704(c) allocation methods - · pdf file704(c) allocation methods 2. ... outside basis 30,000...
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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.
Melvin’sCap. Acct.
Tax Book Tax BookBeg. Bal. 10 50 50 50
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.
Melvin’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.
Melvin’sCap. Acct.
Tax Book Tax BookBeg. Bal. 10 50 50 50
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
Outside Basis 30,000 50,000
Cash Distributed -40,000 -40,000
Cap. Gain (sec. 731) $10,000
$10,000 Cap. Gain to Adam
27
Adam Melvin
Outside Basis 30,000 50,000
Cash Distributed -40,000 -40,000
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.
Melvin’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.
Melvin’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.
Melvin’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.
Melvin’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.
Melvin’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
After Revaluation of Cap. Accts.
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.
Cash 90 90 90Land 120 120 180Total Assets 210 210 270Capital:
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
Total Capital 270 270 270
Ending Balance Sheet
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.
Cash 90 90 90Land 120 120 180Total Assets 210 210 270Capital:
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
Total Capital 270 270 270
Ending Balance Sheet
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
The partnership purchases land for
$120,000 in Yr. 2 and it appreciates to $180,000 in Yr. 5
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.
Cash 90 90 90Land 120 180 180Total Assets 210 270 270Capital:
Alice (1/3) 90 90 90 90Adam (1/3) 60 90 90 60Mel (1/3) 60 90 90 60
Total Cap. 210 270 270
After Revaluation of Cap. Accts.
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.
Cash 210 210 210Land 120 180 180Total Assets 330 390 390Capital:
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.
Cash 210 210 210Land 120 180 180Total Assets 330 390 390Capital:
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.
Cash 90 90 90Land 120 120 180Total Assets 210 210 270Capital:
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
Liquidation Waterfall:
1) $180,000 to Adam and Mel equally.
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**
3rd***End Bk. 330- Beg. Bk. 210 60 60 90= Bk Inc. 120
*1st $180K to Adam and Mel
115
Hypo.Cash
Adam Mel Alice
1st* 90 902nd** 90
3rd***End Bk. 330- Beg. Bk. 210 60 60 90= Bk Inc. 120
*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
3rd*** 20 20 20End Bk. 330 110 110 110- Beg. Bk. 210 60 60 90= Bk Inc. 120 50 50 20
Target AllocationThe allocation should meet the
sec. 704(b) economic equivalence test or the PIP
test
Assets Tax Basis
BookBasis
FMV O.B.
Cash 210 210 210Land 120 120 180Total Assets 330 330 390Capital:
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
End Bk. 390- Beg. Bk. 330 110 110 110= Bk Inc. 60
122
Hypo.Cash
Adam Mel Alice
1st* 90 90
End Bk. 390- Beg. Bk. 330 110 110 110= Bk Inc. 60
*1st $180K to Adam and Mel
123
Hypo.Cash
Adam Mel Alice
1st* 90 902nd** 90
End Bk. 390- Beg. Bk. 330 110 110 110= Bk Inc. 60
*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
3rd*** 40 40 40End Bk. 390 130 130 130- Beg. Bk. 330 110 110 110= Bk Inc. 60 20 20 20
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
Liquidation Waterfall:
1) $180,000 to Adam and Mel equally.
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
The partnership purchases land for
$120,000 in Yr. 2 and it appreciates to $180,000 in Yr. 5
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
Liquidation Waterfall:
1) $180,000 to Adam and Mel equally.
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
Total Capital 120 180 180
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
Total Capital 220 280 280
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:
Adam 135 135 135 135Melvin 135 135 135 135Alice 10 10 10 10
Total Capital 280 280 280
Balance Sheet Before Liquidation
Liquidation is tax free recovery of O.B.
Taxable IncomeWith Revaluation
156
Ord. Inc. Cap. Gain
Adam 45,000 30,000
Melvin 45,000 30,000
Alice 10,000 0
All capital gain to Adam and Mel
Example YSame as X but
without revaluation
179
157
158
Assets Tax Basis
BookBasis
FMV OB
Land 120 120 180Capital:
Adam 60 60 90 60Melvin 60 60 90 60Alice 0 0 0 0
Total Capital 120 120 180
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
End BK 220* 108** 108** 4***- Beg. BK 120 60 60 0= Bk Inc. 100 48 48 4
**1st 90K (50% x 180K)2nd 18K (45% x $40K)
***2nd 4K (10% x $40K)
161
Hypo.Cash
Adam Mel Alice
End BK 220* 108** 108** 4***- Beg. BK 120 60 60 0= Bk Inc. 100 48 48 4
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
Taxable IncomeWith Revaluation
167
Ord. Inc. Cap. Gain
Adam 45,000 30,000
Melvin 45,000 30,000
Alice 10,000 0
All capital gain to Adam and Mel
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.
186
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.
186
• 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.
Cash 7,500 7,500 7,500Building 1,500 6,000 6,000Total Assets 9,000 13,500 13,500Capital:
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
202
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)
189
203
204
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.
205
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
208
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.
Cash 7,500 7,500 7,500Building 1,500 6,000 6,000Total Assets 9,000 13,500 13,500Capital:
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)
214
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
218
219
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.
Cash 3,000 3,000 3,000Building 1,500 1,500 6,000Total Assets 4,500 4,500 9,000Capital:
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.
Cash 7,500 7,500 7,500Building 1,500 1,500 6,000Total Assets 9,000 9,000 13,500Capital:
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