704(c) allocation methods - · pdf file704(c) allocation methods 2. ... outside basis 30,000...

Partners Share For Contributed

Property

Sec. 704(c)1

168

704(c)Allocation Methods

2

Three Methods

• Traditional Method

• The Curative Method

• The Remedial Method

169

3

Example 2

704(c)Traditional

Method

172

4

AM Partnership

Adam

Land FMV $50,000Adj. Basis: $10,000

50%

50%

Melvin

$50,000

5

Balance Sheet After Formation

Assets Tax Basis

BookBasis

FMV O.B.

Cash 50 50Land 50 50Total Assets 100 100Capital:

Adam 50 50Melvin 50 50

Total Cap. 100 100

In Thousands

6

Balance Sheet After Formation

Assets Tax Basis

BookBasis

FMV O.B.

Cash 50 50 50Land 10 50 50Total Assets 60 100 100Capital:

Adam 10 50 50 10Melvin 50 50 50 50

Total Cap. 60 100 100

In Thousands

7

The Land is sold for $50,000

8

$0 Book Gain/Loss($50,000 (sale price)-

$50,000 (book basis))

9

$40,000 Tax Gain

($50,000 (sale price)-$10,000

(tax basis))

10

704(c) forces the entire tax gain to

Adam

11

Adam’sCap. Acct.

Melvin’sCap. Acct.

Tax Book Tax BookBeg. Bal. 10 50 50 50

In ThousandsTax Gain Allocation

12

Adam’sCap. Acct.



Land Salefor 50K +40 0 0 0

End Bal. 50 50 50 50

In ThousandsTax Gain Allocation

13

Landmark Apartment

14

“Section 704(c) Method. The Partnership shall report allocations of income, gain, loss and deduction (as computed for tax purposes) with respect to each Contribution so as to take account of the Section 704(c) built-in gain of such properties under Code Section 704(c) or the principles set forth in Treasury Regulations section 1.704-3(a), as the case may be, using the traditional method (as specifically provided in Treasury Regulations section 1.704-3(b)).”

LVP - “Tax Protection Agreement”

15

“Section 704(c) Method. LVP shall use, and shall cause any other entity in which LVP has a direct or indirect interest to use, the "traditional method" under Treasury Regulation Section 1.704-3(b) without curative allocations for purposes of making allocations under Section 704(c) of the Code or reverse Section 704(c) allocations with respect to the Contributed Interest and the Properties to take into account the book-tax disparities as of the effective time of the Contribution with respect to the Contributed Interest and the Properties.”

Corsite Realty +

16

With respect to Partnership Property that is contributed to the Partnership in connection with the General Partner's initial public offering, such variation between basis and initial Gross Asset Value shall be taken into account under the "traditional method" as described in Regulations Section 1.704-3(b). With respect to other Properties, the Partnership shall account for such variation under any method approved under Code Section 704(c) and the applicable Regulationsas chosen by the General Partner.

Example 3

The Ceiling RuleBut Traditional

Method

173

17

The Land is sold for $30,000

18

<$20,000> Book Loss

($30,000 (sale price)-$50,000

(book basis))

19

$20,000 Tax Gain

($30,000 (sale price)-$10,000

(tax basis))

All allocated to Adam(704(c))

20

Adam’sCap. Acct.


Tax Book Tax BookBeg. Bal. 50 50

Land Salefor 30K -10 -10

End Bal. 40 40

In Thousands

Book Loss Allocation

21

Adam’sCap. Acct.



Land Salefor 30K +20 -10 0 -10

End Bal. 30 40 50 40

In Thousands

Tax Gain Allocation

22

Ceiling rule prevents Melvin from claiming a tax loss equal to

his <$10,000> book & economic

loss 23

Example 4

Example (3) Continued to Liquidation

173

24

Balance Sheet Before Liquidation

Assets Tax Basis

BookBasis

FMV O.B.

Cash 80 80 80Capital:

Adam 30 40 40 30Melvin 50 40 40 50

Total Cap. 80 80 80

In Thousands

25

Adam Melvin

Outside Basis 30,000 50,000

Cash Distributed -40,000 -40,000

$80,000 Liquidating Distribution

26

Adam Melvin



Cap. Gain (sec. 731) $10,000

$10,000 Cap. Gain to Adam

27

Adam Melvin



Capital Gain 10,000

Outside Basis 10,000

Capital Loss <10,000>

<$10,000> Cap. Loss to Melvin

28

Adam is pleased with the

traditional method and

likes the ceiling rule

29

If the land is an ordinary asset, then Adam has both deferred part of the built-in gain and partly converted it

to capital gain

Exact opposite for Mel: ordinary loss is delayed and

becomes a capital loss 30

If the land were a depreciable asset, the

traditional method ceiling rule denies Mel full depreciation, but eventually allows a capital loss for the

shortage.31

Example 5Traditional Method

with Curative Allocation

174

32

Same as Example (3) --the Land is

sold for $30,000--but the partners agree to

use the traditional with curative method

33

Adam’sCap. Acct.


Tax Book Tax BookBeg. 10 50 50 50Land Sale +20 -10 0 -10Bal. 30 40 50 40

In ThousandsTraditional Method

34

The same year the partnership incurred a <$20,000> capital loss on the sale of

stock XYZ

35

Adam’sCap. Acct.


Tax Book Tax BookBeg. 10 50 50 50Land Sale +20 -10 0 -10Bal. 30 40 50 40Stock Sale -10 -10

End. 30 30

In ThousandsBook Allocation of Stock Loss

36

Adam’sCap. Acct.


Tax Book Tax BookBeg. 10 50 50 50Land Sale +20 -10 0 -10Bal. 30 40 50 40Stock Sale -10 -10Stock Sale 0 -20End. 30 30 30 30

In Thousands

Curative Allocation

37

Melvin prefers the curative

method

38

Example 6

Remedial Method

175

39

Same as Example (3) --the Land is

sold for $30,000--but the partners agree to

use the remedial method

40

Adam’sCap. Acct.


Tax Book Tax BookBeg. 10 50 50 50Land Sale +20 -10 0 -10Bal. 30 40 50 40

In ThousandsTraditional Method

41

Adam’sCap. Acct.


Tax Book Tax BookBeg. 10 50 50 50Land Sale +20 -10 0 -10Bal. 30 40 50 40Remedial*Allocation +10 -10

End. 40 40 40 40

In ThousandsRemedial Allocation

*K-1 Items 42

Melvin also likes the remedial

method

43

Example 7

Reverse 704(c)

With Traditional Method

176

44

AM Partnership

Adam

50%50%

Melvin

$60,000$60,000

45

The partnership purchases land for

$120,000 in Yr. 2 and it appreciates to $180,000 in Yr. 5

46

AM Partnership

AdamMelvin

50%50%

FMV $180,00047

AM Partnership

AdamMelvin

Alice

$90,000

33.3%

FMV $180,000

33.3%

33.3%

Yr. 5

48

Capital Accounts are

(optionally)Revalued

49

Thus, a reverse 704(c) with respect to

Adam and Mel50

Assets Tax Basis

BookBasis

FMV O.B.

Cash 90 90Land 180 180

Total Assets

270 270

Capital:Alice (1/3) 90 90 90Adam (1/3) 90 90 60Mel (1/3) 90 90 60

Total Cap. 270 270

After Revaluation of Cap. Accts.

51

Assets Tax Basis

BookBasis

FMV O.B.

Cash 90 90 90Land 120 180 180

Total Assets

210 270 270

Capital:Alice (1/3) 90 90 90 90Adam (1/3) 60 90 90 60Mel (1/3) 60 90 90 60

Total Cap. 210 270 270


52

Next, the Land is sold for $180,000

53

$0 Book Gain/Loss($180,000 (sale price)-

$180,000 (book basis))

54

$60,000 Tax Gain

($180,000 (sale price)-$120,000

(tax basis))Allocated 30K-30K

to Adam and Mel55

Assets Tax Basis

BookBasis

FMV O.B.

Cash 270 270 270

Capital:

Alice (1/3) 90 90 90 90

Adam (1/3) 90 90 90 90

Mel (1/3) 90 90 90 90

Total Capital 270 270 270

Ending Balance Sheet

56

DeWind SWI – Traditional Method

57

For income tax purposes, each item of income, gain, loss, and deduction shall be allocable in the same manner such items are allocated for book purposes…; provided, however, that income, gain, loss and deductions with respect to property contributed to the Company by a Member or revalued pursuant to Treasury Regulation Section 1.704-1(b)(2)(iv)(f) shall be allocated … using the traditional allocation method permitted by Treasury Regulation Section 1.704-3(b).

Example 8

177

58

Same as Example (7) except no revaluation

of book capital accounts but a special

704(b) allocation of built-in book and tax

gain to Adam and Melvin

59

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 90 90 90 90Adam (1/3) 60 60 90 60Mel (1/3) 60 60 90 60

Total Cap 210 210 270

Tax and Book are Equal

60

Next, the Land is sold for $180,000

61

$60,000 Book & Tax Gain($180,000 (sale price)-

$120,000 (basis))

62

Tax and Book Gain

isAllocated 30K-30K

to Adam and Mel per Sec. 704(b)

63

Assets Tax Basis

BookBasis

FMV O.B.

Cash 270 270 270

Capital:

Alice (1/3) 90 90 90 90

Adam (1/3) 90 90 90 90

Mel (1/3) 90 90 90 90



64

Per sec. 1.704-1(b) (5), Example 14, (iv) (with

similar facts), the allocation has substantial economic effect and thus

satisfies both IRC sec. 704(c) principles and

section 704(b). 65

Example 9

No revaluation of capital accts, and no special

allocation

178

66

All gains (and losses)

are shared

1/3-1/3-1/3 67

A shift of $20K unrealized gain (true economic benefit) to Alice

perhaps to entice Alice to contribute.

68

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 90 90 110 90Adam (1/3) 60 60 80 60Mel (1/3) 60 60 80 60

Total Cap 210 210 270

Following Alice’s Contribution

69

70

There is no book/tax disparity thus no sec.

704(c) built-in gain (due to the absence of a

revaluation) – sec. 704(c) allocation method is

irrelevant

Is the shift of $20,000 of unrealized gain a

taxable capital shift to Alice?

None of Adam or Mel’s book capital account is being shifted to Alice so not a taxable capital shift. See CCA 201517006 (4/24/2015)

71

Next the Land is sold for $180,000: the tax and book gain of $60,000 is

allocated 1/3-1/3-1/3:20K-20K-20K

72

Assets Tax Basis

BookBasis

FMV O.B.

Cash 270 270 270

Capital:

Alice (1/3) 110 110 110 110

Adam (1/3) 80 80 80 80

Mel (1/3) 80 80 80 80



73

If liquidated, Alice receives $110,000 (tax

free O.B. recovery)

74

The section 704(b) regs. indicate that

this deal will be closely scrutinized

75

Noble Environmental Power

76

….In accordance with Code Section 704(c) and the Treasury Regulations thereunder, income, gain, loss, …with respect to any Property contributed to the capital of the Company shall, solely for tax purposes, … using the remedial allocation method permitted by Treasury Regulation Section 1.704-3(d).

77

In the event the Gross Asset Value of any Company asset is adjusted [reverse 704(c)] … in the same manner as under Code Section 704(c) and the Treasury Regulations thereunder. Any elections or other decisions relating to such allocations shall be made by the Managing Member in any manner that reasonably reflects the purpose and intention of this Agreement;

78

provided, for the avoidance of doubt, any items of loss or deduction attributable to property contributed by a Member shall, to the extent of an amount equal to the excess of (A) the federal income tax basis of such property at the time of its contribution over (B) the Gross Asset Value of such property at such time, be allocated in its entirety to such contributing Member and the tax basis of such property for purposes of computing the amounts of all items allocated to any

[Section 704(c)(1)(C) compliance]

79

other Member (including a transferee of the contributing Member) shall be equal to its Gross Asset Value upon its contribution to the Company. Allocations pursuant to this Section 5.01(f) are solely for purposes of federal, state, and local taxes and shall not affect, or in any way be taken into account in computing, any Member’s Capital Account or share of Profits, Losses, other items, or distributions pursuant to any provision of this Agreement.

MGM Growth – [Max. Flexibility]

80

In accordance with Section 704(b) and 704(c) of the Code and the Regulations thereunder, income, gain, loss and deduction with respect to any property contributed to the capital of the Partnership shall, solely for federal income tax purposes, be allocated among the Partners on a property by property basis so as to take account of any variation between the adjusted basis of such property to the Partnership for federal income tax purposes and the initial Gross Asset Value of such property.

81

If the Gross Asset Value of any Partnership property is adjusted as described in the definition of Gross Asset Value [reverse 704(c)], subsequent allocations of income, gains or losses from taxable sales or other dispositions and deductions with respect to such asset shall take account of any variation between the adjusted basis of such asset for federal income tax purposes and theGross Asset Value of such asset in the manner prescribed under Sections 704(b) and 704(c) of the Code and the Regulations thereunder.

82

Any elections or other decisions relating to allocations under Section 704(c) of the Code (including under Regulations Section 1.704-3, whether to use the“traditional method,” the “traditional method with curative allocations” or the “remedial method) shall be made by the General Partner.

Variation on Example 7 but with a target

allocation

83

Example 9B(not in text)

AM Partnership

Adam

50%50%

Melvin

$60,000$60,000

84



85

AM Partnership

AdamMelvin

50%50%

FMV $180,00086

AM Partnership

AdamMelvin

Alice

$90,000

33.3%

FMV $180,000

33.3%

33.3%

Beg. of Yr. 5

87

Capital accounts are

(optionally)revalued thus

creating a book/tax difference

(and a reverse 704(c))88

A reverse 704(c) with respect to

Adam and Mel89

Assume the partnership earns

$120,000 of ordinary operating income in Year 5. How is the income allocated?

90

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 90 90 90 90Adam (1/3) 60 90 90 60Mel (1/3) 60 90 90 60

Total Cap. 210 270 270


91

The partnership agreement contains a

target allocation provision

92

The target of the liquidation waterfall is the year end book

capital account balance, if the PSP

is liquidated.93

Liquidation Waterfall:

1) $180,000 to Adam and Mel equally.

2) $90,000 to Alice

3) 1/3 – 1/3 – 1/3

94

95

Hypo.Cash

Adam Mel Alice

End Bk. 390- Beg. Bk. 270 90 90 90= Bk. Inc. 120

96

Hypo.Cash

Adam Mel Alice

1st* 90 902nd**

3rd***End Bk. 390

- Beg. Bk. 270 90 90 90= Bk Inc. 120

*1st $180,000 to Adam and Mel

97

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd***End Bk. 390- Beg. Bk. 270 90 90 90= Bk Inc. 120

*1st $180,000 to Adam and Mel**2ND $90,000 to Alice

98

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd*** 40 40 40End Bk. 390 130 130 130

- Beg. Bk. 270 90 90 90= Bk Inc. 120

*1st $180K to Adam and Mel**2ND $90K to Alice***3rd $120K 1/3 – 1/3 – 1/3

99

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd*** 40 40 40End Bk. 390 130 130 130

- Beg. Bk. 270 90 90 90= Bk Inc. 120 40 40 40

Target Allocation

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 130 130 130 130Adam (1/3) 100 130 130 100Mel (1/3) 100 130 130 100

Total Cap. 330 390 390

End of Year 5

100

In Yr 6, the Land is sold for $180,000and it is the only

transaction during the year.

101

Tax gain of $60,000($180K - $120K) on

the land saleallocated 50/50

between Adam and Melvin -- reverse

704(c)102

103

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd*** 40 40 40End Bk. 390 130 130 130- Beg. Bk. 390 130 130 130= Bk Inc. 0 0 0 0

*1st $180K to Adam and Mel**2ND $90K to Alice***3rd $120K 1/3 – 1/3 – 1/3

104

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd*** 40 40 40End Bk. 390 130 130 130- Beg. Bk. 390 130 130 130= Bk Inc. 0 0 0 0+704(c) Adj. +30 +30= Tax. Inc. =30 =30

Tax. Inc. Summary:

105

Ord.Inc.

Capital Gain

Total

Adam 40,000 30,000 70,000

Mel 40,000 30,000 70,000Alice 40,000 0 40,000

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 130 130 130 130Adam (1/3) 100 130 130 100Mel (1/3) 100 130 130 100

Total Cap. 330 390 390

End of Year 5

106

Assets Tax Basis

BookBasis

FMV O.B.

Cash 390 390 390Total Assets 390 390 390Capital:

Alice (1/3) 130 130 130 130Adam (1/3) 130 130 130 130Mel (1/3) 130 130 130 130

Total Cap. 390 390 390

End of Yr. 6 (after land sale)

107

Same as 9B, but without the revaluation of the

capital accounts

108

Example 9C(not in text)

Recall, the partnership earns

$120,000 of ordinary operating income in Year 5. How is the income allocated?

109

Because capital accounts are not

revalued, no reverse 704(c).

704(b) controls110

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 90 90 90 90Adam (1/3) 60 60 90 60Mel (1/3) 60 60 90 60

Total Cap. 210 210 210

Beginning Balance Sheet

111



2) $90,000 to Alice

3) 1/3 – 1/3 – 1/3

112

113

Hypo.Cash

Adam Mel Alice

End Bk. 330- Beg. Bk. 210 60 60 90= Bk Inc. 120

114

Hypo.Cash

Adam Mel Alice

1st* 90 902nd**


*1st $180K to Adam and Mel

115

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90


*1st $180K to Adam and Mel**2ND $90K to Alice

116

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd*** 20 20 20End Bk. 330 110 110 110- Beg. Bk. 210 60 60 90= Bk Inc. 120

*1st $180K to Adam and Mel**2ND $90K to Alice***3rd $60K (330 – 270) 1/3 – 1/3 – 1/3

117

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90


Target AllocationThe allocation should meet the

sec. 704(b) economic equivalence test or the PIP

test

Assets Tax Basis

BookBasis

FMV O.B.


Alice (1/3) 130 130 130 130Adam (1/3) 100 100 130 100Mel (1/3) 100 100 130 100

Total Cap. 330 330 390

End of Year 5

118

In Yr 6, the Land is sold for $180,000 and it is the only

transaction during the year.

119

Tax AND book gain of $60,000

($180K - $120K) on the land sale

120

121

Hypo.Cash

Adam Mel Alice


122

Hypo.Cash

Adam Mel Alice

1st* 90 90


*1st $180K to Adam and Mel

123

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90


*1st $180K to Adam and Mel**2ND $90K to Alice

124

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90

3rd*** 40 40 40End Bk. 390 130 130 130- Beg. Bk. 330 110 110 110= Bk Inc. 60

*1st $180K to Adam and Mel**2ND $90K to Alice***3rd $120K (390 – 270) 1/3 – 1/3 – 1/3

125

Hypo.Cash

Adam Mel Alice

1st* 90 902nd** 90


704(c) is not triggered. The allocation should meet the sec. 704(b) economic

equivalence test or the PIP test

Target Allocation

Taxable Inc.W/0 Revaluation

126

Ord.Inc.

Capital Gain

Total

Adam 50,000 20,000 70,000

Mel 50,000 20,000 70,000Alice 20,000 20,000 40,000

More capital gain to Alice

Taxable IncomeWith Revaluation

127

Ord.Inc.

Capital Gain

Total

Adam 40,000 30,000 70,000

Mel 40,000 30,000 70,000Alice 40,000 0 40,000

All capital gain to Adam and Mel

Aside from revaluation, any

downside for Alice with this distribution

waterfall? 128



2) $90,000 to Alice

3) 1/3 – 1/3 – 1/3

129

If the partnership had a net loss of say

<$90,000> in the first year, then it

would all be allocated to Alice.

130

Observation #1:

Revaluation is mandatory with a forward section

704(c). 131

Observation #2:

Revaluation is optional when a

partner contributes services in exchange

for a partnership interest 132

Observation #3:With a profits only interest for

services, revaluation is normally necessary in order to allow the service partner to be

entitled to zero on a hypothetical liquidation at

FMV and meet Rev. Proc. 93-27.

133

Example XService Partner

Reverse 704(c)

179

134

AM Partnership

Adam

50%50%

Melvin

$60,000$60,000

135



136

AM Partnership

AdamMelvin

50%50%

FMV $180,000137

At the beginning of Year 5 Alice agrees to provide future services

to the partnership in exchange for a 10%

profits-only interest in the partnership.

138

The partnership agreement contains a

target allocation provision

139



2) 45% (Adam) 45% (Mel) 10% (Alice).

140

To meet Rev. Proc. 93-27 definition

of profits only: in a complete hypothetical liquidation for FMV the

service partner must not be eligible to receive a

distribution141

AM Partnership

AdamMelvin

Alice

Services

10%Profits Only

FMV $180,000

Yr. 5

142

Capital Accounts are

(optionally)Revalued

143

144

Assets Tax Basis

BookBasis

FMV OutsideBasis

Land 120 180 180

Capital:

Adam 60 90 90 60

Melvin 60 90 90 60

Alice 0 0 0 0


After Revaluation

Thus, a reverse 704(c) with respect to

Adam and Mel145

Assume the partnership earns

$100,000 of ordinary operating income in Year 5, how is the income allocated?

146

147

Hypo.Cash

Adam Mel Alice

End BK 280- Beg. BK 180 90 90 0= Bk Inc. 100

148

Hypo.Cash

Adam Mel Alice

End BK 280* 135** 135** 10***- Beg. BK 180 90 90 0= Bk Inc. 100

**1st 90K (50% x 180K)2nd 45K (45% x $100K)

***2nd 10K (10% x $100K)

149

Hypo.Cash

Adam Mel Alice

End BK 280* 135** 135** 10***- Beg. BK 180 90 90 0= Bk Inc. 100 45 45 10

Target Allocation

150

End of Year 5 (In Thousands)Assets Tax

BasisBookBasis

FMV O.B.

Cash 100 100 100Land 120 180 180

Total Assets 220 280 280Capital:

Adam 105 135 135 105Melvin 105 135 135 105Alice 10 10 10 10


Assume that in Year 6 the land is sold for $180,000

and the partnership liquidated.

151

Tax gain of $60,000 on the land sale

allocated 50/50 to Adam and Melvin per

reverse 704(c).Assume this is only

transaction in Year 6 152

153

Hypo.Cash

Adam Mel Alice

End BK 280 135 135 10- Beg. BK 280 135 135 10= Bk Inc. 0 0 0 0

Target Allocation

154

Hypo.Cash

Adam Mel Alice

End BK 280 135 135 10- Beg. BK 280 135 135 10= Bk Inc. 0 0 0 0+ 704(c) Adj. 60 30 30 0Tax. Inc. 60 30 30 0

Adjustment to arrive at taxable income

155

Assets Tax Basis

BookBasis

FMV O.B.

Cash 280 280 280Capital:



Balance Sheet Before Liquidation

Liquidation is tax free recovery of O.B.


156

Ord. Inc. Cap. Gain

Adam 45,000 30,000

Melvin 45,000 30,000

Alice 10,000 0


Example YSame as X but

without revaluation

179

157

158

Assets Tax Basis

BookBasis

FMV OB

Land 120 120 180Capital:



After Alice Joins

159

Hypo.Cash

Adam Mel Alice

End BK 220- Beg. BK 120 60 60 0= Bk Inc. 100

160

Hypo.Cash

Adam Mel Alice


**1st 90K (50% x 180K)2nd 18K (45% x $40K)

***2nd 4K (10% x $40K)

161

Hypo.Cash

Adam Mel Alice


Target Allocation

In Year 6 the land is sold for $180,000 and the partnership

liquidates.

162

Tax gain and book gain of $60,000 on

the land sale

Assume this is only transaction in Year 6

163

164

Hypo.Cash

Adam Mel Alice

End BK 280* 135** 135** 10***- Beg. BK 220 108 108 4= Bk Inc. & T.I.

60

**1st 90K (50% x 180K)2nd 45K (45% x $100K)

***2nd 10K (10% x $100K)

165

Hypo.Cash

Adam Mel Alice

End BK 280* 135** 135** 10***- Beg. BK 220 108 108 4= Bk Inc. & T.I.

60 27 27 6

Target Allocation

Taxable IncomeWithout Revaluation

166

Ord. Inc. Cap. Gain

Adam 48,000 27,000

Melvin 48,000 27,000

Alice 4,000 6,000

$6,000 of capital gain to Alice


167

Ord. Inc. Cap. Gain

Adam 45,000 30,000

Melvin 45,000 30,000

Alice 10,000 0


168

Observation #2: What if the liquidation waterfall read:

1) Adam and Mel’s book capital on the date Alice becomes a partner.

2) 45% (Adam) 45% (Mel) 10% (Alice).

169

If the capital accounts are revalued, then the analysisis the same as the flat $180K ($90K each to Adam and Melvin) language above.

Alice can rely on the safe harbor protection in Rev. Proc. 93-27.

170

If the capital accounts are not revalued, then Alice will not receive the safe harbor protection in Rev. Proc. 93-27 because her interest is acapital interest not a profits only interest. She is entitled to a share of capital in the event of an immediate liquidation.

171

Depreciable Property

184

172

Traditional Method

173

“Noncontributing” partner is allocated tax depreciation up to the amount of the

partner’s book depreciation.

174

Book depreciationis calculated using

the same method as tax (remaining

recovery period).

175

Ceiling rule limits the noncontributing

partner’s tax depreciation allocation

to the partnership’s total tax depreciation

on the contributed asset.

176

Traditional Method With

CurativeAllocation

177

If a noncontributing partner is allocated less tax depreciation than book, the

partnership may make a curative allocation to that partner of tax depreciation

from another item of partnership property to make up the difference

178

The partnership can alternatively

use ordinary income to complete the

curative allocation

179

RemedialAllocation

Method

180

Notional tax depreciation sufficient to correct the ceiling rule is

allocated to the noncontributing partner and same amount is treated as income to the contributing

partner.

181

Unique calculation of book depreciation:

1) Portion of book basis equal to the adjusted tax basis is recovered using the property’s remaining recovery period.

182

2)The remaining book depreciation is calculated using the recovery period for newly purchased property.

Example 10Reverse 704(c) with

Depreciation, Traditional Method and

Revaluation.

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183

184

• Abe and Bonnie form the AB equal LLC/tax partnership.

• Each partner contributes $2,250,000 and the partnership uses the $4,500,000 to purchase a residential rental real estate building on leased land.

185

• For simplicity, the building is depreciated over 30 years (instead of 27.5).

• Abe is the sole managing member of the LLC.

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• 20 years transpire and each year the partnership earns zero net rental income (after depreciation), and generates cash flow each year equal to the depreciation deduction.

187

The adjusted basis of the building at the end of 20 years is $1,500,000, but the building has in fact appreciated in value to

$6,000,000.

188

• At the beginning of Year 21, Cindy contributes $4,500,000 for a one-third interest in AB.

• The partnership revalues all of the book capital accounts (reg. 1.704-1(b)(2)(iv)(f)(5)).

189

The partnership uses the

traditional method of section 704(c)

allocation.

190

Assets Tax Basis

Book Basis

FMV O.B.

Cash 3,000 3,000 3,000Building 1,500 6,000 6,000Total Assets 4,500 9,000 9,000Capital:

Abe (1/2) 2,250 4,500 4,500 2,250Bonnie (1/2) 2,250 4,500 4,500 2,250

Total Capital 4,500 9,000 9,000

After Revaluation (In Thousands)

191

Following Cindy’s Contribution:Assets Tax

BasisBook Basis

FMV O.B.


Abe (1/3) 2,250 4,500 4,500 2,250Bonnie (1/3) 2,250 4,500 4,500 2,250Cindy (1/3) 4,500 4,500 4,500 4,500

Total Capital 9,000 13,500 13,500

192

• If the building were sold the next day, the tax gain of $4,500,000 ($6,000,000 (amount realized) minus $1,500,000 (adjusted tax basis of building) would be allocated 50-50 to Abe and Bonnie, each $2,250,000 per section 704(c) in “reverse”.

193

• $3,000,000 of the sale gain would be section 1250 capital gain (25% maximum rate), and the balance of $1,500,000, section 1231 gain (normally, 20% max. rate).

194

However, the building is not sold and it has 10 years remaining in its 30 year MACRS life.

195

Each partner’s book depreciation, is

$200,000 per year ($6,000,000 (book

basis) ÷ 10 (remaining MACRS life) ÷ 3 (equal

allocation))

196

Tax Depreciation Yrs 21 – 30Year Abe Bonnie Cindy21 $0 $0 <$150,000>22 $0 $0 <$150,000>23 $0 $0 <$150,000>24 $0 $0 <$150,000>25 $0 $0 <$150,000>26 $0 $0 <$150,000>27 $0 $0 <$150,000>28 $0 $0 <$150,000>29 $0 $0 <$150,000>30 $0 $0 <$150,000>

Totals $0 $0 <$1,500,000>

197

Cindy is being allocated $50,000

too little tax depreciation per year

for 10 years ($200,000 book minus$150,000 tax per Yr.)

198

Assets Tax Basis

Book Basis

FMV OutsideBasis

Cash 7,500 7,500 7,500Building 0 0 6,000Total Assets 7,500 7,500 13,500Capital:

Abe (1/3) 2,250 2,500 4,500 3,000Bonnie (1/3) 2,250 2,500 4,500 3,000Cindy (1/3) 3,000 2,500 4,500 3,000

Total Capital 7,500 7,500 13,500

End of Yr. 30

199

If the building were sold for $6,000,000,

the partnership would recognize a

tax and book gain of $6,000,000.

200

Because the book and tax basis of the building are

equal, no built-in gain remains to specially allocate to Abe and

Bonnie under section 704(c). See reg. 1.704-

3(b)(2) Example 1.

201

Assets Tax Basis

Book Basis

FMV O.B.

Cash 13,500 13,500 13,500

Capital:

Abe (1/3) 4,250 4,500 4,500 4,250

Bonnie (1/3) 4,250 4,500 4,500 4,250

Cindy (1/3) 5,000 4,500 4,500 5,000

Total Capital 13,500 13,500 13,500

Following Sale and Before Liquidation:

Capital Gain or Loss per Sec. 731

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Cap. Gain<Loss>

Abe $250,000

Bonnie $250,000

Cindy <$500,000*>

The best deal for Abe and Bonnie!

*Represent’s Cindy’s lost depreciation due to ceiling rule

Example 11Traditional Method

with Curative Allocation (via gross

rent re-allocation)

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203

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The effect of the curative allocation is that Cindy

experiences the same tax consequences that she

would be entitled to if she were allowed MACRS

depreciation of $50,000 (in addition to the $150,000)

per year over the remaining 10 year MACRS life.

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Abe and Bonnie each recognize

$25,000 of additional income each year for 10

years.

206

End of Yr. 30Assets Tax

BasisBook Basis

FMV O.B.

Cash 7,500 7,500 7,500Building 0 0 6,000Total Assets 7,500 7,500 13,500Capital:

Abe (1/3) 2,500 2,500 4,500 2,500Bonnie (1/3) 2,500 2,500 4,500 2,500Cindy (1/3) 2,500 2,500 4,500 2,500

Total Capital 7,500 7,500 13,500

207

If the building were sold for $6,000,000, each partner would

be allocated $2,000,000 gain and

no further gain or loss on liquidation

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The best tax deal for Cindy!

Worst for Abe and Bonnie!

Example 12Remedial Method

Abe and Bonnie might agree to this as a

compromise

191

209

210

Following Cindy’s Contribution:Assets Tax

BasisBook Basis

FMV O.B.


Abe (1/3) 2,250 4,500 4,500 2,250Bonnie (1/3) 2,250 4,500 4,500 2,250Cindy (1/3) 4,500 4,500 4,500 4,500

Total Capital 9,000 13,500 13,500

211

Total tax depreciation in

Years 21 through 30 is <$150,000> per year (<$300,000> remedial method

book)

212

Year Abe Bonnie Cindy21 <$25,000> <$25,000> <$100,000>22 <$25,000> <$25,000> <$100,000>23 <$25,000> <$25,000> <$100,000>24 <$25,000> <$25,000> <$100,000>25 <$25,000> <$25,000> <$100,000>26 <$25,000> <$25,000> <$100,000>27 <$25,000> <$25,000> <$100,000>28 <$25,000> <$25,000> <$100,000>29 <$25,000> <$25,000> <$100,000>30 <$25,000> <$25,000> <$100,000>

Totals <250,000> <250,000> <$1,000,000>

Tax Depreciation Allocation

213

Year Abe Bonnie Cindy31 25,000 25,000 <50,000>32 25,000 25,000 <50,000>33 25,000 25,000 <50,000>… … … …50 25,000 25,000 <50,000>Totals $500,000 $500,000 <$1,000,000>

Remedial Allocations (Notional Tax Items)

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End of Yr. 50Assets Tax

BasisBook Basis

FMV Outside

BasisCash 7,500 7,500 7,500Building 0 0 6,000Total Assets 7,500 7,500 13,500Capital:

Abe (1/3) 2,500 2,500 4,500 2,500Bonnie (1/3) 2,500 2,500 4,500 2,500Cindy (1/3) 2,500 2,500 4,500 2,500

Total Capital 7,500 7,500 13,500

215

If the building were sold for $6,000,000, each partner would

be allocated $2,000,000 gain and

no further gain or loss on liquidation

216

Remedial method is a better tax deal for Cindy than the

traditional method but not asgood for Cindy as the

Traditional with Curative (TC) Method because the remedial method extends

tax benefit fix over an additional 20 years (30 (remedial) v. 10 (TC))

217

Remedial method a better tax deal for Abe and

Bonnie (vs. traditional with curative allocation) because the additional

income is deferred for 20 more years (30 (remedial)

v. 10 (TC))

Example 13Same as Ex. 10 but Without Revaluation

193

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At the beginning of Year 21, Cindy

contributes $4,500,000 for a

one-third interest in AB.

220

Before Cindy Joins (No Revaluation)(In Thousands)

Assets Tax Basis

Book Basis

FMV O.B.


Abe (1/2) 2,250 2,250 4,500 2,250Bonnie (1/2) 2,250 2,250 4,500 2,250

Total Capital 4,500 4,500 9,000

221

The partnership does not revalue the capital accounts and does not

compensate with a special sec. 704(b)allocation of built-in

gain of $4.5 mil. to Abe and Bonnie

222

Abe and Bonnie are shifting $1,500,000

of unrealized built-in economic

gain on the building to Cindy.

(likely a taxable gift if A and B are C’s parents)

223

Assets Tax Basis

Book Basis

FMV O.B.


Abe (1/3) 2,250 2,250 ? 2,250Bonnie (1/3) 2,250 2,250 ? 2,250Cindy (1/3) 4,500 4,500 ? 4,500

Total Capital 9,000 9,000 13,500

Following Cindy’s Contribution:

224

There is no book/tax disparity thus no sec.

704(c) built-in gain (due to the absence of a

revaluation) – sec. 704(c) allocation method is

irrelevant

225

• While $1,500,000 of unrealized economic gain is shifted to Cindy, there is no “capital shift”.

• None of Abe and Bonnie’s book capital account is being shifted to Cindy. See CCA 201517006 (4/24/2015)

226

If the building were sold the next day, the book and tax gain of $4,500,000 would be

allocated $1,500,000 to each partner.

227

Following Building Sale:

Assets Tax Basis

Book Basis

FMV O.B.

Cash 13,500 13,500 13,500

Capital:

Abe (1/3) 3,750 3,750 3,750 3,750

Bonnie (1/3) 3,750 3,750 3,750 3,750

Cindy (1/3) 6,000 6,000 6,000 6,000

Total Capital 13,500 13,500 13,500

No tax consequence on liquidation

228

What if theproperty is sold

before the end of the recovery

period?

229

With the traditional method, when section 704(c)

depreciable property is sold before the end of its

recovery period, remaining 704(c) built-in gain is the excess of its book basis

over tax basis.

See Reg. 1.704-3(b)(2) Ex. 1

704(c) allocation methods - · pdf file704(c) allocation methods 2. ... outside basis 30,000...

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