Chapter 6 – Allocation of Partnership Income Among the Partners: The
Substantial Economic Effect Requirement
What requirements must be met in order for an allocation of income or loss to
have economic effect?
(a) Capital accounts must be properly maintained
(b) Liquidating distributions must be made according to capital accounts
(c) Partners must be required to restore deficit capital accounts upon
liquidation
1.
A, B, and C form the equal ABC partnership. Capital accounts are properly
maintained. Depreciation is allocated completely to C, but any distributions in
liquidation will be made equally to each partner, although partners are required to
restore deficit capital accounts upon liquidation. Does the allocation of
depreciation have economic effect?
No. Liquidating distributions must be made according to capital accounts
2. A, B, and C form the equal ABC partnership. Capital accounts are properly
maintained. Depreciation is allocated completely to C, and any distributions in
liquidation will be made according to the capital accounts of each partner.
However, under local law any excess of liabilities over assets at the time of
liquidation must be made up equally by each partner. Does the allocation of
depreciation have economic effect?
No. Partners must be required to restore deficit capital accounts upon
liquidation, although it can be local law, rather than the partnership
agreement, that requires the restoration.
3. A, B, and C form the equal ABC partnership by contributing $100,000 each, and
purchasing some equipment for $300,000. The equipment has a depreciable life
of six years, and all depreciation (straight line) is allocated to A. Capital accounts
are properly maintained. Any distributions in liquidation will be made according
to the capital accounts of each partner. Partners are required to restore deficit
capital accounts upon liquidation. Income aside from depreciation is $60,000
each year. If the partnership were liquidated at the end of year three, how much
would each partner get?
Contribution
Income (3 yrs)
Depreciation (3 yrs)
Liquidation
Amount
A
$100,000
$60,000
- $150,000
$10,000
B
$100,000
$60,000
C
$100,000
$60,000
$160,000
$160,000
What would your answer be if the liquidation occurred at the end of year four?
Contribution
Income (4 yrs)
Depreciation (4 yrs)
Capital Account
Balance
Liquidation amount
A
$100,000
$80,000
- $200,000
-$20,000
B
$100,000
$80,000
C
$100,000
$80,000
$180,000
$180,000
$0
$180,000
$180,000
Note that the only way B and C will actually receive $180,000 each is if A contributes
$20,000 to the partnership. Otherwise the partnership assets will only total $300,000 +
$240,000 - $200,000 = $340,000 (assuming the equipment is sold for its adjusted basis
at the time of liquidation). If this were the case then B and C, not A, would be bearing
the economic burden of the last $20,000 of depreciation deduction allocated to A.
4. Partner A of the AB partnership has $100,000 of NOLs, and partner B has
$100,000 of long term capital losses. The partnership is expected to earn
$100,000 of ordinary income and $100,000 of long term capital gains during the
year. The partnership agreement is amended to allocate this year’s ordinary
income to A and long term capital gain to B. Assume that the three tests for
economic effect are met. Is this allocation substantial? Why or why not? What
type of allocation is it, a shifting allocation or a transitory allocation? Would the
allocation be substantial if A did not have a net operating loss carryforward?
This allocation is not substantial, because there is at least one partner (in this case
both of them) who benefits, on a present value basis, from the allocation, and there
is a strong likelihood that none of the partners will be hurt by the allocation, again
on a present value basis. This is an example of a shifting allocation, because it
occurs in one year. Transitory allocations are allocations that occur in one or
more current years and are offset by other allocations in future years. If A did not
have a net operating loss carryforward, then the allocation would be substantial.
This is because the allocation of all of the ordinary income to A would not result in
a strong likelihood that the after-tax consequences of no partner would be
diminished, since A’s consequences would almost certainly be diminished. This is
due to the fact that without the special allocation A would have $50,000 of ordinary
income and $50,000 of long term capital gain, which would be subject to a
maximum tax rate of 15%. With the special allocation, A instead has $100,000 of
ordinary income, all subject to regular tax rates.
5. The ABCD Partnership owns an office building. In a special allocation that has
economic effect, partner D is allocated all of the depreciation from the building,
and all of the gain from any sale of the building, up to the amount of depreciation
taken. Any gain in excess of depreciation taken is to be split equally among the
partners. The building is expected to be sold for a substantial gain within four
years. Is this allocation substantial? Why or why not?
Yes, this allocation is substantial, because the fair market value of the building in
the future when it is sold is presumed to be equal to its book value. This would
mean that there is a nonrebuttable presumption that there will be no gain on the
sale, and D’s decrease in her capital account from the extra depreciation is not
expected to be made up by the gain, at least according to the tax rules. Her
potential hypothetical liquidation proceeds from the partnership would therefore be
reduced by the additional depreciation, by an amount that exceeds the tax savings
from her additional depreciation deductions. In short, there would not be a strong
likelihood that no partner would be hurt by the allocation, so the allocation would
be substantial.
Paragraph 607.
1. Suppose that a partner’s capital account balance and tax basis in her partnership
interest is $200, and the FMV of her partnership interest is $300. In liquidation of
her interest she gets distributed property with a FMV of $300 and a book value of
$200. She had a 25% interest, so this leaves her with a capital account of $200 +
$25 - $300 = -$75. She is no longer a partner, so what can the partnership do to
make this deficit capital account go away?
It can revalue all partnership assets, and the book gain on the remaining assets should
zero out her capital account.
2. If a partner contributes encumbered property to a partnership, what are the effects
on his capital account for book purposes? How is this different from the effects
on his basis when he contributes encumbered property?
The capital account is increased by FMV – liability.
His basis will be increased by basis of the property – liability + his share of the liability
(through the partnership).
3. If a partnership distributes encumbered property to a partner, what are the effects
on her capital account? How is this different from the effects on her basis when
she is distributed encumbered property?
The capital account is increased/reduced by her share of the book gain/loss, and the
capital account is then reduced by FMV – liability assumed.
Her basis will be decreased by the basis of the property, increased by the liability
assumed, and is decreased by her reduction in her share of the partnership’s liabilities.
4. Partner A is a 25% partner, and has a basis in her interest and capital account
balance of $200,000. She contributes some land (FMV = $100,000, basis =
$60,000, liability attached = $40,000) to the partnership. How much are her book
capital account and basis afterward?
Book capital account: $200,000 + $100,000 - $40,000 = $260,000.
Basis = $200,000 + $60,000 -$40,000 + $10,000 (share of liability) = $230,000.
Chapter 7 – Allocation of Income and Losses from Contributed
Property: Code Sec. 704(c)
Reading:
Paragraphs 701-702.
1. T and K formed new partnership TK to operate a charter boat service in Florida. T
contributed a boat with a tax basis of $210,000 and a fair market value of
$350,000. K contributed $350,000 cash. The partnership agreement allocates
profits, losses, and capital 50% to each partner. The agreement satisfies the
requirements of Code Sec. 704(b).
a. Assume the fishing boat is depreciated using the straight-line method over 7
years. Further assume that the partnership deducts a half-year of depreciation
expense in its first year of operations. How will year 1 book and tax
depreciation be allocated between the partners?
Under Code Sec. 704(b), book depreciation will be allocated equally in
accordance with the partnership agreement. The allocation of tax
depreciation, however, must be allocated under Code Sec. 704(c) in a
manner that reflects the difference between the book and tax basis of the
boat. Sec. 704(c) requires that tax depreciation be allocated to the noncontributing partner in the same amount as she is allocated for book if
possible. The remainder, if any, will be allocated to the contributing
partner:
T
Book depreciation ($350,000 ÷ 7 x ½)
Tax depreciation ($210,000 ÷ 7 x ½)
K
∑
$12,500
$12,500
$25,000
2,500
12,500
15,000
b. Assume the partners agreed to dissolve the partnership at the end of year 1. The
partnership sold the boat for $400,000 and liquidated. How much gain will it
recognize on sale of the boat for book and tax? How will this gain be allocated
between the partners?
As with depreciation expense, K (the non-contributing partner) is allocated
tax gain in an amount equal to her book allocation. Under Code Sec. 704(c),
the remainder is allocated to T (the contributing partner):
T
K
∑
Book gain ($400,000 –[325,000])
$37,500
$37,500
$75,000
Tax gain ($400,000 –[210,00015,000])
167,500
37,500
205,000
2. Assume the same facts as above, except that the tax basis of the fishing boat was
only $140,000, rather than $210,000. If the partnership uses the traditional
method under Code Sec. 704(c), how will year 1 tax depreciation be allocated
between the partners?
Under Code Sec. 704(b), book depreciation will be allocated equally in
accordance with the partnership agreement. The allocation of tax depreciation,
however, must be allocated under Code Sec. 704(c) in a manner that reflects the
difference between the book and tax basis of the boat. Sec. 704(c) requires that
tax depreciation be allocated to the non-contributing partner in the same
amount as she is allocated for book if possible. The remainder, if any, will be
allocated to the contributing partner:
T
Book depreciation ($350,000 ÷ 7 x ½)
Tax depreciation ($140,000 ÷ 7 x ½)
K
∑
$12,500
$12,500
$25,000
0
10,000
10,000
3. Assume the tax basis of the fishing boat was $140,000 as above. Further assume
that the partnership used the traditional method to allocate tax depreciation in year
1, and that at the end of year 1, it sold the boat for $400,000 and liquidated. How
will it allocate book and tax gain between the partners? Will this allocation offset
the distortion caused by the ceiling rule in allocating year 1 depreciation between
the partners?
As with depreciation expense, K (the non-contributing partner) is allocated tax
gain in an amount equal to her book allocation. Under Code Sec. 704(c), the
remainder is allocated to T (the contributing partner):
T
K
∑
Book gain ($400,000 –[350,00025,000])
$37,500
$37,500
$75,000
Tax gain ($400,000 –[140,00010,000])
232,500
37,500
270,000
4. A and B form the equal AB partnership. A contributes property (FMV =
$100,000, basis = $60,000) and B contributes $100,000 cash. The property is
depreciated straight line over a 10 year life for both book and tax purposes. Using
the traditional method under Code Sec. 704(c), how much of the tax depreciation
in the first year will A get? How much will B be allocated? How much of the
gain would be allocated to A if the asset is sold for $110,000 at the beginning of
year 2?
Book depreciation for the asset is $10,000, and tax depreciation is $6,000. The
noncontributing partner (B) will be allocated tax depreciation up to her book
depreciation, or $5,000. A will be allocated the rest, $1,000. Each year for 10 years A
will get $4,000 less in depreciation than B, which is somewhat equivalent to having to
recognize the $40,000 gain.
The total gain would be $110,000 - $54,000 = $56,000. After year 1, the remaining
book/tax differential (built-in gain) for the property is $90,000 - $54,000 = $36,000. A
would have to recognize all of this $36,000 plus 50% of the remaining gain of $20,000,
for a total of $46,000.
Reading:
Paragraph 703.
1. Daisy Tree Partnership owns and operates two apartment complexes in the
metropolitan area. The first complex was contributed to the partnership by partner L.
The other two partners (M and N) contributed cash which, together with borrowed
funds, was used to purchase the second complex. The three partners share partnership
income, loss, gain and deduction equally. The tax basis and book value of the
partnership’s assets at the end of the current year are as follows:
Tax
Book
$60,000
$60,000
0
45,000
600,000
1,500,000
Accumulated depreciation, complex 1
(120,000)
(300,000)
Apartment Complex 2
2,475,000
2,475,000
Accumulated depreciation, complex 2
(180,000)
(180,000)
200,000
200,000
$2,035,000
$4,070,000
Cash and equivalents
Receivables
Apartment Complex 1
Land and other assets
Total assets
a.
Assume that the partnership uses the traditional method with curative allocations
to make allocations under Code Sec. 704(c). Further assume that complex 1 has a
remaining useful life of 8 years for book and tax. Complex 2 has a remaining
useful life of 25.5 years. Both are depreciated using the straight line method for
both book and tax. Show how book and tax depreciation will be allocated among
the partners.
L
Tax
Book
Book
depreciation,
Complex 1
Tax depreciation,
Complex 1
Curative
allocation, depr.
Complex 2
Totals
Tax
(50,000)
0
Book
depreciation,
Complex 2
Tax depreciation,
Complex 2
M
Book
(30,000)
(30,000)
30,000 _______
(80,000)
Tax
(50,000)
(30,000)
0
N
Book
(50,000)
(30,000)
(30,000)
(30,000)
(30,000)
(30,000)
(15,000) _______
(15,000) _______
(75,000)
(75,000)
(80,000)
(80,000)
b. Does the curative allocation of depreciation on complex 2 from L to M and N
completely “cure” the discrepancy caused by the ceiling rule with respect to the
allocation of depreciation on complex 1?
No. Partners M and N are each allocated total book depreciation of $80,000,
but only $75,000 for tax. They are short $20,000 each on complex 1. The
curative allocation is only $15,000. Thus, a $5,000 discrepancy remains.
c. How can the partnership eliminate the remaining discrepancy?
If the partnership has ordinary income from other sources (e.g., rent), it can
allocate $10,000 of this income away from M and N ($5,000 each) and to L to
cure the remaining discrepancy. If it does not have any ordinary income from
other sources, it can correct the discrepancy in a future year when it does have
such income.
2. Assume the partnership in the above problem sells apartment complex 1 in
January next year for $1,000,000.
a. What will be its gain or loss for book and tax?
The book and tax bases of the apartment complex and the gain or loss to be
recognized by the partnership are as follows:
Tax
Book
Original cost/book value
$600,000
$1,500,000
Accumulated depreciation
(180,000)
(450,000)
Net tax basis/book value
$420,000
$1,050,000
$1,000,000
$1,000,000
$580,000
(50,000)
Selling proceeds
Gain (loss)
b. How will the tax gain be allocated between the partners?
All $580,000 of the tax gain will be allocated to partner L, the contributing
partner. There was no gain for book and thus, no gain can be allocated to the
non-contributing partners (M and N).
c. Does the application of the ceiling rule create any book/tax distortions under
Code Sec. 704(c)? Can this discrepancy be cured this year?
Yes, the ceiling rule prohibits the partnership from allocating a loss on sale of
the apartment complex to partners M and N, though the partnership realized a
loss for book purposes. This discrepancy likely cannot be cured this year
unless the partnership has other Code Sec. 1250 gain from the sale of other
property.
3. A and B form the equal AB partnership. A contributes property (FMV =
$100,000, basis = $40,000) and B contributes $100,000 cash. The property is
depreciated straight line over a 10 year life for both book and tax purposes. The
partnership also has other property (FMV = $200,000, basis = $200,000) that is
depreciated straight line over 10 years. Under Code Sec. 704(c), how much of the
tax depreciation of the contributed property in the first year will B get? Assuming
a curative allocation is made, how much will it be? If there were no other
depreciable assets, what type of curative allocation could be made?
Book depreciation for the asset is $10,000, and tax depreciation is $4,000. The
noncontributing partner (B) will be allocated tax depreciation up to her book
depreciation, or $5,000, but there is only $4,000 of tax depreciation, so this is not
possible. A curative allocation of depreciation of $1,000 from A’s share of the tax
depreciation of the other assets can be made to B. If there were no other assets, partner
A could be allocated an extra $1,000 of B’s share of the ordinary income of the
partnership.
Reading:
Paragraph 704.
1. A and B form the equal AB partnership. A contributes property (FMV = $100,000,
basis = $30,000) and B contributes $100,000 cash. The property has three years
remaining on its 10 year life. The partnership uses the remedial allocations method to
eliminate ceiling rule disparities. Under Code Sec. 704(c), how much of tax
depreciation with respect to the contributed property in the first year will be allocated
to B? Assuming a remedial allocation is made, how much will it be? What will be its
character?
Book depreciation will be ($30,000/3 years) + ($70,000/10 years) = $17,000 per year, of
which each partner will be allocated 50%, or $8500. Tax depreciation will be
$30,000/3 years = $10,000 per year. Under the remedial allocation method, in the first
three years B will be allocated tax depreciation equal to her book depreciation, $8,500,
and A will be allocated the remainder, $1,500. (Remember that under the remedial
allocation method book basis up to the tax basis is recovered in the same manner as the
tax basis - $30,000 in this case. The remainder of the book basis - $70,000 in this case
- is recovered over the full original life of the asset.) No remedial allocation will be
necessary until the fourth year, when tax depreciation will be $0, but book depreciation
will be $7,000 per year. In that year B will be allocated $3,500 (50%) of the book
depreciation, and a remedial allocation of $3,500 of ordinary deductions to B and
$3,500 of ordinary income to A will be necessary.
2. K, G and L form a new partnership to operate a charter airplane company. K
contributes a plane with a tax basis of $400,000 and fair market value of $1,200,000
in exchange for a one-third interest. The plane is subject to a $600,000 liability, for
which the partnership assumes responsibility. G contributes a second plane with a tax
basis of $450,000 and a book value of $600,000 in exchange for a one-third interest.
L contributes $600,000 cash in exchange for the remaining one-third interest. Assume
that both planes have remaining useful lives for book and tax purposes of 10 years
and that the partnership uses the straight-line method to compute depreciation.
a. Show how the partnership will allocate tax depreciation among the partners using
the traditional method under Code Sec. 704(c). Assume that the partnership
agreement allocates all items of income, deduction, gain and loss equally among
the partners.
Using the traditional method, book and tax depreciation will be allocated as
follows:
K
Tax
Book
Book
depreciation,
Plane 1
Tax depreciation,
Plane 1
G
Tax
(40,000)
0
Book
depreciation,
Plane 2
L
Book
Tax
(40,000)
(20,000)
Book
(40,000)
(20,000)
(20,000)
(20,000)
(20,000)
(5,000) _______
(20,000) _______
Tax depreciation,
Plane 2
(20,000)
_______
Totals
(20,000)
(60,000)
(25,000)
(60,000)
(40,000)
(60,000)
b. How would depreciation expense be allocated if the partnership uses the
traditional method with curative allocations under Code Sec. 704(c)? (Assume the
partnership had gross rental income of $120,000 from its charter activity in the
current year).
K
Tax
Book
Book
depreciation,
Plane 1
Tax depreciation,
Complex 1
Tax
(40,000)
0
Book
depreciation,
Plane 2
Tax depreciation,
Complex 2
G
L
Book
Tax
(40,000)
(20,000)
(20,000)
Book
(40,000)
(20,000)
(20,000)
(20,000)
(20,000)
(5,000)
(20,000)
Curative
allocation, depr
Plane 2
20,000
(10,000)
(10,000)
Curative
allocation, gross
rental income
20,000 _______
(10,000) _______
(10,000) _______
Totals
20,000
(45,000)
(60,000)
(60,000)
(60,000)
(60,000)
c. How would depreciation be allocated if the partnership uses the remedial
allocations method under Code Sec. 704(c)?
K
Tax
Book
depreciation,
Plane 1
Tax depreciation,
Complex 1
Totals
Book
Tax
(40,000)
40,000
Book
depreciation,
Plane 2
Tax depreciation,
Complex 2
G
L
Book
Tax
(40,000)
(40,000)
Book
(40,000)
(40,000)
(20,000)
(20,000)
(20,000)
(20,000) _______
(5,000) _______
(20,000) _______
20,000
(60,000)
(45,000)
(60,000)
(60,000)
(60,000)
Note that the results are the same under the remedial allocations method and the
traditional method with curative allocations. However, the remedial allocations
method is simpler and does not require that the partnership have other items of
income or loss of a similar character in order to eliminate the ceiling rule
discrepancy. A disadvantage of the remedial allocations method is that depreciation
computations are slightly more complex.