. Without a book-up, both book and tax depreciation for the first year after E’s entry would be $2 (1/10 of $20), and E will be allocated 20%, or $0.40, as her share. In the absence of a book-up by the partnership, partner E will be allocated tax depreciation equal to her 20% share of all tax depreciation, as provided in the partnership agreement, just like the other four partners.
If the partnership elects to book-up its assets upon E’s entry into the partnership (again, assuming that the remaining depreciable life of the real estate is ten years and ignoring depreciation conventions), the book basis of the property will be $100 and book depreciation for each of the ten years of the property’s remaining life will be $10. In this scenario, E’s share of the annual book depreciation is $2.
Because the tax basis of the property remains $20, the property’s annual tax depreciation for each of the remaining years of its recovery period is $2. In this scenario, E is allocated all the partnership’s tax depreciation under the post-book-up rule that “tax follows book” for the entering partner under the principles of section 704(c).
Comparing the book-up choice to the no-book-up choice, one can see that the book-up deprives the original partners of some (here, all) tax depreciation benefits. This result could lead the pre-existing partners to consider not electing a book-up. There are, however, significant potential economic costs to the pre-existing partners in declining to do so.
In the absence of a book-up, the five partners will share the remaining book and tax depreciation (which do not differ) equally as provided in the partnership agreement (assuming no special allocation of gain beyond the required allocation of minimum gain). In that event, upon sale of the partnership property and after the allocation of minimum gain, the remaining gain will be allocated equally among all the partners. Since E begins with a capital account greater than the other partners after the allocation of minimum gain, her ending capital account will be greater as well. The following example will illustrate this point.
Example 9. Returning to the facts of Example 8, assume that the property appreciates to $110 and is sold for that amount. The four pre-existing partners each share the minimum gain amount among themselves only, in the amount of $10 each, increasing each of their respective capital accounts from negative $10 to zero. All the partners then share the remaining $50 of gain at 20% each (i.e., in the amount of $10 each), increasing each of the original partners’ respective capital accounts to $10 and E’s capital account from its beginning point of $10 to $20. A sharing of the net proceeds of liquidation of the partnership in the amount of $60 (i.e., sale proceeds of $110 reduced by the liability pay-off of $60, amounting to $50, plus $10 from E’s capital contribution) results in E receiving $20, the amount of her original contribution plus her share of the post-entry appreciation. In contrast, the other four partners each receive only $10, the amount of their capital accounts after the sale and allocation of gain. This would be a good deal indeed for E, but unlikely the deal intended by the other four partners. Likely, the four partners expected E to receive only 20% of the appreciation that occurred after E entered the partnership (i.e., 20% of $10, or $2). Under these nonbook-up circumstances, the resulting liquidating distributions made in accordance with the partners’ capital accounts will not be consistent with the original partners’ business expectations of an equal division of liquidation proceeds when the partnership is liquidated.
With regard to the allocation of depreciation, however, the original four partners would view the situation differently. Declining to do a book-up leaves minimum gain intact and allocable to the old partners. In that event, subsequent tax and book depreciation (which are equal) generates nonrecourse deductions that can be allocated in accordance with the partners’ percentage interests if that allocation is reasonably consistent with allocations of another significant partnership item attributable to the property securing the nonrecourse liability.
The most assured and practical course to pursue is to choose the alternative that accomplishes the business deal, an alternative that requires a book-up, which then triggers the application of the principles of section 704(c). The original partners’ sacrifice with the no-book-up approach, which would maintain their tax depreciation allocations, is the risk created with regard to the economics of the deal. The magnitude of that economic risk depends upon the amount by which the value of the partnership’s property exceeds the amount of the nonrecourse liability secured by that property.
An examination of the book-up choice and the no-book-up choice yields the following conclusions:
1. A minimum gain chargeback will substitute for a book-up as long as the positive “adjusted capital accounts” (i.e., each pre-existing partner’s capital account plus that partner’s share of partnership minimum gain) will be what that partner’s capital account would have been in the case of a book-up. If the adjusted capital accounts are less than that amount, and the gain inherent in the property exceeds the minimum gain, then the pre-existing partners will need to provide for a special allocation of gain (or income) in the partnership agreement to ensure that the pre-existing partners’ capital accounts will reach that level by the time of liquidation of the partnership.
2. In the exceptional case that the nonrecourse liability secured by the property is exactly equal to the value of the property, the minimum gain chargeback will ensure that the foregoing will be the case. Any shortfall, however, carries a risk; that is, in the absence of the special allocation of some of the gain to the pre-existing partners, as described above and which they presumably will insist upon, the pre-existing partners’ capital accounts will fall short of the amounts equal to the new partner’s capital account at the time of liquidation of the partnership. The pre-existing partners must also weigh that risk against the need to have a special allocation of operating income to them prior to liquidation, as the value of the partnership’s property may not increase to create sufficient gain (in addition to the minimum gain) upon sale of the property for an allocation to them before liquidation.
3. The book-up is the alternative to that gamble because it equalizes the adjusted capital accounts at the time of the book-up to their value. The book-up alternative, however, will cause the new partner to be allocated a disproportionately large amount of the future tax depreciation (relative to his sharing percentage) under the principles of section 704(c), pursuant to which the entering partner will be allocated tax depreciation equal to his book depreciation, and the pre-existing partners disproportionately less. Moreover, in many cases, some of the “post-entry” depreciation deductions in the ensuing years could foreseeably result in a reduction of the book value of the property below the amount of the nonrecourse liability, thereby generating nonrecourse deductions. The resulting minimum gain in that event will eventually be charged back to the partners to whom the nonrecourse deductions were allocated and would therefore have no economic consequences. These consequences may dissuade the pre-existing partners from electing the book-up, particularly if another method is available to reduce the new partner’s capital account (e.g., through a special allocation of deductions other than depreciation) or to increase the capital accounts of the pre-existing partners (e.g., through a special allocation to the pre-existing partners of a portion of the gain in excess of minimum gain).
4. Recognizing the implications of the choice to book-up or not provides significant tax planning opportunities, particularly when the economic consequences of forgoing a book-up may be minimal relative to the shifting of tax benefits. Additionally, the tax positions of the parties may provide ample incentive to undertake this arduous tax planning task.
A book-up situation also arises when a new partner is admitted to the partnership and receives a partnership interest for past or future services. If the partnership interest is an interest in partnership capital (a capital interest), the new partner receives a capital account in the partnership and therefore the right to receive a distribution from the partnership in the amount of that capital account upon the liquidation of the partnership. An example can illustrate this situation.
Example 10(a). Returning to the facts in Example 4, assume an existing equal four-partner partnership, ABCD Partnership, owns appreciated property with a tax basis of $4,000 and a value of $10,000. E enters into the partnership and receives a 20% capital interest in the partnership by contributing services worth $2,500. The value of the services are capitalized by the partnership so that the partnership’s assets after E’s entry are worth $12,500 in the aggregate (including goodwill).
If the partnership elects to book-up its assets, then the partnership would revalue its property to its fair market value of $12,500, which would become the book basis of the assets, and increase the pre-existing partners’ book capital accounts by $1,500 each (their share of the $6,000 appreciation) to $2,500 each, for an aggregate of the four pre-existing partners of $10,000. E would have a book capital account of $2,500. The tax basis of the hard assets of $4,000 remains unchanged and the additional asset of goodwill will receive a basis of $2,500.
If the partnership thereupon sold its property for $12,500 and recognized $6,000 of tax gain (but no book gain), the entire tax gain would be allocated to partners A, B, C, and D under the “reverse section 704(c) allocation.”
Alternatively, in exchange for future services, the new partner may receive only an interest in the future profits of the partnership (a profits interest). In such a situation, the new service partner would not be entitled to any distribution on liquidation of the partnership but would instead only obtain a capital account up to his share of undistributed future profits as they accrue.
Example 10(b). Assume the same facts as in Example 10(a), except that the partnership’s assets do not increase by virtue of E’s entry into the partnership for services. Thus, if the partnership liquidates immediately after his entry, E, the new service partner, will receive nothing from the partnership, and the partnership’s balance sheet will remain unchanged.
A new service partner who receives her interest for services performed, or to be performed, as in Example 10(a), obtains a book capital account equal to the value of her partnership interest and is taxable on the value of that interest. Under proposed regulations published by the Treasury Department several years ago, and consistent with academic writing that may have prompted them, the transaction is analyzed as if it consisted of a cash payment (referred to as “deemed cash”) to the new partner in the amount of the value of the partnership interest in exchange for the partner’s services, followed immediately by a contribution by the new partner in that amount of cash to the partnership. The deemed cash payment to the new partner gives rise to income to the new partner in the amount of that deemed cash payment, subject to the timing limitations of section 83 if all or a part of the new partner’s partnership interest is subject to a substantial risk of forfeiture. Furthermore, a deduction to the partnership is available at the time of the partner’s income inclusion, subject to possible capitalization if appropriate (as was the case posited in Example 10(a)), in the amount of the deemed cash payment. Any immediate deduction (or amortization in the event of capitalization of the payment by the partnership) would be allocable to the pre-existing partners. The contribution of that deemed cash by the new service partner is treated as an actual cash contribution by the new partner to the partnership, which would give rise to the book-up situation and the related issues discussed in the previous parts of this Article.
Although the situation is somewhat different from the capital-partner situation described above if the new partner receives only a profits interest, the book-up situation should be the same. For example, assume a two-person partnership, Partnership AB, admits new partner C into the partnership in exchange for future services to be rendered to the partnership. If C’s partnership interest is a profits interest, C will receive no interest in the current capital of the partnership. Rather, C has an interest only in the profits of the partnership that are allocated in the future. Therefore, C’s partnership interest has no liquidation value until an accrual of undistributed future profits arises. As a result, no change in the ownership of the capital of the partnership or its pre-entry appreciation at the time C receives the profits interest occurs. This was the situation dealt with in Example 7 in Part IV.A.1 and Example 10(b) in Part V.A. A book-up, nevertheless, is available in this situation in order to identify and freeze the appreciation in the partnership’s assets prior to the new partner’s entry. If a book-up is elected, the pre-entry appreciation, when realized, will be allocated for tax purposes to the pre-existing partners only by virtue of the application of the principles of section 704(c). Such a book-up in this situation will thereby cause an appropriate allocation to be made regarding gain or depreciation or both with respect to any existing appreciated properties held by the partnership. Appreciation beyond that amount will be allocated in accordance with all the partners’ interests in profits or as otherwise agreed in the partnership agreement.
If the new service partner obtains a profits interest for services to the partnership in a manner that is nontaxable to the service partner under the Treasury’s current guidelines, as in the situation set forth above, the consequences of a book-up can vary. If the partnership has no liabilities and, following the new partner’s entry as a partner, suffers losses, all of the losses will be allocated to the pre-existing partners unless the partnership agreement provides for a loss allocation to the new service partner and imposes a “Deficit Restoration Obligation” (DRO) on the new partner (or such an obligation is otherwise imposed by law, as for example, a general partner who shares payment responsibility with the other general partners for a partnership recourse liability that funded the loss). The allocation of losses to the pre-existing partners would occur because the new partner will begin with a zero book capital account. Thus, in the absence of a DRO, losses cannot be allocated to the new partner (until or unless profits have been allocated to that partner) if the losses would cause his capital account to become negative. This result would be the same under the safe harbor test and the general PIP test.
Perhaps the most interesting situation in this context (and more commonplace as it relates to loss allocations) involves a real estate partnership that owns property subject to a nonrecourse liability. This situation was introduced in Example 7 discussed in Part IV.A.1 and is explored further in this Part.
Assume a real estate partnership in which the book and tax basis of the real estate are the same and are equal to the amount of a nonrecourse liability secured by the real estate at the time of entry of the new “profits interest” service partner into the partnership. Assume also that the partnership agreement provides that the four pre-existing partners will share profits and nonrecourse deductions equally. If the partnership agreement provides for a minimum gain chargeback and satisfies the other three requirements for specially allocating nonrecourse deductions, then, in the absence of a book-up under the nonrecourse loss allocation provision described above, any loss attributable to depreciation that is allocable to the new profits partner will create minimum gain in the amount of the nonrecourse loss allocation. That allocation will result in a negative capital account for the profits partner, supported by her share of partnership minimum gain.
Suppose, however, that at the time of the new profits partner’s entry, the property’s value (but not tax or book basis) exceeds the amount of the nonrecourse liability. In that case, a book-up of the property and book capital accounts will still eliminate partnership minimum gain (which is measured by the excess of nonrecourse liability over book basis) but will make it impossible to generate new minimum gain until the new, booked-up book basis of the property declines below the amount of the nonrecourse liability. Only then will depreciation (book) deductions create minimum gain, which is measured using the book basis rather than the tax basis of the property. As a result, the new profits partner will not be allocated book depreciation (unless the new profits partner agrees to an actual DRO, which, as a practical matter, would be unlikely) until book basis is, again, reduced to the amount of the nonrecourse liability, at which point the future losses generate nonrecourse deductions. Since tax follows book for the new partner after a book-up, the new profits partner will not be entitled to depreciation deductions until the new book basis of the property declines below the level of the nonrecourse loan (i.e., until depreciation generates nonrecourse deductions). The preclusion of the profits partner from nonrecourse deduction allocations will occur as a result of the book-up to an amount in excess of the nonrecourse liability, as the depreciation will neither constitute a nonrecourse deduction nor generate minimum gain unless and until it causes book basis to be reduced to the amount of the nonrecourse liability to which the property is subject. The generation of nonrecourse deductions will only occur sometime in the future (i.e., sometime after the entry of the new partner).
If, however, the book-up of the real estate is limited to the amount of the minimum gain so that its book basis exactly equals the amount of the nonrecourse liability, then the depreciation deductions will generate an equal increase in partnership minimum gain. Thus, an allocation of depreciation (i.e., “nonrecourse deductions”) to the new partner will generate a share of book loss and a share of partnership minimum gain. An example will illustrate this situation.
Example 11. Assume that new partner C enters the AB real estate partnership, whose real estate asset (its only asset) has a fair market value of $60 and a remaining tax and book basis (after depreciation) of $20 and is subject to a nonrecourse mortgage of $60. As a result, its partnership minimum gain is $40.
A book-up of the property to its fair market value of $60 will eliminate the partnership’s $40 minimum gain (replacing it with section 704(c) gain) and cause future depreciation deductions to be nonrecourse deductions as the book basis of the property is less than the nonrecourse liability by virtue of the depreciation. This circumstance will allow C to share in the nonrecourse deductions.
Note that in order to be respected under the regulations, an allocation of nonrecourse deductions to the new partner must also satisfy the “significant item consistency” requirement, which in this situation, would presumably be analyzed anew when the new partner enters the partnership rather than depend on the pre-entry allocation of nonrecourse deductions. Thus, the allocation of the nonrecourse deductions to the profits partner should be allowed because it is consistent with the profits partner’s profit-sharing percentage.
Further, after the book-up, the new profits partner will be entitled to tax loss equal to her book loss (from depreciation) under the principles of section 704(c), a result that effectively shifts some losses to the new profits partner that would otherwise have been allocated to the existing partners. Thus, a book-up can significantly affect the allocation of losses among the partners and can be used to increase the allocation of post-book-up nonrecourse deductions to the new profits partner. This result could be planned if all the partners understand the ramifications of the book-up. But it could also occur inadvertently. Further, it could be planned by the new partner and unplanned by the pre-existing partners. A book-up can be your friend, sometimes, and not at other times.
Finally, the above scenario may not occur immediately if the value of the depreciable real estate (and therefore its booked-up book basis) exceeds, even by a relatively small amount, the nonrecourse liability secured by the real estate. Note, however, that after the equity in the property (book basis minus nonrecourse liability) is depreciated away, the minimum gain scenario described above would come to pass if the partnership agreement specially allocates nonrecourse deductions and satisfies the item consistency requirement for such an allocation of nonrecourse deductions (as it should). These aspects of a book-up in the context of a profits interest should be kept in mind in these situations.
In both the capital interest and profits interest situations, the benefits and detriments of proceeding either with or without a book-up would exist. Some would see the book-up choice as generating opportunities while others would see it as creating pitfalls, depending on whether they were pre-existing partners or a new partner. Since book-ups are not mandatory, avenues of planning and inadvertence open up. As a result, the nonmandatory nature of book-ups in these situations may be questionable as a matter of policy. Alternatively, the nonmandatory nature of book-ups may be consistent with the idea of flexibility embedded in Subchapter K, in particular with respect to nonrecourse deductions.
Book-ups are permissible when a partner’s partnership interest is completely liquidated or his interest in the partnership is disproportionally reduced by a nonliquidating distribution (either with respect to percentage interests or with respect to properties received), which fits into the category of “operating distribution.” Book-ups, however, are not mandatory under the current section 751(b) regulations, although they would be under proposed regulations that may very well replace them in the near future. The proposed regulations are a great deal more sensible, albeit more complicated, than the current regulations.
In a complete liquidation of a partner’s interest, no long-term benefit from a book-up will result because the relative values of the remaining partners’ interests remain unchanged, unless the distribution is made in the form of other property of the partnership and affected one of the remaining partners differently than the others. Nevertheless, a book-up will serve the purpose of freezing the pre-book-up appreciation or depreciation of properties of the partnership, including ordinary income assets in particular, so that pre-book-up gain can be allocated using reverse section 704(c) allocations. Moreover, little, if anything, will be sacrificed by the book-up because the partners will have already determined asset values in arriving at the liquidation consideration to the retiring partner.
In an operating distribution that reduces the distributee’s continuing interest in the partnership, however, a book-up serves an important purpose because it permits the partnership to make use of reverse section 704(c) allocations to distinguish between pre-reduction gains and post-reduction gains from the sale of partnership properties; it thereby facilitates the memorializing of that division. Its availability also suggests its use as a convenient method for avoiding (or at least managing) the triggering of the complexities and adverse tax effects of section 751(b) when a partner receives a nonpro rata distribution from a partnership that reduces his future interest in the partnership assets.
Alternatively, the partnership could forgo a book-up and instead specially allocate the income or loss in proportion to the pre-disposition appreciation (or depreciation) of partnership assets in accordance with the partnership’s pre-distribution sharing arrangements. This latter option appears much more cumbersome than simply electing the book-up and relying on reverse section 704(c) allocations. McKee, Nelson, and Whitmire note that book-ups will not work to defuse the application of section 751(b) if a disproportionately greater share of potential ordinary income in the form of appreciated property, like unrealized receivables, is distributed to a partner; but then again, no work-around using special allocations will work successfully either.
A book-up freezes the built-up appreciation in the property allocable to the original partners as section 704(c) gain allocable among those partners in accordance with their pre-book-up percentages and facilitates the allocation of any subsequent gains in accordance with their post-book-up percentages. These new, post-book-up sharing percentages will apply to book gain, bearing in mind that book will reflect the value of the properties at the time the sharing percentages change, and sale proceeds in excess of that book value should be shared in accordance with the new sharing percentages. Any post book-up gain, if realized, will then be reflected in the partners’ capital accounts and thereby determine distributions upon ultimate liquidation of the partnership. They could also affect the mix of capital gains and ordinary income allocated to the partners under section 751(b). An example will illustrate these possibilities.
Example 12. Assume the ABC equal partnership owns “capital gain property” (i.e., property that is not an ordinary income asset under section 751(c) or (d)), with a basis of $30 and a value of $90, and cash of $90 and thus has the following adjusted basis/tax balance sheet:
| Assets | Partner's Capital | ||||
| AB | FMV | Tax (OB) | FMV | ||
| Cash | 90 | 90 | A | 40 | 60 |
| Property | 30 | 90 | B | 40 | 60 |
| 120 | 180 | C | 40 | 60 | |
| 120 | 180 |
The partnership in an operating distribution distributes cash in the amount of $30 to A, reducing A’s percentage interest from one-third (60/180) to one-fifth (30/150), pursuant to which A will share in future profits and property appreciation in accordance with that percentage. Booking up the property by $60, from its $30 basis to its current fair market value of $90, increases each partner’s book capital account from $40 to $60, from which A’s book capital account is reduced to $30 by virtue of the $30 cash distribution. After the book-up, the partnership has the following adjusted basis/tax balance sheet:
| Assets | Partner's Capital | ||||
| AB | FMV | Tax (OB) | FMV | ||
| Cash | 60 | 60 | A | 10 | 30 |
| Property | 30 | 90 | B | 40 | 60 |
| 90 | 150 | C | 40 | 60 | |
| 90 | 150 |
As a result of the book-up, the first $60 of tax gain realized when the property is sold is shared $20 per partner under the principles of section 704(c). Thereafter, book gain determined by a sale price above book basis of $90 will cause the partners to share gain under the percentages agreed by the partners for sharing future gains, in the ratio 20%, 40%, and 40%. The book-up allows for easy, assured, and appropriate allocation of the “tax-only gain” as well as any additional book gain and, therefore, additional tax gain upon sale of the property.
Continuing the facts of the previous example, assume that the property on the balance sheet of the ABC partnership is inventory, a section 751(d) ordinary income asset or “hot asset” rather than capital gain property. As in the previous example, the partnership makes a cash operating distribution to A in the amount of $30, thereby adjusting the percentage interests in future profits to 20%, 40%, and 40%. A book-up would thereby freeze the pre-distribution ordinary income from future sale of the inventory at $20 each, just as it froze the capital gain in the earlier example. Nevertheless, the “hot asset,” with its attendant section 704(c) gain, would retain its ordinary income character to ensure that even if the newly purchased capital asset later appreciated, the gain from its sale attributable to the future appreciation would be shared 20% to A and 40% to each of B and C, while the section 704(c) gain on the inventory would continue to be shared one-third to each partner. Thus, the disproportionate cash distribution to A would not affect the sharing of the partnership’s unrealized ordinary income among the three partners. Logic also dictates that the disproportionate cash distribution should not trigger ordinary income to A at that point.
In the absence of a book-up, however (and with no special provision allocating the first $60 of ordinary income equally among the partners), section 704(c) would not have been triggered. Instead, the cash distribution to A would have triggered section 751(b) because of the shift in ordinary income among the partners (i.e., from A, B, and C equally to 20%, 40%, and 40%, respectively). Section 751(b) is intended to identify the shift and ensure that the reducing partner will be forced to realize the reduction in his proportional share of the partnership’s unrealized ordinary income as ordinary income at the time of the transaction that reduces that share. Section 751(b), as interpreted in the current regulations issued under that section requires that result. Its mechanism contemplates a constructive exchange of assets between A, the reducing partner, and the other partners of the partnership in order to ensure that partner A does not shift some of his ordinary income to partners B and C.
The proposed regulations under section 751(b), however, would replace the much-criticized current regulations. The proposed regulations recognize the unworkability and shortcomings of the current regulations and view section 751(b) as preserving the allocation of ordinary income among the partners rather than the ownership of the gross value of the ordinary income assets themselves. In contrast, the current regulations trigger section 751(b) only when the percentage of the gross value of the ordinary income assets are shifted, creating a shocking and complicated system that does not operate to avoid the shifting of the ordinary income itself.
The replacement proposed regulations focus on the shifting of the ordinary income itself and require a book-up and the application of reverse section 704(c) allocations in accordance with the principles of section 704(c). The Service has indicated that it will follow the proposed regulations, and the book-up mechanism should therefore be acceptable to the Service as complying with the proposed regulations and, indeed, the original purpose of section 751(b).
Thus, under the current regulations and in the absence of a book-up, A’s share of ordinary income is reduced from $20 (one-third of $60) to $12 (one-fifth of $60). Thus, A will recognize $8 of ordinary income and increase his outside basis in his partnership interest by $8. The partnership will also increase its inside basis in the inventory by $8. The current regulations reach this result as well, but in a more complicated, multi-step process involving partner-partnership distributions and exchanges.
In contrast, the proposed regulations avoid this result because they require a book-up of the partnership’s assets to fair market value (here, a revaluation of the inventory from $30 to $90), followed by the cash operating distribution of $30 to A. The revaluation and book-up will freeze the current appreciation in the inventory of $60 as a section 704(c) amount, divided among the partners equally, thus eliminating the current recognition of ordinary income by A. Each of the partners will then recognize ordinary income of $20 when the inventory is sold.
If the liquidation of a portion of (but not the entire) partnership interest of a partner involves gain recognition to the distributee partner, the book-up opportunity becomes more complicated. Gain recognition by the distributee partner will only occur if that partner receives cash (or deemed cash (i.e., a reduction in the partner’s share of liabilities )) in excess of her outside basis. Assume the tax balance sheet of the partnership is as follows:
| Assets | Partner's Capital | ||||
| AB | FMV | Tax (OB) | FMV | ||
| Cash | 60 | 60 | A | 25 | 60 |
| Property | 15 | 120 | B | 25 | 60 |
| 75 | 180 | C | 25 | 60 | |
| 75 | 180 |
Assume that the partially redeemed partner A receives cash in the amount of $30, which is in excess of that partner’s outside basis, thereby generating gain of $5 to A and reducing her interest from one-third to one-fifth. Following the distribution, the partnership’s tax balance sheet would be as follows:
| Assets | Partner's Capital | ||||
| AB | FMV | Tax (OB) | FMV | ||
| Cash | 30 | 30 | A | 0 | 30 |
| Property | 15 | 120 | B | 25 | 60 |
| 45 | 150 | C | 25 | 60 | |
| 50 | 150 |
Section 734(b) affords the partnership the opportunity, by making a section 754 election, to increase the inside basis in its appreciated property by the amount of that gain, which represents the excess of the inside basis that is lost ($30) over the outside basis that is lost ($25) by virtue of the distribution. The adjustment of $5 to the basis of the partnership’s properties, equal to the gain recognized by the partner, will be allocated among the partnership’s assets as provided in section 755 and the regulations thereunder (i.e., capital gain to the partner triggering an increase in inside basis to “capital gain” property and ordinary income to the partner triggering an increase in inside basis to “ordinary income property.”) Thus, in this example, the adjustment will increase the basis in the capital asset by $5.
The remaining unrecognized gain in the partnership’s property in the amount of $100 (in the capital gain asset), when recognized by the partnership, in the absence of a book-up, will be allocated in accordance with the partners’ profit-sharing arrangement after the partial liquidation of the interest, which in this example is 20% to A and 40% to each of B and C. Such a gain on sale will increase A’s capital account from $0 to $20 and B’s and C’s respective capital accounts to $40 each, which may very well be inconsistent with a more fair and reasonable allocation under the circumstances. Indeed, it shortchanges A because her reduced sharing percentage will apply to all of the unrealized gain, not just future increases in value.
Note, however, that a disproportionate distribution by the partnership that alters the profit or loss sharing ratio among the partners regarding the partnership’s properties triggers an opportunity for a book-up. In the book-up of the property by $105 (i.e., from $15 to $120) immediately prior to the transaction, each partner would have a potential section 704(c) allocation of $35. Then, upon the distribution of $30 of cash to A, whose outside basis is $25, A would recognize gain of $5 and should therefore have only $30 of unrealized gain remaining. Any further gain beyond the current unrealized gain would be shared according to the new sharing percentages: 20%, 40%, and 40%.
Nevertheless, a question remains regarding how the section 704(c) gain should be shared because A has already recognized gain of $5 upon receiving the distribution in excess of her outside basis, and by virtue of the section 734(b) adjustment, the section 704(c) gain in the partnership’s capital asset would likewise be reduced by that amount. Presumably, A should receive the benefit of the adjustment even though a section 734(b) adjustment is technically an adjustment to the partnership’s common basis. The means to accomplish this adjustment is to adjust A’s tax capital account upward so that the remaining unrealized section 704(c) gain in the capital asset of $100 ($120 – $20) is matched by the $100 sum of the 704(c) amounts with regard to the capital asset ($30 + $35 + $35). An adjustment to A’s tax capital account of $5 would reduce A’s section 704(c) amount from $25 to $20, the appropriate amount, as demonstrated above, taking into account the section 734(b) basis adjustment to the property and giving credit to A alone for the partnership’s section 734(b) inside basis adjustment. This appropriate result is accomplished under the regulations by increasing A’s tax capital account by the section 734(b) adjustment to thereby reduce her resulting section 704(c) amount with regard to the property, even though this approach appears at odds with the normal operation of section 734(b), which generally applies the section 734(b) basis increase to common basis rather than to the specific benefit of any partner. Apparently, the regulations accommodate this approach rather than requiring book-ups to operate normally (i.e., to common basis) in order to accomplish the intended goal, which works to the benefit of taxpayers and to the revenue alike.
The technical problem here lies in section 734(b), which places the adjustment in common basis instead of following the rules of section 743(b), which are not applicable here, but which would create a “special basis” to the purchasing partner for whom additional gain would not be appropriate, as would be the case in the situation described above with regard to partner A. The Treasury has taken care of this problem. As explained above, alteration of the general operating rules of section 734 takes the form of an altered profit or loss sharing arrangement regarding the properties of the partnership that are subject to the principles of section 704(c) as a result of the book-up, which would include a change in relationship created by virtue of an inside basis adjustment under section 734(b), triggered by a distribution of cash or property by the partnership. The adjustment would generate gain or loss basis in the distributed property in the hands of the distributee partner, coupled with an inside basis adjustment by the partnership triggered by a partnership section 754 election made or in effect.
If no book-up were elected, a special allocation provision could be drafted. The parties could choose between a book-up and the automatically resulting section 704(c) consequences or no book-up and special allocations. One of these should be chosen because neither the pre-distribution sharing percentage nor the post-distribution sharing percentage will produce a satisfactory, single-sharing percentage. The book-up choice, as explained above, is easiest and most directly achieves the aforementioned result, among other positive results for the partners. Yet, book-ups are not mandatory. The partnership’s alternative to achieve the appropriate tax allocation result, in the absence of a book-up with the ability to rely on the principles of section 704(c), is to draft a special allocation provision. If the partnership fails to adopt such an allocation, the distributee’s book gain (and therefore tax) allocation would eventually be too large and cause the distributee’s entitlement to liquidation proceeds, if distributed in accordance with the partners’ positive (book) capital account balances, to exceed her entitlement under the business deal. The drafting correction to avoid this result would specially allocate the book (and therefore tax) gain in the appreciated properties and, during subsequent appreciations of the partnership, the depreciation, if relevant. Applying the principles of section 704(c) after the book-up, which the regulations under section 704 can achieve, accomplishes the conceptually correct result automatically.
As suggested above, a book-up with section 704(c) principles applied will provide that appropriate result if the SEE safe harbor is employed so that book capital accounts determine ultimate distributions. In essence, the allocations made by the partnership will reduce proportionally each partner’s share of that book-tax disparity based on the section 704(c) gain. Such an allocation of section 704(c)-type gain in the partnership should eliminate all the partners’ book-tax disparities in their capital accounts.
A different situation would obtain, however, if the partnership’s liabilities are nonrecourse and secured by the partnership’s property. In that case, depreciation subsequent to the book-up that reduces the book value of the property to less than the nonrecourse liability will result in nonrecourse deductions (which will never require partner contributions and therefore do not entail economic losses). Rather, those losses will be reflected in both partnership and partner minimum gain, which will ultimately be offset by gain when that minimum gain is realized upon sale or foreclosure of the property. Thus, a book-up in the case of nonrecourse debt does not carry with it any economic consequences but rather only tax consequences (i.e., the allocation of loss and realization of its offsetting minimum gain). What is accomplished by a book-up in this setting, however, is a prioritization of minimum gain realization, with the section 704(c) minimum gain portion occurring first followed by the post-book-up gain. This prioritization could be important if some of the minimum gain is eliminated by future capital contributions or pay down of, or conversion to recourse of, some of the debt. It could also be important upon the liquidation of an individual partner from the partnership. As a result, book-ups can have significance even in the nonrecourse liability situation.
A similar problem and solution apply when an existing partner makes a nonproportionate additional capital contribution to the partnership that increases his interest in the partnership. A book-up in that case will freeze the section 704(c) gain at the book-tax difference in the properties’ values as of the time of the capital contribution and automatically allocate any gain, when realized by the partnership that is attributable to this newly established built-in gain at the time of the new contribution, to the pre-existing partners in the amount of their respective shares of that built-in gain.
A “noncompensatory option” (NCO), the latest subject for regulations under section 704(b), is an option issued by a partnership to acquire an interest in the issuing partnership “other than an option issued in connection with the performance of services.” In general, an option holder is not treated as a partner until the option holder exercises the option. Thus, an option holder has no capital account even though the option holder paid for the option. The partnership, however, can elect a revaluation and book-up at the time the NCO is issued but, in doing so, must adjust the book value of its property to account for the NCO.
When the holder of an NCO exercises the option, the partnership must revalue its property immediately after the exercise, as provided in the regulations. Further, the regulations provide examples of various “scenarios” to provide guidance regarding the revaluation itself.
In summary, the Treasury’s position with respect to NCOs illustrates a larger point: Treasury believes that (1) circumstances exist in which book-ups should be mandatory and (2) Treasury has the authority to make book-ups mandatory and, indeed, exercised that authority in the area of NCOs.
Since the promulgation of the section 704(b) regulations in 1985 and through the current day, book basis and book capital accounts rather than tax basis and tax capital accounts have been central in drafting partnership agreements and regulating the tax accounting, allocations, and liquidations of partnerships. Tax capital accounts and outside basis control the partners’ tax consequences, and section 704(c) provides the link between the book basis and tax basis of partnership assets (and therefore book capital accounts and tax capital accounts of the partners). The difference between book basis and tax basis of partnership assets (often called book-tax disparities) is important in the five kinds of transactions discussed in this Article. Tax allocations under section 704(c) and reverse tax allocations under the principles of section 704(c) are important to partnerships that are formed with contributions of appreciated property, partnerships that take on new partners, and partnerships that make distributions that could potentially change the allocation of ordinary income and capital gains among the partners of the partnership.
Revaluations and book-ups have become important instruments in dealing with the complications of these transactions to ensure tax fairness to both the participants and the Treasury. Following a book-up, the principles of section 704(c) will apply to subsequent allocations (i.e., reverse section 704(c) allocations) to deal with the resulting book-tax disparity.
As previously explained, the Ceiling Rule limitation of the Traditional Method may apply to either section 704(c) allocations or reverse section 704(c) allocations. The Ceiling Rule interferes with the ability of such allocations to eliminate book-tax disparities completely. Although either Curative or Remedial Method allocations might eliminate the problem caused by the Ceiling Rule, in many situations, the actual tax items that can be used as curative allocations may not exist and the partnership may not elect to use the Remedial Method. As explained earlier, the book-up regulations borrow the section 704(c) rules but do not expressly apply section 704(c) itself because that section is limited to actual contributions of property. Thus, the same issues regarding built-in gain (or loss) on the sale of partnership property and depreciation must be confronted following a book-up by virtue of the application of the principles of section 704(c) under the section 704(b) regulations as are confronted when applying 704(c) in the context of actual contributions of appreciated property to a partnership.
Book-ups require revaluations of all the partnership’s properties and are expressly made optional to the partnership (except in the proposed regulations under section 751(b) and for NCOs), presumably because of the complexity entailed in a book-up. But making partnership allocations achieve the economic deal of the partners in the absence of a book-up is not simple, and none of the alternatives to a book-up is easily accomplished. Yet, because book-ups are generally optional, partnerships in some situations may be tempted to avoid a book-up. These situations could, and perhaps often do, lead to complexity and imperfect solutions in designing allocations that comply with the SEE safe harbor without the benefit of the application of section 704(c) principles under the book-up approach.
Book-ups are a clever and convenient method to ensure that pre-revaluation income, gains, deductions, and losses, as well as post-revaluation income, gains, deductions, and losses, will be allocated in accordance with the economic impact of these items. Based on that observation, tax administration in the partnership area would be improved if book-ups were mandatory rather than optional. The drafters of the recently proposed regulations under section 751(b) apparently recognized the benefits of that approach and therefore sought to require book-ups in those situations, principally to prevent an unfair result to a distributee partner as discussed in Part VI. The Treasury in its recently issued noncompensatory option regulations also reached the conclusion that book-ups should be mandatory in the NCO area as discussed in Part VII.
Although some taxpayers may prefer greater flexibility and tax creativity, book-ups should be required in the interest of good tax administration under the current regulations. The Treasury should amend the “partners interest in the partnership” regulations and the SEE regulations to require that the SEE safe harbor will not be satisfied unless there has been a book-up by the partnership following certain types of events for which book-ups are currently only optional. Because the drafters of partnership agreements generally attempt to satisfy the SEE “Big Three,” they will necessarily include such a provision in any agreement at the inception of the partnership. In that case, book-ups will be a matter of ordinary practice, the norm, rather than the subject of a subsequent planning decision that requires consideration and the weighing of opportunities to game the system.
Moreover, the use of book-ups in the circumstances discussed in this Article should become an important factor in judging whether other methods of allocations contained in a partnership agreement, such as the Target Method, are in accordance with PIP, the ultimate test under the Code and regulations for respecting allocations in a partnership agreement. Such a change in the PIP regulatory provisions should push all knowledgeable drafters of partnership agreements, regardless of the allocation scheme chosen, to provide in their agreements for mandatory book-ups.
Importantly, the mismatch of tax and book is not always the direct result of the book-up. Rather, it is sometimes the result of incorporating the section 704(c) treatment with all its faults, principally the Ceiling Rule, into the book-up result. A suggested fix for this problem lies in eliminating the Ceiling Rule, which has questionable justification for compulsion anyway. If that proposal is a step too far under section 704(c) generally, then the section 704(b) regulations (rather than the Code subsection itself) should be modified to provide that the Ceiling Rule does not apply and to incorporate section 704(c) principles in the situation of a new partner’s entry into an existing partnership. The Treasury could also provide for the mandatory application of the Remedial Method rather than merely allowing it as an option. To date, however, such a rule is regarded as violating a central premise of Subchapter K, that notional tax items will not be required (i.e., “allocation rules cannot create tax items not recognized by the [partnership]).” If we were formulating regulations on a clean slate, however, the Ceiling Rule should be abandoned, and the Remedial Method, as it stands today, should be required.
While there has been a Treasury Department principle against rules that would compel the creation of tax income to a partner in the absence of the partnership having tax income, the Remedial Method allows for precisely that, but only at the election of the partnership. As to the partner to whom this “phantom income” is allocated, it may be quite involuntary or coerced anyway in that circumstance. Perhaps building it into the book-up situation without election is fairer than the present rule.
Nevertheless, the Treasury has taken a contrary view thus far (other than in its proposed regulations under section 751(b) and for NCOs), and its belief in this self-imposed restriction is evidenced in its rules that permit the Remedial Method by partnership election only, as well as its statement that the Treasury may not create “notional” items of income on its own. This view should be reconsidered. Rules that make book-ups optional upon the entry of a new partner and preclude automatic application of the Remedial Method when the Ceiling Rule would become applicable seem antithetical to a set of voluminous regulations that coerce partnerships to provide that liquidation proceeds should be distributed in accordance with book capital accounts.
Indeed, while adherence to this concept in the context of section 704(c) itself may have historical justification, stemming from a time when Subchapter K governed simple and unsophisticated situations, the concept may no longer be warranted. But even if historical precedent limiting the Treasury’s authority should prevail in the case of a direct application of section 704(c), a different rule may very well be sensible in the application of reverse 704(c) situations, by which the Treasury’s rules in its section 704(b) regulations have grown to become the “settled law” unto itself. Those regulations prescribe an application of the principles of section 704(c), which may now be viewed as encompassing the Remedial Method unencumbered by any notional tax restriction. Such a rule would facilitate simplification of the working of income and loss allocations, thereby allowing the Treasury to protect against unfortunate opportunities for assignments of income and tax arbitrages under the special allocation regulations. The rule would better ensure that tax allocations are made in accordance with the “partner[s’] interest in the partnership,” the fundamental principle undergirding section 704(b) and the voluminous regulations promulgated under that section.
Because we are not writing on a clean slate, Treasury may regard such a change as beyond its regulatory authority in the absence of new legislation. If so, then such legislation should be seriously considered.
The Author thanks Professor Walter Schwidetzky of the University of Baltimore School of Law for his helpful comments to a draft of this Article. The Author also thanks Marisa Booth for her assistance in preparing this Article.
