February 2014
Partnership Code Sec. 704(b)
Capital Account Maintenance—
Permitted Adjustments Can Track
Partners’ Economic Arrangements
By James R. Hamill
James R. Hamill discusses the benefits of a partnership maintaining
Code Sec. 704(b) book capital accounts, either in isolation or in
addition to one of the other available methods and how those
capital accounts should be maintained.
Introduction
With the growth in the use of limited liability
companies
(LLCs), partnership tax filings have
pan
niess (L
increased
from
2,165,000 in 2001, the first year that
crreaseed
d ffr
rom 2,
Form
lings
orm
m 1065
10
065 fi
filin
lin
ngs exceeded
ceeded Form 1120 filings,
ng to
more
million in 2012
2012.1 Any
mor
re than
th
han 3.5
3 mi
Any “bo
“boiler
ler pla
plate”
te”
partnership
nition
arttnersship or LLC
L C agreement
a ement contains
co tains a defi
d fin
on
of h
how
maintained
and
often
ow capi
ccapital
tal ac
aaccounts
ou will be m
oun
ntaine an
d oft
en
determines
ines partners’ rights to assets upon liquidation
by reference to the capitall acc
accounts.
Beginning with
oun s. Be
2004 tax filings, Schedulee K-1 now
that the
w requires
req
partnership identify the method used to report capital
accounts. Nonetheless, the professional tax literature
pays surprisingly little attention to the determination
of partners’ capital accounts and why one method
may be preferred to another.
Most practitioners are familiar with the requirement
that “Code Sec. 704(b)” capital accounts be
maintained to satisfy the safe harbor for economic
effect under Reg. §1.704-1(b). Code Sec. 704(b)
capital accounts also facilitate compliance with the
“deemed in accordance with the partner’s interest”
test for nonrecourse deductions that cannot satisfy the
economic effect test and with Code Sec. 704(c) and
James R. Hamill, CPA, Ph.D., is the Director of Tax Practice
at Reynolds, Hix & Co., P.A. in Albuquerque, New Mexico.
©
®
TAXES—THE TAX MAGAZINE
reverse Code Sec. 704(c) allocations. The Schedule
K-1 reporting now lists four options to maintain
capital accounts, including Code Sec. 704(b)
book,2 GAAP, tax basis and “other,” which must be
specified. While
hi e it has
has become quite common to see
references
reference to the maintenance
ai e nce of Code Sec. 704(b)
04(b
capital
ca al in operating
eratin agreements,
a re ments, there seem to be
few
fe practitioners
prac
ners who
who are aware
aw re of how
w to satisfy
a
the language of the agreement with respect to capital
account maintenance. Because the safe harbor for
economic effect requires that Code Sec. 704(b)
capital accounts be maintained “throughout the full
term of the partnership,”3 failure to maintain Code
Sec. 704(b) capital accounts for any year cannot be
corrected by subsequent year adjustments.
This article will discuss the benefits of a partnership
maintaining Code Sec. 704(b) book capital accounts,
either in isolation or in addition to one of the other
available methods and how those capital accounts
should be maintained. Understanding the Code Sec.
704(b) capital account provisions helps a practitioner
to understand both the tax and economic effects of
a variety of partnership transactions. Therefore, this
article will analyze capital account maintenance, both
on a Code Sec. 704(b) and tax basis, in the context
of specific transactions that a practitioner would
encounter for partnership clients. It will include an
2014 J.R. Hamill
35
Partnership Code Sec. 704(b) Capital Account Maintenance
analysis of how Code Sec. 704(b) capital accounts
are adjusted to reflect the economics associated with
a contribution to an existing partnership in exchange
for an interest, a distribution of property, including
both liquidating and nonliquidating distributions,4
a transfer of a compensatory profits interest, a
partnership Code Sec. 1031 exchange with boot,
Code Secs. 734 and 743 basis adjustments, a Code
Sec. 708(b)(1)(B) termination and the grant or exercise
of noncompensatory options to acquire a partnership
equity interest.
Why Maintain Code Sec. 704(b)
Capital Accounts?
As noted above, the most significant reason to
maintain Code Sec. 704(b) capital accounts is to
satisfy the safe harbor for economic effect, either
under the “three requirements” test or the alternate
test for economic effect.5 Code Sec. 704(b) capital
accounts are also required to meet the safe harbor
that allows allocations of nonrecourse deductions as
specified in the agreement to be “deemed” to be in
accordance with the partners’ interests.6 Finally, the
use of Code Sec. 704(b) capital assists in tracking
Code
704(c) and reverse Code Sec. 704(c)
e Sec.
S
70
7
allocations.
ocatio
tions. In
I aad
addition, Code Sec. 704(b) capital can
help
partners
understand
elp
p par
rtnerrs un
nde nd and track the economics
n m of
a va
variety
transactions.
arietyy of partnership
parttne
transactions.
Because
704(b)
Be
ecau
use Code
C e Sec.
S
Sec
04(b) capital
cap al accounts
accou s were
ere
developed
velop
ped to
ped
t comply
co
omply
pl with
h the economic
e nomic effect
effect test,
test
they are
designed, as best one can, to track the
e de
economics of the arrangement
ement among
among the partners.
The effectiveness of the Code
capital
Code Sec.
Sec. 704(b)
7
accounts in tracking “true” economics has been
criticized, including the inability of the provisions to
track economics on a real-time basis.8 But the Code
Sec. 704(b) book capital accounts defer valuation
restatements intended to better reflect the current
economic arrangement until they are supported
by arm’s-length bargaining, so that it is the lack of
objective evidence to support annual restatements
that prevents tracking the economic arrangement
on a real-time basis. Moreover, those who want to
avoid the Code Sec. 704(b) capital accounts must
both rely on the subjective “partner’s interest in the
partnership” (PIP) test for allocating partnership items
and adopt some alternative capital account structure
which itself would be subject to criticism. While it
may be comforting to many partners to see a specific
division of assets upon liquidation, rather than a
36
reference to distributions following Code Sec. 704(b)
capital, avoiding a safe harbor economic effect test
introduces uncertainty into the allocation process.9
Thus, the Code Sec. 704(b) capital account provisions
are most useful for tax purposes to permit allocations
to be respected under a safe harbor.
Because Code Sec. 704(b) capital account revaluations intended to better reflect the economics of
the partnership must, by necessity, wait until some
arm’s-length transaction provides sufficient evidence
to justify the adjustment, it is certainly true that Code
Sec. 704(b) capital cannot reflect the economics of
the partnership on a real-time basis. Certain transactions permit adjustments that, arguably, allow the
capital to be restated to true-up the economics for
a moment in time. However, even in such circumstances, the values assigned to partnership properties
must be based on a “rough justice” approach that
ignores valuation adjustments typically used for lack
of marketability and lack of control because the effect of such discounts is not subject to bargaining
between the parties. In spite of these limitations,
the Code Sec. 704(b) capital accounts best reflect
the economics of the partners’ arrangement when
compared to available alternatives. For this reason,
maintenance of Code Sec. 704(b) capital, alone or
in conjunction with other methods, may be done
for nontax economic
conom c reasons in addition to the tax
allocation
Butt any economic benefits are
alloccatio benefi
enefits. B
ar
more
likely to
tax motiv
motivations
m
like
o be a by-product
y roduc of the ta
at
for
fo keeping
keepi Code Sec.
Sec 704(b) capital.
apital
Capital Account
Maintenance Provisions
The basic structure of the Code Sec. 704(b) capital
account maintenance provisions is that partnership
assets will be recorded at fair market value (FMV).
Contributed properties are debited at FMV, associated
liabilities that are either assumed by the partnership
or taken subject to the debt are credited to the Code
Sec. 704(b) accounts, so that the partner’s initial
capital account is reflected as the amount of money
and the FMV of property contributed, net of any
associated liabilities. When assets are distributed
by the partnership, the assets are credited at FMV
so the associated debit to the distributee partner’s
Code Sec. 704(b) capital is also at FMV of the
distributed property. Where the distributed property
is not already reflected at date-of-distribution FMV,
it is then necessary to adjust the value that the
February 2014
property is carried at to its FMV immediately before
distribution. Where appropriate, based on arm’slength bargaining, asset values may also be adjusted
during the life of the partnership for other permitted
events with an offsetting adjustment to the partners’
Code Sec. 704(b) capital. The key to use of such
adjustments is the existence of a transaction that
requires the partners to bargain at arm’s length with
adverse interests to support adjustments to the values
of partnership properties.
As noted earlier, Code Sec. 704(b) capital account
maintenance rules were created in connection with
the regulations defining when an allocation satisfies
the substantial economic effect test. Proper maintenance of Code Sec. 704(b) capital is required to meet
both of the safe harbors for economic effect, whether
the partners decide to use the three requirements or
the alternate test,10 and also to satisfy the safe harbor
by which nonrecourse allocations are deemed to
be in accordance with the partners’ interests. When
used for these purposes, the partnership agreement
must require that distributions in liquidation of a
partner’s interest be made in accordance with Code
Sec. 704(b) capital.11 It is the partner’s desire to see
adjustments to his or her capital for the purpose of
securing
uringg rights
rig
ghts to partnership assets that creates the
adverse
dvversee interests
i terestts
inte
t that justify use of arm’s-length bargaining
ain
ning between
betw
weeen the
t partners as establishing
es
n FMV.
FM 12
If the partnership
parrtnerrsh agreement
reement does
does not make
make disd
tributions
based on Code Sec.
ributions in
n liquidation
liq
quidat
Sec 704(b)
7 (b)
capital,
such
where the pa
partnership
pital,, su
p
pital
ch aas wh
w
nersh p cchooses
hoo es
“targett allocations”
to determine the amounts that
allo
each partner will receive, the use of agreements
beag
tween the partners as the mea
means
FMV
ns of establishing
esta
for purposes of Code Sec. 704(b) capital account
maintenance becomes suspect. Many partnership
agreements use target allocations to avoid complying with the three-requirements or the alternate test
for economic effect, and such a partnership may not
even maintain Code Sec. 704(b) capital.13 Failure to
maintain Code Sec. 704(b) capital will prevent the
partnership from relying on a regulatory safe harbor,
but allocations may still be made in accordance with
the partner’s interest in the partnership. This article
recognizes that most partnerships that choose to use
Code Sec. 704(b) capital do so to comply with a safe
harbor provision, but the article will also note situations where Code Sec. 704(b) capital may be used
to best illustrate the economic arrangement between
the partners. Partnerships relying on target allocations
may still require Code Sec. 704(b) capital to track
TAXES—THE TAX MAGAZINE®
the economics of the arrangement, and the target
allocations will then adjust that capital to match the
distributions made.
At the time the Code Sec. 704(b) regulations were
written, it was generally easy to identify the scope
of arrangements classified as a partnership. Recent
introduction of “Series LLC” statutes in many states
raises the issue of whether each economically independent series should maintain its own Code Sec.
704(b) capital even if the entire series files a single
Form 1065. Because the purpose of the Code Sec.
704(b) capital account provisions is to reflect the
economic arrangement between the parties, it seems
most consistent with that purpose that each economically independent series should maintain its own
Code Sec. 704(b) capital accounts.
Because partnership capital account maintenance
may be done to achieve more objectives than satisfying a safe harbor for economic effect, a partnership
may maintain multiple sets of capital accounts. Even
where a partnership maintains Code Sec. 704(b)
capital to comply with a safe harbor provision, that
partnership is not required to use Code Sec. 704(b)
capital on the tax return.14 While Code Sec. 704(b)
capital may best reflect the underlying economic
arrangement among the partners, tax-basis capital
may be more useful to a partner receiving a Schedule
K-1 because it can be used to track the basis of the
partner’s
partner’s interest.
rest
P oper Contr
Property
Contributions
ibution in Ex
Exchange
hange for
an Interest at Partnership Formation
When property is contributed at formation of the
partnership, and Code Sec. 704(b) capital is the
basis for determining partners’ rights to assets for
distributions in liquidation of the partner’s interest,
the arm’s-length bargaining between the partners that
results in an agreed-to FMV for contributed assets
should be accepted for Code Sec. 704(b) capital. Each
property partner will have an incentive to advocate
for the highest possible value to be assigned to his
contributed property to establish a greater right to
assets of the partnership. Conversely, other partners
should be expected to argue for the lowest possible
value to be assigned to property contributed by other
partners. Partnership agreements often include a
schedule of agreed value contributed by each partner.
This schedule should include a statement of value
for each item of contributed property, although the
partners often do not specify value in that much
detail. However, failure to specify value for each item
37
Partnership Code Sec. 704(b) Capital Account Maintenance
of property may lead to difficulty in making future
allocations that are subject to Code Sec. 704(c).15
Example 1. Ally and Sarah form the AS partnership
with each contributing $500,000 of value. Ally
contributes money, and Sarah contributes an
unencumbered parcel of undeveloped land with
a tax basis of $300,000 and an agreed FMV of
$500,000. The partnership agreement satisfies
the alternate test for economic effect and states
that all items of income, gain, deduction and loss
will be allocated 50 percent to each partner.16
The partnership also maintains tax-basis capital
accounts to assist in tracking the tax basis of
partners’ interests and facilitating Code Sec.
704(c) allocations. The date-of-contribution
capital is shown in Chart 1 (with 000s omitted
from this and all subsequent examples).
Code Sec. 704(b)
Ally
500
Sarah
Code Sec. 704(b)
Contributed Value
Sale of Land
500
Tax Basis
Ally
Sarah
Ally
Sarah
500
500
500
300
50
50
50
250
550
550
550
550
Tax Basis
Ally
500
Sarah
300
The disparity between the Code Sec. 704(b)
and
tax-basis
d ta
ax-baasis capital represents the built-in gain
attributable
at
tt ibutab
ttribu
t b
bl to
ble
to Sarah’s land, and this disparity
between
be
etweeen value
vvalue and
a basis is subject
subje to Code
od Sec.
S
704(c)
principles.
maintenance
both
Code
70
04(c) pri
ncip
ples The maintenan
ce of b
th Cod
e
Sec.
Se
ec. 704(b)
7 b) and
704(b
an
nd tax
t capital
ital helps to
o distinguish
distingu h thee
allocations
al
locaation
ation
ns subject
sub ect
ct to Code
ode Sec.
Sec 704(c)
04(c) principles
inc ple
from thos
those allocations subject to the general
rule that partners may agree
agree how
how to allocate
items provided that agreement
reem
ment has substantial
economic effect. For example, the Code Sec.
704(b) capital tracks the economic arrangement
between the partners, and any allocation that
cannot be reflected in the Code Sec. 704(b)
capital accounts cannot have economic effect.
This point can be illustrated by continuing
our example with the assumption that Sarah’s
contributed land is later sold for $600,000 (we
will assume that no other adjustments have been
made to the capital accounts before the sale).
The sale of Sarah’s property will result in a Code
Sec. 704(b) “book” gain of $100,000 ($600,000
amount realized minus $500,000 book basis) and
a tax gain of $300,000 ($600,000 – $300,000
Code Sec. 723 tax basis). The $100,000 gain
that can be recorded in the Code Sec. 704(b)
capital accounts represents an economic gain
38
Chart 2.
Post-Sale
Chart 1.
Contributed Value
to the partnership, and this amount can then
be allocated by agreement as it can satisfy the
economic effect test. The balance of the gain that
must be reported by the partnership on its tax
return, $200,000, cannot be reflected in the Code
Sec. 704(b) capital because it does not reflect
economic gain realized by the partnership.17
Because the $200,000 gain cannot be reflected
in Code Sec. 704(b) capital, any allocation of that
$200,000 gain cannot have economic effect.18
The effect of the sale in the capital accounts is
shown in Chart 2.
Because the Code Sec. 704(b) capital accounts
reflect the date-of-contribution economic
arrangement between the partners by recording
all asset values at agreed-to FMV, the only gains
that can be reflected in the Code Sec. 704(b)
capital are those that economically accrued after
formation. While Code
Co Sec. 704(a) allows partners
allocate items
partnership
to alloc
tem of tthe
ep
tnership by
y agreem
aagreement,
ent,
it iss only
on the
he gain
ga n refl
eflected
ected in the Code Sec.
Se
704(b)
can
said to be a gain
of th
the
04(b) capital
tal that ca
n be sa
ain o
partnership. The balance of the tax gain, $200,000
in the above example, is an item to be reported
by the partnership but does not represent an item
of (economic) gain of the partnership.
Code Sec. 704(a) allows partners to agree how
to allocate items of the partnership but not items
that economically arise before the partnership is
formed. This is the distinction between the general
rule of Code Sec. 704(a) and the exception of Code
Sec. 704(c). The Code Sec. 704(b) capital accounts
are the easiest way to track allocations subject to
each provision.19 Code Sec. 704(c) requires that
the disparity between book and tax values be
resolved as quickly as possible, which means that
depreciation allocations with respect to contributed
Code Sec. 704(c) property must use the principles
of Code Sec. 704(c). As the depreciation allocations
reduce the disparity between book and tax values,
the allocations of gain from the sale of contributed
February 2014
property must also be adjusted, a process made easier
to track by use of Code Sec. 704(b) book and tax-basis
capital accounts.
Example 2. Ally and Sarah form the AS partnership
with each contributing $500,000 of value. Ally
contributes money, and Sarah contributes an item
of five-year recovery property with a tax basis of
$300,000 and an agreed FMV of $500,000. The
partnership agreement satisfies the alternate test
for economic effect and states that all items of
income, gain, deduction and loss will be allocated
50 percent to each partner. The partnership also
maintains tax-basis capital accounts to assist
in tracking the tax basis of partners’ interests
and Code Sec. 704(c) allocations. The property
contributed by Sarah is depreciated at the rate
of 20 percent per year for both book and tax20
and is sold at the beginning of the third year for
$350,000. Depreciation deductions for Code
Sec. 704(b) book purposes are based on the
recorded FMV of the property.21 For simplicity
of illustration, no depreciation is claimed for the
year of disposition. The capital from formation
through the date of sale is shown in Chart 3.
Chart
ha
art
a
rt 3.
3.
Code Sec. 704(
704(b)
Ally
Con
ntribu
ution
Contribution
preciation
i ti n – 2 years
ars
Depreciation
Pre-Sale Capital
Sale
Ending
arah
Sarah
50
500
00
500
Tax
ax Basis
asi
Al
Ally
Sarah
Sarah
5
00
500
00
300
<100>
0
<100> <100>
0>
<20>
<2
400
400
400
280
25
25
25
145
425
4
425
2
425
425
This analysis shows that the built-in gain of
$200,000 attributable to Sarah’s contributed
property is subject to Code Sec. 704(c) both
with respect to the annual depreciation
deductions as well as the gain from sale.
Code Sec. 704(b) book depreciation is based
on contributed FMV while tax depreciation is
based on the partnership’s carryover basis in the
contributed property. Book depreciation is split
equally pursuant to the agreement, while tax
depreciation is allocated first to Ally to match
her share of book depreciation,22 and then to
Sarah. For the two years that depreciation is
claimed, Ally is allocated $80,000 more tax
depreciation deductions than Sarah. When
TAXES—THE TAX MAGAZINE®
the property is sold, the Code Sec. 704(c)
gain allocation to Sarah is $120,000, which is
the contributed gain of $200,000 reduced by
the differential depreciation for the first two
years. The pre-sale capital balances show the
amount that is subject to Code Sec. 704(c) as
the $120,000 difference between Sarah’s Code
Sec. 704(b) and tax-basis capital.
Property Contributions in Exchange
for an Interest Post-Formation
When money or property is contributed to the
partnership in exchange for an interest at some time
after formation of the entity, the amount contributed
and the percentage interest received will allow the
partners to infer the value of partnership properties
at the time of the new contribution. Arm’s-length
bargaining should establish the fair payment
required for the interest to be received, and that
payment should also reflect the net asset value of
partnership properties. It could be argued that the
amount paid for the interest cannot readily be used
to determine the value of properties because the
interest value would be expected to be discounted
by factors such as lack of marketability and lack
of control. While this is certainly true, even
ignoring the factor
factors tthat may justify a discount for
value of the interest
allows
partnership
the valu
e st allo
ws the pa
artnership tto
betterr re
reflectt the economic
between
be
co omic arrangement
rrangement be
w
the partn
partners. Furth
Further,
objective
way to
th
er there
here is no obj
tive wa
incorporate valuation discounts into a revaluation
of the properties. Discounts are not bargained
by the partners, and if an outside expert is used
to establish a discount, there may be a conflict
of interest between the partner responsible for
hiring that expert and one or more other affected
partners. For example, when money or property
is contributed to an existing partnership for an
interest, the existing partners could seek an expert
to support a high discount to inflate the implied
value of partnership properties so that more preadmittance capital is shifted to them. So when an
interest is acquired by contribution, the Code Sec.
704(b) capital accounts may be restated to reflect
the value implied by the contribution but absent
any discounts. This restatement is optional, but it
assists the partnership in making reverse Code Sec.
704(c) allocations to reflect any inherent gain or loss
that existed before the new interest is acquired.23 If
the restatement is not done, the partnership is still
39
Partnership Code Sec. 704(b) Capital Account Maintenance
required to follow Code Sec. 704(c) principles with
respect to any pre-admittance gains and losses. The
restatement simply facilitates this analysis.
Example 3. Ally and Sarah form the AS
partnership, with each contributing $500,000
in exchange for a 50-percent interest. All
contributions are made with money. The
partnership agreement satisfies the requirements
for the safe harbor for the alternate test for
economic effect, and all items are allocated 50
percent to each partner. The partnership uses
the contributions to purchase $1,000,000 of
undeveloped land to be held for investment.
Three years after formation, Katie offers to join
the partnership by contributing money for a
one-third interest. The amount to be paid by
Katie is the subject of arm’s-length bargaining
where Katie would like to contribute the
smallest amount, and Ally and Sarah would
like her to contribute a much larger amount.
The parties agree that Katie will contribute
$800,000 for a one-third interest in all items.
Katie’s contribution implies that the value of all
partnership properties, after her admittance, is
$2,400,000
,40
00,00
00 (so that her contribution properly
refl
ects
one-third
of the total value). Because
re
efl
flec
t o
ts
ne-tth
t
this
monetary
th
his amount
am
mount includes
in
ncl
s Katie’s $800,000
$800
o et
contribution,
co
ontr ibuttion,, the
th land
nd purchased
purcha sed by the
t e AS
AS
partnership
must
$1,600,000
pa
artneership m
mu
st be worth $1
600,000 at tthe
e
time
Katie’s
partnership
im
me of K
Katie
e ad
aadmittance.
tance The
e pa
ne ship
may now adjust the value of the land upward
from its current Code Sec. 704
704(b)
$1,000,000
(b) $
value to $1,600,000. The
offsetting
he o
ffsetting ccredit entry
of $600,000 is made to the Code Sec. 704(b)
capital accounts of Ally and Sarah based on how
they have agreed to share the economic gains
associated with the land. Therefore, each partner
has a $300,000 adjustment made to her capital.
The Code Sec. 704(b) and tax-basis capital
accounts then appear as shown in Chart 4.
Chart 4.
Code Sec. 704(b)
Initial Formation
Tax Basis
Ally Sarah Katie
Ally
Sarah
500
500
500
500
Katie Admittance
800
Katie
800
Restatement
300
300
-0-
-0-
-0-
-0-
Ending Capital
800
800
800
500
500
800
40
While the entries are fairly simple, they also tell
a story. First, the restatement causes the Code
Sec. 704(b) capital of each partner to be equal,
reflecting their revised economic agreement by
which each owns one-third of the partnership.
Second, the $300,000 disparity between the
Code Sec. 704(b) and tax-basis capital of both
Ally and Sarah reflect their respective shares
of the appreciation in the value of partnership
properties that occurred from the date they
formed the entity through the date that Katie
was admitted as a new partner. This book-tax
disparity is subject to Code Sec. 704(c), and
the reverse Code Sec. 704(c) allocations when
the land is sold will distinguish the gain that
occurred when Ally and Sarah were the only
partners from any gain or loss that occurs when
there are three partners. To illustrate, assume
that the land is later sold by the partnership
for $1,900,000. The Code Sec. 704(b) gain,
measured relative to the restated value of the
land, is $300,000 ($1,900,000 – $1,600,000).
The gain to be shown on the tax return is
$900,000 ($1,900,000 – $1,000,000 cost basis).
Book and tax gain are then allocated as shown
in Chart 5.
Chart 5.
Code
od Sec. 70
704(b)
4(b
Al
Allyy
Initial Formation
500
Sarah Katie
atie
500
Katie Admittance
Tax Bas
Basiss
All
Ally Sarah K
Katie
500
500
800
800
Restatement
300
300
Sale of Land
100
100
100
400
400
100
Ending Capital
900
900
900
900
900
900
Only $300,000 of gain, the amount that can
be reflected in the Code Sec. 704(b) capital,
can be allocated among the three partners
by agreement and satisfy the economic effect
test. The remaining tax gain of $600,000 must
be allocated using the principles of Code Sec.
704(c), and this reverse Code Sec. 704(c) gain,
which reflects appreciation in the land value
from date of formation through the date that
Katie was admitted as a new partner, must
be allocated between Ally and Sarah based
on how they have agreed to share that gain.
The example reflects a 50/50 split of the gain,
February 2014
but Ally and Sarah may agree to an allocation
other than 50 percent each, and that allocation
can have economic effect because it can be
reflected in the Code Sec. 704(b) capital. If
their agreement with respect to this gain was
something other than 50 percent each, that
agreement would have been reflected in the
allocation of the restatement and later matched
by an allocation in the tax-basis capital.
Post-Formation Contribution by an
Existing Partner for an Interest
Example 3 shows an optional restatement
when a new partner joins the partnership by
contribution of money or property in exchange
for an interest. The new partner scenario is the
simplest to demonstrate, as the post-contribution
value of partnership properties implied by the
contribution is simply the FMV of the contribution
divided by the percentage interest acquired by
the contribution (in Example 3, $800,000 divided
by one-third). If the contribution is made by an
existing partner, the calculation of implied value is
a bit more difficult as it is based on the change in
the partner’s
interest.24 It is necessary
partnerr s percentage
p
to measure
both
m
meaasuree the
th
he partner’s share of capital
p
before
to determine
efo
ore and
a after
afteer his
h new
ew contribution
contribut
de er
the
he value
vallue implied
imp
plie byy the incremental
incr ement l interest
nter est
received
new
contribution,
eceeiveed in
n exchange
exxch
han for the n
ew co
tr u on,
which
requires
The
h ich req
quir e a four-step
r step calculation.
lcul io n T
he
four-step
t ep ccalculation is a generalized form of
determining the implied
ed value
vvalu e of partnership
properties and can also
o bee used
us ed to
t determine
value in the preceding example. The following
example will illustrate the four steps.
Example 4. Ally, Sarah and Katie form the ASK
partnership, with each partner contributing
$500,000 of money in exchange for a one-third
interest in all items. The partnership satisfies all
requirements of the alternate test for economic
effect. The partners use their cash contributions to
purchase $1,500,000 of undeveloped land. Three
years after formation, Ally contributes $400,000
additional cash in exchange for increasing her
interest in partnership capital from one-third to
40 percent. The partnership will restate the value
of the land to reflect the value implied by Ally’s
second contribution. This value is determined
as follows:
TAXES—THE TAX MAGAZINE®
Step 1—Ally’s share of capital, including any
change in value after formation, immediately
before the new contribution is: Apre = 500 + 0.333(X
– 1,500), where X is the value of partnership assets
before the second contribution. Ally’s Code Sec.
704(b) capital will be adjusted only if the value (X)
is different than the 1,500 value currently reflected
in Code Sec. 704(b) capital.
Step 2—Ally’s share of total capital after the
second contribution is: Apost = 400 + Apre = .40
Total Capital
This step adds Ally’s new contribution (400) to
her restated pre-contribution capital and sets her
post-contribution capital equal to 40 percent
of the total post-contribution capital (both
computed post-revaluation).
Step 3—Total Capital after the second contribution
= 1,900 + (X – 1,500). This shows total capital
is the total amount contributed (1,900) adjusted
for the revaluation.
Step 4—Determine X by substitution from above,
where we can substitute Ally’s share of capital
after the second contribution as the numerator
(substitutingg step 1 into
step 2), total capital after
i
contribution
denominator
the second
sec
con
bu o ass the denom
inato and
set that quotient
otient equal
eq al to
o .40,
0, the agreed
a reed share
sha
of capital
capi that
hat now
w belongs
belongs to
o Ally:
900 + 0.333X – 500 = .40
400 + X
Then simplifying,
160 + .4X = 400 + 0.333X
0.067X = 240
X = 3,600
Therefore the value of the land immediately
before Ally’s second contribution is $3,600,000,
which requires a book up of $2,100,000 from its
original $1,500,000 value. This is shared onethird by each of the original partners, and capital
accounts then appear as shown in Chart 6.
41
Partnership Code Sec. 704(b) Capital Account Maintenance
Chart 6.
Code Sec. 704(b)
Ally
Initial Formation
500
Ally Contribution
400
Restatement
700
Ending Capital
1600
Sarah Katie
500
500
Tax Basis
Ally Sarah Katie
500
500
500
400
700
700
-0-
-0-
-0-
1200 1200
900
500
500
after the second contribution as the numerator
(again substituting step 1 into step 2), total capital
after the second contribution as the denominator
and set that quotient equal to 0.333:
800
800 + X
= 0.333
Then simplifying,
Several issues stand out based on the ending
capital accounts. First, the Code Sec. 704(b)
capital has been restated to a total value of
$4,000,000, and Ally’s share of that total is 40
percent ($1,600,000/$4,000,000), consistent
with the revised agreement among the partners.
Second, there is a total book-tax disparity of
$2,100,000 ($4,000,000 – $1,900,000) which
reflects the change in value of the land from the
date of formation through the date that Ally’s
interest increased. This amount is subject to
a reverse Code Sec. 704(c) allocation where
each partner will be allocated $700,000 (the
book-tax disparity for that partner). The prechange appreciation is shared equally; any
post-change appreciation is shared in the revised
40/30/30
ratios. The restatement recorded in this
30
0/30 rat
transaction
tra
ansaactio
tion may
ma become part of a larger Code
m
Sec.
in future
Se
ec 704(c)
ec.
7
704(cc) allocation
alloc
n as interests change
c
ut
years,
ye
ears, including
inclludin
ng the possibility
ossibility of admitting
admitti g a new
w
partner
pa
artneer in exchange
exccha
ang for
or a contribution.
contr bution.
As noted
the four steps shown in Example 4
ted aabove,
b
to determine the value of partnership
before
artneership properties
pro
the new contribution is a gene
generalized
form that could
ralized fo
also be applied to Example 3, as shown here:
Step 1—Katie’s share of capital, including any
change in value after formation, immediately
before the new contribution is: Kpre = 0 + 0 (X –
1,000), where X is the value of partnership assets
before the second contribution.
Step 2—Katie’s share of total capital after the
second contribution is: Kpost = 800 + Kpre = 0.333
Total Capital
Step 3—Total Capital after the second contribution
= 1,800 + (X – 1,000)
Step 4—Determine X by substitution from above,
where we can substitute Katie’s share of capital
42
266.67 + 0.333X = 800
0.333X = 533.33
X = 1,600
This restated value of partnership properties is the
same as was obtained in Example 3 but where a
new partner is the one making the contribution the
computation can be shortened by the method shown
in that earlier example.
Effect of Distribution of Property
As noted earlier, the economic-based capital accounts
record property contributions at FMV but also record
distributions at FMV. Where values are not reflected at
FMV immediately before distribution, either because
the value changed during the partnership’s holding
period or changed
to any pre-distribution
anged relative
re
restatements,
it is
resta
teme
i necessary
ec ss y to restate the value
va ue of
o
the distri
distributed
properties
immediately
before
th
ed pr
pe tie im
mediate y befo
e the
distribution.
How this
adjustment
occurs
generally
di
ibuti
this adjust
ent oc
rs ge
er
depends on two issues. First, to what extent any
changes in value have already been reflected by
prior restatements. Second, whether the partnership
restates the value only of the property actually
distributed or whether all partnership properties
are restated. As is the case with contributions, the
partnership needs an objective measure of FMV,
generally determined by agreement between the
partners who are dealing at arm’s length and with
adverse interests. Where Code Sec. 704(b) capital is
the basis for rights to assets upon liquidation, partners
should have sufficient adverse interests to support an
agreed value as reflective of FMV.
If a partner is to receive a property distribution that
does not liquidate his interest, the distributee partner
has an incentive to argue that the distributed property
has a small value. This is so because the value assigned
will reduce his capital and thereby reduce his rights to
future distributions. This leads the distributee partner
to argue for a small reduction in his Code Sec. 704(b)
February 2014
capital.25 In contrast, the other partners should be
expected to argue for assignment of a large value to the
distributed property, reducing the distributee partner’s
capital by a larger amount and protecting their interest
to future distributions relative to the partner receiving
the current distribution. However, the partners do not
generally have adverse interests with respect to the
value of any partnership properties that are not the
subject of the current distribution. Therefore, when
the distribution is not in liquidation of the distributee’s
interest, a restatement is permitted only for the
distributed property. This is done through a “deemed
sale adjustment,” or DSA, in which the distributed
asset is deemed sold for its FMV with the resultant
(book only) gain or loss charged to all partners’ Code
Sec. 704(b) capital based upon their agreement. The
property is then removed from the partnership at its
restated FMV with the offset to the capital account of
the partner receiving the distribution.26
If the distribution liquidates the interest of the
partner, the partners must first agree to the value of
the entire interest held by the partner who will be
liquidated. Once that total value is determined, the
partners must agree which assets will be distributed
to satisfy the partner’s rights to the total assets of the
partnership.
nersship
p. The
Th distributee again has an incentive
to argue
a e that
thatt each
tha
eaac asset received has a small value,
ass that
properties
that will
w justify
justify receipt
eipt of additional
additio
op rt to
equal
value of his
equ
ual the
the total
total agreed
ag
his interest.
inte es . Other
Other
partners
arttnerss have
ha
ave an
a incentive
in
tive to argue
a gue the opposite,
o po te,
so that
a smaller
t
sm
malle number
n
nu
er of distributed
di buted properties
propert es
will satisfy
tiisfy their
tth obligation to the liquidated partner.
Unlike the nonliquidating
ng sscenario,
cenario, it is possible
to restate the value of alll partnership
partnership assets, again
through the DSA, because the partners have
determined by arm’s-length bargaining the total
value of partnership properties. It is not mandatory
to revalue all partnership assets in a distribution
in liquidation of a partner’s interest, but the full
restatement should permit Code Sec. 704(b) capital
to better reflect the economic arrangement between
the partners, including continuing partners.
The following example will present a base fact
pattern that will be used to show how a DSA may be
used in a nonliquidating distribution, and the same
facts will be used in the next example to add a variation
of a complete liquidation of the partner’s interest with
a DSA applying to all partnership properties.
Example 5. Ally, Sarah and Katie form the ASK
Partnership with each partner contributing
TAXES—THE TAX MAGAZINE®
$500,000 in exchange for a one-third interest
in all items of the partnership. The partnership
agreement complies with the alternate test
for economic effect. The partnership uses the
contributed funds to purchase a parcel of land
for $1,500,000 and subsequently replats the
land into 15 equal-sized lots. At the time of the
replat, the partners do not believe that any lot
is more valuable than any other, so they assign
a $100,000 value to each lot. The intent of the
partners is to passively hold the land until a bulk
sale to a developer can be arranged. Three years
after formation, Katie decides that she would like
to build her residence on one of the lots, and
she negotiates with Ally and Sarah to receive a
distribution of a single lot, with the understanding
that the distribution will reduce her interest in the
partnership below one-third. The three partners
negotiate the value of the lot, and all agree that it
is worth $160,000. Because the distribution is not
in liquidation of Katie’s interest, there is no arm’slength bargaining to establish the total value of
partnership properties, nor is there any bargaining
with respect to the value of any parcel other than
the one to be distributed. The distributed lot is
revalued at $160,000, with the $60,000 debit
entry offset by a $20,000 adjustment to the Code
Sec. 704(b)) book capital
of each partner, based
ca
on their
the agreed-to
greed o split
pli of economic
ec nomic gain from
rom
the property.
pro
y. Code
Co e Sec.
ec. 704(b)
70 (b) capital
capit l accounts
accoun
aree then
ected in Chart 7.
the refl
flected
Chart 7.
Code Sec. 704(b)
Ally
Initial Formation
Deemed Sale
Distribution
Ending Capital
Sarah Katie
500
500
20
20
-0520
Ally Sarah Katie
500 500
500
500
20
-0- <160>
520
Tax Basis
-0-
360 500
-0- <100>
500
400
The aggregate values of the Code Sec. 704(b)
and tax-basis capital remain equal, with book
first adjusted upward by $60,000 but then
reduced by $160,000, and tax reduced by the
original $100,000 cost of the distributed lot.
Katie takes a carryover basis in the distributed
lot,27 so there is no Code Sec. 734 adjustment to
the basis of undistributed partnership properties
even if the partnership has a Code Sec. 754
43
Partnership Code Sec. 704(b) Capital Account Maintenance
election in effect. The tax basis of her interest
and her tax-basis capital are both reduced by
the $100,000 assigned to the distributed lot.28
Katie will bear the potential $60,000 taxable
gain if the distributed lot is sold by her after the
distribution for its current FMV. Katie’s Code Sec.
704(b) capital is $160,000 less than both Ally’s
and Sarah’s, which reflects the value that she has
already extracted by way of the distribution.29
While not required as part of the analysis of
this example, it is instructive to consider what
happens when remaining partnership properties
are disposed of in a taxable transaction. That is,
we should be able to reconcile the economics
shown in the Code Sec. 704(b) capital with
the ultimate tax result to each of the partners.
To illustrate, assume that each of the 15 lots is
valued at $160,000, so that total partnership
value is $2,400,000 before the distribution.
Post-distribution, the partnership has remaining
$2,240,000 of value ($160,000 × 14 lots), with
a tax basis of $1,400,000 ($100,000 for each
of the 14 remaining lots). A taxable disposition
would create $840,000 of book and tax gain.
Because there is no Code Sec. 704(c) issue
(none
properties has a disparity
onee of the
th
he remaining
r
book
in
n boo
b
okk and
and
d ta
ttax
ax values), Code Sec. 704(b) book
gain
to each
ga
ain would
wou
uld be allocated
ocated $280,000
$280
ea
partner.
pa
artneer. Tax
T gain
ga will
ill follow the Code
Co d Sec.
Sec .
704(b)
70
04(b
b) book
bo
ook gain
gaain under
der the economic
econom c effect
ff t
test.
Capital
eest. Cap
est
C
apital aaccounts
cco
co
would then
hen aappear
pe r aas
shown
Chart 8.
n in C
Chart 8.
Code Sec. 704(b)
Tax Basis
Ally Sarah Katie
Ally Sarah Katie
Capital, from above
520
520
360
500
500
400
Sale—remaining lots
280
280
280
280
280
280
Ending Capital
800
800
640
780
780
680
From this analysis we see that available
partnership assets ($2,240,000 sale proceeds)
will be distributed $800,000 each to Ally and
Sarah and $640,000 to Katie. Katie’s reduced
distribution reflects the value she earlier received
from the property distribution. Each partner
will have a separate tax effect attributable to
receipt of a liquidating distribution of cash sale
proceeds, with Ally and Sarah each reporting
an additional $20,000 capital gain from a
44
distribution in excess of tax basis ($800,000 –
$780,000). Thus, Ally and Sarah report a total
gain of $300,000 each, $280,000 from a K-1
item and $20,000 on Schedule D from a deemed
exchange of their partnership interest. Katie
has a $40,000 capital loss from receipt of a
$640,000 cash distribution (determined by her
Code Sec. 704(b) book capital) in exchange
for an interest with a tax basis of $680,000.
Katie then reports a net gain of $240,000,
which is the $280,000 K-1 item net of the
$40,000 Schedule D loss item. Katie’s overall
gain is $60,000 less than both Ally and Sarah
because she still has the distributed lot with a
FMV that exceeds basis by $60,000 ($160,000
– $100,000). The $60,000 gain is deferred in
the distributed lot and if Katie disposes of that
lot in a taxable transaction her overall gain
will be the same as Ally and Sarah. Obviously
this expanded analysis assumes facts beyond a
simple distribution of one lot, but it illustrates
that over the life of the investment the tax
consequences to each partner will match the
economics shown through the Code Sec. 704(b)
capital accounts. Matching allocations of taxable
gain and loss to economic benefits and detriments
is the essence of the Code Sec. 704(b) economic
effect test, and th
thiss matching is reflected in the
Code Sec.
704(b)
S
704 capital
ca it accounts.
accounts 300
Example
amp 6. The facts
facts are the same
ame as in Examp
Example
5 except Katie wants to receive one-third of
the value of partnership properties in complete
liquidation of her interest in the ASK partnership.
In this case, the partners will have to negotiate
the total value of partnership properties to reach
an agreement as to what value Katie is entitled to
for her one-third interest. The partners will also
need to negotiate the value of specific lots to be
distributed to match the value of Katie’s interest.
Ally, Sarah and Katie agree that each of the 15 lots
is now worth $160,000, so that the total value of
partnership properties is $2,400,000. Katie will
be given title to five of the 15 lots, with a total
value of $800,000. Because the partners have
reached an arm’s-length agreement of the value
of all partnership properties, they are able to use
a deemed sale adjustment to restate the value
of every lot. They agree to restate all lot values,
and the Code Sec. 704(b) capital accounts are
adjusted as shown in Chart 9.
February 2014
Chart 9.
Code Sec. 704(b)
Ally
Sarah
Katie
Initial Formation
500
500
500
Deemed Sale
300
300
300
Distribution
-0-
-0- <800>
Ending Capital
800
800
-0-
Tax Basis
Ally Sarah Katie
500
500
-0-
-0- <500>
500
500
500
-0-
Katie substitutes the basis of her interest
($500,000) for the basis of the distributed
properties, so she has a potential gain of
$300,000 in the distributed properties that is
deferred until she disposes of one or more of
the lots in a taxable transaction. The tax basis
of undistributed properties has not changed,
so Ally and Sarah will each (ultimately)
recognize a $300,000 gain when all of the
remaining properties are disposed of by the
partnership. Again, there is no Code Sec. 734
adjustment (if the partnership had a Code Sec.
754 election) because Katie’s substituted basis
is the same basis as the distributed properties
had to the partnership.
Code
o Se
ode
Sec.
ec. 7
734 Adjustments
In
n the preceding
preeced
di
examples, there were
w re no
Code
734
Cod
de Sec.
S
4 adjustments
a
tments to the tax
ta x basis of
undistributed
properties
result
nd
distr ibutted p
pro
ope
p
es as a re
ult of tthe
he facts
ac of
the
example.
Code
occurs
e exa
a mplle
ampl
le. A Cod
od Sec.
c 734 adjustment
justm nt occ
rs
only when
hen tthe partnership has a Code Sec. 754
election in effect, and the adjustment
can be
ad ustm
used to maintain the Code
704(b) book and
ode SSec. 704
tax-basis capital accounts in balance over the life
of the partnership. Unlike the Code Sec. 704(b)
restatements shown above, which did not affect
tax-basis capital, Code Sec. 734 adjustments are
made to the tax basis of undistributed partnership
properties when a distributee partner recognizes
gain or loss from the distribution or when the
basis of the distributed property to the partner
is more or less than the partnership’s basis in
that distributed property. 31 Therefore, Code Sec.
734 adjustments may be made to the tax-basis
capital of the partners, to offset the adjustment
made to the asset side of the balance sheet. If
the distribution giving rise to a Code Sec. 734
adjustment occurs because of a liquidating
distribution, the adjustment is made only to the
capital account of the partner whose interest
TAXES—THE TAX MAGAZINE®
was liquidated. If the adjustment arises from a
nonliquidating distribution, it is made to the
capital accounts of all partners based on how
they would share any gains and losses from the
property subject to the adjustment. 32
Example 7. Ally, Sarah and Katie form the ASK
partnership with each partner contributing
$500,000 of money. The partnership satisfies
the alternate test for economic effect and
all items will be shared equally by the three
partners. The partnership uses the funds to
purchase $1,500,000 of property, and the
partnership generates $1,500,000 of operating
income in its first five years of operations. For
simplicity of illustration, it is assumed that all
profits of operations are retained as cash and
that no cost recovery adjustments have been
made to the partnership property. As a result,
at the end of the fifth year of operations, the
partnership holds property with a Code Sec.
704(b) book and tax basis of $1,500,000
and money of $1,500,000, and partners’
Code Sec. 704(b) book and tax-basis capital
is $1,000,000 each, or $3,000,000 in total.
Katie wants to liquidate her interest at the
end of the fifth year,
and the three partners
y
negotiate a cash
cas buyout of $1,400,000 for
interest.
Katie’s one-third
e-th
te s . The buyout
buyyout price
p rice
implies
plie a total net
et FMV
M of
o partnership
partner hip assets
a se
of $4,200,000,
$4 2
000 which
w ch consists
whi
con sts of $1,500,000
500 00
of money and $2,700,000 of property. The
property is currently carried on the books at
$1,500,000, so a $1,200,000 restatement is
possible before the liquidating distribution.
The partners have agreed to restate the value
of all partnership properties using the values
implied by the agreement with Katie. 33 The
capital accounts will appear as shown in
Chart 10.
Chart 10.
Code Sec. 704(b)
Ally Sarah
Katie
Tax Basis
Ally Sarah
Katie
Initial Formation
500
500
500
500
500
500
Operations
500
500
500
500
500
500
Deemed Sale
400
400
400
-0-
-0- <1400>
-0-
-0- <1400>
Distribution
Ending Capital
1400 1400
-0- 1000 1000
<400>
45
Partnership Code Sec. 704(b) Capital Account Maintenance
At this point, the partnership still holds property
valued at $2,700,000 (the value implied by
the redemption price) and money of $100,000
($1,500,000 – the distribution to Katie). The total
assets of $2,800,000 are shared economically
$1,400,000 to each of the continuing partners,
as is reflected in the restated Code Sec. 704(b)
capital accounts. The tax-basis capital of the
continuing partners remains at $1,000,000
each, reflecting the unrealized gain of $400,000
attributable to each partner. Katie’s Code Sec.
704(b) capital is zero, as she no longer has
any right to assets of the partnership, but note
that Katie’s tax-basis capital ends at a negative
number. This figure reflects the $400,000 Code
Sec. 731 gain that Katie recognizes from receipt
of a distribution of money in excess of the basis
of her partnership interest. If the partnership
has a Code Sec. 754 election in effect, or
makes one for the year of the distribution, a
$400,000 positive Code Sec. 734 adjustment
will be made to the tax basis of undistributed
properties. This adjustment will also be made to
the tax-basis capital, with the adjustment made
to Katie’s capital only, because it arises from a
distribution
strib
butio
on in liquidation. The Code Sec. 734
adjustment,
which is a debit entry to the tax
ad
dj tmen
djust
t nt,
t w
basis
ba
asis of partnership
p
partn
ne
p properties, is offset
e by a
credit
Katie’s
capitall and rresults
cr
reditt to Katie
K
e’s tax-basis
basis capita
esults iin
n
balance
capital aat ye
yearr
a zero
o ba
alancce in herr tax-basis
tax-basi capita
end,
en
nd, matching
nd
matchin
ng the
th Code
ode Sec.
Sec 704(b)
704(b capital.
capital
See Chart
11.
C t1
Chart 11.
Code Sec. 704(b)
Ally Sarah
Katie
Tax Basis
Ally Sarah
Katie
Initial Formation
500
500
500
500
500
500
Operations
500
500
500
500
500
500
Deemed Sale
400
400
400
Section 734 Adj.
Distribution
Ending Capital
400
-0-
-0- <1400>
1400 1400
-0-
-0- <1400>
-0- 1000 1000
-0-
A Code Sec. 734 adjustment may also be made
when the basis of the distributed property to the
partner is different than the basis of that property
to the partnership. That adjustment can be positive
or negative, and the effect on tax-basis capital will
again be as an offsetting entry to the adjustment
46
made to the basis of undistributed partnership
property. The DSA and the removal of the asset
from the Code Sec. 704(b) books will reflect the
entire effect of the distribution on the economic
arrangement between the partners. The Code Sec.
704(b) capital should match the post-Code Sec.
734 adjustment tax-basis capital of the liquidated
partner as she should report tax consequences
matching her Code Sec. 704(b) economic benefits
and burdens over the life of her ownership interest
in the partnership.
Example 8. The facts are the same as in
Example 6 except the total value assigned to
the 15 lots is $1,800,000 and at the time of the
liquidating distribution to Katie the partners
agree that not all lots have the same value.
Katie agrees to take four lots with an agreed
value of $600,000 in liquidation of her interest.
The four distributed lots have a tax basis to the
partnership of $400,000. The partnership has
a Code Sec. 754 election in effect for the year
of the distribution. A DSA is recorded for all
partnership properties, resulting in a bookup of $300,000 ($1,800,000 – $1,500,000)
immediately prior to the distribution. The
four distributed lots are removed from
the Code Sec.
accounts at their
ec. 704(b)
7
restated
resstate FMV
MV of $600,000
$ 0 000 and from
fro m the tax
basis
sis books
b ks at the
h partnership’s
p rtn ership’s $400,000
$400, 00
basis.
distributed
asis Katie’s
ie’s basis
b asi in the
t
distr uted lots
o
is $500,000, the substituted basis of her
partnership interest. 34 Before considering
the effect of the Code Sec. 734 adjustment,
undistributed partnership properties have a
FMV of $1,200,000 ($1,800,000 – $600,000
distribution) and a tax basis of $1,100,000
($1,500,000 – $400,000 distributed basis).
There is a negative Code Sec. 734 adjustment
to the basis of undistributed partnership
properties because the basis of the distributed
property in Katie’s hands exceeds that of the
partnership by $100,000. 35 The entry made
to the tax basis books to reflect this Code
Sec. 734 adjustment to remaining partnership
properties is shown in Chart 12.
Chart 12.
Katie Capital
Undistributed Property
100
100
February 2014
Partnership capital accounts, post-distribution
and after the Code Sec. 734 adjustment, are
shown in Chart 13.
Chart 13.
Code Sec. 704(b)
Ally Sarah
Initial Formation
500
500
Deemed Sale
100
100
Distribution
Section 734
Ending Capital
Katie
500
Code Sec. 705(a)(2)(B) Items
Tax Basis
Ally Sarah
500
500
Katie
500
100
<600>
<400>
-0-
-0-
-0-
-0-
600
600
-0-
500
-0- <100>
500
-0-
The Code Sec. 734 adjustment zeroes out
Katie’s tax-basis capital, and the Code Sec.
704(b) revaluation creates a $200,000 total
disparity between the FMV and tax basis of
undistributed properties. The properties have
a FMV of $1,200,000 and after the negative
$100,000 Code Sec. 734 adjustment have a
tax basis of $1,000,000. This disparity is also
reflected in the excess of the Code Sec. 704(b)
capital over the tax-basis capital of the remainingg partners.
p
partn
ners The Code Sec. 734 adjustment
allows
book-tax
disparity to reflect only the
al
ll ws the
llow
the bo
b
oo
share
unrealized
partnership
sh
hare of unre
u
eal
gain in par
p assets
ss
that
Sarah
($100,000
th
hat “bel
““belongs”
onggs” to Ally
lly and Sa
rah ($
00,000
each).
ea
ach)). Katie’s
Kaatie’’s $100,000
$10 000 share
shar is deferred
defer d in
n
the
four
in the liquidating
h fo
he
our lots
our
lots received
r cei
e
uidat g distridistri
bution
($600,000
FMV in excess of $500,000
n ($
6
substituted basis).
Code Sec. 743 Adjustments
Code Sec. 743 adjustments occur when the
partnership has a Code Sec. 754 election in effect,
and a partner acquires an interest by purchase
from another partner. For this purpose, a purchase
includes inheritance of a partnership interest. Code
Sec. 743 adjustments must be accounted for by the
partnership provided the transferee partner timely
notifies the partnership of the transfer,36 but the
adjustment itself belongs only to the purchasing
partner. As a result, no adjustments are made to
the common basis of partnership properties so that
no adjustment is made to partnership capital.37 The
purchaser simply steps into the shoes of the seller
with respect to capital and may also succeed to
any inherent Code Sec. 704(c) items reflected as a
TAXES—THE TAX MAGAZINE®
disparity between Code Sec. 704(b) book and tax
capital.38 This is so because, unlike a Code Sec. 734
distribution adjustment, the mechanism giving rise
to the Code Sec. 743 adjustment occurs outside of
the partnership.39
Code Sec. 705(a)(2)(B) items are expenditures
of the partnership that are not deductible in
computing taxable income and not properly
charged to capital. They are items that have a
permanent effect on the basis of partnership assets
without a corresponding current or future effect
on taxable income.40 That is, items capitalized to
property that may be recovered through future
cost recovery deductions or as reductions in gain
from sale are not Code Sec. 705(a)(2)(B) items,
which are instead permanent book-tax differences.
Examples would include nondeductible premiums
paid on partnership owned life insurance, expenses
related to the production of tax-exempt income,
disallowed related-party losses and the 50-percent
disallowance for meals and entertainment. The
Code Sec. 704(b) capital reflects the economic
effect of these expenditures, and the items would
fully reduce the economic-based capital. This is
similar to the adjustments that would be made to
a corporation’s
earnings
and profits, which is used
n’s ear
ni
determine
the corporation’s
to d
eterm
rporatio ’s economic
econom
mic ability
ab ity to
t
pay a dividend.
pa
div nd. Code
C d Sec. 705(a)(2)(B)
05(a)(2) B) items
items can
create
cr
ate permanent
pe anent book-tax
boo tax differences
d erence that
hat will
w l not
automatically adjust themselves at liquidation of
the partnership. Without any explicit guidance, the
partnership may need to adopt self-help measures
such as charging off some asset account against
tax-basis capital at liquidation to avoid a lingering
positive tax-basis capital account when a partner’s
interest is liquidated.
Example 9. Ally and Sarah form a partnership,
each contributing $100,000 in exchange
for a 50-percent interest in all items of the
partnership. During the life of the partnership,
net income of $400,000 is reported for book
and tax purposes, and $20,000 of meals
and entertainment expense is incurred. The
capital accounts appear as shown in Chart
14 immediately after each partner receives a
liquidating distribution of $290,000 (an equal
division of the $380,000 income net of the meals
plus the original $200,000 capital).
47
Partnership Code Sec. 704(b) Capital Account Maintenance
Chart 14.
Code Sec. 704(b)
Ally
Sarah
Tax Basis
Ally
Sarah
Initial Formation
100
100
100
100
Operating
Income
200
200
200
200
<10>
<10>
< 5>
< 5>
<290>
<290>
<290>
<290>
-0-
-0-
5
5
Meals &
Entertainment
Distribution
Ending Capital
The partnership was required to make some debit
entries to reflect the nondeductible meals and
entertainment in the tax basis books. That is, cash
was credited for $20,000, a tax deduction was
debited for $10,000, and there was a balancing
entry. If the partnership created a fictional asset
account, that account could be eliminated with
a credit entry at liquidation with the offsetting
debit made to the capital accounts of both Ally
and Sarah to zero out their tax-basis capital.
Code Sec. 708(b)(1)(B) Terminations
A partnership
rtneershiip terminates
te
under Code Sec. 708(b)(1)(B)
when
heen there
there
h e has
has been a sale or exchange
ha
g of 50
percent
of the interests in ccapital an
and p
profits
erccent or more
m eo
within
12-month
case, a deem
deemed
with
hin a 12-month period.
od. In such a case
ed
transaction
an
nsacttion occurs
occcurs in
i which the “old” partnership
par e hip
transfers
nsferss its assets
aassets to
o a “new”
w” partnership
part ship in
i exchange
ex hange
for all of the
th
h interests of the new partnership, and
the old partnership then liquidates
liquidates by distributing
the interests of the new partnership
partnership to its partners,
which includes the purchasing partner.41 A strict
application of the mechanics of the Code Sec. 704(b)
capital account maintenance rules would require
a restatement of the value of all properties when
they are contributed to the new partnership in this
“assets-over” transaction. However, because this
transfer is merely a deemed transfer, and the actual
transaction is a purchase of a partnership interest,
the Code Sec. 704(b) capital of the selling partner is
simply transferred to the purchasing partner, and no
adjustments are made to partner capital.42
Guaranteed Payments
A guaranteed payment is one that is determined
without regard to the income of the partnership.43 It
is treated as if made to a nonpartner because, unlike
items of the partnership, the partner’s right to the
48
payment is not subject to entrepreneurial risk. The
partnership reports the payment as a separately stated
item on the K-1 of the recipient and deducts the
payment subject to the general tax rules applicable
to deduction or capitalization of partnership items.
Because the payment is made to the recipient partner
in a nonpartner capacity, it does not affect the capital
account of any partner except through the effect of
the deduction of the item by the partnership.44 In this
sense, it is treated the same as if the payment had
actually been made to a third party.
Transfer of a Profits Interest as
Compensation
A partnership may grant a profits-only interest as
compensation for services, with the service provider
avoiding a taxable event at grant. Once the service
provider becomes a partner, he is subject to the
normal distributive share rules with respect to
any income allocable to the profits interest. This
means that if the partnership’s income is Code
Sec. 1231 gain or long-term capital gain, what was
intended to be compensation income may instead
be recognized by the partner at tax-favored rates.
Of course, the partnership loses a deduction for the
putative compensation as a price for granting the
compensatory profits interest holder the benefit of
flowthrough treatment
treatmen for the character of the item.
The other partners
tner benefi
en fit only
nly through
th ough a reduction
reduc ion of
o
their share
with
th
shar of the flowthrough
w rough income
ncome iitem,
em, w
th the
benefi
be
efitt determined
d
mined at rates
rates applicable
ap licable to net capital
ap
gains if the service provider’s gains are taxed at the
favorable rates applicable to such gains.
Rev. Proc. 93-27 defines a profits interest by
reference to what the partner would receive if the
partnership liquidated at the date of grant. To be
a profits interest, the recipient of the interest must
not be entitled to any assets if the partnership were
to liquidate on the date of grant.45 This liquidation
approach to valuation may require a restatement
of the value of partnership properties if there is an
inherent gain with respect to partnership assets at the
date of grant of the award. Reg. §1.704-1(b)(2)(iv)(f)(iii)
makes the grant of the compensatory interest one of
the permitted revaluation events for purposes of the
Code Sec. 704(b) capital account maintenance rules.
Example 10. Ally and Sarah form the AS partnership, with each contributing $500,000 of money
in exchange for a 50-percent interest in all items
of the partnership. The partnership agreement
February 2014
satisfies the alternate test for economic effect.
The partnership uses the contributed money
to purchase a tract of undeveloped land for
$1,000,000. The partners’ intent is to hold the
property for appreciation. Three years later,
after Ally and Sarah believe the property has
appreciated, they decide that they would like to
enhance the land’s value with partnership-level
development activities. Because they are not
experienced in real estate development, they
approach Katie with an offer to help supervise all
development work in exchange for a 20-percent
interest in future development profits. To ensure
that Katie’s share of profits relates only to gains
that occur after the date of the award of the
profits interest, the parties have to agree on the
date-of-award value of the property. Katie would
be expected to argue for a relatively small value
to provide a lower base for measuring future
profits, and Ally and Sarah would argue for a
large value, creating adverse interests. If they
settle on an agreed value of $1,800,000 at the
date of the award, the partnership can restate the
value of the land by $800,000 and then define
Katie’s profit award to be based on Code Sec.
704(b)
capital
04(b
b) ca
apit values. This justifies no current
income
in
ncom
me to
to Katie
K tie
Kat
t by use of a liquidation valuation
off herr interest,
inteerestt,
t because
b
use Code Sec.
Sec 704(b)) capital
p
basis
for
distributions
is thee bas
sis fo
or partners’
ners’ rights to dist
ibutions
in
n liquidation.
liqu
uidaation
n. The
T capital
pital accounts
accounts would
woul then
th n
appear
shown
15.
ap
ppeaar
ar ass sho
ow
wn
n iin Chart
hart 15
Chart 15.
Code Sec. 704(b)
Ally Sarah
Katie
Tax Basis
Ally Sarah Katie
Initial Formation
500
500
500
500
Restatement
400
400
-0-
-0-
-0-
-0-
Ending Capital
900
900
-0-
500
500
-0-
If the partnership later sells the property for
$3,000,000, the development gain would be
$1,200,000, which is split in a 40/40/20 ratio using Code Sec. 704(b) capital values. The tax gain
is $2,000,000, which includes a reverse Code
Sec. 704(c) allocation for the economic gain that
accrued before Katie’s admittance and a postgrant economic gain that is split among all three
partners. The reverse Code Sec. 704(c) item was
reflected in the earlier restatement and creates
TAXES—THE TAX MAGAZINE®
a disparity between Ally and Sarah’s Code Sec.
704(b) and tax-basis capital. Ignoring any other
capital account adjustments for ease of exposition, the capital accounts after sale of the land
and immediately before distribution of proceeds
of sale will appear as shown in Chart 16.
Chart 16.
Code Sec. 704(b)
Ally
Sarah
Katie
Tax Basis
Ally
Sarah Katie
Initial Formation
500
500
500
500
Restatement
400
400
-0-
-0-
-0-
-0-
Sale @ 3000
480
480
240
880
880
240
1,380 1,380
240
1,380 1,380
240
Ending Capital
The restatement at the time of Katie’s admittance
helps to clarify that Katie’s profit share is computed on a base asset value of $1,800,000. Katie’s
award is then ultimately worth 20 percent of
$1,200,000, or $240,000. This gain is reported in
the year of sale of the land based on the character
of income determined at the partnership level.
Tax Credits
Tax credits generallyy have no effect on partnership
capital, either
Code Sec. 704(b) or tax-basis
er for C
capital.
capi
tal. Credits
C its do
d not
no create
c ate an economic
econo
omic benefi
enefit
independent
of tax consequences
in
pend
cons u nces and therefore
theref re do
not adjust
no
adju Code
ode Sec.
Sec 704(b)
704(b capital.
capital Because
Because tax
credits have no effect on Code Sec. 704(b) capital,
an allocation of tax credits cannot have economic
effect.46 Certain tax credits may reduce the tax basis
of the property that gives rise to the credit, and any
recapture of such credits may increase the basis of
that property.47 Where the credit affects the tax basis
of the property, the offsetting entry will be to the
partners’ tax-basis capital accounts, based on how
they share the credit.
Code Sec. 1031 Boot Gain
Allocations: Interaction with
Code Sec. 704(c)
Code Sec. 1031 provides for nonrecognition of gain
or loss when property held for investment or trade or
business use is exchanged for property of a like kind
also to be held for investment or trade or business
use. If non-like-kind property is received as part of the
exchange, the taxpayer recognizes gain measured by
49
Partnership Code Sec. 704(b) Capital Account Maintenance
the lesser of the gain realized on the exchange or the
FMV of non-like-kind property received. The basis of
the replacement property is most simply computed on
the Form 8824 as the cost basis of the replacement
property minus the gain deferred on the exchange.48
If the relinquished property had unrealized Code Sec.
704(c) gain, and the partnership recognizes a portion
of the realized gain as a result of the receipt of boot
in the exchange, an issue arises with respect to the
timing of the recognition of the Code Sec. 704(c)
gain. Specifically, must Code Sec. 704(c) gain be
recognized first, to the extent of the boot received,
or may the boot gain be attributed to economic
gains realized after the contribution that created the
Code Sec. 704(c) gain with the result that it can be
shared by all partners under the economic effect
test? The Code Sec. 704(b) capital account analysis
is the easiest way to track the nature of the boot gain
recognized and to which partner(s) that gain should
be allocated, as shown in the following example.
Example 11. Ally and Sarah form the AS partnership,
with Ally contributing $1,000,000 of money and
Sarah contributing undeveloped land with an
agreed FMV of $1,000,000 and a tax basis of
$600,000.
00,000. All
Al items are agreed to be shared 50
percent
peercen
ntt by
by each
eacch partner and the partnership satisfies
the
the requirements
req
quireemen
nts for the
he alternate test
te for economic
co om
effect.
efffect.. Three
Threee years
yeear afterr formation,
formation the partnership
pa tnership
p
sells
se
ells Sarah’s
S h’s contributed
Sarah
co
ontrib d land for $2,000,000.
$2,000 00 The
T e
funds
Code Sec
Sec. 103
1031 qualifi
ed
escrow,
unds aare held
h in a C
Co
ualifie
d es
row
and the
uses a qualified intermediary
th
he partnership
pa
to facilitate an exchange.
The
partnership
timely
e. Th
e pa
rtner
identifies and receives $1,800,000
$1,800,000 of
o qualifying
replacement property and $200,000 of boot from
the exchange. The partnership has a $1,400,000
realized gain ($2,000,000 – $600,000 basis) and
a $200,000 recognized gain from the exchange.
The partnership has $1,000,000 of economic gain
realized from the sale ($2,000,000 – $1,000,000
date-of-contribution FMV),49 and that gain may be
reflected in the Code Sec. 704(b) capital accounts.
Notwithstanding the existence of unrealized Code
Sec. 704(c) gain with respect to Sarah’s contributed
property, the $200,000 boot gain may be allocated
50 percent to each partner. This gain can be
reflected in the Code Sec. 704(b) capital accounts,
as shown in the capital account analysis, so that
the tax gain may be allocated to both partners
consistent with an economic benefit realized by
each (see Chart 17).
50
Chart 17.
Code Sec. 704(b)
Ally
Contributed Value
Sale of Land
Post-Sale
1000
Sarah
Tax Basis
Ally
1000
Sarah
1000
600
500
500
100
100
1500
1500
1100
700
The tax basis of the replacement property is
$600,000, creating a deferred gain of $1,200,000.
The deferred gain “belongs” $400,000 to Ally
and $800,000 to Sarah, which is reflected in
the disparity between each partner’s Code Sec.
704(b) book and tax-basis capital. There are no
examples, or discussion, in the Code Sec. 704(b)
regulations that relate to the Code Sec. 1031
partial recognition transaction shown above.
However, the regulations do permit following
the principles of the regulations in situations
where specific guidance is lacking.50 Also, an
allocation can have economic effect where
it can be reflected in the Code Sec. 704(b)
capital accounts, and the regulations do have
an example where a post-formation economic
loss is allocated to all partners, even where
the property sold has Code Sec. 704(c) gain
potential.51 The capital
p
account entries shown
above reflect the full
fu economic profit realized
from the
th sale
ale in the
h Code
C de Sec.
Sec. 704(b)
704(b) capital
ca ital
and
book-tax
disparity
both
partners.
d create
cre a boo
ta dispa
ty for bo
h part
e
However,
disparity
$400,000
owev Sarah’s d
sparity remains
emain $400
00
higher than Ally’s, which allows us to continue
to track the built-in gain from her formation
transfer. Although it may also be argued that the
book gain should be $200,000, matching the tax
gain, the conclusion that the taxable gain can be
split by agreement under the economic effect test
will not change. The principles of the Code Sec.
704(b) regulations seem to support reflecting
the full economic gain realized by the sale in
the Code Sec. 704(b) capital accounts because
the end result best reflects the current economic
position of the partnership and states the value of
the replacement property based on arm’s-length
bargaining with the seller of that property.
Debt-for-Equity Exchanges
When a partnership enters into an exchange of a
debt instrument held by a creditor of the partnership
for equity issued by the partnership, the exchange is
February 2014
generally governed by Code Sec. 721. The creditor
recognizes no gain or loss on the exchange and
acquires a tax basis in the partnership interest
by substituting the basis of the debt instrument
exchanged. 52 However, the partnership may
recognize cancellation-of-debt (COD) income to
the extent the FMV of the interest transferred in the
exchange is less than the principal balance of the
debt. Any COD income is allocated to those partners
who were partners at the time of the discharge. If the
creditor has not previously been a partner, no COD
income is allocated to the creditor; if the creditor
were a partner, COD income would be allocated to
the creditor–partner based on the interest held prior
to the exchange.53 Any loss realized by the creditor
as a result of the exchange is impounded in the basis
of the partnership interest. While such a loss appears
like a Code Sec. 704(c) item in the partnership capital
accounts, the property contributed is extinguished
by the exchange and the deferred loss cannot be
recognized until the creditor–partner disposes of
the interest.
Example 12. Ally and Sarah form a partnership
with each contributing $500,000. They borrow
$2,000,000
,00
00,00
00 ffrom Katie and purchase $3,000,000
real
off rea
all property.
pro
operrty
When
W
n thee partnership
parrtn
p is in default
default on payments
payments
Katie’s
on
n Ka
atie’ss debt,
deb
bt, and
an thee principal
princip l balance
balance iss still
s l
$2,000,000,
parties
agree that K
Katie
will
$2
2,00
2
00
00,0
00
000
00, tthe
e p
es agre
atie wi
exchange
hange her
h debt instrument for 60 percent of
the equity of the partnership.
agree
ersh p. The
The parties
pa
that the equity transferred
Katie
has a FMV of
ed to
o Kat
ie ha
$1,500,000. The exchange results in $500,000
of COD income that is allocated to Ally and
Sarah. Katie has a realized loss on the exchange
of $500,000 that is not recognized pursuant to
Code Sec. 721. Katie’s basis in her partnership
interest becomes $2,000,000. The exchange
that establishes $1,500,000 as the value of a
60-percent interest implies total partnership value
is $2,500,000 ($1,500,000/.6). Because Katie’s
debt instrument is cancelled by the exchange,
and does not become an asset of the partnership
(as contributed property typically would be), the
implied value of the real property is $2,500,000,
or $500,000 less than it is currently carried on
the Code Sec. 704(b) books. A revaluation of the
property is then permitted. The capital account
entries are shown in Chart 18.
TAXES—THE TAX MAGAZINE®
Chart 18.
Code Sec. 704(b)
Ally
Initial Formation
Sarah Katie
500
500
Debt-for-Equity
Restatement
Tax Basis
Ally
Sarah Katie
500
500
1500
2000
<250> <250>
COD Income
250
250
-0-
250
250
-0-
Ending Capital
500
500 1500
750
750 2000
This analysis shows total Code Sec. 704(b)
capital of $2,500,000, of which Katie owns
60 percent, and Ally and Sarah each own 20
percent. Ally and Sarah each have a reverse
Code Sec. 704(c) allocation of a $250,000
loss, which reflects the decline in value of the
property before Katie was admitted as a partner.
When the land is disposed of in a taxable
transaction, this loss will be allocated to Ally
and Sarah. Katie’s tax-basis capital exceeds
her book basis capital by $500,000, but since
her debt instrument was extinguished as part
of the exchange, there is no Code Sec. 704(c)
property the sale of which would allow her
to recognize this built-in loss. Instead, Katie’s
realized but unrecognized loss on the debtfor-equity excha
exchange
g will be recognized when
sells her
she se
er partnership
p ne sh interest
interest or receives
receives a
liquidating
distribution
partnership
uida g dist
b io ffrom
m the p
artner h
that
would allow a loss
under
Code Sec
Sec. 731.
at w
oss u
er Cod
3
For example, if the partnership property were
sold for its restated value of $2,500,000, with
liquidating distributions following Code Sec.
704(b) capital, the following entries would be
made as shown in Chart 19.
Chart 19.
Code Sec. 704(b)
Ally
Pre-Sale
Sale @ 2500
Distribution
PostLiquidation
Sarah
500
500
0
0
Tax Basis
Katie
1500
Ally
750
Sarah
Katie
750
2000
0 <250> <250>
0
<500> <500> <1500> <500> <500> <1500>
-0-
-0-
-0-
-0-
-0-
500
Katie’s unrecovered $500,000 tax basis will
be recognized as a capital loss when the
partnership liquidates.
51
Partnership Code Sec. 704(b) Capital Account Maintenance
Noncompensatory Option:
Grant and Exercise
In addition to the grant of an equity interest in
exchange for services, which may include the grant
of options to acquire equity, partnerships can grant
noncompensatory options to acquire interests.
The noncompensatory option (NCO) provisions
apply to call options, warrants,54 convertible debt
instruments and convertible equity. The grant of
an NCO is generally treated as a open transaction,
so there is no immediate tax effect to the NCO
holder or to the partnership. The amount paid to
the partnership in exchange for grant of the NCO
is debited to the partnership books (however they
may be maintained), and the offsetting credit is
to a premium account. Although neither of these
entries affects partnership capital, the grant of
the NCO is a permitted revaluation transaction.
Any unrealized gain or loss with respect to
partnership properties “belongs” to the existing
partners, and the revaluation allows the capital
accounts to reflect the value attributable to capital
represented by existing interests to prevent a shift
of pre-grant gains and losses to the recipient of an
NCO.
NCO holder has no capital account at
O. The
T NC
N
this
is time
time because
tim
becau
us he is not yet a partner, so any
restatement
just
capital accounts
esttatem
men t ju
st affects
cts the cap
co n of
existing
partners.
xisstingg pa
rtneers.
Upon
exercise
transfer
of the
U
pon
n exe
ercisse of the
e NCO, tthe
e tran
fe o
he
option
tiion exercise
exerrcise
e price
pric
ri in exchange
excha e for an
n interest
nterest
is not a taxa
taxable
b event pursuant to Code Sec. 721.55
The new partner’s capital
al account,
account, for
fo both Code
Sec. 704(b) book and tax,, is tthe
of the amount
he ssum
um o
previously paid for grant of the NCO (which is now
moved from a premium account to partner capital)
and the strike price paid to acquire the interest.
Exercise is also a revaluation event, which allows
the Code Sec. 704(b) capital accounts to reflect
the value of partnership properties pre-exercise
and also creates a Code Sec. 704(c) layer for the
pre-exercise gain or loss. The NCO partner will
be entitled to a Code Sec. 704(b) capital account
adjustment to refl ect his share of appreciation
from the date of grant through the date of exercise.
The NCO holder’s Code Sec. 704(b) capital, postadjustment, should then reflect his date-of-exercise
proportionate share of total Code Sec. 704(b)
capital. The revaluation must take into account the
effect of any prior revaluation that occurred at grant
52
of the NCO.56 The revaluation must also adjust
the FMV of partnership properties, either up or
down, to reflect the share of that FMV represented
by other NCOs outstanding at exercise. This is
because outstanding NCO holders have secured,
through the call feature of the NCO, a right to some
of the partnership asset value. If the FMV of the
outstanding NCOs exceeds the option premium
paid by the holders, the value of partnership
properties is reduced in the revaluation. If the
FMV of the outstanding NCOs is less than the
option premium paid by the holders, the FMV of
partnership properties is increased.57
Example 13. Ally and Sarah form the AS
partnership with each contributing $500,000
of money. The partnership satisfies the
requirements for the alternate test for economic
effect. The partnership uses the contributed
capital to purchase $1,000,000 of undeveloped
land. At a time when the land is valued at
$1,500,000, the AS partnership grants an
option to Katie to acquire a 25-percent interest
in exchange for paying an exercise price of
$500,000. Katie pays an option premium of
$40,000 for the right to exercise the option
at any time within the next three years. When
the land has
to $2,020,000, Katie
as appreciated
app ec
exercises the
option.
exercis
he o
io . Capital
ap ta account
ac ount entries
en ries
willl be made
20.
de aas shown
h wn in Chart 20
Chart 20.
Code Sec. 704(b)
Ally
Sarah Katie
Initial Formation
500
500
Grant Revaluation
250
250
-0-
-0-
Exercise
Revaluation
210
Ending Capital
960
Exercise
Tax Basis
Ally
Sarah Katie
500
500
540
-0-
-0-
540
210
100
-0-
-0-
-0-
960
640
500
500
540
The entries in the example require more
explanation that can be provided by the one-sided
entries shown to the capital accounts. When the
option is granted to Katie, the partnership makes
the entry to its Code Sec. 704(b) and tax basis
books as shown in Chart 21.58
February 2014
Chart 21.
Cash
40,000
Option Premium
40,000
The land is revalued to its date-of-grant value of
$1,500,000, with the capital accounts of Ally and
Sarah adjusted to reflect how they would share
the gain attributable to the appreciation shown
in Chart 22.
each. The restatement of the land then must
adjust economic-based capital to lead to
these respective interests and is then shown
in Chart 24.
Chart 24.
Land
520,000
Ally capital
210,000
Sarah capital
210,000
Katie capital
100,000
Chart 22.
Land
500,000
Ally capital
250,000
Sarah capital
250,000
This entry is to reflect the pre-grant appreciation,
which economically belongs to Ally and Sarah.
At exercise of the option, the date that Katie
becomes a partner, Katie’s capital account is
credited for the option exercise price as well
as the option premium (which is eliminated
from the books by this entry) previously paid
in Chart 23.
Chart
ha
art 23.
23
Cash
C
assh
h
Opt
tion P
Premi
um
Option
Premium
atie cap
p
pital
Katie
capital
500,0
500,000
000
40,000
40,00
00
540,000
The land is again revalued,
eval ued this
thi time by
$520,000, to its date-of-exercise
e-of -exe rcise value of
$2,020,000. The offsetting credits reflect how
the partners share in the economic gains
associated with this appreciation. Katie is
entitled to some of the appreciation because,
during the period she held an open option
position, the option conferred an economic
right to a share of the appreciation in the
value of the property. Following exercise,
Katie holds a 25-percent interest in partnership
capital, Ally holds 37.5 percent, and Sarah
also holds 37.5 percent. Total capital will be
$2,560,000, the sum of the value of the land
($2,020,000) and the $540,000 cash received
from the grant and exercise of Katie’s option.
Katie’s share is $640,000 (25 percent), and Ally
and Sarah’s share is $960,000 (37.5 percent)
TAXES—THE TAX MAGAZINE®
The land has a Code Sec. 704(b) book basis of
$2,020,000 and a tax basis of its original cost of
$1,000,000. When sold, there is $1,020,000 of
Code Sec. 704(c) gain to allocate, with $920,000
allocated to Ally and Sarah and $100,000 to
Katie. Katie’s share is based on her sharing in the
appreciation as a result of her option position,
which provided her with some measure of equity
ownership during the period the option was
open. A call option allows the holder to share in
appreciation in the underlying asset subject to
the option right, without risk of loss beyond the
amount paid to acquire the option position, an
economic right that justifies the payment of the
option premium.
Thee above
example
Th
ab
ex p is
i more
more complicated
comp icated than
tha
the
previouss one
ones b
because
revaluation
must
th prev
ca se the
he reva
uation m
recognize
economic
position
re ogniz the
he eco
no mic p
ition of the option
p
holder from date of grant through date of exercise.
If the partnership holds multiple properties, and
one property is sold between the grant date and
exercise date, the revaluation and adjustment to
the capital of the option holder are even more
complicated. This is so because the disposition of
the asset prior to exercise prevents the partnership
from using a revaluation to record the option
holder’s share of the post-grant gain attributable
to the property that was disposed. To correct
this, the NCO regulations provide for a capital
account reallocation using “corrective” allocations.
Corrective allocations result in a capital shift from
existing partners to the option partner to reflect
the option holder’s share of post-grant economic
gains that had been allocated only to the partners
holding interests at the date of sale.59 The correction
is to effectively “true-up” the tax allocations
with the overall economic arrangement of the
53
Partnership Code Sec. 704(b) Capital Account Maintenance
partners. The option partner then ends up with the
proper amount of post-grant gain that would have
occurred had the property disposed of instead been
held until the option partner became a legal owner
of the interest.60
Conclusion
Partnership Code Sec. 704(b) capital accounts are
generally used when the partnership agreement
is drafted to satisfy one of the safe harbors for
economic effect and the safe harbor to deem
allocations of nonrecourse deductions to be
in accordance with the partners’ interests.
The economic effect test is satisfied when tax
deductions are allocated to the partner who
bears the economic detriment associated with
the deduction, and taxable income is allocated
to the partner who enjoys the economic benefit
associated with the income. The purpose of the
Code Sec. 704(b) capital accounts is to show the
economics of the partners’ arrangement, so that
it is possible to track the benefits and detriments
associated with tax allocations. Code Sec. 704(b)
capital is also useful in tracking Code Sec. 704(c)
allocations, which are generally measured by the
disparity between Code Sec. 704(b) and tax-basis
capital and permitted revaluations to Code Sec.
704(b) capital allow the partnership to also track
reverse Code Sec. 704(c) allocations. Finally,
where Code Sec. 704(b) capital is used to reflect
partnership economics, it is easier to understand
a variety of other partnership-related tax issues
arising from transactions undertaken for economic
reasons. Where tax allocations must follow
associated economic benefits and burdens, capital
accounts that reflect the economic arrangement
can be crucial to properly allocating the tax
consequences of a transaction. This article reviews
those transactions most commonly encountered
by the tax adviser and illustrates how to make the
required capital account adjustments.
ENDNOTES
1
2
3
4
5
6
2012 IRS SOI Tax Statistics, Table 21. S
corporations remain the most popular
entity
ty ty
type,
ype, w
with 2012 Form 1120S filings
approximating
pp
pro im
proxim
mating 4.5
45m
million.
Code
Co
ode Sec.
S
7
704(b
704(b)
b) book refers to the
capital
cap
pital
i l account
a
accou
unt maintenance
main
i
e rules found
in Reg. §1.704-1(b)(2)(iv),
§1.70
04-1(b
b)(2)
which
ich are often
incorporated
inc
corporrated by re
reference
fere
in a partnership
agreement.
agr
reeme
ent. The
T
te
term
er m cca
can be confusin
confusing
because
ause practitioners
practtition often think of financial
accounting principles when the term “book”
is used. However, since Treasury Regulations
egula ions
are drafted for tax purposes, “book”
“boo k” is
instead defined as a shortened reference
refer nce
to Code Sec. 704(b) book, which assists
in applying tax principles to partnership
allocations.
Reg. §1.704-1(b)(2)(ii)(b).
In partnership convention, the terms
“liquidating” and “nonliquidating” refer
to whether the distribution terminates
the interest of the distributee partner. The
partnership itself may continue to exist in
either type of distribution. This contrasts with
the entity-type approach of corporations
where a liquidating distribution refers to one
that terminates the corporate existence.
Reg. §1.704-1(b)(2)(ii)(b) and (d).
Reg. §1.704-2(e). Allocations of
nonrecourse deductions cannot have
economic effect because the economic
detriment associated with the deductions
is borne by the nonrecourse creditor.
Thus, such allocations must be made in
54
7
8
9
10
11
accordance with the partner’s interest in
the partnership. Satisfying the safe harbor
will allow the allocation specified in the
agreement to be deemed to satisfy the
partner’s
ne interest test.
Reg. §§1.704-3(a)(3)(i)
R
.704-3 a)(3)(i identifi
dentifies Co
Code Sec.
c.
704(c)
704
c) property
op y by a d
disparity
sparity betw
between the
he
property’s
pro
er s C
Code
e Sec. 7
704(b)
4( book
ok va
value and
nd
that property’s
tha
property’s tax
tax basis.
basis Reg.
Re §1.704-3(a)(6)(i)
1.704-3
(i)
similarly identifies “reverse” Code Sec.
704(c) property by reference to disparities
created by revaluations permitted by Reg.
§1.704-1(b)(2)(iv)(f).
See, for example, Simon Friedman,
Noncompensatory Capital Shifts: Rethinking
Capital Accounts, 107 TAX NOTES 597 (May
2, 2005), Doc 2005-6565, 2005 TNT 84-43.
For a review of factors used in measuring
the partner’s interest in the partnership, and
the difficulties in applying those factors, see
Reg. §1.704-1(b)(3), Vecchio, 103 TC 170,
Dec. 50,027 (1994), J.R. Tobias Est., 81 TCM
1163, Dec. 54,245(M), TC Memo. 2001-37,
and M.W. Ballantyne Est., 83 TCM 1896,
Dec. 54,796(M), TC Memo. 2002-160, aff’d
CA-8, 2004-1 USTC ¶50,120, 341 F3d 802.
See Reg. §1.704-1(b)(2)(ii)(b) for a description
of the three-requirements test and Reg.
§1.704-1(b)(2)(ii)(d) for a description of the
alternate test.
Where the distributions are based on
ending capital balances, it is common
to build up capital with allocations of
gain from sale of partnership assets to
12
13
match capital to the partners’ agreed-to
allocations of money. This can create
multiple tiers of gain allocation, often
referred to as a “layer cake” approach,
to reflect the agreed priority of cash
allocations.
layer
al ca n . The
T
la r cake
ake approach
a proac
can
be co
complicated
mustt al
also
ca b
mp cate aass it mu
consider
any m
minimum
charge
co sid an
nimum gain
ain char
e back
or qualified
qualifie income
ncome offset
o et allocations.
allo at
It is wise to test how the layers match
partners’ expected cash distributions in a
variety of possible economic states of the
partnership.
See Reg. §1.704-1(b)(2)(iv)(h). The use of
Code Sec. 704(b) capital as the basis for
liquidating distributions will generally
create the adverse interests needed to
use partner agreements with respect to
FMV as acceptable for Code Sec. 704(b)
capital account maintenance. There is a
limited exception to the capital accounts
determining rights to assets that may apply
when a partner’s interest is purchased at a
price negotiated at arm’s length. It is not
clear to what extent this exception may
be relied upon when the partnership is the
purchaser. See Reg. §1.704-1(b)(2)(ii)(b).
To ensure that partners receive what
their deal points state, Code Sec. 704(b)
compliant agreements must rely on often
complex gain allocation tiers to build up
capital to match the partners’ agreement
as to division of assets. These provisions,
when written in a partnership agreement,
February 2014
14
15
16
17
18
19
20
can be confusing to partners expecting
to see a clear statement of how assets
will be distributed. Target allocation
provisions seek to minimize confusion
to the partners by a clearer statement
of what each partner’s share of assets
will be and then use income and loss
allocations to create capital accounts
that match the distributions. However,
target allocation provisions do not base
liquidating distributions on Code Sec.
704(b) capital account determinations, so
they do not comply with any safe harbor
for economic effect. If the values assigned
to partnership properties do not affect the
amounts to be received by the partners
upon liquidation, it is more difficult to
argue that the agreed-to values are based
on bargaining by parties with adverse
interests.
The partnership may maintain multiple
capital account records for different
purposes. The examples in this article
show both Code Sec. 704(b) and tax
basis capital, and a comparison of those
two capital accounts facilitates, among
other items, tracking Code Sec. 704(c)
allocations, as is also shown in the
examples in Reg. §1.704-3. The IRS MSSP
for partnership allocations notes that an
examiner may see tax basis capital on a
partnership return even if the partnership
also has Code Sec. 704(b) capital to satisfy
a safe
afe harbor
h
r for economic effect.
Reg.
Re
eg. §1
§1.704-3(a)(2)
1.704
4-3(a))(2 applies Code Sec.
704(c)
70
04(c) on a property-by-property
p p
prop
pert
property basis.
However,
Ho
owevver, Reg.
R
§1.
§1.704-3(e)(2)
(e)(2) allows
items
ite
ems in
n the same
s
Code
Co Sec. 168 recovery
Cod
period,
pe
eriod, other
otheer than
thaan real property,
perty, to be
b
aggregated.
g
ggrega
ated. Securities
ated
Secu
ur ies
es partnerships
p
erships are
a
also granted
grranted
d flexibility
fl
in aggregating
for purposes of reverse Code Sec. 704(c)
( )
allocations.
The alternate test requires that the
partnership will maintain Code Sec. 704(b)
capital, that distributions in liquidation
of a partner’s interest will be made in
accordance with Code Sec. 704(b) capital
and that the partnership agreement
contains a qualified income offset. See
Reg. §1.704-1(b)(2)(ii)(d).
A sale of contributed property for its
agreed-to value at date of contribution
simply changes the type of asset recorded
on the debit side of the balance sheet but
does not affect the partnership’s economic
position.
See Reg. §1.704-1(b)(5), Example 14.
This is why the Reg. §1.704-3 examples all
illustrate the application of Code Sec. 704(c)
principles by using Code Sec. 704(b) and tax
basis capital accounts.
This is assumed for ease of computations.
C o d e S e c . 1 6 8 ( i ) ( 7 ) w i l l h ave t h e
partnership step into the shoes of the
TAXES—THE TAX MAGAZINE®
21
22
23
24
25
26
27
28
29
30
31
1
32
33
34
35
36
37
38
39
40
41
contributing partner with respect to
cost recovery conventions, including
determination of the cost recovery year.
Reg. §1.704-1(b)(2)(iv)(g)(3).
Reg. §1.704-3(b)(1).
See Reg. §1.704-2(d)(4) for the effect of
revaluations on computations of changes in
partnership minimum gain (used to measure
nonrecourse deductions and determine
the timing and amount of minimum gain
chargebacks).
The Code Sec. 704(b) regulations only
use examples where the post-formation
interest transfer is made to a new partner.
See Reg. §1.704-1(b)(5), Examples 14
and 18. This is computationally simple,
but it requires the practitioner to develop
the analysis required for a transfer to an
existing partner.
Partnership distributions of property are
not taxable under the Code Sec. 731
distribution rules. In appropriate fact
patterns, a distribution may cause a
partner to recognize gain pursuant to a
disguised sale under Code Sec. 707(a)(2)
(B) or to accelerate recognition of Code
Sec. 704(c) gain under Code Sec. 704(c)
(1)(B) or 737. If any of these anti-abuse
provisions apply, the distributee still has
an incentive to argue for a low value to
be assigned to the distributed property to
reduce gain to be reported.
Reg. §1.704-1(b)(2)(iv)(e).
Code Sec. 732(a)(1).
Code Sec. 733(2).
This also
a o illustrates the adverse interests
st
involved
in
olv d in the
the partners’
partne ’ negotiations
nego
otiatio of the
he
valuee of the
va
th distributed
istribute lo
lot. Had
ad Katie been
en
able
ab
e to negotiate
eg ate a smaller
le value,, he
her capital
ta
would
w
uld bee closer
clo er in li
line tto that
hat of tthe other
he
partners.
Reg. §1.704-1(b)(2)(ii)(a) includes a
statement of fundamental principles.
Reg. §1.734-1(b)(1) and (b)(2).
Reg. §1.704-1(b)(2)(iv)(m)(4).
Because Katie is redeemed with money,
there is no requirement to restate the
value of any properties. However,
the partnership may, in a liquidating
distribution, choose to restate the value of
undistributed properties because the arm’slength bargaining required to determine
the value of the liquidated partner’s interest
provides objective evidence of the value of
all properties.
Code Sec. 732(b).
Reg. §1.734-1(b)(2)(ii).
Reg. §1.743-1(k)(2) and (k)(4).
Reg. §1.743-1(j)(1) and (j)(2).
See Reg. §1.704-1(b)(2)(iv)(l) and (b)(5),
Example 13(ii) and §1.704-3(a)(7).
Reg. §1.704-1(b)(2)(iv)(m)(2) and (b)(5),
Example 13(iii) and (iv).
Rev. Rul. 96-10, 1996-1 CB 138.
Reg. §1.708-1(b)(1)(iv).
42
43
44
45
46
47
48
49
50
51
52
5
53
54
55
Reg. §1.704-1(b)(2)(iv)(l). The only
change is the new partnership is not
bound by the consistency rules for the
method of Code Sec. 704(c) allocations
(Reg. §1.704-3(a)(2)).
Code Sec. 707(c).
Reg. §1.704-1(b)(2)(iv)(o). Of course,
there may be a dispute as to the character
of the payment as a guaranteed payment
or perhaps a normal distribution. If the
partnership wants the item to be treated
as a guaranteed payment, it is important to
make its status clear by agreement among
the partners.
Rev. Proc. 93-27, 1993-2 CB 343. See also
Proposed Reg. §1.704-1(b)(4)(xii) for other
provisions that may, when the regulations
are finalized, be required in the partnership
agreement to use the liquidation valuation
approach.
See Reg. §1.704-1(b)(5), Example 11(i).
Reg. §1.704-1(b)(2)(iv)(j).
Code Sec. 1031(d) is the official means by
which the basis of replacement property
is computed. The basis is the basis of the
relinquished property increased by any
gain recognized and the FMV of any boot
property transferred and reduced by any
loss recognized and the FMV of any boot
property received.
This is the economic gain of the partnership
measured relative to the agreed FMV of the
property at date of contribution.
Reg. §1.704-1(b)(2)(iv)(r).
Reg. §1.704-1(b)(5), Example 14(iii).
Code Sec. 722.
C
COD
C
D income
ome in a partne
partnership
ship is generally
enera
aallocated
ca
to
t the partner(s)
partner( ) who enjoy
e jo the
benefi
b
efit of thee debt discharge,
dis arg under
de the
general
ge
eral principles
pri ples of the
t economic
econom c effect
test. However, the specific application of
the economic effect test to COD income is
beyond the scope of the analysis presented
in this article.
Although people often use the terms
interchangeably, or mix the definitions,
warrants are generally defined to be dilutive
because new partnership units would be
issued upon exercise, whereas options are
generally nondilutive because the option is
to acquire an existing interest.
An NCO may be settled for cash rather
than for an equity interest, and a cash
settlement may create a gain or loss to the
partnership measured by the difference
between the amount paid at settlement
and the amount received at grant. If the
NCO lapses unexercised, the partnership
will also have a gain for the option
premium received at grant. These gains
or losses will affect the capital of existing
partners in the same manner as any item
of gain or loss but are not an issue for
this article, which is limited to discussion
of Code Sec. 704(b) capital account
55
Partnership Code Sec. 704(b) Capital Account Maintenance
56
57
adjustments to reflect the economics of
partnership transactions.
See Reg. §1.704-1(b)(5), Example 31, for
the adjustments made at grant and exercise
of the NCO.
Reg. §1.704-1(b)(2)(iv)(h)(2).
58
The premium is paid for the right, but
not the obligation, to exercise the NCO
pursuant to its terms. The transaction is
treated as open until the option is either
exercised or allowed to lapse. The entry
shown does not affect any partner’s capital
59
60
because the option premium is part of
an open transaction. The premium will
affect capital upon exercise or lapse of
the option right.
Reg. §1.704-1(b)(2)(iv)(s)(3) and (s)(4).
See Reg. §1.704-1(b)(5), Example 32.
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56