Section 704c

What Is Section 704c?

Section 704c of the Internal Revenue Code (IRC) is a crucial provision within Tax Law that governs how partnerships must allocate income, gain, loss, and deduction with respect to property contributed by a partner when the property's fair market value differs from its adjusted tax basis at the time of contribution. Its primary purpose is to prevent the shifting of pre-contribution tax consequences among partners. This means that any "built-in" disparity between the contributed property's value and its tax basis must be accounted for by the contributing partner upon subsequent disposition or depreciation of the property by the partnership. Without Section 704c, partners could potentially manipulate allocations to defer or avoid taxes, undermining the integrity of partnership taxation.

History and Origin

Prior to the enactment of Section 704c, inconsistencies could arise in how partnerships accounted for property contributed with a value different from its tax basis. This allowed for potential abuse, where tax liabilities related to the property's pre-contribution appreciation or depreciation could be shifted from the contributing partner to other partners. To address this, Section 704(c)(1)(A) was introduced as part of the Tax Reform Act of 1984⁷. Congress identified the need for "special rules to prevent an artificial shifting of tax consequences between the partners with respect to pre-contribution gain or loss," particularly because partners often have varying tax positions⁶. The intent was to ensure that the inherent gain or loss at the time of contribution remained with the contributing partner. Subsequent amendments and regulations further refined the rules, including the introduction of Section 704(c)(1)(B) as part of the Omnibus Budget Reconciliation Act of 1989 to prevent circumvention of the pre-contribution gain allocation rules⁵. The detailed regulations that provide specific methods for complying with Section 704c are found under 26 CFR § 1.704-3.⁴

Key Takeaways

• Section 704c mandates that partnerships specifically allocate built-in gain or built-in loss on contributed property to the contributing partner.
• The goal is to prevent the shifting of tax consequences related to pre-contribution appreciation or depreciation among partners.
• Partnerships can generally choose from three primary methods—traditional, traditional with curative allocations, and remedial—to comply with Section 704c.
• Compliance with Section 704c is essential for all partnerships receiving contributed property where the fair market value differs from the tax basis.
• Failure to adhere to Section 704c rules can lead to the Internal Revenue Service (IRS) reallocating partnership items.

Formula and Calculation

Section 704c itself does not present a single formula but rather requires partnerships to adopt a "reasonable method" for allocating tax items related to contributed property with a disparity between book value (fair market value at contribution) and tax basis. The regulations provide three generally accepted methods:

1. Traditional Method: This method allocates tax items (e.g., depreciation, gain, loss) associated with the contributed property to the partners in a manner that, to the extent possible, equalizes the non-contributing partners' book and tax allocations. The "ceiling rule" is a significant limitation of this method, where the total tax depreciation or gain allocated to partners cannot exceed the partnership's actual tax depreciation or gain for the property.

   • Built-in Gain Calculation: $$Built-in\ Gain = Fair\ Market\ Value_{Contribution} - Adjusted\ Tax\ Basis_{Contribution}$$

2. Traditional Method with Curative Allocations: This method attempts to correct distortions caused by the ceiling rule under the traditional method. If the ceiling rule prevents the non-contributing partners from receiving an allocation of tax items equal to their book allocations, the partnership may make "curative allocations" of other partnership tax items (not necessarily from the contributed property itself) to offset the disparity. These curative allocations must be made from tax items that have the same character as the tax item limited by the ceiling rule.

3. Remedial Method: This method is also designed to overcome the ceiling rule. If the traditional method's ceiling rule creates a book-tax disparity for a non-contributing partner, the partnership creates hypothetical "remedial" tax items (income, gain, loss, or deduction) to eliminate the disparity. Corresponding, but offsetting, remedial items are created for the contributing partner. These created items are hypothetical and solely for tax purposes; they do not affect the partnership's book capital accounts.

Each method aims to ensure that the built-in gain or loss is allocated to the contributing partner, preventing tax consequences from shifting.

Interpreting Section 704c

Interpreting Section 704c involves understanding its purpose: to ensure tax fairness among partners when assets are brought into a partnership with pre-existing untaxed appreciation or unrecognized losses. The core principle is that the "economic" gain or loss, as reflected by the difference between the fair market value and tax basis at the time of contribution, should ultimately be recognized by the partner who contributed the property.

For example, if a partner contributes appreciated real estate, Section 704c dictates that the appreciation that occurred before the property entered the partnership will eventually be allocated to that specific contributing partner when the property is sold or its depreciation is recognized. This prevents other partners from inadvertently being allocated a share of that pre-existing gain or loss, which would be inconsistent with their actual economic interest in the partnership's operations. The choice of allocation method (traditional, curative, or remedial) impacts how and when these allocations occur for tax purposes, but the fundamental principle of preventing tax shifting remains constant.

Hypothetical Example

Suppose Alice and Bob form a 50/50 partnership, AB Partnership. Alice contributes a piece of land with a fair market value of $100,000 and an adjusted tax basis of $40,000. Bob contributes $100,000 in cash.

At the time of contribution, the land has a built-in gain of $60,000 ($100,000 FMV - $40,000 Basis). This $60,000 is Section 704c property.

If AB Partnership later sells the land for $120,000:

1. Total Book Gain: The partnership recognizes a book gain of $20,000 ($120,000 sale price - $100,000 book value). This book gain is allocated 50/50, so Alice gets $10,000 and Bob gets $10,000.
2. Total Tax Gain: The partnership recognizes a tax gain of $80,000 ($120,000 sale price - $40,000 tax basis).
3. Section 704c Allocation: According to Section 704c, the initial $60,000 built-in gain must be allocated to Alice, the contributing partner.
4. Remaining Tax Gain Allocation: The remaining $20,000 of tax gain ($80,000 total tax gain - $60,000 Section 704c gain) is allocated in proportion to the partners' shares, which is 50/50. So, Alice gets another $10,000 and Bob gets $10,000.

In total, for tax purposes:

• Alice is allocated $60,000 (pre-contribution) + $10,000 (post-contribution) = $70,000 of taxable gain.
• Bob is allocated $10,000 of taxable income.

This ensures that the $60,000 of appreciation that occurred while Alice owned the land is properly taxed to her.

Practical Applications

Section 704c is fundamental in various aspects of partnership taxation and structuring, particularly when partners make capital contributions of property rather than cash.

• Partnership Formation: It is a critical consideration when forming new partnerships or limited liability company (LLC) taxed as partnerships, especially if some partners contribute appreciated or depreciated assets while others contribute cash. Proper application ensures equitable tax treatment from the outset.
• Property Contributions: Any time a partner contributes property (e.g., real estate, intellectual property, equipment) to a partnership where its market value differs from its tax basis, Section 704c rules apply. This is common in real estate joint ventures, private equity funds, and venture capital structures.
• Depreciation and Amortization: For depreciable or amortizable contributed property, Section 704c dictates how the partnership's tax depreciation or amortization deductions are allocated among partners, often differing from book depreciation. This can have significant implications for partners' annual tax liabilities.
• Exit Strategies: When contributed property is eventually sold or distributed out of the partnership, Section 704c ensures that the initial built-in gain or loss is appropriately recognized by the contributing partner.
• Tiered Partnerships and Mergers: The principles of Section 704c can extend to complex structures involving tiered partnerships (a partnership owning an interest in another partnership) or partnership mergers, requiring careful consideration of how built-in gains and losses flow through these structures. A detailed discussion of its application can be found in professional publications like the Journal of Accountancy.

##³ Limitations and Criticisms

While designed to prevent tax shifting, Section 704c can introduce considerable complexity into partnership tax compliance.

• Complexity of Methods: Choosing and applying one of the three allocation methods (traditional, traditional with curative allocations, or remedial) can be intricate. Each method has its own nuances and potential for unintended consequences, particularly the ceiling rule under the traditional method, which can still result in tax distortions for non-contributing partners. The Tax Adviser notes that the IRS scrutinizes the "reasonableness" of chosen methods and that any method selected by related or accommodative partners is subject to challenge if it substantially reduces aggregate tax liability.
• ² Data Tracking: Partnerships must meticulously track the difference between the book value and tax basis of each piece of contributed property, as well as the remaining built-in gain or loss, over the property's life. This requires robust accounting and tax systems.
• Anti-Abuse Rule: Section 1.704-3(a)(10) of the regulations includes an anti-abuse rule, which states that an allocation method is not reasonable if the contribution and corresponding allocations are made "with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability". Thi¹s rule provides the IRS with discretion to challenge allocations deemed abusive, adding an element of uncertainty for taxpayers.
• Impact on Partners: The specific Section 704c method chosen can significantly impact the timing and character of income allocation for both contributing and non-contributing partners, potentially leading to disputes if not properly understood and agreed upon at the partnership's formation.

Section 704c vs. Partnership Basis Adjustment

Section 704c and a Partnership Basis Adjustment (specifically referring to a Section 754 election and the resulting Section 743(b) adjustment) both relate to partner tax basis, but they address different situations and serve distinct purposes.

While Section 704c ensures the original contributing partner accounts for their pre-contribution gain or loss, a Partnership Basis Adjustment typically arises when a partner sells their interest or passes away. If the partnership has a Section 754 election in place, the transferee partner may receive an adjustment to their share of the inside basis of partnership assets to align with their outside basis (the cost of their partnership interest). This adjustment is unique to the transferee and does not reallocate pre-contribution gains from the initial contribution, which is the domain of Section 704c. Confusion can arise because both provisions affect how a partner's tax consequences relate to underlying partnership assets.

FAQs

What is "built-in gain" or "built-in loss" in the context of Section 704c?

A built-in gain exists when the fair market value of property contributed to a partnership is greater than its adjusted tax basis at the time of contribution. Conversely, a built-in loss occurs when the fair market value is less than the tax basis. Section 704c requires that this specific pre-contribution gain or loss be allocated to the partner who contributed the property.

Can a partnership choose any allocation method under Section 704c?

Yes, a partnership can generally choose any "reasonable method" that is consistent with the purpose of Section 704c, which is to prevent the shifting of tax consequences. The IRS regulations explicitly endorse three methods as generally reasonable: the traditional method, the traditional method with curative allocations, and the remedial method. The partnership agreement typically specifies the chosen method.

Does Section 704c apply to all property contributed to a partnership?

Section 704c applies specifically to property contributed to a partnership if, at the time of contribution, its book value (which is usually its fair market value) differs from the contributing partner's adjusted tax basis. Cash contributions do not trigger Section 704c, as there is no built-in gain or loss.

What is the "ceiling rule" under Section 704c?

The ceiling rule is a limitation of the traditional method under Section 704c. It states that the total amount of tax items (like depreciation or gain) allocated to partners with respect to a contributed property cannot exceed the partnership's actual tax items generated by that property. This can sometimes prevent non-contributing partners from receiving tax allocations that fully match their economic (book) allocations, leading to disparities. The curative and remedial methods were developed to address this limitation.