Section 704(c) and Allocation of
Gain with Respect to Contributed Property • Section 704(c)(1)(A) requires
items of income, gain, loss, and deduction with respect to property contributed to a partnership by
a partner to be shared among the partners to take
into account any difference between the basis of the
property to the partnership and the fair market value of the property at the time of the contribution.
When a partnership receives a contribution of appreciated property from a partner, the partnership
has property with a “built-in gain” in the amount
of the excess of the fair market value of the property on contribution (the fair market value being its
initial “book value” for partnership purposes) over
its tax basis. (As used in this article, “book value”
means book value as determined in accordance
with section 704(b), not book value under GAAP
or other financial accounting measures.) This initial
built-in gain may be reduced over time by the excess of basis recovery deductions (e.g., depreciation)
as calculated for “book” purposes over those same
deductions as calculated for tax purposes. When
the partnership sells this “section 704(c) property”
and recognizes a gain, the built-in gain on the property must be allocated to the contributing partner.
Treas. Reg. §1.704-3(b)(1). The contributing partner
should know that responsibility for any income tax
attributable to this built-in gain sticks with him or
her after the contribution.
Example: A and B form partnership AB and agree
each will be allocated 50 percent of all partnership
items. A and B also agree that allocations required
by section 704(c) must be given effect. A contributes land with an adjusted tax basis of $5,000 and a
fair market value of $10,000. B contributes $10,000
cash. Two years later AB sells the land for $30,000.
A is allocated $5,000 of (built-in) gain under section
704(c) and $10,000 of (book) gain. B is allocated
$10,000 of (book) gain.
The regulations approve of three methods of
allocating items of income, gain, loss, or deduction
with respect to section 704(c) property: the traditional method, the traditional method with curative
allocations, and the remedial allocation method.
Under the traditional method, if the partnership
sells section 704(c) property and realizes a gain, the
built-in gain is allocated to the contributing partner. Treas. Reg. §1.704-3(b). This method works
well when, as in the example, there is enough gain
to allocate (i) the appropriate amount of book gain
to the partners and (ii) the appropriate amount of
built-in gain to the contributing partner. But what
about other situations? Under the traditional method, there is a “ceiling rule.” The total income, gain,
loss, or deduction allocated to the partners with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to
that property for the year.
so the partnership can sell the items and then makes a special allocation of the gain in the simplest terms using the above example in a 50/50 partnership
per above in its simplest form, the land was sold for $30,000 with an actual tax basis of $5,000. thus the tax gain is $25,000 but book gain is $20,000 ($30,000 sales price less $10,000 valuation for book purpose) . 1/2 of the book gain is allocated to each partner.
since the book basis for A is $5,000 higher than his tax basis (the built-in gain) the $5,000 of additional tax gain is allocated specifically to A.
