704 (B) Capital Account Maintenance White Paper

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 reverse Code Sec. 704(c) allocations. The Schedule

With the growth in the use of limited liability K-1 reporting now lists four options to maintain
companies
pan niess (L(LLCs), partnership tax filings have capital accounts, including Code Sec. 704(b)
increased
crreaseed from
d ffr
rom 2, 2,165,000 in 2001, the first year that book,2 GAAP, tax basis and other, which must be
Form
orm m 1065
10 065 fi lings
ngs exceeded
filin
lin ceeded Form 1120 filings,ng to specified. While
hi e it has
has become quite common to see
more
mor re than
th
han 3.53 mi 2012.1 Any
million in 2012 Any bo
boiler
ler pla
plate
te references
reference to the maintenance
ai e nce of Code Sec. 704(b)04(b
partnership
arttnersship or LLC L C agreement
a ement contains
co tains a defi
d finnition
on capital
ca al in operating
eratin agreements,
a re ments, there seem to be
of h
how ccapital
ow capi aaccounts
tal ac ou will be m
oun maintained
ntaine anand often
d oft en few
fe practitioners
prac ners who
who are aware
aw re of how w to satisfy
a
determines
ines partners rights to assets upon liquidation the language of the agreement with respect to capital
by reference to the capitall acc accounts. Beginning with
oun s. Be account maintenance. Because the safe harbor for
2004 tax filings, Schedulee K-1 now w requires
req that the economic effect requires that Code Sec. 704(b)
partnership identify the method used to report capital capital accounts be maintained throughout the full
accounts. Nonetheless, the professional tax literature term of the partnership,3 failure to maintain Code
pays surprisingly little attention to the determination Sec. 704(b) capital accounts for any year cannot be
of partners capital accounts and why one method corrected by subsequent year adjustments.
may be preferred to another. This article will discuss the benefits of a partnership
Most practitioners are familiar with the requirement maintaining Code Sec. 704(b) book capital accounts,
that Code Sec. 704(b) capital accounts be either in isolation or in addition to one of the other
maintained to satisfy the safe harbor for economic available methods and how those capital accounts
effect under Reg. 1.704-1(b). Code Sec. 704(b) should be maintained. Understanding the Code Sec.
capital accounts also facilitate compliance with the 704(b) capital account provisions helps a practitioner
deemed in accordance with the partners interest to understand both the tax and economic effects of
test for nonrecourse deductions that cannot satisfy the a variety of partnership transactions. Therefore, this
economic effect test and with Code Sec. 704(c) and article will analyze capital account maintenance, both
on a Code Sec. 704(b) and tax basis, in the context
James R. Hamill, CPA, Ph.D., is the Director of Tax Practice of specific transactions that a practitioner would
at Reynolds, Hix & Co., P.A. in Albuquerque, New Mexico. encounter for partnership clients. It will include an

2014 J.R. Hamill
TAXESTHE TAX MAGAZINE

35
Partnership Code Sec. 704(b) Capital Account Maintenance
analysis of how Code Sec. 704(b) capital accounts reference to distributions following Code Sec. 704(b)
are adjusted to reflect the economics associated with capital, avoiding a safe harbor economic effect test
a contribution to an existing partnership in exchange introduces uncertainty into the allocation process.9
for an interest, a distribution of property, including Thus, the Code Sec. 704(b) capital account provisions
both liquidating and nonliquidating distributions,4 are most useful for tax purposes to permit allocations
a transfer of a compensatory profits interest, a to be respected under a safe harbor.
partnership Code Sec. 1031 exchange with boot, Because Code Sec. 704(b) capital account revalu-
Code Secs. 734 and 743 basis adjustments, a Code ations intended to better reflect the economics of
Sec. 708(b)(1)(B) termination and the grant or exercise the partnership must, by necessity, wait until some
of noncompensatory options to acquire a partnership arms-length transaction provides sufficient evidence
equity interest. to justify the adjustment, it is certainly true that Code
Sec. 704(b) capital cannot reflect the economics of
Why Maintain Code Sec. 704(b) the partnership on a real-time basis. Certain transac-
tions permit adjustments that, arguably, allow the
Capital Accounts? capital to be restated to true-up the economics for
As noted above, the most significant reason to a moment in time. However, even in such circum-
maintain Code Sec. 704(b) capital accounts is to stances, the values assigned to partnership properties
satisfy the safe harbor for economic effect, either must be based on a rough justice approach that
under the three requirements test or the alternate ignores valuation adjustments typically used for lack
test for economic effect.5 Code Sec. 704(b) capital of marketability and lack of control because the ef-
accounts are also required to meet the safe harbor fect of such discounts is not subject to bargaining
that allows allocations of nonrecourse deductions as between the parties. In spite of these limitations,
specified in the agreement to be deemed to be in the Code Sec. 704(b) capital accounts best reflect
accordance with the partners interests.6 Finally, the the economics of the partners arrangement when
use of Code Sec. 704(b) capital assists in tracking compared to available alternatives. For this reason,
Code e Sec.
S 704(c) and reverse Code Sec. 704(c)
70 maintenance of Code Sec. 704(b) capital, alone or
7
allocations.
ocatio
tions. In I aad
addition, Code Sec. 704(b) capital can in conjunction with other methods, may be done
help
elp partners
p par understand
nde nd and track the economics
rtnerrs un n m of for nontax economic
conom c reasons in addition to the tax
a va
variety
arietyy of partnership
parttne transactions.
transactions. allocation
alloccatio benefi
enefits. B
Butt any economic benefits are ar
Because
Be
ecau C e Sec.
use Code S
Sec 704(b)
04(b) capital
cap al accounts
accou s wereere more
m likely to
like o be a by-product
y roduc of the tatax motiv
motivations
at
developed
velopped to
ped t comply
co pl with
omply h the economic
e nomic effect
effect test,
test for
fo keeping
keepi Code Sec. Sec 704(b) capital.
apital
they are designed, as best one can, to track the
e de
economics of the arrangement ement among
among the partners. Capital Account
The effectiveness of the Code Code Sec.
Sec. 704(b)
7 capital
accounts in tracking true economics has been Maintenance Provisions
criticized, including the inability of the provisions to The basic structure of the Code Sec. 704(b) capital
track economics on a real-time basis.8 But the Code account maintenance provisions is that partnership
Sec. 704(b) book capital accounts defer valuation assets will be recorded at fair market value (FMV).
restatements intended to better reflect the current Contributed properties are debited at FMV, associated
economic arrangement until they are supported liabilities that are either assumed by the partnership
by arms-length bargaining, so that it is the lack of or taken subject to the debt are credited to the Code
objective evidence to support annual restatements Sec. 704(b) accounts, so that the partners initial
that prevents tracking the economic arrangement capital account is reflected as the amount of money
on a real-time basis. Moreover, those who want to and the FMV of property contributed, net of any
avoid the Code Sec. 704(b) capital accounts must associated liabilities. When assets are distributed
both rely on the subjective partners interest in the by the partnership, the assets are credited at FMV
partnership (PIP) test for allocating partnership items so the associated debit to the distributee partners
and adopt some alternative capital account structure Code Sec. 704(b) capital is also at FMV of the
which itself would be subject to criticism. While it distributed property. Where the distributed property
may be comforting to many partners to see a specific is not already reflected at date-of-distribution FMV,
division of assets upon liquidation, rather than a it is then necessary to adjust the value that the
36
February 2014
property is carried at to its FMV immediately before the economics of the arrangement, and the target
distribution. Where appropriate, based on arms- allocations will then adjust that capital to match the
length bargaining, asset values may also be adjusted distributions made.
during the life of the partnership for other permitted At the time the Code Sec. 704(b) regulations were
events with an offsetting adjustment to the partners written, it was generally easy to identify the scope
Code Sec. 704(b) capital. The key to use of such of arrangements classified as a partnership. Recent
adjustments is the existence of a transaction that introduction of Series LLC statutes in many states
requires the partners to bargain at arms length with raises the issue of whether each economically inde-
adverse interests to support adjustments to the values pendent series should maintain its own Code Sec.
of partnership properties. 704(b) capital even if the entire series files a single
As noted earlier, Code Sec. 704(b) capital account Form 1065. Because the purpose of the Code Sec.
maintenance rules were created in connection with 704(b) capital account provisions is to reflect the
the regulations defining when an allocation satisfies economic arrangement between the parties, it seems
the substantial economic effect test. Proper mainte- most consistent with that purpose that each economi-
nance of Code Sec. 704(b) capital is required to meet cally independent series should maintain its own
both of the safe harbors for economic effect, whether Code Sec. 704(b) capital accounts.
the partners decide to use the three requirements or Because partnership capital account maintenance
the alternate test,10 and also to satisfy the safe harbor may be done to achieve more objectives than satisfy-
by which nonrecourse allocations are deemed to ing a safe harbor for economic effect, a partnership
be in accordance with the partners interests. When may maintain multiple sets of capital accounts. Even
used for these purposes, the partnership agreement where a partnership maintains Code Sec. 704(b)
must require that distributions in liquidation of a capital to comply with a safe harbor provision, that
partners interest be made in accordance with Code partnership is not required to use Code Sec. 704(b)
Sec. 704(b) capital.11 It is the partners desire to see capital on the tax return.14 While Code Sec. 704(b)
adjustments to his or her capital for the purpose of capital may best reflect the underlying economic
securing
uringg rights
ghts to partnership assets that creates the
rig arrangement among the partners, tax-basis capital
adverse
dvversee interests
i terestts
inte t that justify use of arms-length bar- may be more useful to a partner receiving a Schedule
gaining
ainning between
betwweeen the
t partners as establishing
es FM 12
n FMV. K-1 because it can be used to track the basis of the
If the partnership
parrtnerrsh agreement
reement does
does not make
make dis-
d partners
partners interest.
rest
tributions
ributions in n liquidation
liq
quidat based on Code Sec.Sec 704(b)
7 (b)
capital,
pital,, su
p
pital such
ch aas wh
where the pa
w partnership
nersh p cchooses
hoo es P oper Contr
Property Contributions
ibution in Ex
Exchange
hange for
targett allocations
allo to determine the amounts that an Interest at Partnership Formation
each partner will receive, the use of agreements
ag be- When property is contributed at formation of the
tween the partners as the mea meansns of establishing
esta FMV partnership, and Code Sec. 704(b) capital is the
for purposes of Code Sec. 704(b) capital account basis for determining partners rights to assets for
maintenance becomes suspect. Many partnership distributions in liquidation of the partners interest,
agreements use target allocations to avoid comply- the arms-length bargaining between the partners that
ing with the three-requirements or the alternate test results in an agreed-to FMV for contributed assets
for economic effect, and such a partnership may not should be accepted for Code Sec. 704(b) capital. Each
even maintain Code Sec. 704(b) capital.13 Failure to property partner will have an incentive to advocate
maintain Code Sec. 704(b) capital will prevent the for the highest possible value to be assigned to his
partnership from relying on a regulatory safe harbor, contributed property to establish a greater right to
but allocations may still be made in accordance with assets of the partnership. Conversely, other partners
the partners interest in the partnership. This article should be expected to argue for the lowest possible
recognizes that most partnerships that choose to use value to be assigned to property contributed by other
Code Sec. 704(b) capital do so to comply with a safe partners. Partnership agreements often include a
harbor provision, but the article will also note situ- schedule of agreed value contributed by each partner.
ations where Code Sec. 704(b) capital may be used This schedule should include a statement of value
to best illustrate the economic arrangement between for each item of contributed property, although the
the partners. Partnerships relying on target allocations partners often do not specify value in that much
may still require Code Sec. 704(b) capital to track detail. However, failure to specify value for each item
TAXESTHE TAX MAGAZINE 37

of property may lead to difficulty in making future to the partnership, and this amount can then
allocations that are subject to Code Sec. 704(c).15 be allocated by agreement as it can satisfy the
economic effect test. The balance of the gain that
Example 1. Ally and Sarah form the AS partnership must be reported by the partnership on its tax
with each contributing $500,000 of value. Ally return, $200,000, cannot be reflected in the Code
contributes money, and Sarah contributes an Sec. 704(b) capital because it does not reflect
unencumbered parcel of undeveloped land with economic gain realized by the partnership.17
a tax basis of $300,000 and an agreed FMV of Because the $200,000 gain cannot be reflected
$500,000. The partnership agreement satisfies in Code Sec. 704(b) capital, any allocation of that
the alternate test for economic effect and states $200,000 gain cannot have economic effect.18
that all items of income, gain, deduction and loss The effect of the sale in the capital accounts is
will be allocated 50 percent to each partner.16 shown in Chart 2.
The partnership also maintains tax-basis capital
accounts to assist in tracking the tax basis of Chart 2.
partners interests and facilitating Code Sec. Code Sec. 704(b) Tax Basis
704(c) allocations. The date-of-contribution Ally Sarah Ally Sarah
capital is shown in Chart 1 (with 000s omitted Contributed Value 500 500 500 300
from this and all subsequent examples). Sale of Land 50 50 50 250
Post-Sale 550 550 550 550
Chart 1.
Code Sec. 704(b) Tax Basis
Ally Sarah Ally Sarah Because the Code Sec. 704(b) capital accounts
Contributed Value 500 500 500 300 reflect the date-of-contribution economic
arrangement between the partners by recording
The disparity between the Code Sec. 704(b) all asset values at agreed-to FMV, the only gains
and tax-basis
ax-baasis capital represents the built-in gain
d ta that can be reflected in the Code Sec. 704(b)
attributable
attt ibutab
ttribu t b
bl to
ble to Sarahs land, and this disparity capital are those that economically accrued after
between
beetweeen value
vvalue and
a basis is subject
subje to Code od Sec.
S formation. While Code
Co Sec. 704(a) allows partners
704(c)
70 principles.
04(c) pri ples The maintenan
ncip maintenance both
ce of b Code
th Cod e allocate items
to alloc tem of ttheeppartnership
tnership by aagreement,
y agreem ent,
Sec.
Seec. 704(b)
7 b) and
704(b nd tax
an t capital
ital helps to
o distinguish
distingu h thee it iss only
on thehe gain
ga n refl
eflected
ected in the Code Sec. Se
allocations
al ns subject
locaation
ation ct to Code
sub ect ode Sec.
Sec 704(c)
04(c) principles
inc ple 704(b)
04(b) capital can
tal that ca said to be a gain
n be sa of th
ain o the
from thos
those allocations subject to the general partnership. The balance of the tax gain, $200,000
rule that partners may agree agree how
how to allocate in the above example, is an item to be reported
items provided that agreementreemment has substantial by the partnership but does not represent an item
economic effect. For example, the Code Sec. of (economic) gain of the partnership.
704(b) capital tracks the economic arrangement
between the partners, and any allocation that Code Sec. 704(a) allows partners to agree how
cannot be reflected in the Code Sec. 704(b) to allocate items of the partnership but not items
capital accounts cannot have economic effect. that economically arise before the partnership is
This point can be illustrated by continuing formed. This is the distinction between the general
our example with the assumption that Sarahs rule of Code Sec. 704(a) and the exception of Code
contributed land is later sold for $600,000 (we Sec. 704(c). The Code Sec. 704(b) capital accounts
will assume that no other adjustments have been are the easiest way to track allocations subject to
made to the capital accounts before the sale). each provision.19 Code Sec. 704(c) requires that
The sale of Sarahs property will result in a Code the disparity between book and tax values be
Sec. 704(b) book gain of $100,000 ($600,000 resolved as quickly as possible, which means that
amount realized minus $500,000 book basis) and depreciation allocations with respect to contributed
a tax gain of $300,000 ($600,000 $300,000 Code Sec. 704(c) property must use the principles
Code Sec. 723 tax basis). The $100,000 gain of Code Sec. 704(c). As the depreciation allocations
that can be recorded in the Code Sec. 704(b) reduce the disparity between book and tax values,
capital accounts represents an economic gain the allocations of gain from the sale of contributed
38
February 2014
property must also be adjusted, a process made easier the property is sold, the Code Sec. 704(c)
to track by use of Code Sec. 704(b) book and tax-basis gain allocation to Sarah is $120,000, which is
capital accounts. the contributed gain of $200,000 reduced by
the differential depreciation for the first two
Example 2. Ally and Sarah form the AS partnership years. The pre-sale capital balances show the
with each contributing $500,000 of value. Ally amount that is subject to Code Sec. 704(c) as
contributes money, and Sarah contributes an item the $120,000 difference between Sarahs Code
of five-year recovery property with a tax basis of Sec. 704(b) and tax-basis capital.
$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 Property Contributions in Exchange
income, gain, deduction and loss will be allocated for an Interest Post-Formation
50 percent to each partner. The partnership also When money or property is contributed to the
maintains tax-basis capital accounts to assist partnership in exchange for an interest at some time
in tracking the tax basis of partners interests after formation of the entity, the amount contributed
and Code Sec. 704(c) allocations. The property and the percentage interest received will allow the
contributed by Sarah is depreciated at the rate partners to infer the value of partnership properties
of 20 percent per year for both book and tax20 at the time of the new contribution. Arms-length
and is sold at the beginning of the third year for bargaining should establish the fair payment
$350,000. Depreciation deductions for Code required for the interest to be received, and that
Sec. 704(b) book purposes are based on the payment should also reflect the net asset value of
recorded FMV of the property.21 For simplicity partnership properties. It could be argued that the
of illustration, no depreciation is claimed for the amount paid for the interest cannot readily be used
year of disposition. The capital from formation to determine the value of properties because the
through the date of sale is shown in Chart 3. interest value would be expected to be discounted
by factors such as lack of marketability and lack
Chart
ha
art
a rt 3.
3. of control. While this is certainly true, even
Code Sec. 704(
704(b) Tax
ax Basis
asi ignoring the factor
factors tthat may justify a discount for
Ally arah
Sarah Al
Ally Sarah
Sarah value of the interest
the valu allows
e st allo partnership
ws the paartnership tto
Con
ntribu
ution
Contribution 50
500 00
500 500
500 00
300 betterr re
be reflectt the economic
co omic arrangement
rrangement be between
w
preciation
i ti n 2 years
Depreciation ars <100>
0 <100> <100>
0> <20>
<2 the partn
th partners. Furth
Further,
er there
here is no obj
objective way to
tive wa
Pre-Sale Capital 400 400 400 280 incorporate valuation discounts into a revaluation
Sale 25 25 25 145
of the properties. Discounts are not bargained
by the partners, and if an outside expert is used
Ending 425 4
425
2 425 425
to establish a discount, there may be a conflict
of interest between the partner responsible for
This analysis shows that the built-in gain of hiring that expert and one or more other affected
$200,000 attributable to Sarahs contributed partners. For example, when money or property
property is subject to Code Sec. 704(c) both is contributed to an existing partnership for an
with respect to the annual depreciation interest, the existing partners could seek an expert
deductions as well as the gain from sale. to support a high discount to inflate the implied
Code Sec. 704(b) book depreciation is based value of partnership properties so that more pre-
on contributed FMV while tax depreciation is admittance capital is shifted to them. So when an
based on the partnerships carryover basis in the interest is acquired by contribution, the Code Sec.
contributed property. Book depreciation is split 704(b) capital accounts may be restated to reflect
equally pursuant to the agreement, while tax the value implied by the contribution but absent
depreciation is allocated first to Ally to match any discounts. This restatement is optional, but it
her share of book depreciation,22 and then to assists the partnership in making reverse Code Sec.
Sarah. For the two years that depreciation is 704(c) allocations to reflect any inherent gain or loss
claimed, Ally is allocated $80,000 more tax that existed before the new interest is acquired.23 If
depreciation deductions than Sarah. When the restatement is not done, the partnership is still

required to follow Code Sec. 704(c) principles with While the entries are fairly simple, they also tell
respect to any pre-admittance gains and losses. The a story. First, the restatement causes the Code
restatement simply facilitates this analysis. Sec. 704(b) capital of each partner to be equal,
reflecting their revised economic agreement by
Example 3. Ally and Sarah form the AS which each owns one-third of the partnership.
partnership, with each contributing $500,000 Second, the $300,000 disparity between the
in exchange for a 50-percent interest. All Code Sec. 704(b) and tax-basis capital of both
contributions are made with money. The Ally and Sarah reflect their respective shares
partnership agreement satisfies the requirements of the appreciation in the value of partnership
for the safe harbor for the alternate test for properties that occurred from the date they
economic effect, and all items are allocated 50 formed the entity through the date that Katie
percent to each partner. The partnership uses was admitted as a new partner. This book-tax
the contributions to purchase $1,000,000 of disparity is subject to Code Sec. 704(c), and
undeveloped land to be held for investment. the reverse Code Sec. 704(c) allocations when
Three years after formation, Katie offers to join the land is sold will distinguish the gain that
the partnership by contributing money for a occurred when Ally and Sarah were the only
one-third interest. The amount to be paid by partners from any gain or loss that occurs when
Katie is the subject of arms-length bargaining there are three partners. To illustrate, assume
where Katie would like to contribute the that the land is later sold by the partnership
smallest amount, and Ally and Sarah would for $1,900,000. The Code Sec. 704(b) gain,
like her to contribute a much larger amount. measured relative to the restated value of the
The parties agree that Katie will contribute land, is $300,000 ($1,900,000 $1,600,000).
$800,000 for a one-third interest in all items. The gain to be shown on the tax return is
Katies contribution implies that the value of all $900,000 ($1,900,000 $1,000,000 cost basis).
partnership properties, after her admittance, is Book and tax gain are then allocated as shown
$2,400,000
,4000,0000 (so that her contribution properly in Chart 5.
refl
re
efl ects
flec t o
ts one-third
ne-tth
t of the total value). Because
this
his amount
th mount includes
am in
ncl s Katies $800,000
$800 monetary
o et Chart 5.
contribution,
coontr ibuttion,, the
th landnd purchased
purcha sed by the t e AS
AS Code
od Sec. 70
704(b)
4(b Tax Bas
Basiss
partnership
paartneership m must
mu st be worth $1 $1,600,000
600,000 at tthe e Al
Allyy Sarah Katie
atie All
Ally Sarah K
Katie
time
im
me of K Katies
Katie
e ad aadmittance.
tance The partnership
e pa ne ship
Initial Formation 500 500 500 500
may now adjust the value of the land upward
from its current Code Sec. 704 704(b) Katie Admittance 800 800
$1,000,000
(b) $
value to $1,600,000. The he ooffsetting
ffsetting ccredit entry Restatement 300 300
of $600,000 is made to the Code Sec. 704(b) Sale of Land 100 100 100 400 400 100
capital accounts of Ally and Sarah based on how Ending Capital 900 900 900 900 900 900
they have agreed to share the economic gains
associated with the land. Therefore, each partner
has a $300,000 adjustment made to her capital. Only $300,000 of gain, the amount that can
The Code Sec. 704(b) and tax-basis capital be reflected in the Code Sec. 704(b) capital,
accounts then appear as shown in Chart 4. can be allocated among the three partners
by agreement and satisfy the economic effect
Chart 4. 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,
Ally Sarah Katie Ally Sarah Katie
which reflects appreciation in the land value
Initial Formation 500 500 500 500 from date of formation through the date that
Katie Admittance 800 800 Katie was admitted as a new partner, must
Restatement 300 300 -0- -0- -0- -0- be allocated between Ally and Sarah based
Ending Capital 800 800 800 500 500 800
on how they have agreed to share that gain.
The example reflects a 50/50 split of the gain,
40
February 2014
but Ally and Sarah may agree to an allocation Step 1Allys share of capital, including any
other than 50 percent each, and that allocation change in value after formation, immediately
can have economic effect because it can be before the new contribution is: Apre = 500 + 0.333(X
reflected in the Code Sec. 704(b) capital. If 1,500), where X is the value of partnership assets
their agreement with respect to this gain was before the second contribution. Allys Code Sec.
something other than 50 percent each, that 704(b) capital will be adjusted only if the value (X)
agreement would have been reflected in the is different than the 1,500 value currently reflected
allocation of the restatement and later matched in Code Sec. 704(b) capital.
by an allocation in the tax-basis capital.
Step 2Allys share of total capital after the
second contribution is: Apost = 400 + Apre = .40
Post-Formation Contribution by an Total Capital
Existing Partner for an Interest
Example 3 shows an optional restatement This step adds Allys new contribution (400) to
when a new partner joins the partnership by her restated pre-contribution capital and sets her
contribution of money or property in exchange post-contribution capital equal to 40 percent
for an interest. The new partner scenario is the of the total post-contribution capital (both
simplest to demonstrate, as the post-contribution computed post-revaluation).
value of partnership properties implied by the
contribution is simply the FMV of the contribution Step 3Total Capital after the second contribution
divided by the percentage interest acquired by = 1,900 + (X 1,500). This shows total capital
the contribution (in Example 3, $800,000 divided is the total amount contributed (1,900) adjusted
by one-third). If the contribution is made by an for the revaluation.
existing partner, the calculation of implied value is
a bit more difficult as it is based on the change in Step 4Determine X by substitution from above,
the partners
partnerr s percentage
p interest.24 It is necessary where we can substitute Allys share of capital
to measure
meaasuree the
m he partners share of capital
th p both after the second contribution as the numerator
before
ore and
efo a after
afteer his
h new
ew contribution
contribut to determine
de er (substitutingg step 1 into
i step 2), total capital after
the
he value
vallue implied
imp plie byy the incremental
incr ement l interest
nter est the second
sec contribution
con bu o ass the denom
denominator
inato and
received
eceeiveed inn exchange
exxch han for the n new contribution,
ew co tr u on, set that quotient
otient equal
eq al too .40,
0, the agreed
a reed share
sha
which requires
h ich req quir e a four-step
r step calculation.
lcul io n T The
he of capital
capi thathat now w belongs
belongs to
o Ally:
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 900 + 0.333X 500 = .40
value in the preceding example. The following
400 + X
example will illustrate the four steps.
Example 4. Ally, Sarah and Katie form the ASK Then simplifying,
partnership, with each partner contributing
$500,000 of money in exchange for a one-third 160 + .4X = 400 + 0.333X
interest in all items. The partnership satisfies all
requirements of the alternate test for economic 0.067X = 240
effect. The partners use their cash contributions to
X = 3,600
purchase $1,500,000 of undeveloped land. Three
years after formation, Ally contributes $400,000
additional cash in exchange for increasing her Therefore the value of the land immediately
interest in partnership capital from one-third to before Allys second contribution is $3,600,000,
40 percent. The partnership will restate the value which requires a book up of $2,100,000 from its
of the land to reflect the value implied by Allys original $1,500,000 value. This is shared one-
second contribution. This value is determined third by each of the original partners, and capital
as follows: accounts then appear as shown in Chart 6.

Chart 6. after the second contribution as the numerator

Code Sec. 704(b) Tax Basis (again substituting step 1 into step 2), total capital
Ally Sarah Katie Ally Sarah Katie after the second contribution as the denominator
Initial Formation 500 500 500 500 500 500 and set that quotient equal to 0.333:
Ally Contribution 400 400
800
Restatement 700 700 700 -0- -0- -0- = 0.333
800 + X
Ending Capital 1600 1200 1200 900 500 500
Then simplifying,
Several issues stand out based on the ending 266.67 + 0.333X = 800
capital accounts. First, the Code Sec. 704(b)
capital has been restated to a total value of 0.333X = 533.33
$4,000,000, and Allys share of that total is 40 X = 1,600
percent ($1,600,000/$4,000,000), consistent
with the revised agreement among the partners.
Second, there is a total book-tax disparity of This restated value of partnership properties is the
$2,100,000 ($4,000,000 $1,900,000) which same as was obtained in Example 3 but where a
reflects the change in value of the land from the new partner is the one making the contribution the
date of formation through the date that Allys computation can be shortened by the method shown
interest increased. This amount is subject to in that earlier example.
a reverse Code Sec. 704(c) allocation where
each partner will be allocated $700,000 (the Effect of Distribution of Property
book-tax disparity for that partner). The pre- As noted earlier, the economic-based capital accounts
change appreciation is shared equally; any record property contributions at FMV but also record
post-change appreciation is shared in the revised distributions at FMV. Where values are not reflected at
40/30/30
30 ratios. The restatement recorded in this
0/30 rat FMV immediately before distribution, either because
transaction
tra tion may
ansaactio ma become part of a larger Code
m the value changed during the partnerships holding
Sec.
Seec 704(c)
ec. 704(cc) allocation
7 alloc n as interests change
c in future
ut period or changed
anged relative
re to any pre-distribution
years,
yeears, including
inclludinng the possibility
ossibility of admitting
admitti g a neww restatements,
resta teme it is
i necessary
ec ss y to restate the value
va ue of
o
partner
paartneer in exchange
ang for
exccha or a contribution.
contr bution. the distri
th distributed
ed prproperties immediately
pe tie im before
mediate y befo e the
distribution.
di ibuti How this adjustment
this adjust occurs
ent oc generally
rs ge er
As noted
ted aabove,
b the four steps shown in Example 4 depends on two issues. First, to what extent any
to determine the value of partnership
artneership properties
pro before changes in value have already been reflected by
the new contribution is a gene
generalized form that could
ralized fo prior restatements. Second, whether the partnership
also be applied to Example 3, as shown here: restates the value only of the property actually
distributed or whether all partnership properties
Step 1Katies share of capital, including any are restated. As is the case with contributions, the
change in value after formation, immediately partnership needs an objective measure of FMV,
before the new contribution is: Kpre = 0 + 0 (X generally determined by agreement between the
1,000), where X is the value of partnership assets partners who are dealing at arms length and with
before the second contribution. adverse interests. Where Code Sec. 704(b) capital is
the basis for rights to assets upon liquidation, partners
Step 2Katies share of total capital after the should have sufficient adverse interests to support an
second contribution is: Kpost = 800 + Kpre = 0.333 agreed value as reflective of FMV.
Total Capital If a partner is to receive a property distribution that
does not liquidate his interest, the distributee partner
Step 3Total Capital after the second contribution has an incentive to argue that the distributed property
= 1,800 + (X 1,000) has a small value. This is so because the value assigned
will reduce his capital and thereby reduce his rights to
Step 4Determine X by substitution from above, future distributions. This leads the distributee partner
where we can substitute Katies share of capital to argue for a small reduction in his Code Sec. 704(b)
42
February 2014
capital.25 In contrast, the other partners should be $500,000 in exchange for a one-third interest
expected to argue for assignment of a large value to the in all items of the partnership. The partnership
distributed property, reducing the distributee partners agreement complies with the alternate test
capital by a larger amount and protecting their interest for economic effect. The partnership uses the
to future distributions relative to the partner receiving contributed funds to purchase a parcel of land
the current distribution. However, the partners do not for $1,500,000 and subsequently replats the
generally have adverse interests with respect to the land into 15 equal-sized lots. At the time of the
value of any partnership properties that are not the replat, the partners do not believe that any lot
subject of the current distribution. Therefore, when is more valuable than any other, so they assign
the distribution is not in liquidation of the distributees a $100,000 value to each lot. The intent of the
interest, a restatement is permitted only for the partners is to passively hold the land until a bulk
distributed property. This is done through a deemed sale to a developer can be arranged. Three years
sale adjustment, or DSA, in which the distributed after formation, Katie decides that she would like
asset is deemed sold for its FMV with the resultant to build her residence on one of the lots, and
(book only) gain or loss charged to all partners Code she negotiates with Ally and Sarah to receive a
Sec. 704(b) capital based upon their agreement. The distribution of a single lot, with the understanding
property is then removed from the partnership at its that the distribution will reduce her interest in the
restated FMV with the offset to the capital account of partnership below one-third. The three partners
the partner receiving the distribution.26 negotiate the value of the lot, and all agree that it
If the distribution liquidates the interest of the is worth $160,000. Because the distribution is not
partner, the partners must first agree to the value of in liquidation of Katies interest, there is no arms-
the entire interest held by the partner who will be length bargaining to establish the total value of
liquidated. Once that total value is determined, the partnership properties, nor is there any bargaining
partners must agree which assets will be distributed with respect to the value of any parcel other than
to satisfy the partners rights to the total assets of the the one to be distributed. The distributed lot is
partnership.
nersshipp. The
Th distributee again has an incentive revalued at $160,000, with the $60,000 debit
to argue
a e that thatt each
tha eaac asset received has a small value, entry offset by a $20,000 adjustment to the Code
ass that
that will
w justifyjustify receipt
eipt of additional
additio properties
op rt to Sec. 704(b)) book capital
ca of each partner, based
equal
equ ual the
the total
total agreed
ag value of his
his interest.
inte es . Other
Other on their
the agreed-to
greed o split
pli of economic
ec nomic gain fromrom
partners
arttnerss have
haave an a incentive
in tive to argue
a gue the opposite,
o po te, the property.
pro y. Code
Co e Sec.
ec. 704(b)
70 (b) capital
capit l accounts
accoun
so that
t a smaller
malle number
sm n
nu er of distributed
di buted properties
propert es aree then
the refl ected in Chart 7.
flected
will satisfy
tiisfy their
tth obligation to the liquidated partner.
Unlike the nonliquidating ng sscenario,
cenario, it is possible Chart 7.
to restate the value of alll partnership
partnership assets, again
through the DSA, because the partners have
determined by arms-length bargaining the total
value of partnership properties. It is not mandatory Initial Formation 500 500 500 500 500 500
to revalue all partnership assets in a distribution Deemed Sale 20 20 20
in liquidation of a partners interest, but the full Distribution -0- -0- <160> -0- -0- <100>
restatement should permit Code Sec. 704(b) capital Ending Capital 520 520 360 500 500 400
to better reflect the economic arrangement between
the partners, including continuing partners.
The following example will present a base fact The aggregate values of the Code Sec. 704(b)
pattern that will be used to show how a DSA may be and tax-basis capital remain equal, with book
used in a nonliquidating distribution, and the same first adjusted upward by $60,000 but then
facts will be used in the next example to add a variation reduced by $160,000, and tax reduced by the
of a complete liquidation of the partners interest with original $100,000 cost of the distributed lot.
a DSA applying to all partnership properties. Katie takes a carryover basis in the distributed
lot,27 so there is no Code Sec. 734 adjustment to
Example 5. Ally, Sarah and Katie form the ASK the basis of undistributed partnership properties
Partnership with each partner contributing even if the partnership has a Code Sec. 754

election in effect. The tax basis of her interest distribution in excess of tax basis ($800,000
and her tax-basis capital are both reduced by $780,000). Thus, Ally and Sarah report a total
the $100,000 assigned to the distributed lot.28 gain of $300,000 each, $280,000 from a K-1
Katie will bear the potential $60,000 taxable item and $20,000 on Schedule D from a deemed
gain if the distributed lot is sold by her after the exchange of their partnership interest. Katie
distribution for its current FMV. Katies Code Sec. has a $40,000 capital loss from receipt of a
704(b) capital is $160,000 less than both Allys $640,000 cash distribution (determined by her
and Sarahs, which reflects the value that she has Code Sec. 704(b) book capital) in exchange
already extracted by way of the distribution.29 for an interest with a tax basis of $680,000.
While not required as part of the analysis of Katie then reports a net gain of $240,000,
this example, it is instructive to consider what which is the $280,000 K-1 item net of the
happens when remaining partnership properties $40,000 Schedule D loss item. Katies overall
are disposed of in a taxable transaction. That is, gain is $60,000 less than both Ally and Sarah
we should be able to reconcile the economics because she still has the distributed lot with a
shown in the Code Sec. 704(b) capital with FMV that exceeds basis by $60,000 ($160,000
the ultimate tax result to each of the partners. $100,000). The $60,000 gain is deferred in
To illustrate, assume that each of the 15 lots is the distributed lot and if Katie disposes of that
valued at $160,000, so that total partnership lot in a taxable transaction her overall gain
value is $2,400,000 before the distribution. will be the same as Ally and Sarah. Obviously
Post-distribution, the partnership has remaining this expanded analysis assumes facts beyond a
$2,240,000 of value ($160,000 14 lots), with simple distribution of one lot, but it illustrates
a tax basis of $1,400,000 ($100,000 for each that over the life of the investment the tax
of the 14 remaining lots). A taxable disposition consequences to each partner will match the
would create $840,000 of book and tax gain. economics shown through the Code Sec. 704(b)
Because there is no Code Sec. 704(c) issue capital accounts. Matching allocations of taxable
(none
onee of the
he remaining
th r properties has a disparity gain and loss to economic benefits and detriments
in book
n boo
b okk and
and ttax
d taax values), Code Sec. 704(b) book is the essence of the Code Sec. 704(b) economic
gain
gaain would
wou uld be allocated
ocated $280,000
$280 to each
ea effect test, and th
thiss matching is reflected in the
partner.
pa artneer. Tax
T gainga will ill follow the Code
Co d Sec.
Sec . Code Sec.
S 704(b)
704 capital accounts 300
ca it accounts.
704(b)
70 b) book
04(b bo ook gain
gaain under
der the economic
econom c effect
ff t
test. Capital
apital aaccounts
eest. Cap
est C cco
co would then
hen aappear
pe r aas Example
amp 6. The facts
facts are the same
ame as in Examp
Example
shown n in C Chart 8. 5 except Katie wants to receive one-third of
the value of partnership properties in complete
Chart 8. liquidation of her interest in the ASK partnership.
Code Sec. 704(b) Tax Basis In this case, the partners will have to negotiate
Ally Sarah Katie Ally Sarah Katie the total value of partnership properties to reach
Capital, from above 520 520 360 500 500 400 an agreement as to what value Katie is entitled to
Saleremaining lots 280 280 280 280 280 280 for her one-third interest. The partners will also
need to negotiate the value of specific lots to be
Ending Capital 800 800 640 780 780 680
distributed to match the value of Katies interest.
Ally, Sarah and Katie agree that each of the 15 lots
From this analysis we see that available is now worth $160,000, so that the total value of
partnership assets ($2,240,000 sale proceeds) partnership properties is $2,400,000. Katie will
will be distributed $800,000 each to Ally and be given title to five of the 15 lots, with a total
Sarah and $640,000 to Katie. Katies reduced value of $800,000. Because the partners have
distribution reflects the value she earlier received reached an arms-length agreement of the value
from the property distribution. Each partner of all partnership properties, they are able to use
will have a separate tax effect attributable to a deemed sale adjustment to restate the value
receipt of a liquidating distribution of cash sale of every lot. They agree to restate all lot values,
proceeds, with Ally and Sarah each reporting and the Code Sec. 704(b) capital accounts are
an additional $20,000 capital gain from a adjusted as shown in Chart 9.
44
February 2014
Chart 9. was liquidated. If the adjustment arises from a

Code Sec. 704(b) Tax Basis nonliquidating distribution, it is made to the
Ally Sarah Katie Ally Sarah Katie capital accounts of all partners based on how
Initial Formation 500 500 500 500 500 500 they would share any gains and losses from the
property subject to the adjustment. 32
Deemed Sale 300 300 300
Distribution -0- -0- <800> -0- -0- <500>
Example 7. Ally, Sarah and Katie form the ASK
Ending Capital 800 800 -0- 500 500 -0- partnership with each partner contributing
$500,000 of money. The partnership satisfies
Katie substitutes the basis of her interest the alternate test for economic effect and
($500,000) for the basis of the distributed all items will be shared equally by the three
properties, so she has a potential gain of partners. The partnership uses the funds to
$300,000 in the distributed properties that is purchase $1,500,000 of property, and the
deferred until she disposes of one or more of partnership generates $1,500,000 of operating
the lots in a taxable transaction. The tax basis income in its first five years of operations. For
of undistributed properties has not changed, simplicity of illustration, it is assumed that all
so Ally and Sarah will each (ultimately) profits of operations are retained as cash and
recognize a $300,000 gain when all of the that no cost recovery adjustments have been
remaining properties are disposed of by the made to the partnership property. As a result,
partnership. Again, there is no Code Sec. 734 at the end of the fifth year of operations, the
adjustment (if the partnership had a Code Sec. partnership holds property with a Code Sec.
754 election) because Katies substituted basis 704(b) book and tax basis of $1,500,000
is the same basis as the distributed properties and money of $1,500,000, and partners
had to the partnership. 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
Code
o Se
ode Sec.
ec. 7
734 Adjustments end of the fifth year,
y and the three partners
In
n the preceding
preeced di examples, there were w re no negotiate a cash
cas buyout of $1,400,000 for
Code
Cod de Sec.
S 734 4 adjustments
a tments to the taxta x basis of Katies one-third
e-th interest.
te s . The buyout
buyyout price
p rice
undistributed
nd properties
distr ibutted p
proope
p result
es as a re ult of tthe
he facts
ac of implies
plie a total netet FMV
M ofo partnership
partner hip assets
a se
the example.
e exaa mplle
ampl Code
le. A Codod Sec.
c 734 adjustment
justm nt occoccurs
rs of $4,200,000,
$4 2 000 which
w ch consists
whi con sts of $1,500,000
500 00
only whenhen tthe partnership has a Code Sec. 754 of money and $2,700,000 of property. The
election in effect, and the adjustment
ad ustm can be property is currently carried on the books at
used to maintain the Code 704(b) book and
ode SSec. 704 $1,500,000, so a $1,200,000 restatement is
tax-basis capital accounts in balance over the life possible before the liquidating distribution.
of the partnership. Unlike the Code Sec. 704(b) The partners have agreed to restate the value
restatements shown above, which did not affect of all partnership properties using the values
tax-basis capital, Code Sec. 734 adjustments are implied by the agreement with Katie. 33 The
made to the tax basis of undistributed partnership capital accounts will appear as shown in
properties when a distributee partner recognizes Chart 10.
gain or loss from the distribution or when the
basis of the distributed property to the partner Chart 10.
is more or less than the partnerships 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 Initial Formation 500 500 500 500 500 500
made to the asset side of the balance sheet. If Operations 500 500 500 500 500 500
the distribution giving rise to a Code Sec. 734 Deemed Sale 400 400 400
adjustment occurs because of a liquidating Distribution -0- -0- <1400> -0- -0- <1400>
distribution, the adjustment is made only to the Ending Capital 1400 1400 -0- 1000 1000 <400>
capital account of the partner whose interest

At this point, the partnership still holds property made to the basis of undistributed partnership
valued at $2,700,000 (the value implied by property. The DSA and the removal of the asset
the redemption price) and money of $100,000 from the Code Sec. 704(b) books will reflect the
($1,500,000 the distribution to Katie). The total entire effect of the distribution on the economic
assets of $2,800,000 are shared economically arrangement between the partners. The Code Sec.
$1,400,000 to each of the continuing partners, 704(b) capital should match the post-Code Sec.
as is reflected in the restated Code Sec. 704(b) 734 adjustment tax-basis capital of the liquidated
capital accounts. The tax-basis capital of the partner as she should report tax consequences
continuing partners remains at $1,000,000 matching her Code Sec. 704(b) economic benefits
each, reflecting the unrealized gain of $400,000 and burdens over the life of her ownership interest
attributable to each partner. Katies Code Sec. in the partnership.
704(b) capital is zero, as she no longer has
any right to assets of the partnership, but note Example 8. The facts are the same as in
that Katies tax-basis capital ends at a negative Example 6 except the total value assigned to
number. This figure reflects the $400,000 Code the 15 lots is $1,800,000 and at the time of the
Sec. 731 gain that Katie recognizes from receipt liquidating distribution to Katie the partners
of a distribution of money in excess of the basis agree that not all lots have the same value.
of her partnership interest. If the partnership Katie agrees to take four lots with an agreed
has a Code Sec. 754 election in effect, or value of $600,000 in liquidation of her interest.
makes one for the year of the distribution, a The four distributed lots have a tax basis to the
$400,000 positive Code Sec. 734 adjustment partnership of $400,000. The partnership has
will be made to the tax basis of undistributed a Code Sec. 754 election in effect for the year
properties. This adjustment will also be made to of the distribution. A DSA is recorded for all
the tax-basis capital, with the adjustment made partnership properties, resulting in a book-
to Katies capital only, because it arises from a up of $300,000 ($1,800,000 $1,500,000)
distribution
strib on in liquidation. The Code Sec. 734
butio immediately prior to the distribution. The
adjustment,
ad
dj tmen
djust t nt, which is a debit entry to the tax
t w four distributed lots are removed from
basis
baasis of partnership
p
partn
ne p properties, is offsete by a the Code Sec. ec. 704(b)
7 accounts at their
credit
cr Katies
reditt to Katie
K es tax-basis capitall and rresults
basis capita esults iin
n restated
resstate FMV
MV of $600,000
$ 0 000 and fromfro m the tax
a zero balance
alancce in herr tax-basis
o ba capital aat ye
tax-basi capita yearr basis
sis books
b ks at the h partnerships
p rtn erships $400,000
$400, 00
end,
nd, matching
en
nd matchin ng the
th Code
ode Sec.
Sec 704(b)
704(b capital.
capital basis.
asis Katies
ies basis
b asi in the
t distributed
distr uted lots
o
See Chart
C t1 11. is $500,000, the substituted basis of her
partnership interest. 34 Before considering
Chart 11. 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
Initial Formation 500 500 500 500 500 500
($1,500,000 $400,000 distributed basis).
Operations 500 500 500 500 500 500 There is a negative Code Sec. 734 adjustment
Deemed Sale 400 400 400 to the basis of undistributed partnership
Section 734 Adj. 400 properties because the basis of the distributed
Distribution -0- -0- <1400> -0- -0- <1400> property in Katies hands exceeds that of the
Ending Capital 1400 1400 -0- 1000 1000 -0- partnership by $100,000. 35 The entry made
to the tax basis books to reflect this Code
Sec. 734 adjustment to remaining partnership
A Code Sec. 734 adjustment may also be made properties is shown in Chart 12.
when the basis of the distributed property to the
partner is different than the basis of that property Chart 12.
to the partnership. That adjustment can be positive Katie Capital 100
or negative, and the effect on tax-basis capital will
Undistributed Property 100
again be as an offsetting entry to the adjustment
46
February 2014
Partnership capital accounts, post-distribution disparity between Code Sec. 704(b) book and tax
and after the Code Sec. 734 adjustment, are capital.38 This is so because, unlike a Code Sec. 734
shown in Chart 13. distribution adjustment, the mechanism giving rise
to the Code Sec. 743 adjustment occurs outside of
Chart 13. the partnership.39
Code Sec. 704(b) Tax Basis Code Sec. 705(a)(2)(B) Items
Code Sec. 705(a)(2)(B) items are expenditures
Initial Formation 500 500 500 500 500 500
of the partnership that are not deductible in
Deemed Sale 100 100 100 computing taxable income and not properly
Distribution <600> <400> charged to capital. They are items that have a
Section 734 -0- -0- -0- -0- -0- <100> permanent effect on the basis of partnership assets
Ending Capital 600 600 -0- 500 500 -0- without a corresponding current or future effect
on taxable income.40 That is, items capitalized to
property that may be recovered through future
The Code Sec. 734 adjustment zeroes out cost recovery deductions or as reductions in gain
Katies tax-basis capital, and the Code Sec. from sale are not Code Sec. 705(a)(2)(B) items,
704(b) revaluation creates a $200,000 total which are instead permanent book-tax differences.
disparity between the FMV and tax basis of Examples would include nondeductible premiums
undistributed properties. The properties have paid on partnership owned life insurance, expenses
a FMV of $1,200,000 and after the negative related to the production of tax-exempt income,
$100,000 Code Sec. 734 adjustment have a disallowed related-party losses and the 50-percent
tax basis of $1,000,000. This disparity is also disallowance for meals and entertainment. The
reflected in the excess of the Code Sec. 704(b) Code Sec. 704(b) capital reflects the economic
capital over the tax-basis capital of the remain- effect of these expenditures, and the items would
ingg partners.
p
partnners The Code Sec. 734 adjustment fully reduce the economic-based capital. This is
allows
al
ll ws the
llow book-tax
the bo
b oo disparity to reflect only the similar to the adjustments that would be made to
share
sh unrealized
hare of unre
u eal partnership
gain in par p assets
ss a corporations earnings
ns ear ni and profits, which is used
that
th belongs
hat bel onggs to Ally
lly and SaSarah ($100,000
rah ($ 00,000 determine
to d eterm the corporations
rporatio s economic
econommic ability
ab ity to
t
each).
ach)). Katies
ea Kaaties $100,000
$10 000 share
shar is deferred
defer d in n pay a dividend.
pa div nd. Code
C d Sec. 705(a)(2)(B)
05(a)(2) B) items
items can
the
h fo
he four
our lots
our lots received
r cei
e in the liquidating
uidat g distri-
distri create
cr ate permanent
pe anent book-tax
boo tax differences
d erence that
hat will
w l not
bution ($600,000
n ($ 6 FMV in excess of $500,000 automatically adjust themselves at liquidation of
substituted basis). the partnership. Without any explicit guidance, the
partnership may need to adopt self-help measures
such as charging off some asset account against
Code Sec. 743 Adjustments tax-basis capital at liquidation to avoid a lingering
Code Sec. 743 adjustments occur when the positive tax-basis capital account when a partners
partnership has a Code Sec. 754 election in effect, interest is liquidated.
and a partner acquires an interest by purchase
from another partner. For this purpose, a purchase Example 9. Ally and Sarah form a partnership,
includes inheritance of a partnership interest. Code each contributing $100,000 in exchange
Sec. 743 adjustments must be accounted for by the for a 50-percent interest in all items of the
partnership provided the transferee partner timely partnership. During the life of the partnership,
notifies the partnership of the transfer,36 but the net income of $400,000 is reported for book
adjustment itself belongs only to the purchasing and tax purposes, and $20,000 of meals
partner. As a result, no adjustments are made to and entertainment expense is incurred. The
the common basis of partnership properties so that capital accounts appear as shown in Chart
no adjustment is made to partnership capital.37 The 14 immediately after each partner receives a
purchaser simply steps into the shoes of the seller liquidating distribution of $290,000 (an equal
with respect to capital and may also succeed to division of the $380,000 income net of the meals
any inherent Code Sec. 704(c) items reflected as a plus the original $200,000 capital).

Chart 14. payment is not subject to entrepreneurial risk. The

Code Sec. 704(b) Tax Basis partnership reports the payment as a separately stated
Ally Sarah Ally Sarah item on the K-1 of the recipient and deducts the
Initial Formation 100 100 100 100 payment subject to the general tax rules applicable
to deduction or capitalization of partnership items.
Operating 200 200 200 200
Income Because the payment is made to the recipient partner
Meals & <10> <10> < 5> < 5> in a nonpartner capacity, it does not affect the capital
Entertainment account of any partner except through the effect of
Distribution <290> <290> <290> <290> the deduction of the item by the partnership.44 In this
Ending Capital -0- -0- 5 5 sense, it is treated the same as if the payment had
actually been made to a third party.
The partnership was required to make some debit Transfer of a Profits Interest as
entries to reflect the nondeductible meals and Compensation
entertainment in the tax basis books. That is, cash A partnership may grant a profits-only interest as
was credited for $20,000, a tax deduction was compensation for services, with the service provider
debited for $10,000, and there was a balancing avoiding a taxable event at grant. Once the service
entry. If the partnership created a fictional asset provider becomes a partner, he is subject to the
account, that account could be eliminated with normal distributive share rules with respect to
a credit entry at liquidation with the offsetting any income allocable to the profits interest. This
debit made to the capital accounts of both Ally means that if the partnerships income is Code
and Sarah to zero out their tax-basis capital. 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.
Code Sec. 708(b)(1)(B) Terminations Of course, the partnership loses a deduction for the
A partnership
rtneershiip terminates
te under Code Sec. 708(b)(1)(B) putative compensation as a price for granting the
when
heen there
h e has
there has been a sale or exchange
ha g of 50 compensatory profits interest holder the benefit of
percent
erccent or more
m eo of the interests in ccapital an
and p
profits flowthrough treatment
treatmen for the character of the item.
within
with 12-month
hin a 12- -month period. case, a deem
od. In such a case deemed
ed The other partners
tner benefi
en fit only
nly through
th ough a reduction
reduc ion ofo
transaction
nsacttion occurs
an occcurs in
i which the old partnership
par e hip their share
th shar of the flowthrough
w rough income
ncome iitem, with
em, w th the
transfers
nsferss its assets
aassets to
o a new
w partnership
part ship in i exchange
ex hange benefi
be efitt determined
d mined at rates
rates applicable
ap licable to net capital
ap
for all of theh interests of the new partnership, and
th gains if the service providers gains are taxed at the
the old partnership then liquidates
liquidates by distributing favorable rates applicable to such gains.
the interests of the new partnership
partnership to its partners, Rev. Proc. 93-27 defines a profits interest by
which includes the purchasing partner.41 A strict reference to what the partner would receive if the
application of the mechanics of the Code Sec. 704(b) partnership liquidated at the date of grant. To be
capital account maintenance rules would require a profits interest, the recipient of the interest must
a restatement of the value of all properties when not be entitled to any assets if the partnership were
they are contributed to the new partnership in this to liquidate on the date of grant.45 This liquidation
assets-over transaction. However, because this approach to valuation may require a restatement
transfer is merely a deemed transfer, and the actual of the value of partnership properties if there is an
transaction is a purchase of a partnership interest, inherent gain with respect to partnership assets at the
the Code Sec. 704(b) capital of the selling partner is date of grant of the award. Reg. 1.704-1(b)(2)(iv)(f)(iii)
simply transferred to the purchasing partner, and no makes the grant of the compensatory interest one of
adjustments are made to partner capital.42 the permitted revaluation events for purposes of the
Code Sec. 704(b) capital account maintenance rules.
Guaranteed Payments
A guaranteed payment is one that is determined Example 10. Ally and Sarah form the AS partner-
without regard to the income of the partnership.43 It ship, with each contributing $500,000 of money
is treated as if made to a nonpartner because, unlike in exchange for a 50-percent interest in all items
items of the partnership, the partners right to the of the partnership. The partnership agreement
48
February 2014
satisfies the alternate test for economic effect. a disparity between Ally and Sarahs Code Sec.
The partnership uses the contributed money 704(b) and tax-basis capital. Ignoring any other
to purchase a tract of undeveloped land for capital account adjustments for ease of exposi-
$1,000,000. The partners intent is to hold the tion, the capital accounts after sale of the land
property for appreciation. Three years later, and immediately before distribution of proceeds
after Ally and Sarah believe the property has of sale will appear as shown in Chart 16.
appreciated, they decide that they would like to
enhance the lands value with partnership-level Chart 16.
development activities. Because they are not Code Sec. 704(b) Tax Basis
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 Restatement 400 400 -0- -0- -0- -0-
that Katies share of profits relates only to gains Sale @ 3000 480 480 240 880 880 240
that occur after the date of the award of the Ending Capital 1,380 1,380 240 1,380 1,380 240
profits interest, the parties have to agree on the
date-of-award value of the property. Katie would The restatement at the time of Katies admittance
be expected to argue for a relatively small value helps to clarify that Katies profit share is com-
to provide a lower base for measuring future puted on a base asset value of $1,800,000. Katies
profits, and Ally and Sarah would argue for a award is then ultimately worth 20 percent of
large value, creating adverse interests. If they $1,200,000, or $240,000. This gain is reported in
settle on an agreed value of $1,800,000 at the the year of sale of the land based on the character
date of the award, the partnership can restate the of income determined at the partnership level.
value of the land by $800,000 and then define
Katies profit award to be based on Code Sec.
704(b)
04(b capital
b) caapit values. This justifies no current Tax Credits
income
in
ncom me toto Katie
K tie
Katt by use of a liquidation valuation Tax credits generallyy have no effect on partnership
off herr interest,t because
inteerestt, b use Code Sec.
Sec 704(b)) capital
p capital, either
er for CCode Sec. 704(b) or tax-basis
basis
is thee bas for
or partners
sis fo distributions
ners rights to dist ibutions capital.
capi tal. Credits
C its dod not
no create
c ate an economic
econoomic benefi
enefit
n liquidation.
in liqu
uidaation n. The
T capital
pital accounts
accounts would
woul then
th n independent
in pend of tax consequences
cons u nces and therefore
theref re do
appear
apppeaar shown
ar ass shoow wnn iin Chart 15.
hart 15 not adjust
no adju Codeode 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
Chart 15. effect.46 Certain tax credits may reduce the tax basis
Code Sec. 704(b) Tax Basis of the property that gives rise to the credit, and any
Ally Sarah Katie Ally Sarah Katie recapture of such credits may increase the basis of
Initial Formation 500 500 500 500 that property.47 Where the credit affects the tax basis
Restatement 400 400 -0- -0- -0- -0- of the property, the offsetting entry will be to the
Ending Capital 900 900 -0- 500 500 -0-
partners tax-basis capital accounts, based on how
they share the credit.
If the partnership later sells the property for Code Sec. 1031 Boot Gain
$3,000,000, the development gain would be Allocations: Interaction with
$1,200,000, which is split in a 40/40/20 ratio us- Code Sec. 704(c)
ing Code Sec. 704(b) capital values. The tax gain
is $2,000,000, which includes a reverse Code Code Sec. 1031 provides for nonrecognition of gain
Sec. 704(c) allocation for the economic gain that or loss when property held for investment or trade or
accrued before Katies admittance and a post- business use is exchanged for property of a like kind
grant economic gain that is split among all three also to be held for investment or trade or business
partners. The reverse Code Sec. 704(c) item was use. If non-like-kind property is received as part of the
reflected in the earlier restatement and creates exchange, the taxpayer recognizes gain measured by

the lesser of the gain realized on the exchange or the Chart 17.
FMV of non-like-kind property received. The basis of Code Sec. 704(b) Tax Basis
the replacement property is most simply computed on Ally Sarah Ally Sarah
the Form 8824 as the cost basis of the replacement Contributed Value 1000 1000 1000 600
property minus the gain deferred on the exchange.48
Sale of Land 500 500 100 100
If the relinquished property had unrealized Code Sec.
Post-Sale 1500 1500 1100 700
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 The tax basis of the replacement property is
timing of the recognition of the Code Sec. 704(c) $600,000, creating a deferred gain of $1,200,000.
gain. Specifically, must Code Sec. 704(c) gain be The deferred gain belongs $400,000 to Ally
recognized first, to the extent of the boot received, and $800,000 to Sarah, which is reflected in
or may the boot gain be attributed to economic the disparity between each partners Code Sec.
gains realized after the contribution that created the 704(b) book and tax-basis capital. There are no
Code Sec. 704(c) gain with the result that it can be examples, or discussion, in the Code Sec. 704(b)
shared by all partners under the economic effect regulations that relate to the Code Sec. 1031
test? The Code Sec. 704(b) capital account analysis partial recognition transaction shown above.
is the easiest way to track the nature of the boot gain However, the regulations do permit following
recognized and to which partner(s) that gain should the principles of the regulations in situations
be allocated, as shown in the following example. where specific guidance is lacking.50 Also, an
allocation can have economic effect where
Example 11. Ally and Sarah form the AS partnership, it can be reflected in the Code Sec. 704(b)
with Ally contributing $1,000,000 of money and capital accounts, and the regulations do have
Sarah contributing undeveloped land with an an example where a post-formation economic
agreed FMV of $1,000,000 and a tax basis of loss is allocated to all partners, even where
$600,000.
00,000. All Al items are agreed to be shared 50 the property sold has Code Sec. 704(c) gain
percent
peercenntt by
by each
eacch partner and the partnership satisfies potential.51 The capital
p account entries shown
the
the requirements
reqquireemen nts for the
he alternate test
te for economic
co om above reflect the full
fu economic profit realized
effect.
efffect.. Three
Threee years
yeear afterr formation,
formation the partnership
pa tnershipp from the
th sale
ale in the
h Code
C de Sec.
Sec. 704(b)
704(b) capital
ca ital
sells
ells Sarahs
se S hs contributed
Sarah coontrib d land for $2,000,000.
$2,000 00 The T e andd create
cre a boobook-tax disparity
ta dispa both
ty for bo partners.
h part e
funds
unds aare held
h in a C Code Sec
Co Sec. 103
1031 qualifi ed
ualifie escrow,
d es row However,
owev Sarahs d disparity
sparity remains $400,000
emain $400 00
and thehe partnership
th pa uses a qualified intermediary higher than Allys, which allows us to continue
to facilitate an exchange. The
e. Th partnership
e pa rtner timely to track the built-in gain from her formation
identifies and receives $1,800,000
$1,800,000 of o qualifying transfer. Although it may also be argued that the
replacement property and $200,000 of boot from book gain should be $200,000, matching the tax
the exchange. The partnership has a $1,400,000 gain, the conclusion that the taxable gain can be
realized gain ($2,000,000 $600,000 basis) and split by agreement under the economic effect test
a $200,000 recognized gain from the exchange. will not change. The principles of the Code Sec.
The partnership has $1,000,000 of economic gain 704(b) regulations seem to support reflecting
realized from the sale ($2,000,000 $1,000,000 the full economic gain realized by the sale in
date-of-contribution FMV),49 and that gain may be the Code Sec. 704(b) capital accounts because
reflected in the Code Sec. 704(b) capital accounts. the end result best reflects the current economic
Notwithstanding the existence of unrealized Code position of the partnership and states the value of
Sec. 704(c) gain with respect to Sarahs contributed the replacement property based on arms-length
property, the $200,000 boot gain may be allocated bargaining with the seller of that property.
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 Debt-for-Equity Exchanges
the tax gain may be allocated to both partners When a partnership enters into an exchange of a
consistent with an economic benefit realized by debt instrument held by a creditor of the partnership
each (see Chart 17). for equity issued by the partnership, the exchange is
50
February 2014
generally governed by Code Sec. 721. The creditor Chart 18.

recognizes no gain or loss on the exchange and Code Sec. 704(b) Tax Basis
acquires a tax basis in the partnership interest Ally Sarah Katie Ally Sarah Katie
by substituting the basis of the debt instrument Initial Formation 500 500 500 500
exchanged. 52 However, the partnership may
Debt-for-Equity 1500 2000
recognize cancellation-of-debt (COD) income to
the extent the FMV of the interest transferred in the Restatement <250> <250>
exchange is less than the principal balance of the COD Income 250 250 -0- 250 250 -0-
debt. Any COD income is allocated to those partners Ending Capital 500 500 1500 750 750 2000
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 This analysis shows total Code Sec. 704(b)
were a partner, COD income would be allocated to capital of $2,500,000, of which Katie owns
the creditorpartner based on the interest held prior 60 percent, and Ally and Sarah each own 20
to the exchange.53 Any loss realized by the creditor percent. Ally and Sarah each have a reverse
as a result of the exchange is impounded in the basis Code Sec. 704(c) allocation of a $250,000
of the partnership interest. While such a loss appears loss, which reflects the decline in value of the
like a Code Sec. 704(c) item in the partnership capital property before Katie was admitted as a partner.
accounts, the property contributed is extinguished When the land is disposed of in a taxable
by the exchange and the deferred loss cannot be transaction, this loss will be allocated to Ally
recognized until the creditorpartner disposes of and Sarah. Katies tax-basis capital exceeds
the interest. her book basis capital by $500,000, but since
her debt instrument was extinguished as part
Example 12. Ally and Sarah form a partnership of the exchange, there is no Code Sec. 704(c)
with each contributing $500,000. They borrow property the sale of which would allow her
$2,000,000
,00
00,00 00 ffrom Katie and purchase $3,000,000 to recognize this built-in loss. Instead, Katies
real
all property.
off rea pro
operrty realized but unrecognized loss on the debt-
for-equity excha
exchangeg will be recognized when
When
W n thee partnership
parrtn p is in default
default on payments
payments sells her
she se er partnership
p ne sh interest
interest or receives
receives a
on Katies
atiess debt,
n Ka bt, and
deb an thee principal
princip l balance
balance iss still
s l liquidating
uida g distdistribution
b io ffrom m the ppartnership
artner h
$2,000,000,
$22,00
2 00
00,0
00 00, tthe
000 parties
e p agree that K
es agre Katie will
atie wi that would allow a loss
at w under
oss u Code Sec
er Cod Sec. 731.
3
exchange
hange herh debt instrument for 60 percent of For example, if the partnership property were
the equity of the partnership.
ersh p. The
The parties
pa agree sold for its restated value of $2,500,000, with
that the equity transferreded to Katie
o Kat has a FMV of
ie ha liquidating distributions following Code Sec.
$1,500,000. The exchange results in $500,000 704(b) capital, the following entries would be
of COD income that is allocated to Ally and made as shown in Chart 19.
Sarah. Katie has a realized loss on the exchange
of $500,000 that is not recognized pursuant to
Code Sec. 721. Katies basis in her partnership Chart 19.
interest becomes $2,000,000. The exchange Code Sec. 704(b) Tax Basis
that establishes $1,500,000 as the value of a Ally Sarah Katie Ally Sarah Katie
60-percent interest implies total partnership value Pre-Sale 500 500 1500 750 750 2000
is $2,500,000 ($1,500,000/.6). Because Katies Sale @ 2500 0 0 0 <250> <250> 0
debt instrument is cancelled by the exchange, Distribution <500> <500> <1500> <500> <500> <1500>
and does not become an asset of the partnership
Post- -0- -0- -0- -0- -0- 500
(as contributed property typically would be), the Liquidation
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 Katies unrecovered $500,000 tax basis will
property is then permitted. The capital account be recognized as a capital loss when the
entries are shown in Chart 18. partnership liquidates.

Noncompensatory Option: of the NCO.56 The revaluation must also adjust

Grant and Exercise the FMV of partnership properties, either up or
down, to reflect the share of that FMV represented
In addition to the grant of an equity interest in by other NCOs outstanding at exercise. This is
exchange for services, which may include the grant because outstanding NCO holders have secured,
of options to acquire equity, partnerships can grant through the call feature of the NCO, a right to some
noncompensatory options to acquire interests. of the partnership asset value. If the FMV of the
The noncompensatory option (NCO) provisions outstanding NCOs exceeds the option premium
apply to call options, warrants,54 convertible debt paid by the holders, the value of partnership
instruments and convertible equity. The grant of properties is reduced in the revaluation. If the
an NCO is generally treated as a open transaction, FMV of the outstanding NCOs is less than the
so there is no immediate tax effect to the NCO option premium paid by the holders, the FMV of
holder or to the partnership. The amount paid to partnership properties is increased.57
the partnership in exchange for grant of the NCO
is debited to the partnership books (however they Example 13. Ally and Sarah form the AS
may be maintained), and the offsetting credit is partnership with each contributing $500,000
to a premium account. Although neither of these of money. The partnership satisfies the
entries affects partnership capital, the grant of requirements for the alternate test for economic
the NCO is a permitted revaluation transaction. effect. The partnership uses the contributed
Any unrealized gain or loss with respect to capital to purchase $1,000,000 of undeveloped
partnership properties belongs to the existing land. At a time when the land is valued at
partners, and the revaluation allows the capital $1,500,000, the AS partnership grants an
accounts to reflect the value attributable to capital option to Katie to acquire a 25-percent interest
represented by existing interests to prevent a shift in exchange for paying an exercise price of
of pre-grant gains and losses to the recipient of an $500,000. Katie pays an option premium of
NCO. O. The
T NCNCO holder has no capital account at
N $40,000 for the right to exercise the option
this
is time
time because
tim becau us he is not yet a partner, so any at any time within the next three years. When
restatement
esttatem just
men t ju st affects capital accounts
cts the cap co n of the land has
as appreciated
app ec to $2,020,000, Katie
existing partners.
xisstingg pa rtneers. exercises the
exercis he ooption.
io . Capital
ap ta account
ac ount entries
en ries
Upon
U pon exercise
ercisse of the
n exe e NCO, tthe transfer
e tran fe oof the
he willl be made
de aas shown
h wn in Chart 2020.
option
tiion exercise
exerrcisee price
ri in exchange
pric excha e for an n interest
nterest
is not a taxa b event pursuant to Code Sec. 721.55
taxable
The new partners capital al account,
account, for
fo both Code Chart 20.
Sec. 704(b) book and tax,, is tthe he ssum
um oof the amount Code Sec. 704(b) Tax Basis
previously paid for grant of the NCO (which is now Ally Sarah Katie Ally Sarah Katie
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 Grant Revaluation 250 250
the Code Sec. 704(b) capital accounts to reflect Exercise -0- -0- 540 -0- -0- 540
the value of partnership properties pre-exercise Exercise 210 210 100 -0- -0- -0-
and also creates a Code Sec. 704(c) layer for the Revaluation
pre-exercise gain or loss. The NCO partner will Ending Capital 960 960 640 500 500 540
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 entries in the example require more
The NCO holders Code Sec. 704(b) capital, post- explanation that can be provided by the one-sided
adjustment, should then reflect his date-of-exercise entries shown to the capital accounts. When the
proportionate share of total Code Sec. 704(b) option is granted to Katie, the partnership makes
capital. The revaluation must take into account the the entry to its Code Sec. 704(b) and tax basis
effect of any prior revaluation that occurred at grant books as shown in Chart 21.58
52
February 2014
Chart 21. each. The restatement of the land then must

Cash 40,000 adjust economic-based capital to lead to
Option Premium 40,000 these respective interests and is then shown
in Chart 24.
The land is revalued to its date-of-grant value of Chart 24.

$1,500,000, with the capital accounts of Ally and Land 520,000
Sarah adjusted to reflect how they would share
Ally capital 210,000
the gain attributable to the appreciation shown
Sarah capital 210,000
in Chart 22.
Katie capital 100,000
Chart 22.
Land 500,000
The land has a Code Sec. 704(b) book basis of
$2,020,000 and a tax basis of its original cost of
Ally capital 250,000
$1,000,000. When sold, there is $1,020,000 of
Sarah capital 250,000
Code Sec. 704(c) gain to allocate, with $920,000
allocated to Ally and Sarah and $100,000 to
This entry is to reflect the pre-grant appreciation, Katie. Katies share is based on her sharing in the
which economically belongs to Ally and Sarah. appreciation as a result of her option position,
At exercise of the option, the date that Katie which provided her with some measure of equity
becomes a partner, Katies capital account is ownership during the period the option was
credited for the option exercise price as well open. A call option allows the holder to share in
as the option premium (which is eliminated appreciation in the underlying asset subject to
from the books by this entry) previously paid the option right, without risk of loss beyond the
in Chart 23. amount paid to acquire the option position, an
economic right that justifies the payment of the
Chart
ha
art 23.
23 option premium.
Cash
Cassh
h 500,0
500,000
Thee above
Th ab example
ex p is i more
more complicated
comp icated than
tha
Opt
tion P
Option Premium
Premium 000
40,000
the previouss one
th prev ones b because
ca se the revaluation
he reva must
uation m
atie cap
Katie p
pital
capital 40,00
00
540,000
recognize
re ogniz the economic
he eco no mic pposition
ition of the option
p
holder from date of grant through date of exercise.
The land is again revalued,
eval ued this
thi time by If the partnership holds multiple properties, and
$520,000, to its date-of-exercise
e-of -exe rcise value of one property is sold between the grant date and
$2,020,000. The offsetting credits reflect how exercise date, the revaluation and adjustment to
the partners share in the economic gains the capital of the option holder are even more
associated with this appreciation. Katie is complicated. This is so because the disposition of
entitled to some of the appreciation because, the asset prior to exercise prevents the partnership
during the period she held an open option from using a revaluation to record the option
position, the option conferred an economic holders share of the post-grant gain attributable
right to a share of the appreciation in the to the property that was disposed. To correct
value of the property. Following exercise, this, the NCO regulations provide for a capital
Katie holds a 25-percent interest in partnership account reallocation using corrective allocations.
capital, Ally holds 37.5 percent, and Sarah Corrective allocations result in a capital shift from
also holds 37.5 percent. Total capital will be existing partners to the option partner to reflect
$2,560,000, the sum of the value of the land the option holders share of post-grant economic
($2,020,000) and the $540,000 cash received gains that had been allocated only to the partners
from the grant and exercise of Katies option. holding interests at the date of sale.59 The correction
Katies share is $640,000 (25 percent), and Ally is to effectively true-up the tax allocations
and Sarahs share is $960,000 (37.5 percent) with the overall economic arrangement of the

partners. The option partner then ends up with the economics of the partners arrangement, so that
proper amount of post-grant gain that would have it is possible to track the benefits and detriments
occurred had the property disposed of instead been associated with tax allocations. Code Sec. 704(b)
held until the option partner became a legal owner capital is also useful in tracking Code Sec. 704(c)
of the interest.60 allocations, which are generally measured by the
disparity between Code Sec. 704(b) and tax-basis
Conclusion capital and permitted revaluations to Code Sec.
704(b) capital allow the partnership to also track
Partnership Code Sec. 704(b) capital accounts are reverse Code Sec. 704(c) allocations. Finally,
generally used when the partnership agreement where Code Sec. 704(b) capital is used to reflect
is drafted to satisfy one of the safe harbors for partnership economics, it is easier to understand
economic effect and the safe harbor to deem a variety of other partnership-related tax issues
allocations of nonrecourse deductions to be arising from transactions undertaken for economic
in accordance with the partners interests. reasons. Where tax allocations must follow
The economic effect test is satisfied when tax associated economic benefits and burdens, capital
deductions are allocated to the partner who accounts that reflect the economic arrangement
bears the economic detriment associated with can be crucial to properly allocating the tax
the deduction, and taxable income is allocated consequences of a transaction. This article reviews
to the partner who enjoys the economic benefit those transactions most commonly encountered
associated with the income. The purpose of the by the tax adviser and illustrates how to make the
Code Sec. 704(b) capital accounts is to show the required capital account adjustments.
ENDNOTES
1
2012 IRS SOI Tax Statistics, Table 21. S accordance with the partners interest in match capital to the partners agreed-to
corporations remain the most popular the partnership. Satisfying the safe harbor allocations of money. This can create
entity
ty ty
type,
ype, wwith 2012 Form 1120S filings will allow the allocation specified in the multiple tiers of gain allocation, often
approximating
pp
pro im
proximmating 4.5 45m million. agreement to be deemed to satisfy the referred to as a layer cake approach,
2
Code
Coode Sec.
S 7
704(b
704(b) b) book refers to the partners
ne interest test. to reflect the agreed priority of cash
7
capital
cappital
i l account
a
accouunt maintenance
maini e rules found Reg. 1.704-3(a)(3)(i)
R .704-3 a)(3)(i identifi
dentifies Co
Code Sec. c. allocations.
al ca n . The T layer
la r cake
ake approach
a proac
in Reg. 1.704-1(b)(2)(iv),
1.7004-1(b b)(2) which
ich are often 704(c)
704 c) property
op y by a d disparity
sparity betw
between thehe can
ca b be co
complicated
mp cate aass it mu mustt al
also
incorporated
inccorporrated by re reference
fere in a partnership propertys
pro er s CCode e Sec. 7
704(b)
4( book ok va
value and
nd consider
co sid an any m
minimum
nimum gain charge
ain char e back
agreement.
agrreeme ent. The
T te
term
er m cca
can be confusin
confusing that propertys
tha propertys tax
tax basis.
basis Reg.
Re 1.704-3(a)(6)(i)
1.704-3 (i) or qualified
qualifie income
ncome offset
o et allocations.
allo at
because
ause practitioners
practtition often think of financial similarly identifies reverse Code Sec. It is wise to test how the layers match
accounting principles when the term book 704(c) property by reference to disparities partners expected cash distributions in a
is used. However, since Treasury Regulations
egula ions created by revaluations permitted by Reg. variety of possible economic states of the
are drafted for tax purposes, book boo k is 1.704-1(b)(2)(iv)(f). partnership.
8 12
instead defined as a shortened referencerefer nce See, for example, Simon Friedman, See Reg. 1.704-1(b)(2)(iv)(h). The use of
to Code Sec. 704(b) book, which assists Noncompensatory Capital Shifts: Rethinking Code Sec. 704(b) capital as the basis for
in applying tax principles to partnership Capital Accounts, 107 TAX NOTES 597 (May liquidating distributions will generally
allocations. 2, 2005), Doc 2005-6565, 2005 TNT 84-43. create the adverse interests needed to
3 9
Reg. 1.704-1(b)(2)(ii)(b). For a review of factors used in measuring use partner agreements with respect to
4
In partnership convention, the terms the partners interest in the partnership, and FMV as acceptable for Code Sec. 704(b)
liquidating and nonliquidating refer the difficulties in applying those factors, see capital account maintenance. There is a
to whether the distribution terminates Reg. 1.704-1(b)(3), Vecchio, 103 TC 170, limited exception to the capital accounts
the interest of the distributee partner. The Dec. 50,027 (1994), J.R. Tobias Est., 81 TCM determining rights to assets that may apply
partnership itself may continue to exist in 1163, Dec. 54,245(M), TC Memo. 2001-37, when a partners interest is purchased at a
either type of distribution. This contrasts with and M.W. Ballantyne Est., 83 TCM 1896, price negotiated at arms length. It is not
the entity-type approach of corporations Dec. 54,796(M), TC Memo. 2002-160, affd clear to what extent this exception may
where a liquidating distribution refers to one CA-8, 2004-1 USTC 50,120, 341 F3d 802. be relied upon when the partnership is the
10
that terminates the corporate existence. See Reg. 1.704-1(b)(2)(ii)(b) for a description purchaser. See Reg. 1.704-1(b)(2)(ii)(b).
5 13
Reg. 1.704-1(b)(2)(ii)(b) and (d). of the three-requirements test and Reg. To ensure that partners receive what
6
Reg. 1.704-2(e). Allocations of 1.704-1(b)(2)(ii)(d) for a description of the their deal points state, Code Sec. 704(b)
nonrecourse deductions cannot have alternate test. compliant agreements must rely on often
11
economic effect because the economic Where the distributions are based on complex gain allocation tiers to build up
detriment associated with the deductions ending capital balances, it is common capital to match the partners agreement
is borne by the nonrecourse creditor. to build up capital with allocations of as to division of assets. These provisions,
Thus, such allocations must be made in gain from sale of partnership assets to when written in a partnership agreement,
54
February 2014
42
can be confusing to partners expecting contributing partner with respect to Reg. 1.704-1(b)(2)(iv)(l). The only
to see a clear statement of how assets cost recovery conventions, including change is the new partnership is not
will be distributed. Target allocation determination of the cost recovery year. bound by the consistency rules for the
21
provisions seek to minimize confusion Reg. 1.704-1(b)(2)(iv)(g)(3). method of Code Sec. 704(c) allocations
22
to the partners by a clearer statement Reg. 1.704-3(b)(1). (Reg. 1.704-3(a)(2)).
23 43
of what each partners share of assets See Reg. 1.704-2(d)(4) for the effect of Code Sec. 707(c).
44
will be and then use income and loss revaluations on computations of changes in Reg. 1.704-1(b)(2)(iv)(o). Of course,
allocations to create capital accounts partnership minimum gain (used to measure there may be a dispute as to the character
that match the distributions. However, nonrecourse deductions and determine of the payment as a guaranteed payment
target allocation provisions do not base the timing and amount of minimum gain or perhaps a normal distribution. If the
liquidating distributions on Code Sec. chargebacks). partnership wants the item to be treated
24
704(b) capital account determinations, so The Code Sec. 704(b) regulations only as a guaranteed payment, it is important to
they do not comply with any safe harbor use examples where the post-formation make its status clear by agreement among
for economic effect. If the values assigned interest transfer is made to a new partner. the partners.
45
to partnership properties do not affect the See Reg. 1.704-1(b)(5), Examples 14 Rev. Proc. 93-27, 1993-2 CB 343. See also
amounts to be received by the partners and 18. This is computationally simple, Proposed Reg. 1.704-1(b)(4)(xii) for other
upon liquidation, it is more difficult to but it requires the practitioner to develop provisions that may, when the regulations
argue that the agreed-to values are based the analysis required for a transfer to an are finalized, be required in the partnership
on bargaining by parties with adverse existing partner. agreement to use the liquidation valuation
25
interests. Partnership distributions of property are approach.
14 46
The partnership may maintain multiple not taxable under the Code Sec. 731 See Reg. 1.704-1(b)(5), Example 11(i).
47
capital account records for different distribution rules. In appropriate fact Reg. 1.704-1(b)(2)(iv)(j).
48
purposes. The examples in this article patterns, a distribution may cause a Code Sec. 1031(d) is the official means by
show both Code Sec. 704(b) and tax partner to recognize gain pursuant to a which the basis of replacement property
basis capital, and a comparison of those disguised sale under Code Sec. 707(a)(2) is computed. The basis is the basis of the
two capital accounts facilitates, among (B) or to accelerate recognition of Code relinquished property increased by any
other items, tracking Code Sec. 704(c) Sec. 704(c) gain under Code Sec. 704(c) gain recognized and the FMV of any boot
allocations, as is also shown in the (1)(B) or 737. If any of these anti-abuse property transferred and reduced by any
examples in Reg. 1.704-3. The IRS MSSP provisions apply, the distributee still has loss recognized and the FMV of any boot
for partnership allocations notes that an an incentive to argue for a low value to property received.
49
examiner may see tax basis capital on a be assigned to the distributed property to This is the economic gain of the partnership
partnership return even if the partnership reduce gain to be reported. measured relative to the agreed FMV of the
26
also has Code Sec. 704(b) capital to satisfy Reg. 1.704-1(b)(2)(iv)(e). property at date of contribution.
27 50
a safe
afe harbor
h r for economic effect. Code Sec. 732(a)(1). Reg. 1.704-1(b)(2)(iv)(r).
15 28 51
Reg.
Reeg. 1
1.704-3(a)(2)
1.704 4-3(a))(2 applies Code Sec. Code Sec. 733(2). Reg. 1.704-1(b)(5), Example 14(iii).
29 52
5
704(c)
7004(c) on a property-by-property
p p
proppert property basis. This also
a o illustrates the adverse interests st Code Sec. 722.
C
53
However,
Ho owevver, Reg.
R 1.
1.704-3(e)(2) (e)(2) allows involved
in olv d in the
the partners
partne negotiations
negootiatio of thehe COD
C D income
ome in a partne
partnership
ship is generally
enera
items
ite
ems inn the same
s Code
Co Sec. 168 recovery
Cod valuee of the
va th distributed
istribute lolot. Had
ad Katie beenen aallocated
ca to
t the partner(s)
partner( ) who enjoy
e jo the
period,
peeriod, other
otheer than
thaan real property, perty, to be
b able
ab e to negotiate
eg ate a smallerle value,, he
her capital
ta benefi
b efit of thee debt discharge,
dis arg under de the
aggregated.
g
ggrega ated. Securities
ated Secuur ies es partnerships
p erships are
a would
w uld bee closer
clo er in li
line tto that
hat of tthe other
he general
ge eral principles
pri ples of the
t economic
econom c effect
also granted
grrantedd flexibility
fl in aggregating partners. test. However, the specific application of
30
for purposes of reverse Code Sec. 704(c) ( ) Reg. 1.704-1(b)(2)(ii)(a) includes a the economic effect test to COD income is
allocations. statement of fundamental principles. beyond the scope of the analysis presented
16 31
1
The alternate test requires that the Reg. 1.734-1(b)(1) and (b)(2). in this article.
32 54
partnership will maintain Code Sec. 704(b) Reg. 1.704-1(b)(2)(iv)(m)(4). Although people often use the terms
33
capital, that distributions in liquidation Because Katie is redeemed with money, interchangeably, or mix the definitions,
of a partners interest will be made in there is no requirement to restate the warrants are generally defined to be dilutive
accordance with Code Sec. 704(b) capital value of any properties. However, because new partnership units would be
and that the partnership agreement the partnership may, in a liquidating issued upon exercise, whereas options are
contains a qualified income offset. See distribution, choose to restate the value of generally nondilutive because the option is
Reg. 1.704-1(b)(2)(ii)(d). undistributed properties because the arms- to acquire an existing interest.
17 55
A sale of contributed property for its length bargaining required to determine An NCO may be settled for cash rather
agreed-to value at date of contribution the value of the liquidated partners interest than for an equity interest, and a cash
simply changes the type of asset recorded provides objective evidence of the value of settlement may create a gain or loss to the
on the debit side of the balance sheet but all properties. partnership measured by the difference
34
does not affect the partnerships economic Code Sec. 732(b). between the amount paid at settlement
35
position. Reg. 1.734-1(b)(2)(ii). and the amount received at grant. If the
18 36
See Reg. 1.704-1(b)(5), Example 14. Reg. 1.743-1(k)(2) and (k)(4). NCO lapses unexercised, the partnership
19 37
This is why the Reg. 1.704-3 examples all Reg. 1.743-1(j)(1) and (j)(2). will also have a gain for the option
38
illustrate the application of Code Sec. 704(c) See Reg. 1.704-1(b)(2)(iv)(l) and (b)(5), premium received at grant. These gains
principles by using Code Sec. 704(b) and tax Example 13(ii) and 1.704-3(a)(7). or losses will affect the capital of existing
39
basis capital accounts. Reg. 1.704-1(b)(2)(iv)(m)(2) and (b)(5), partners in the same manner as any item
20
This is assumed for ease of computations. Example 13(iii) and (iv). of gain or loss but are not an issue for
40
C o d e S e c . 1 6 8 ( i ) ( 7 ) w i l l h ave t h e Rev. Rul. 96-10, 1996-1 CB 138. this article, which is limited to discussion
41
partnership step into the shoes of the Reg. 1.708-1(b)(1)(iv). of Code Sec. 704(b) capital account

58
adjustments to reflect the economics of The premium is paid for the right, but because the option premium is part of
partnership transactions. not the obligation, to exercise the NCO an open transaction. The premium will
56
See Reg. 1.704-1(b)(5), Example 31, for pursuant to its terms. The transaction is affect capital upon exercise or lapse of
the adjustments made at grant and exercise treated as open until the option is either the option right.
59
of the NCO. exercised or allowed to lapse. The entry Reg. 1.704-1(b)(2)(iv)(s)(3) and (s)(4).
57 60
Reg. 1.704-1(b)(2)(iv)(h)(2). shown does not affect any partners capital See Reg. 1.704-1(b)(5), Example 32.
This article is reprinted with the publishers permission from the

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February 2014

Partnership Code Sec. 704(b)

James R. Hamill discusses the benefits of a partnership maintaining

Introduction reverse Code Sec. 704(c) allocations. The Schedule

TAXESTHE TAX MAGAZINE

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Chart 6. after the second contribution as the numerator

TAXESTHE TAX MAGAZINE 43

Chart 9. was liquidated. If the adjustment arises from a

TAXESTHE TAX MAGAZINE 45

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Chart 14. payment is not subject to entrepreneurial risk. The

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generally governed by Code Sec. 721. The creditor Chart 18.

TAXESTHE TAX MAGAZINE 51

Noncompensatory Option: of the NCO.56 The revaluation must also adjust

Chart 21. each. The restatement of the land then must

The land is revalued to its date-of-grant value of Chart 24.

TAXESTHE TAX MAGAZINE 53

TAXESTHE TAX MAGAZINE 55

This article is reprinted with the publishers permission from the

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