Section 704(c) sets forth rules which govern the allocation of the tax items of a partnership with respect to contributed property. More specifically, section 704(c)(1)(A) addresses the question of which partner or partners are to be allocated the unrealized appreciation or loss on property contributed to a partnership. The same principle applies with equal vigor to when additional property is contributed to the partnership or where property held by the partnership is distributed in exchange for a partnership interest. The same may be said for assets-over mergers of partnerships as well as revaluations of capital accounts. For a sampling of recent commentary on this subject see New York State Bar Association Tax Section, “Report on the Request for Comments of Section 704(c) Layers Relating to Partnership Mergers, Divisions and Tiered Partnerships”; See Pillow and Dance, "Notice 2009-70: A Focus on Complex Section 704(c) Netting vs. Layering Issues," 111 JTAX 336 (December 2009) . Other articles that have addressed issues raised in the Notice include: Abrams, ''Reverse Allocations: More Than Meets the Eye,'' 20 Tax Mgmt. Real Est. J. 2 (2004); Harris, ''Federal Taxation of Partnership Asset Revaluations,'' 14 Va. Tax Rev. 257 (1994).
Section 704(c)(1)(A) requires that income, gains, losses and deductions that are attributable to built-in gains or losses on contributed property are required to be allocated in a manner which takes into account the variation between the fair market value (FMV) and adjusted tax basis of the property at the time of the contribution. See Deficit Reduction Act of 1984, P.L. No. 98-369, §71(c). The regulations provide that a partnership must account for this “delta” amount or variance between basis and FMV by using “a reasonable method that is consistent with the purpose of section 704(c)”. Treas. Reg. §1.704-3(a)(1); Treas. Reg. §1.704-1(b)(2)(iv)(f)(“book-ups”).
There are three methods approved in the regulations for making section 704(c) allocations: (i) the traditional method, which is generally preferred by contributors of highly appreciated property; (ii) the traditional method with curative allocations, and (iii) the remedial allocation method. Other methods may be permitted. In general, many if not most partnership agreements will use the “traditional method” explained in Treas. Reg. §1.704-3(b) as modified, by a so-called “ceiling rule”, i.e., the total amortization, depletion, depreciation, or gain or loss allocated to the partners cannot exceed the total amount of the partnership's amortization, depletion, depreciation, or gain or loss. The ceiling rule also can create a lingering disparity between the noncontributing partners' section 704(b) capital account and tax capital account.
In Notice 2009-70, 2009-34 IRB 255, comments were solicited by the Treasury and IRS on section 704(c) and its application to revaluations, partnership mergers, divisions and tiered partnerships.
Where section 704(c) property contributed to a partnership is distributed to partners other than the contributor, i.e., in a so-called mixing bowl distribution, within seven years of its contribution, section 704(c)(1)(B) mandates that the contributing partner, or her successor in interest under a “step in the shoes” approach, is required to recognize gain or loss in an amount equal to the gain or loss that would have been allocated to the contributing partnership under section 704(c)(1)(B) had the property been sold to the distribute(s) at FMV at the time of distribution. Where gain or loss is recognized under section 704(c)(1)(B), the basis of the contributing partner’s interest in the partnership and basis of the distributed property are adjusted to reflect the recognized gain or loss. Such adjustment to basis is made prior to tax affecting the distribution. Treas. Reg. §1.704-4(e)(2).
Section 737 requires a contributing partner to recognize gain where the partnership distributes other property to the contributor of appreciated property within 7 years of that partner’s contribution. The gain recognized under section 737 by the distributee-contributing partner is the lesser of: (i) FMV of the distributed property less the adjusted basis of the partner’s interest in the partnership, or (ii) the ne precontribution gain of that partner. The net precontribution gain is gain that the contributing partner would recognize under section 704(c)(1)(B) had the partnership distributed the contributed property to a noncontributing partner within 7 years. §737(b). There are certain exceptions that will override application of section 704(c)(1)(B), such as the termination of a partnership under section 708(b)(1)(B). Moreover, in such instance there is no commencement of a new 7 year period for application of the mixing bowl provision.
Partnership Mergers and Deemed Liquidations: Another Exception to Triggering Section 704(c)(1)(B).
Where a partnership transfers all of its assets and liabilities to another partnership and liquidates or is deemed to liquidate, section 704(c)(1)(B) does not apply to the liquidation. Instead, it operates on the transferee partnership as a successor to the transferor partnership. Treas. Reg. §1.704-4(c)(4). In this instance there is the commencement of a new 7 year period with respect to the difference between the section 704(b) book value and FMV of the transferred property. No new 7 year period is imposed with respect to the FMV and adjusted basis spread existent on date of contribution. Treas. Regs. §§1.704-4(c)(4), 1.737-2(b)(1). The revaluation can result in a new level of section 704(c) gain. In Rev. Rul. 2004-43, 2004-1 C.B. 842, revoked by Rev. Rul. 2005-10, 2005-1 C.B. 492, the Service further stated that section 704(c) principles will apply to reverse section 704(c) allocations. It is noteworthy that the the regulations under section 704(c)(1)(B) and section 737 do not provide a rule requiring both provisions to apply to reverse section 704(c) applications. See Treas. Reg. §1.704-3(a)(6)(i).
The Service in 2007 issued proposed regulations to section 704(c)(1)(B) and related provisions confirming and supplementing Rev. Rul. 2004-43, supra., that such provision would not apply to an assets-over merger where the transferor-partnership is terminated as a result of the merger. Still, Prop. Reg. §1.704-4(c)(4)(ii) states that section 704(c)(1)(B) applies to the transferee-partnership’s subsequent distribution of section 704(c) property contributed by the transferor partnership to the transferee partnership in an assets over merger under certain conditions. See Prop. Regs. §§1.704-4(c)(4)(iii)(A)-(D). In an assets over merger, a new 7 year period will not start for the initial section 704(c) gain or loss to the extent such difference has not be eliminated by remedial or curative allocations or by reporting section 704(c) gain or loss. Still, a distribution of contributed property to another partner after the completion of the assets over merger would tripper application of section 704(c) to the original contributor of the property if within the 7 year period. Of course a new section 704(c) amount and commencement of a new 7 year period would apply to booked-up gain or loss as a result of the merger. See Prop. Regs. §§1.704-4(c)(4)(ii)(D). The proposed regulations retain the rule in Rev. Rul. 2004-43 which provided that such rules would not apply to reverse section 704(c) gain or loss. See Treas. Reg. §1.704-3(a)(6)(i).
Application to Revaluations
Under Treas. Reg. §1.704-1(b)(2)(iv)(f), the partners in a partnership may agree, as part of the partnership agreement, to revalue the partnership’s property to current FMV on the happening of certain events such as contributions or distributions to or from the partnership. The re-valuation increases or decreases the book-tax differences in the partners’ capital accounts. This in turn re-vitalizes further application of section 704(c) which in such instance is referred to as a “reverse section 704(c) allocation”. Partnerships having reverse section 704(c) allocations do not need to employ the same allocation method used for “forward” section 704(c) allocations. If there are more than one reverse section 704(c) allocations caused by re-valuations, the allocations among the “reverse” allocations can vary as long as the method selected is reasonable. This provides the partnership and its members with flexibility on how to account for and adjust such book-tax differences in the asset pool held by the venture.
It is somewhat agreed by tax practitioners working in the partnership area that clearer and more definitive guidance is needed in this area. This “musing” serves simply as a reminder that this area continues to offer a great degree of flexibility but at the cost of a complex and uncertain landscape.