Passthrough Entities/September–October 2002
Reverse Allocations:
More Than Meets the Eye
By
Howard E. Abrams

2002 H.E. Abrams
Howard Abrams explains the intricacies of maintaining
capital accounts for partners in cases of reverse allocations.
Introduction
The usual way to ensure that tax
allocations have economic effect
is to maintain capital accounts for
each partner and then ensure that
every tax allocation is accompanied by a corresponding book
allocation that adjusts those capital accounts. Properly maintained
capital accounts must be increased for the value of property
and cash contributed to the partnership; decreased for the value
of cash and property distributed
by the partnership; and increased
(or decreased) for allocations of
income (or deduction).1 Finally,
liquidation proceeds must be distributed in accordance with final
capital account balances.2
For example, suppose that a partnership earns $100 of income, and
suppose further that this item of
income is allocated under the partnership agreement to partner P. If
capital accounts are maintained
properly, this allocation will result
in a $100 increase in P’s capital
account. And if liquidation proceeds will be distributed in
accordance with final capital accounts, then P will receive 100
dollars more at liquidation (if not
before) by reason of the allocation.
The upward capital account adjust-
ment, in other words, ensures that
the economic benefit (receipt of
more dollars) follows the tax allocation (inclusion of more income).
Because liquidating proceeds
must be distributed in accordance
with final capital account balances, it is the book allocations
that define the economic relationships among the partners. The
partners are free to allocate the
partnership’s economic gains and
losses as they see fit; the requirement of economic effect mandates
only that tax allocations follow
book allocations.
But this relationship between
book allocations and tax allocations presupposes that book items
and the corresponding tax items
arise simultaneously. There are
times, however, when book allocations must be made before the
corresponding tax items occur
and, when that happens, the requirement of economic effect
requires that when the tax items
Howard E. Abrams is a professor of law
at Emory University and spent the 1999–
2000 academic year with the national
office of Deloitte & Touche, LLP, as the
Director of Real Estate Tax Knowledge.
He is a member of the American Law
Institute and the California Bar.
41
Reverse Allocations
mature, they be allocated in the
same way as the prior book items.
This relationship between current
tax allocations and prior tax allocations is enforced by the rules of
Code Sec. 704(c)(1)(A).
When property is contributed to
a partnership, Code Sec.
704(c)(1)(A) requires that any unrealized appreciation or loss in the
contributed property be allocated to
the contributing partner. The regulations promulgated under Code
Sec. 704(c)(1)(A) implement this
mandate by requiring that the contributed property be booked into the
contributing partner’s capital account at current fair market value.3
These regulations further provide
that when the precontribution unrealized gain or loss is finally
realized and recognized by the partnership, it must be allocated to the
contributing partner. 4
Thus, Code Sec. 704(c)(1)(A) has
two functions. First, it specifies that
the contributing partner ultimately
must receive the full value of the
contributed property from the partnership—the economic benefit of
all unrealized appreciation cannot
be shifted to other partners. Second, it imposes the requirement of
economic effect on this
precontribution unrealized gain or
loss by demanding that the tax benefit or burden associated with this
gain or loss must also be allocated
to the contributing partner.
Note
that
Code
Sec.
704(c)(1)(A), by specifying how
the unrealized appreciation is
handled for book purposes, affects
the economics of the venture and
not merely its tax aspects. Thus, it
ultimately affects how many dollars the contributing partner will
receive upon liquidation of his
interest in the partnership. This
aspect of Code Sec. 704(c)(1)(A)
does not speak to the economic
effect requirement of Code Sec.
42
704(b). Rather, it responds to an
assignment of income concern,
something that the partners may
on occasion wish to avoid.5
Book items subject to Code
Sec. 704(b) can be allocated
however the partners desire, subject only to the requirement of
substantial economic effect;
thus, the partners have considerable flexibility in the allocation
of such items. In contradistinction, book items subject to Code
Sec. 704(c)(1)(A) must be made
to the contributing partner; as to
such allocations, the partners
have no flexibility. There are circumstances when a partnership
is permitted to revalue its assets
and restate the capital accounts
to reflect those values.6 When
this is done (called a partnership
“book-up”), the restatement and
revaluation causes a book/tax
disparity for the partners identical to a book/tax disparity
caused by the contribution of
appreciated or loss property.
It should be unsurprising, then,
that the regulations under Code
Sec. 704(b) require the application of Code Sec. 704(c)(1)(A)
principles to such book/tax disparities. 7 These mid-stream
adjustments to the book value of
partnership assets are most often
made when new value is contributed to an ongoing partnership.
If the new value takes the form
of appreciated or loss property,
Code Sec. 704(c)(1)(A) will apply to the contributing partner.8
But whether or not the contributed property has built-in gain or
loss, the principles of Code Sec.
704(c)(1)(A) will apply to the
continuing partners if they elect
to restate their capital accounts
because of the contribution.9 In
such circumstances, application
of Code Sec. 704(c)(1)(A) principles to the continuing partners
are called “reverse 704(c)” allocations because they are made
not to the contributing partner
(as are true Code Sec.
704(c)(1)(A) allocations), but
rather to all the other partners
because of the contribution.
Reverse allocations fall somewhere between allocations
falling within Code Sec.
704(c)(1)(A) and those limited
only by the general provisions of
Code Sec. 704(b). While the
partners have no flexibility with
respect to Code Sec. 704(c)(1)(A)
allocations and virtually complete flexibility with regard to
most Code Sec. 704(b) allocations, partners once had, but no
longer have, flexibility with respect to reverse tax allocations.
That is, the partners have considerable flexibility in allocating
the revaluation book gain or loss,
but when in a subsequent year
that book gain or loss becomes
recognized for tax purposes, it
must then be allocated among
the partners as the prior book
gain or loss was allocated.
In the context of Code Sec.
704(b), book items and tax items
occur simultaneously, while in the
context of Code Sec. 704(c)(1)(A),
book items occur prior to tax
items. But the two provisions both
operate to preserve economic effect by ensuring that tax
allocations follow book allocations. Reverse allocations arise
when book items precede tax
items other than in connection
with the contribution of appreciated property. This will occur
whenever partnership assets are
revalued and partnership capital
accounts are restated to reflect the
revaluation. In general, a partnership is permitted to book its assets
to fair market value only in connection with the contribution of
new equity to the partnership or
Passthrough Entities/September–October 2002
in connection with the distribution
of property (including cash) to a
partner with respect to the partnership interest.10
partner in exchange for a cash
contribution of $70. If the partnership elects to revalue
Blackacre and restate its capital accounts upon the
admission of Z, the books of
the partnership will stand as is
shown in Chart 1 (where CA
refers to capital account and
OB refers to outside basis).
Optional Book-Ups
Example. X and Y each contributes $50 to the XY partnership,
and each becomes a 50-percent partner. The partnership
purchases nondepreciable
Blackacre for its cash of $100.
After Blackacre increases in
value to $140, Z is admitted to
the partnership as a one-third
The capital accounts of the partners stand at $70 each, and that
accurately reflects the equal onethird status of each partner. The
book/tax disparity for X and Y results from the book-up: capital
Chart 1
The Economics of Booking-Up
X
Y
CA
$50
20
0
$70
OB
$50
0
0
$50
Asset
Blackacre
Cash
CA
$50
20
0
$70
Z
OB
$50
0
0
$50
Book Value
$140
70
CA
OB
0
70
$70
0
70
$70
Explanation
Starting Values
Book-Up
Admission of Z
Total
Adjusted Basis
$100
70
Chart 2
X
CA
$70
0
Y
Z
OB
$50
20
CA
$70
0
OB
$50
20
CA
$70
0
OB
$70
0
10
10
10
10
10
$80
$80
$80
$80
$80
10
$80
Asset
Cash
Book Value
$240
Explanation
After Book-Up
Allocations Under Code
Sec. 704(c)(1)(A)
Allocations Under Code
Sec. 704(b)
Total
Adjusted Basis
$240
Chart 3
X
CA
$50
accounts were increased to reflect
the as-yet unrealized appreciation
in Blackacre. As a result, the partners will be required to adopt one
of the Code Sec. 704(c) methods—
the traditional method, the
traditional method with curative allocations or the remedial allocation
method—with respect to the book/
tax disparity in Blackacre.11 In particular, if Blackacre is subsequently
sold for $140 or more, the first $40
of taxable gain must be allocated
equally between X and Y to eliminate the book/tax disparity arising
from the book-up. If, say, Blackacre
is sold for $170, the books will
show what is illustrated in Chart 2.
Y
OB
$50
Asset
Blackacre
Cash
CA
$50
Book Value
$100
$ 70
Z
OB
$50
Adjusted Basis
$100
$ 70
CA
$70
OB
$70
Explanation
No Book-Up
Suppose that the XYZ partnership
discussed above elects not to restate its capital accounts on the
admission of Z. As a result, the
books of the partnership will read
as is shown in Chart 3.
The capital accounts do not accurately reflect the equality of the
partners: Z’s capital account is
greater than that of X and of Y, suggesting (inaccurately) that Z’s
interest in the partnership is
greater than that of the other two
partners. However, there is no inflexible requirement that the
capital accounts always reflect the
partners’ relative interests in the
partnership, and to ensure that the
parties are treated fairly, the partners might agree simply that upon
the disposition of Blackacre, the
first $40 of gain will be divided
equally between X and Y alone.
That is, the parties can use a special allocation of dispositional
gain in lieu of a book-up.
If, for example, Blackacre is
eventually sold for $170, the $70
of gain will be divided into two
components: the first $40 of gain
and the remaining $30 of gain. The
43
Reverse Allocations
first $40 will be allocated $20 to
X and $20 to Y, and the remaining
$30 of gain will be allocated
equally among the partners. As a
result, the books of the partnership
will reflect the equality of the partners, illustrated in Chart 4.
In this circumstance, replacing
the book-up with a special allocation of dispositional gain yielded
the same net effect to the partners.
But if the property had declined in
value after the admission of Z, the
special allocation might not be an
effective substitute. For example,
suppose again that Blackacre is
worth $140 when Z is admitted to
the partnership in exchange for
cash of $70, but now assume that
Blackacre is worth only $134 when
eventually sold by the partnership.
On that sale, there will be a taxable gain of $34, divided equally
between X and Y. Assuming the
partnership booked Blackacre to
fair market value upon the admission of Z, the books will appear as
shown in Chart 5.
These books correctly reflect the
equality among the partners. The
$6 decline in the value of
Blackacre arising after the admission of Z results in a capital
account reduction of $2 per partner; as a result, an immediate
liquidation will result in each part-
Chart 4
X
Y
Z
CA
$50
20
10
OB
$50
20
10
CA
$50
20
10
OB
$50
20
10
CA
$70
0
10
OB
$70
0
10
$80
$80
$80
$80
$80
$80
Asset
Cash
Book Value
$240
Explanation
No Book-Up
Special Allocation of Tax Gain
Allocations Under
§704(c)(1)(A)
Total
Adjusted Basis
$240
Chart 5
X
CA
$70
(2)
0
$68
Y
OB
$50
0
17
$67
Asset
Cash
CA
$70
(2)
0
$68
Book Value
$214
Z
OB
$50
0
17
$67
CA
$70
(2)
0
$68
OB
$70
0
0
$70
Explanation
After Book-Up
Book Loss
Allocations Under §704(b)
Total
Adjusted Basis
$214
Chart 6
X
Z
OB
$50
17
CA
$50
17
OB
$50
17
CA
$70
0
OB
$70
0
$67
$67
$67
$67
$70
$70
Asset
Cash
44
Y
CA
$50
17
Book Value
$214
Adjusted Basis
$214
Explanation
No Book-Up
Special Allocation
of Tax Gain
Total
ner receiving a cash distribution
of $68. But suppose the partnership had elected not to book up
Blackacre upon the admission of
Z. In that case, the sale of
Blackacre would produce a gain
of $34 for both book and tax purposes, so the books would look
like the numbers in Chart 6.
These capital accounts indicate
that if the partnership were now
to liquidate, its cash of $214
would be distributed $67 to X, $67
to Y and $70 to Z. Thus, by failing
to book up, the economics underlying the partnership have been
compromised . The decline in
value of Blackacre accruing after
the admission of Z should be
shared equally among all the partners, Z included. Without the
book-up, though, it was shared
only by X and Y. The great advantage that a book-up offers is that
the partners’ capital accounts will
accurately reflect the underlying
economic relationships at all
times, even if the partnership’s assets turn around in value.
If a partnership elects not to
book up its assets upon the contribution of new equity and then
one or more of its restated assets
turn around in value, the partnership can preserve the economics
among the partners by fashioning
curative allocations with other
items of income or deduction.12
For example, suppose that the
partnership elects not to book up
Blackacre upon the admission of
Z, that Blackacre is eventually sold
for $134 and that in the same or
in a subsequent year, the partnership has a deduction of $3 that
would, under the partnership
agreement, be allocated equally
among the partners. If this deduction is, in fact, allocated entirely
to Z for both book and tax purposes, the books of the partnership
will read as shown in Chart 7.
Passthrough Entities/September–October 2002
Just as the capital account problem can be cured by an extra
allocation of loss to Z, so, too, the
problem could be solved by an
extra allocation of income to X
and to Y.13 However, these cures
are dependent on having income
or deduction with which to cure,
just like the “traditional method
with curative allocations” defined
in the Code Sec. 704(c)(1)(A) regulations.14 The self-help curative
allocations have considerably
more flexibility than those defined
in the regulations, though, because these self-fashioned curative
allocations can be made in any
year or years, in any amounts and
need not be made with income of
the same character as that causing the book/tax disparity.15
However, while these self-help
curative allocations plainly satisfy
the test for economic effect, they
must also be tested against the requirement of “substantiality.”
Suppose, for example, that the XYZ
partnership includes two allocations
with respect to the book/tax disparities caused by the decision not to
book up when Z was admitted.
alized on the disposition of
Blackacre, all other partnership income will be divided
equally between X and Y (and
all partnership deductions will
be allocated only to Z) until
the shortfall from the disposition of Blackacre has been
fully recovered.
Because these allocations will be
reflected identically in the partners’
capital accounts and outside bases,
they have economic effect within
the meaning of Code Sec. 704(b).16
But to be valid, that economic effect must be “substantial.” Are these
two sets of allocations “shifting” or
“transitory” within the meaning of
the substantiality regulations or do
they in some other way violate the
substantiality requirement?17
The condemnation of both shifting and transitory allocations in
the regulations emphasizes that
pairs of allocations likely to have
offsetting economic effects should
be disregarded. For example, an
allocation of excess deductions to
one partner in year one followed
by an offsetting allocation of income to the same partner in year
two generally will be ignored.18
Fortunately, the allocations used
to mimic the economics of a partnership book-up are not shifting
or transitive because they are not
offsetting; rather, they are complementary. If there is sufficient gain
from the disposition of Blackacre,
First, the partners agree that the
first $40 of book and tax gain
realized on the disposition of
Blackacre will be allocated
only to X and Y, $20 to each.
Second, they agree that if there
is less than $40 of income re-
Chart 7
X
Y
Z
CA
$50
17
0
OB
$50
17
0
CA
$50
17
0
OB
$50
17
0
CA
$70
0
(3)
OB
$70
0
(3)
$67
$67
$67
$67
$67
$67
Asset
Cash
Book Value
$211
Adjusted Basis
$211
Explanation
No Book-Up
Sale of Blackacre
Curative Allocation
of Loss
Total
the second allocation will not be
triggered. If there is no gain from
the disposition of Blackacre, only
the second allocation will be triggered. And if there is insufficient
gain from the disposition of
Blackacre, both allocations will be
triggered to work in tandem, giving income to X and Y or loss to
Z. In no sense are these two sets
of allocations offsetting.
To be sure, these allocations together come very close to
mimicking an initial book-up of
Blackacre upon the admission of
Z, but it is hard to see how that
fact alone could subject the allocations to challenge.19 After all,
booking assets to fair market value
upon the contribution of new equity is expressly made optional.20
However, using self-help curative
allocations in lieu of a book-up
can offer some aggressive tax opportunities, and in that context we
will have to re-examine the limits
of the substantiality doctrine.
When Not to Book Up
A partnership should elect not to
book assets to fair market value
upon the contribution of new equity whenever it wishes to shift some
of the unrealized appreciation to the
contributor of the new equity. For
example, a cash-poor partnership
could use the lure of a share of unrealized appreciation to attract a
new investor. If, say, X and Y are
equal partners in the XY partnership
owning a single asset with adjusted
basis and book value of $1,000,000,
they might seek an infusion of cash
to pay operating expenses. Even if
the partnership’s asset were worth
$2,200,000, obtaining loans might
be difficult. New investor Z might
be willing to contribute cash of
$500,000 for a full one-third share,
and that can be accomplished only
by eschewing a book-up when Z
joins the venture.
45
Reverse Allocations
If the partnership elects to book
its asset to fair market value upon
the admission of Z, the books of
the partnership will read as in
Chart 8.
If, say, the asset is eventually
sold for $2,500,000, there will be
book gain of $300,000 and tax
gain of $1,500,000. Even if the
entire book gain is allocated to Z,
Z’s capital account will rise to only
$800,000. And because liquidating distributions must be made in
accordance with final capital account balances,21 that means that
if the partnership then liquidates,
Z will receive only $800,000 of
the partnership’s $3,000,000, with
X and Y each receiving
$1,100,000. In effect, by booking
the unrealized appreciation into
X’s and Y’s capital accounts, that
value is locked away from Z.
But if the partnership had not
booked the unrealized appreciation
into the capital accounts upon the
admission of Z, the books would be
very different. If the asset were sold
for $2,500,000 and the book and
the future, PRS will revalue its assets and restate capital accounts.
The partnership purchases nondepreciable property for $10,000,
using its capital of $2,000 as well
as $8,000 borrowed from a bank.
After one year, the value of the
property falls to $6,000. As part of
a workout with the bank, (1) the
loan is reduced by $2,000 to
$6,000; (2) A contributes additional
capital of $500; and (3) the additional capital contributed by A is
used to pay currently deductible
expenses and triggers a revaluation
of the partnership’s assets and a
restatement of capital accounts.
As a result of the workout, the
partnership recognizes $2,000 of
cancellation of indebtedness income (COI income) for both book
and tax purposes. The partners
agree to allocate this entire
amount to B, who is insolvent. The
partnership also has $4,000 of
book loss resulting from the revaluation of its property, and the
partners agree to allocate this loss,
$1,000 to A and $3,000 to B. Fi-
tax gain were allocated equally
among the partners, the books
would show that Z is, in fact, a full
one-third partner. See Chart 9.
The same technique could be
used when admitting a new investor who takes an initial debt position
with a right to convert to equity. In
such circumstances, the investor
generally seeks the rights of a creditor in case things turn out poorly,
but desires the rights of an equity
participant if things turn out well. If
the debt is converted into equity, it
is essential that the partnership not
book its assets to fair market value
for the investor to be treated as a
full equity participant ab initio.
For a more aggressive use of the
option not to book assets to fair
market value, consider the facts of
Rev. Rul. 99-43.22 In that ruling, A
and B each contribute cash of
$1,000 to the general partnership
PRS. Each partner is allocated 50
percent of profits and losses, and
the partnership agreement provides that if either partner
contributes additional capital in
Chart 8
X
CA
$500,000
600,000
0
$1,100,000
Y
OB
$500,000
0
0
$500,000
Asset
Cash
Property
CA
$ 500,000
600,000
0
$1,100,000
Book Value
$500,000
2,200,000
Z
OB
$500,000
0
0
$500,000
CA
OB
0
0
500,000
$500,000
0
0
500,000
$500,000
Explanation
Starting Values
Book-Up
Admission of Z
Total
Adjusted Basis
$500,000
1,000,000
Chart 9
X
CA
$ 500,000
0
500,000
$1,000,000
Asset
Cash
46
Y
OB
$ 500,000
0
500,000
$1,000,000
Book Value
$3,000,000
CA
$ 500,000
0
500,000
$1,000,000
Z
OB
$ 500,000
0
500,000
$1,000,000
Adjusted Basis
$3,000,000
CA
$
0
500,000
500,000
$1,000,000
OB
$
0
500,000
500,000
$1,000,000
Explanation
Starting Values
Admission of Z
Sale of Asset
Total
Passthrough Entities/September–October 2002
nally, the partnership allocates the
entire $500 of book and tax deductions arising from the payment
of workout expenses entirely to A.
In tabular form, the capital accounts would look like Chart 10.
As a result of these allocations,
each partner’s capital account is
reduced to zero. Had the partners
simply allocated both the COI income and the revaluation loss
equally between the partners, capital accounts also would have been
reduced to zero. But by allocating
both the income and loss disproportionately, the partners attempt
to allocate all the taxable COI income to the insolvent partner,
thereby minimizing the partners’
joint tax liability without affecting
the number of dollars either partner will receive upon liquidation.
The ruling concludes that the
disproportionate allocation of the
COI income and the revaluation
loss together constitute a shifting
pair of allocations because there
is a strong likelihood that they will
have offsetting effects. The disproportionate allocation of COI
income entirely to B has an immediate effect of increasing B’s
capital account and thereby increasing the number of dollars B
will receive upon liquidation of B’s
partnership interest. The disproportionate allocation of the
revaluation loss to B then reduces
the number of dollars B will receive upon liquidation, thereby
restoring the partners’ relative
shares to equality.
Of course, the revaluation loss
will only affect the number of dollars that the partners’ will receive
if the property in fact declines in
value. But partnership property is
conclusively presumed to have fair
market value equal to current partnership book value under the
value-equals-basis rule (discussed
more fully below). Thus, when
property is revalued for adjusting
capital accounts, the value of the
property is conclusively presumed
to have declined to the restated
value.23 As a result, the diminution
in value reflected in the bookdown is conclusively presumed to
have occurred, so that the loss resulting from that book-down is
conclusively assumed to offset the
disproportionate allocation of
COI. These two disproportionate
allocations thus have offsetting
effects and for that reason, fail the
substantiality test.24
While the conclusion of the ruling that the allocations are invalid
seems inescapable, suppose the
partnership agreement had provided that the partnership’s asset
would not be revalued when new
capital was contributed by either
partner. Thus, when the workout
a future allocation can together be
invalid if there is a strong likelihood
that they will have offsetting effects.
Such pair of allocations are called
“transitory” under the regulations.25
Are the current disproportionate allocation of current COI income
and the anticipated future disproportionate allocation of loss invalid
as transitory?
No. While the two allocations will
have offsetting effects, the future loss
allocation is not “reasonably certain” to occur because, under the
value-equals-basis rule of Reg.
§1.704-1(b)(2)(iii)(c)(2), the future
loss is conclusively presumed not
to occur. The partnership’s property
is conclusively presumed to equal
its current book value of $10,000.
By electing not to revalue the
partnership’s property as part of the
workout, the partners can cause the
Chart 10
A
$ 1,000
0
(1,000)
500
(500)
$
0
B
$ 1,000
2,000
(3,000)
0
0
$
0
Explanation
Starting Values
Allocation of COI Income
Allocation of Revaluation Book Loss
Capital Contribution by A
Allocation of Expenses
Total
occurs, the only tax items to be
allocated are the COI income and
the $500 of current expenditures
(this latter item plays no role in the
analysis of the ruling or in the
analysis that follows). Allocation
of the COI to B has economic effect that is substantial and so
should be valid (as should the allocation of the expense to A).
To maintain the economics of the
transaction, the partners must also
agree that when the partnership’s
property is sold, the first $2,000 of
loss will be allocated entirely to B.
This is not a current allocation because no book or tax loss has yet
been realized from disposition of the
property. But a current allocation and
value-equals-basis rule to transmute
what was an unstoppable sword in
the hands of the government into
an impassable shield in the hands
of the taxpayer.
The regulations provide that an
allocation or set of allocations will
lack substantiality as transitory if
at the time the allocation (or allocations) becomes part of the
partnership agreement, there is a
strong likelihood that:26
(1) The net increases and decreases that will be recorded
in the partners’ respective
capital accounts for such taxable years to which the
allocations relate will not dif-
47
Reverse Allocations
fer substantially from the net
increases and decreases that
would be recorded in such
partners’ respective capital
accounts for such years if the
original allocation(s) and offsetting allocation(s) were not
contained in the partnership
agreement, and
ready has declined—the regulations take a different tack. The
regulations ignore with absolute
certainty the true value of a
partnership’s assets in favor of the
book value of those assets: the misnamed value-equals-basis rule
provides that partnership property
is conclusively presumed to be
worth current book value27 so that:
(2)The total tax liability of the
partners (for their respective
taxable years in which the allocations will be taken into
account) will be less than if the
allocations were not contained
in the partnership agreement
(taking into account tax consequences that result from the
interaction of the allocation (or
allocations) with partner tax
attributes that are unrelated to
the partnership).
there cannot be a strong likelihood that the economic effect
of an allocation (or allocations)
will be largely offset by an allocation (or allocations) of gain
or loss from the disposition of
partnership property.28
The special allocation of the
COI income and the offsetting allocation of loss from the decline
in the value of the partnership’s
assets will constitute a set of transitory allocations only if, at the
time the allocations were placed
into the partnership agreement,
there was a “strong likelihood”
that the partnership will incur a
loss from the disposition of the
property with which to offset the
disproportionate allocation of the
COI income.
While you and I might think that
there is a strong likelihood that the
value of the partnership’s asset will
decline—given that in fact it al-
Note that if the AB partnership
had attempted to offset its disproportionate allocation of COI
income to B with offsetting operating profits (to A) or losses (to B),
the pair of allocations could be
subject to a recharacterization under the substantiality regulations.
The IRS would argue that the operating profits or losses had a
strong likelihood of arising, and it
would fall to the taxpayer to provide otherwise. But by using only
dispositional gain or loss, the partnership avoids the challenge
entirely thanks to the valueequals-basis rule.
The value-equals-basis statement in the regulations is
remarkable, and it offers astute
taxpayers great flexibility. For example, suppose in our earlier
example of Z joining the XY part-
Chart 11
A
$ 1,000
500
(500)
0
$ 1,000
48
B
$ 1,000
2,000
0
0
$ 3,000
Explanation
Starting Values
Allocation of COI Income
Capital Contribution by A
Allocation of Expenses
Gain (Loss) from Sale of Asset
Total
nership, the partnership owns not
only Blackacre, but also
Whiteacre. The partnership could
refuse to book-up its assets
(Blackacre and Whiteacre) upon
the admission of Z, but then allocate all pre-admission unrealized
gain in the assets exclusively to X
and Y. Further, the partnership
could provide that if upon the disposition of the first parcel there
was insufficient gain to fulfill the
special allocation, any shortfall
would be made up with dispositional gain from disposition of the
second asset.
To be sure, if both parcels ultimately were sold for less than they
were worth when Z joined the
partnership, there will be an economic loss that cannot be shared
with Z under this approach. But
because cures can be made with
any dispositional gain or loss (including the disposition of property
purchased after Z joins the partnership), this could easily be a risk
that X and Y are willing to take.
Especially if it offers them significant advantages.
Return to the AB partnership of
Rev. Rul. 99-43, and consider what
happens if the partnership elects not
to restate the capital accounts and
the property turns around in value
after the workout. For example, suppose one year after the workout, the
property is sold for its then-current
fair market value of $10,000. This
sale produces no book gain or loss
(because the value of the asset was
not restated as part of the workout)
and no tax gain or loss (because the
property was purchased by the partnership for $10,000 and no
depreciation was allowed or allowable). Thus, the capital accounts
books of the partners will appear
as illustrated in Chart 11.
Because there has, in fact, been
no offsetting disproportionate allocation of loss to B, B’s capital
Passthrough Entities/September–October 2002
account remains disproportionately high. This is not what the
partners intended, and to prevent
its occurrence, the partnership
agreement should provide that if
upon disposition of the property
by the partnership there is less
than $2,000 of loss, additional
items of partnership income or
loss will be allocated to restore
capital accounts of the partners to
parity. As indicated above, though,
unless the self-help curative allocations are limited to dispositional
gain and loss, the allocations risk
challenge as transitory.
Collateral Consequences
of Booking-Up29
A common provision in a partnership agreement is that the
partners will be liable to restore
capital account deficits in favor
of third-party lenders, but not in
favor of other members of the
partnership. In general, allocations of deductions (other than
“nonrecourse” deductions) from
encumbered partnership property are allocated according
to the “substantial-economic-effect” rules in Reg. §1.704-1(b)(2).
When partners lack an unlimited,
unconditional capital account deficit restoration obligation, the
substantial-economic-effect regulations permit such deductions to
be allocated however the partners
wish, so long as (1) the deductions are properly reflected in
the partners’ capital accounts
and (2) the deductions do not
increase a capital account deficit beyond the partner’s
maximum obligation to fund a
deficit out of additional funds.30
A partner who is potentially liable to third-party creditors, but
not to other partners is treated
as having a limited deficit restoration obligation. The amount
of that limited deficit restoration
is computed by assuming the
partnership sells all of its assets
for their current book values
and then the cash so raised is
used to satisfy the partnership’s
creditors. If there are insufficient
funds to satisfy all creditor demands, the partners would be
required to contribute additional funds to the partnership,
and the amount of such funds
that a partner would be required
to contribute under the hypothetical scenario is the partner’s
limited deficit restoration obligation. See Rev. Rul. 97-38. 31
Note that under this standard,
the greater the book value of the
partnership’s assets, the smaller
the partner’s limited deficit restoration obligation. And the
smaller the partner’s deficit restoration obligation, the fewer
deductions that can be allocated to the partner. To be sure,
if a book-up increases the
partner’s capital account, the
amount of the partner’s limited
deficit restoration obligation
will be less relevant because the
increased capital account balance will be able to absorb
allocations of deductions. But if
the book-up is not in the same
proportion as are shared losses,
problems can result.
For example, suppose P and
Q form the PQ partnership by
contributing $100 each. The
partnership purchases depreciable property for $1,000,
paying $200 down and the remainder in the form of a
recourse note. The partners
agree to allocate all depreciation to P, all operating income
equally between P and Q, and
gain from the disposition of assets 50 percent to P and 50
percent to Q after a special allocation of gain charging back
all prior depreciation deduc-
tions. Each partner is obligated
to restore a capital account deficit in favor of the third-party
lender, but not in favor of the
other partner. Assume the property generates $200 of
depreciation each year and that
the partnership has no other
items of income or deduction.
The first year’s depreciation of
$200 must be allocated equally
between the partners, despite the
partnership agreement providing
the contrary, because that depreciation represents a reduction in
the partners’ equity and so cannot generate a capital account
deficit to one partner while maintaining a capital account surplus
for the other. 32 However, the
analysis is different for year two.
In year two, there is again depreciation of $200, and that
depreciation reduces the book
value of the property to $600, an
amount that is $200 less than the
amount of the debt. Allocation
of the entire depreciation to P
will create a $200 capital account deficit to P. Further,
because the property is conclusively presumed to equal its
book value of $600, this capital
account deficit of P is presumed
under Rev. Rul. 97-38 to create
a potential obligation from P to
the third-party lender, and that
obligation supports the capital
account deficit caused by the allocation. In short, the allocation
of the entire $200 depreciation
in year two to P is valid.
Assume, though, that the
property is, in fact, worth $760
during year two, and assume
that new partner R joins the
partnership as a 20-percent
partner in exchange for a cash
contribution of $40. Assuming
the partnership elects to restate
its capital accounts upon the
admission of R (with P and Q
49
Reverse Allocations
each reducing their interests in
the partnership to 40 percent),
the capital accounts of the partnership, prior to the allocation
of the depreciation in year two ,
will read as in Chart 12.
There is now $200 of depreciation to be allocated for year two,
and the parties want to allocate it
entirely to P. Unfortunately, they
cannot do so. Because R contributed fresh equity of $40, R must
be allocated $40 of depreciation
before any of the other partners
can be allocated depreciation
causing a capital account deficit.
Thus, $40 of depreciation must be
allocated to R whether the partnership restates the capital
accounts or not.
The remaining $160 of the depreciation also cannot be
allocated exclusively to P because
the book-up created positive capital accounts for P and Q and
creates a conclusive presumption
that the property is worth $760.
That value, combined with the
fresh cash of $40, means that under the rule of Rev. Rul. 97-38,
there is no obligation on the part
of any partner to restore a capital
account deficit (because the debt
equals $800 and the book value
of the partnership’s assets also
equals $800). Thus, the $160 remaining depreciation for year two
cannot create a capital account
deficit for any partner and so must
be allocated $80 to P and $80 to
Q. After accounting for the fresh
equity contributed by R, what limited P’s ability to claim
depreciation was the book-up. By
giving Q half the $160 book-up,
the partnership was forced to give
Q an equal dollar amount of depreciation. Had the property not
been revalued, fully $160 of the
depreciation in year two could
have been allocated to P.33
Multi-Layer
Book-Ups
If a partnership elects to book up
its assets and it already owns an
asset subject to a Code Sec.
704(c)(1)(A) or reverse Code Sec.
704(c) book/tax disparity, the bookup will create a second layer of
book/tax disparity. This layer is independent of the first layer and can
be addressed by any of the methods permissible under Code Sec.
704(c)(1)(A) without regard to the
method used for the first layer.34 For
example, if P and Q form the PQ
partnership with P contributing
cash and Q contributing appreciated property, the partnership
might elect to recover the unrealized appreciation in Q’s property
by using, say, the traditional
method with curative allocations.
If R subsequently joins the partnership by contributing cash and, if at
that time the fair market value of
the property previously contributed
by Q is not equal to its current book
value, the difference between the
property’s current fair market value
and current book value could be
addressed, say, by the remedial allocation method.
Chart 12
P
100
(100)
0
80
$
80
$
50
Q
100
(100)
0
80
$
80
$
R
$
$
0
0
40
0
40
Explanation
Starting Values
Year 1 Depreciation
Admission of R
Book-Up
Total
The mechanics of multi-layer bookups are not difficult if two key points
are kept in mind. First, each layer must
be addressed independently of the
other layers and, second, for each
layer, one set of partners will always
be entitled to tax depreciation equal
to book depreciation while another
set will pay for it. In the case of true
Code Sec. 704(c)(1)(A) allocations, the
noncontributing partners are entitled
to tax depreciation equal to book depreciation while the contributing
partner is not; in the case of reverse
Code Sec. 704(c) allocations triggered
by the contribution of new value to
an ongoing partnership, the contributing partner is entitled to tax
depreciation equal to book depreciation while the other partners are not.
For example, assume X and Y
form the XY general partnership,
with X contributing cash of
$10,200 and Y contributing depreciable property with adjusted basis
of $6,000 and fair market value
of $10,200. The property contributed by Y has five years remaining
on its depreciation schedule; if
newly placed in service, its basis
would be recovered over seven
years. Assume the partnership
elects to depreciate this property
using the straight-line method, and
that the partnership will allocate
depreciation equally between the
partners except as required by application of Code Sec. 704(c)(1)(A).
The partnership elects to address
the Code Sec. 704(c)(1)(A) book/
tax disparity using the remedial allocation method.35
Under Code Sec. 168(i)(7)(A), the
partnership will continue (for tax purposes) to depreciate the property
contributed by Y, using Y’s depreciation schedule (the “step-in-the-shoes”
rule). Thus, the property’s inside basis
of $6,000 will be recovered over five
years at a rate of $1,200 per year. Under the remedial allocation method,
the partnership recovers an equal
Passthrough Entities/September–October 2002
amount of book value using the same
schedule, but recovers the remainder
of the property’s book value as if
newly placed in service.36 Thus, the
“old” piece of the property yields
book and tax depreciation of $1,200
per year for years one through five;
the “new” piece of the property yields
no tax depreciation but book depreciation of $600 per year for years one
through seven. Combining these two
pieces, there is tax depreciation of
$1,200 for the first five years, book
depreciation of $1,800 during the
first five years and $600 of book depreciation for years six and seven.
X is entitled to tax depreciation
equal to book depreciation each
year, with Y’s share of tax depreciation making up the shortfall. Thus,
after one year, the books of the partnership look like Chart 13.
Note that at this point the property has a book value of $8,400
and inside basis of $4,800.
After one year, assume Z joins the
partnership as a one-third partner
in exchange for a cash contribution of $9,615 because the value
of the property contributed by Y
now equals $9,030. (Thus, X’s and
Y’s interests in the partnership are
each worth exactly $9,615 both
before and after the admission of
Z.)37 The partnership elects to revalue its assets and restate the
capital accounts as a result of the
admission of Z, and it elects to use
the remedial allocation method to
address the reverse-704(c) issue
caused by the asset book-up.
The reverse Code Sec. 704(c) layer
addresses the variation between the
book value of the property immediately before Z joins (that is,
$8,400) and the restated book value
immediately thereafter (that is,
$9,030). Thus, the amount of the
reverse Code Sec. 704(c) layer is
$630. Under the remedial allocation method, the property is now
divided into three pieces—the “old”
piece having adjusted basis and
book value of $4,800, recovered
Chart 13
X
CA
$10,200
(900)
$ 9,300
Y
OB
$10,200
(900)
$ 9,300
CA
$10,200
(900)
$ 9,300
OB
$ 6,000
(300)
$ 5,700
Explanation
Starting Values
Depreciation
Total
Chart 14
Allocation of Tax Depreciation: Year 2
Old Piece
New Piece
Really New Piece
Totals
X’s Share
$ (400)
(200)
15
$ (585)
Y’s Share
$ (400)
400
15
$ 15
Z’s Share
$ (400)
(200)
(30)
$ (630)
Total
$ (1,200)
0
0
$ (1,200)
over the next four years; the “new”
piece having a book value of $3,600
and a $0 adjusted basis, recovered
over the next six years; and the “really new” piece having a book value
of $630 and a zero adjusted basis,
recovered over the next seven years
(that is, over years two through
eight). Combining these three
pieces, we obtain the following results: For years two through five,
there is book depreciation of $1,890
per year and tax depreciation of
$1,200 per year. For years six
through seven, there is book depreciation of $690 per year and no tax
depreciation, and for year eight
there is book depreciation of $90
and no tax depreciation. In each
year, the book depreciation is
shared equally among the partners
because they have agreed to be
equal partners. (See Chart 14.)
Looking at the property layer by
layer, the “old piece” of property has
book value and adjusted tax basis
4,800, and the partners share both
the annual book depreciation of
$1,200 and annual tax depreciation
of $1,200 equally over the next four
years. The second layer (that is, the
“new piece”) has a book value of
$3,600 and an adjusted basis of $0
and the partners share the annual
book depreciation of $600 equally
for the next six years. X and Z are
entitled to tax depreciation equal to
book depreciation (because this
low-basis property was contributed
by Y), so they are entitled to $200
per year of depreciation each. There
is, though, no net depreciation allowable with respect to this layer,
Chart 15
X
CA
$ 9,615
(2,520)
0
$ 7,095
Y
OB
$ 9,300
(2,340)
0
$ 6,960
CA
$ 9,615
(2,520)
0
$ 7,095
Z
OB
$ 5,700
0
60
$ 5,760
CA
$ 9,615
(2,520)
0
$ 7,095
OB
$ 9,615
(2,520)
0
$ 7,095
Explanation
After Year 1
Years 2-5 Depreciation
Years 2-5 Remedial Allocations
Total After Year 5
51
Reverse Allocations
so that Y must include a remedial
allocation of income equal to the
depreciation claimed by X and Z;
that is, Y must include a remedial
allocation of $400 of income each
year for the next six years.
Finally, with regard to the final
layer (the “really new piece”), there
is annual book depreciation of $90,
but no tax depreciation. Z is entitled
to annual tax depreciation equal to
book depreciation of $30 because
this slice represents the reverse
Code Sec. 704(c) book-up that increased the capital accounts of X
and Y. However, because there is
no tax depreciation from this layer,
X and Y must have annual combined remedial allocations of
income that offset Z’s annual allocation of tax depreciation. Because
X and Y had equal shares of the
book-up, they must have equal remedial allocations of income from
the third layer of $15 per year.
Taking all three slices into account
and multiplying these numbers by
4 to get the results for years two
through five yields partnership
books as shown in Chart 15.
In each of years six and seven, the
book depreciation of $690 is allocated $230 to each partner. Because
there is no tax depreciation, there is a
remedial allocation of $230 of depreciation (per year) to Z, of which $200
is from the (new piece) 704(c) layer
and $30 is from the (really new piece)
reverse-704(c) layer. X should get a
full tax share of the (new piece) 704(c)
layer, or $200, less one-half of Z’s remedial allocation from the (really new
piece) reverse-704(c) layer, for a net
depreciation allocation of $185. Because there is no tax depreciation to
the partnership in this year, that means
X receives a remedial allocation of
deduction of $185. Y, therefore, must
receive a remedial allocation of income of $230 + $185, or $415. See
Chart 16 for a tabular form.
Multiplying these numbers by 2
to get the results for years six and
seven yields books for the partnership resembling Chart 17.
In year eight, the book depre-
Chart 16
Allocation of Tax Depreciation: Year 6
New Piece
Really New Piece
Totals
X’s Share
$(200)
15
$(185)
Y’s Share
$400
15
$415
Z’s Share
$(200)
(30)
$ (230)
Total
$ 0
0
$ 0
ciation of $90 is allocated $30
to each partner. Because there is
no tax depreciation, there is a remedial allocation of $30 of
depreciation to Z as well as remedial allocations of $15 of
income to both X and Y. (Thus, Z
obtains a full tax share of book
depreciation, and X and Y split
paying for it.) The property is
now fully depreciated both for
book and tax purposes, and the
book/tax disparities have been
fully eliminated. (See Chart 18.)
Mandatory
Book Ups38
There is one circumstance in which
a partnership is required to revalue
an asset and restate capital accounts. When property is
distributed, the partnership is required to revalue the distributed
property immediately before the
distribution.39 This mandatory revaluation ensures that the
distributee’s capital account is reduced by the full current value of
the distributed property. It also may
have the effect of creating book/tax
disparities for the partners identical
to that created by a routine application of the ceiling limitation.
Chart 17
X
CA
$ 7,095
(460)
0
$ 6,635
Y
OB
$ 6,960
0
(370)
$ 6,590
CA
$ 7,095
(460)
0
$ 6,635
OB
$ 6,590
0
15
$ 6,605
CA
$ 6,635
(30)
0
$ 6,605
Z
OB
$ 5,760
0
830
$ 6,590
CA
$ 7,095
(460)
0
$ 6,635
OB
$ 6,590
0
15
$ 6,605
CA
$ 6,635
(30)
0
$ 6,605
OB
$ 7,095
0
(460)
$ 6,635
Explanation
After Year 5
Years 6-7 Depreciation
Years 6-7 Remedial Allocations
Total After Year 7
OB
$ 6,635
0
(30)
$ 6,605
Explanation
After Year 7
Year 8 Depreciation
Year 8 Remedial Allocations
Total After Year 8
Chart 18
X
CA
$ 6,635
(30)
0
$ 6,605
52
Y
Z
Passthrough Entities/September–October 2002
For example, suppose P and Q are
partners in the PQ partnership. Assume that Blackacre is distributed
to P when Blackacre has an adjusted
basis in the hands of the partnership
of $6,000 and a current fair market
value of $10,000. Assume further
that the partners have agreed to allocate gain from the disposition of
Blackacre 60 percent to P and 40
percent to Q while losses will be
divided equally. Finally, assume that
the partnership also has $10,000 in
cash, so that each partner has an
outside basis and capital account
of $8,000. If Blackacre is distributed
to P,40 the books of the partnership
will look like Chart 19.
As to Q, the effect of the distribution is to increase Q’s capital account
by Q’s share of the unrealized appreciation in Blackacre without an
equivalent increase in Q’s outside
basis; thus, the distribution leaves Q
with a capital account in excess of
outside basis by $1,600. As to P, the
effect of the distribution is to increase
P’s capital account by P’s share of
the unrealized appreciation in
Blackacre and then to reduce P’s
capital account by the full book value
of Blackacre (that is, by the adjusted
basis of Blackacre plus Q’s share of
the unrealized appreciation plus P’s
share of the unrealized appreciation),
for a net reduction equal to the adjusted basis of Blackacre plus P’s
share of the unrealized appreciation.
Because P’s outside basis is reduced
only by the adjusted basis of
Blackacre, P’s capital account ends
up lower than P’s outside basis by
Q’s share of the unrealized appreciation in Blackacre; that is, by
$1,600. Thus, the revaluation and
distribution result in equal and offsetting book/tax disparities for the
partners, book/tax disparities that
cannot be eliminated because the
property that caused the problem is
no longer owned by the partnership.
Can the partners elect to cure their
book/tax disparities by resort to
curative or remedial allocations? For
example, could P be allocated a remedial $1,600 capital loss tax
allocation while Q is allocated an
offsetting remedial $1,600 capital
gain allocation? Because use of
curative or remedial allocations
generally is elective, a partnership
that does not wish to cure these
book/tax disparities presumably is
free to let them remain. But is a partnership that wishes to eliminate
them authorized to do so?
Surprisingly, the answer is not
clear. Book/tax disparities caused
Chart 19
P
CA
$ 8,000
2,400
(10,000)
$
400
Q
OB
$ 8,000
0
( 6,000)
$ 2,000
CA
$ 8,000
1,600
0
$ 9,600
OB
$ 8,000
0
0
$8,000
CA
$ 8,000
1,600
(2,000)
$ 7,600
OB
$ 8,000
0
0
$ 8,000
Explanation
Starting Values
Revaluation of Asset
Distribution
Total
OB
$ 8,000
0
0
$ 8,000
Explanation
Starting Values
Revaluation of Asset
Sale for $6,000
Totals
Chart 20
P
CA
$ 8,000
2,400
(2,000)
$ 8,400
Q
by the revaluation of partnership
assets are to be resolved by resort
to Code Sec. 704(c)(1)(A) principles. The same issue could arise
if contributed property with a book/
tax disparity were distributed to a
partner other than the contributing
partner more than seven years after it had been contributed to the
partnership. In such circumstances,
what do the regulations under
Code Sec. 704(c)(1)(A) provide?
Nothing. While there is a paragraph
covering nontaxable dispositions of
Code Sec. 704(c)(1)(A) property,41 the
regulations assume that such dispositions will be exchanges in which the
partnership acquires qualifying replacement property for the Code Sec.
704(c)(1)(A) property. In such circumstances, the regulations provide that
Code Sec. 704(c)(1)(A) attaches to the
qualifying replacement property, a
reasonable enough result when there
is replacement property.
But when the Code Sec.
704(c)(1)(A) property is distributed
under Code Sec. 731(a)(1), the transaction is tax-free to the partnership,
yet it acquires no replacement property on the transaction. As to this
transaction, the regulations are disappointingly silent; presumably the
drafters simply did not consider this
particular possibility.
What should the answer be?
Had Blackacre been sold rather
than distributed to P, the unrealized gain would have been
realized and recognized to the
partnership and then passed
through to the partners, with P
picking up P’s share of the gain
and Q picking up the rest. Because of the distribution, though,
P will include all of the gain in
income when the property eventually is sold, even though P’s
capital account was only credited
with a portion of it. And Q will
never recognize any of the unrealized gain in Blackacre, even
53
Reverse Allocations
though Q’s capital account already has been credited with Q’s
distributive share of it.
Suppose Blackacre had been
booked up to $10,000 and then
declined in value back to $6,000.
Assume that Blackacre had then
been sold to a third party, producing a book loss of $4,000, but no
gain or loss for tax purposes. After
this sale, the partnership books
would read as is shown in Chart 20.
There is a book/tax disparity for
each partner, equal in amount, but
offsetting in sign. P’s capital account
exceeds P’s outside basis by $400
while Q’s capital account is less
than Q’s outside basis by the same
amount. This is a conventional in-
stance of the operation of the ceiling rule,42 one the drafters of the
Code Sec. 704(c)(1)(A) regulations
anticipated, and there is no question that the book/tax disparities can
be eliminated by curative or remedial allocations if the partners so
choose.43 And if the book/tax disparities are not eliminated, there is
a timing mismatch for each partner
because there was insufficient tax
gain to offset the prior capital account book-up when Blackacre is
sold. Thus, with the property giving
rise to the book/tax disparity now
gone from the partnership, the remaining book/disparities for the
partners cannot be eliminated with
a curative or remedial allocation.
This is the precise situation that
occurs when Blackacre is distributed rather than sold: there are
equal and offsetting book/tax disparities for the partners that can
only be eliminated by curative or
remedial allocations because the
property giving rise to the prior
capital account adjustments is now
out of the partnership. Thus, the distribution in fact works a timing
mismatch for both partners identical to that created by a more
traditional application of the ceiling rule limitation, and so I think
the partnership should be permitted to eliminate the book/tax
disparities by resort to curative or
remedial allocations.
ENDNOTES
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Reg. §1.704-1(b)(2)(iv)(b).
Reg. §1.704-1(b)(2)(ii)(b).
Reg. §1.704-1(b)(2)(iv)(d)(1).
Reg. §1.704-3(a)(1).
See discussion on page 37–40 of this article.
See Reg. §1.704-1(b)(2)(iv)(f)–(g).
Reg. §1.704-1(b)(2)(iv)(g)(1).
See generally Howard E. Abrams, Dealing With the Contribution of Property to
a Partnership: Part I , B US. ENTITIES, Nov.Dec. 2000, at 16; Howard E. Abrams,
Dealing With the Contribution of Property to a Partnership: Part II , B US. ENTITIES,
Jan.-Feb. 2001, at 18.
See generally Howard E. Abrams, Adding
a New Cash Partner to an Operating Partnership: Part I, BUS. ENTITIES, Jan.-Feb. 2002,
at 28; Howard E. Abrams, Adding a New
Cash Partner to an Operating Partnership:
Part II, BUS. ENTITIES, Mar.-Apr. 2002, at 38.
See Reg. §1.704-1(b)(2)(iv)(f).
Reg. §1.704-1(b)(2)(iv)(g).
Called “self-help” curative allocations, to
distinguish them from curative allocations
described in Reg. §1.704-3(c).
For example, if the partnership had $6 of income, it could be allocated $3 to X and $3 to
Y and, thereby, equalize the capital accounts
at $70.
See Reg. 1.704-3(c).
Compare Reg. §1.704-3(c)(3) (limiting
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
the amount, timing and character of
curative allocations).
See Reg. §1.704-1(b)(2)(ii).
See generally Reg. §1.704-1(b)(2)(iii).
See, e.g., Reg. §1.704-1(b)(5), Example 2.
Indeed, under the value-equals-basis rule of
Reg. §1.704-3(b)(2)(iii)(c), the first allocation
is ignored because dispositional gain caused
by post-allocation appreciation is conclusively presumed not to occur.
Reg. §1.704-1(b)(2)(ii)(f); but see Reg.
§1.704-1(b)(1)(iii)–(iv).
Reg. §1.704-1(b)(2)(ii)(b)(2).
Rev. Rul. 99-43, 1999-2 CB 406. See generally Howard E. Abrams, Revenue Ruling
Suggests Strategic Partnership Failure to
Book-Up, THE TAX ADVISOR, Mar. 2000, at 159.
Reg. §1.704-1(b)(2)(iii)(c).
See Reg. §1.704-1(b)(2)(iii)(b).
Id.
Reg. §1.704-1(b)(2)(iii)(c)(1)–(2).
The value-equals-basis rule should more
accurately be called the “fair market value
is presumed to equal book value” rule.
Reg. §1.704-1(b)(2)(iii)(c)(2).
This material is excerpted from Howard E.
Abrams, Adding a New Cash Partner to an Operating Partnership: Part 2, supra note 9, at 41.
See Reg. §1.704-1(b)(2)(ii)(d)(1)–(2).
Rev. Rul. 97-38, 1997-2 CB 69.
See generally HOWARD E. ABRAMS & RICHARD
33
34
35
36
37
38
39
40
41
42
43
L. DOERNBERG, ESSENTIALS OF UNITED STATES TAXATION, 3-56 to 3-57 (1999).
Of course, had this happened, P ultimately
would be forced to recognize an offsetting amount of income. See, e.g. , RICHARD
L. DOERNBERG & H OWARD E. ABRAMS , FEDERAL
INCOME TAXATION OF CORPORATIONS AND PARTNERSHIPS (3d ed. 2000), at 689–90.
Reg. §1.704-3(a)(6)(i).
See generally Reg. §1.704-3(d).
Reg. §1.704-3(d)(2).
Prior to the admission of Z, there is cash
in the partnership of $10,200 and property worth $9,030 for a combined value
of $19,230. Because X and Y are each a
50-percent partner, they each have a
p a r t n e r s h i p i n t e r e s t wo r t h h a l f o f
$19,230, or $9615.
This material is based on R ICHARD L.
DOERNBERG & HOWARD E. ABRAMS, supra note
33, at 753–54.
Reg. §1.704-1(b)(2)(iv)(e)(1).
This example assumes the distribution is not
subject to Code Secs. 707(a)(2)(b),
704(c)(1)(B), 737 or 751(b).
Reg. §1.704-3(a)(8).
See Reg. §1.704-3(b)(1).
But see Reg. §1.704-3(a)(2) for limitation on
a partnership’s discretion to choose among
the various Code Sec. 704(c) methods in
abusive situations.
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