I Want In Selected Tax Considerations in Entering a Partnership

Transcription

1 I Want In Selected Tax Considerations in Entering a Partnership Alabama Federal Tax Clinic November 16, 2012 John J. Rooney KPMG LLP Washington, DC (c) 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity, All rights reserved.

2 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. 1

3 Topics Basic Section 721 rules Exceptions to non-recognition treatment Basic Section 704(c) rules 2

4 Basic Section 721 Rules 3

5 Section 721 General Rule A transfer of property to a partnership in exchange for a partnership interest is generally nontaxable for both the partner and the partnership under Section 721(a). No Section 351(a) control requirement. 4

6 Section Property Definition of property Generally includes money and any other property Property that qualifies for Section 351(a) should also qualify for Section 721(a) Property? Services Accounts Receivable Partner s Note DuPont Issue Partner contributes non-exclusive right to use property Section 752(c) Property subject to nonrecourse debt > FMV of property 5

7 Section 721 Basis Partnership s basis in contributed property Carry-over basis Partner s basis in partnership interest Carry-over basis of contributed assets Plus partner s share of partnership liabilities Minus partner s debt transferred to partnership 6

8 Section 721 Holding Periods Partnership s holding period in assets Carry-over/tacking of partner s holding period Partner s holding period in partnership interest Carry-over holding period Section 1231 assets and capital assets New holding period Cash, inventory, and non-section 1231 assets Possible split holding period 7

9 Section 721 Rev. Rul Situation 1 A 50% interest B SMLLC DE B purchases a 50% interest in LLC from A. A retains the sale proceeds. A and B operate the business of LLC as co-owners. 8

10 Section 721 Rev. Rul Situation 1 A 50% assets B A B 50% assets 50% assets DE LLC Transaction treated as if: (1) B purchased 50% of the LLC s assets from A (2) A and B each contributed 50% of the assets and formed LLC as a partnership. 9

11 Section 721 Rev. Rul Can the owner choose to cherry-pick the assets of the LLC that are deemed sold in Situation 1? Sale is treated as a sale of a portion of all assets Not a sale of selected assets 50% of all assets A B DE 10

12 Section 721 Rev. Rul Situation 2 A B $ DE B contributes $10,000 to DE for a 50% interest. DE keeps the cash. 11

13 Section 721 Rev. Rul Situation 2 A B Assets $ LLC Transaction treated as a contribution of assets by A and a contribution of cash by B in formation of a partnership. 12

14 Section 721 Rev. Rul What if A had previously loaned money to LLC? Loan is disregarded prior to contribution by B, BUT loan is a regarded loan after the contribution. As a result, A may be treated as having sold a portion of the assets to LLC in exchange for the new note. Consider repaying the note prior to formation. A B Assets & N/P to A LLC $ 13

15 Section Exceptions 14

16 Section Exceptions Disguised Sales Liability Shifts in Excess of Basis Investment Company Exception Partnership Interest for Services Deferred Intercompany Transactions Overall Foreign Loss 481(a) Adjustments Acceleration of Advance Payments Section 337(d) ( May Co. Exception ) 15

17 Section 721 Exceptions Disguised Sales 16

18 Disguised Sale Section 707(a)(2)(B) A transfer to a partnership is a taxable sale if: There is a transfer of property to a partnership by a partner; There is a transfer of money or property by the partnership to the partner; and The two transfers, when viewed together, are properly characterized as a sale or exchange of property. 17

19 Disguised Sale Treas. Reg (b)(1) A contribution is treated as a disguised sale if: The partner transfers property to the partnership; The partnership transfers money or other property to the partner (including the assumption of a liability of the partner); The transfer to the partner would not have been made but for the contribution by the partner; and If the transfer to the partner is not simultaneous with the contribution, the transfer by the partnership is not dependent on the entrepreneurial risks of partnership operations. 18

20 Disguised Sale A disguised sale is treated as a sale for all purposes of the Code. A disguised sale is treated as occurring on the date of the contribution by the partner not on the date the partnership transfers property to the partner. If the transfer by the partnership occurs after the contribution by the partner, the partnership is treated as having issued an installment note to the partner on the date of contribution. Reg (a)(2). 19

21 Cherry-Picking Disguised Sale If there is a disguised sale, can the seller designate which assets were sold to the partnership? Relevant authorities: Proposed 707 regulations. Prop. Reg (e). Brown, 27 TC 27 (1956) Collins, 48 TC 45 (1966) Rev. Rul ; Rev. Rul TAM ; TAM TAM ; TAM

22 Disguised Sale Factors for determining a disguised sale: Timing/amount of distribution are reasonably determinable; Partner has a legally enforceable right to the distribution; Partner s right to distribution is secured in any manner; Partner s distribution is funded by: Other partner s loan or future capital commitment Partnership s asset or future borrowing; Partnership terms are designed to effect an exchange of the benefits and burdens of ownership of property ; Distribution is disproportionately large in relation to distributee partner s continuing interest; and Partner has no obligation to return or repay the distribution. 21

23 Disguised Sale Simplified Factors: Type of property contributed Type and amount of debt contributed Economic terms of the interest received by partner Amount of cash or property expected to be distributed Amount of time the contributor will be a partner 22

24 Disguised Sale Rebuttable presumption for a sale A transfer of property and a distribution of property to the partner within a two-year period is presumed to be a disguised sale unless the facts and circumstances clearly establish that the transfers are not a sale. Reg (c). If the partner takes the position that there is no sale on a distribution within two years, disclosure to IRS is required unless the distribution is a guaranteed payment for capital, a reasonable preferred return, or an operating cash flow distribution. 23

25 Disguised Sale Rebuttable presumption for no sale A transfer of property and a distribution of property to the partner that are more than two years apart is presumed not to be a disguised sale unless the facts and circumstances clearly establish that the transfers are a sale. Reg (d). 24

26 Disguised Sale Contribution of a liability to the partnership If a partner contributes a liability to a partnership, the contributing partner is generally deemed to receive cash in a disguised sale to the extent, if any, that a portion of the contributed liability is allocated to other partners under section 752. Reg (a)(1). 25

27 Disguised Sale Property X FMV: 150 Recourse Debt: 100 Basis: 80 A B 50% 50% $50 Cash Liability Shift Amount of recourse debt assumed 100 A s share of recourse debt 50 Potential amount of disguised sale 50 26

28 Disguised Sale Contributing partner s share of contributed debt Contributing partner s share of recourse debt is determined under Reg Contributing partner s share of non-recourse debt is determined under the third-tier allocation rules of Reg (a)(3) EXCEPT the rules for excess 704(c) debt do not apply 27

29 Disguised Sale Contributing partner s share of contributed debt Multiple liabilities contributed by more than one partner A contributing partner s share of its contributed debt equals the partner s combined share of ALL debt contributed as part of the same transaction (except for the contributing partner s share of its own qualified liabilities). Rule does not apply to any liability assumed with a principal purpose of reducing amount of consideration. 28

30 Disguised Sale Time for determining contributing partner s share of debt Partner s share of the liability is determined immediately after the contribution of the liability BUT the partner s share is reduced for any anticipated reductions in the partner s share of liability. Reg (a)(3). 29

31 Property X FMV: 150 Debt: 100 Basis: 80 Disguised Sale A B 50% 50% Liability Shift $50 Cash Amount of debt assumed 100 A s share of debt assumed 50 Potential disguised sale 50 Partner A can avoid a disguised sale by preventing $50 of the liability from being allocated to B. This might be achieved by having Partner A guarantee the debt and/or indemnify Partner B. 30

32 Section 721 Exceptions Disguised Sales Exceptions 31

33 Disguised Sale - Exceptions Qualified liabilities Reimbursements of preformation expenses Debt-financed distributions Distributions of operating cash flow Reasonable guaranteed payments Reasonable preferred returns 32

34 Disguised Sale Exceptions Qualified Liability Exception The contribution of a qualified liability is not treated as a disguised sale unless there is another transfer that triggers a disguised sale. Reg (a)(5). 33

35 Disguised Sale Exceptions Qualified Liability Exception If there is another transfer that triggers a disguised sale, the contribution of the qualified liability is treated as a disguised sale to the extent of the lesser of: the amount of the qualified liability that is allocated to the non-contributing partners or the amount of the qualified debt multiplied by the partner s net equity percentage. 34

36 Disguised Sale - Exceptions Definition of Qualified Liabilities Reg (a)(6) Old and Cold Debt Incurred more than two years before contribution Must have encumbered contributed property for two-year period Not Old and Cold Debt Incurred less than two years before contribution Must disclose to IRS if treat this type of debt as a qualified liability Must have encumbered contributed property for the entire period Debt allocable to capital expenditures with respect to contributed property under Reg T Ordinary trade or business debt Incurred in the ordinary course of a trade or business All material assets of the trade or business are contributed 35

37 Disguised Sale - Exceptions Old and Cold Qualified Liabilities Liability must have encumbered the contributed property for the two-year period prior to contribution Meaning of encumbered Perfected security interest required? 36

38 Disguised Sale - Exceptions Trade or Business Liability SH $25 A B Bank $25 50% 50% A borrows 25 and distributes it to SH prior to contribution. Bank liability is NOT a qualified trade or business liability - even if all of the assets of A s trade or business are contributed to the partnership because the liability was incurred to finance a distribution to SH and was not incurred in the ordinary course of A s trade or business. 37

39 Disguised Sales - Exceptions Reimbursement of Preformation Expenses A transfer of money to a partner is not treated as part of a disguised sale to the extent that the transfer was made to reimburse the partner for capital expenditures that Were incurred during the two-year period prior to the contribution and Were incurred by the partner with respect to the contributed property or to partnership organization or syndication costs. 38

40 Disguised Sales - Exceptions Reimbursement of Preformation Expenses Subject to FMV cap. If the contributed property has appreciated by more than 20%, the amount of reimbursement is limited to 20% of the FMV of the property at the time of contribution. Reg (d)(2)(ii). How is the FMV cap applied if a partner contributes multiple properties? 39

41 Disguised Sale - Exceptions Property A B 50% 50% Cash Properties Contributed by A Basis FMV Gain Acquired Prop A: Prop B: Prop C:

42 Disguised Sales - Exceptions Possible ways to apply FMV cap and exception Apply FMV cap to all properties whenever acquired 20% FMV cap applies (200 basis and 150 gain) Apply FMV cap to all properties acquired in last two years 20% FMV cap applies (200 basis and 50 gain) Apply FMV and the exception on property-by-property basis Exception does not apply to Prop A (acquired > 2 years ago) 20% FMV cap applies to Prop B (100 basis and 50 gain) 20% FMV cap does not apply to Prop C (100 basis; 0 gain) 41

43 Disguised Sales - Exceptions Reimbursement of Preformation Expenses Double dip potential? 42

44 Disguised Sales - Exceptions Reg (a)(5) If a partner contributes property subject to a liability the proceeds of which were used to acquire or improve the contributed asset, the liability is a qualified liability, and a shift in the sharing of that liability will not give rise to a disguised sale. Reg (d) A partner may receive a distribution of cash in reimbursement for capitalized expenditures incurred within the two-year period prior to contribution, subject to certain limitations. 43

45 Disguised Sale - Exceptions Property + Liability A B 50% 50% Cash Properties Contributed by A Basis FMV Gain Acquired Prop A: Prop B: Partner A borrowed 50 to buy property B. Can A receive a 50 distribution as preformation reimbursement? If so, A has been reimbursed even though it never actually paid the

46 Disguised Sales - Exceptions Debt-financed distribution: If a partnership borrows money and the proceeds are allocable under Reg T to a distribution of money to the contributing partner, the distribution is treated as a disguised sale only to the extent that the distribution exceeds the partner s allocable share of the partnership liability. Reg (b)(1). 45

47 Disguised Sales - Exceptions Debt-financed distribution: A partner s share of the partnership liability for purposes of this exception is equal to the partner s allocable share of the liability under Section 752 multiplied by a fraction: The numerator is the portion of the liability that is allocable to the money transferred to the partner. The denominator is the total amount of the liability. 46

48 Disguised Sale - Exceptions Property X FMV: 100 $25 Basis: 10 A B 50% 50% $100 Cash $50 Bank Partnership borrows $50 and distributes $25 to A. A s share of the debt under section 752 is $25. Distribution of $25 to Partner A is treated as a partial disguised sale (with an amount realized of $12.50) even through Partner A is allocated $25 of the $50 Bank debt. 47

49 Disguised Sale - Exceptions Property X FMV: 100 $25 Basis: 10 A B 50% 50% $100 Cash $50 Bank Under the fraction rule for the exception, A s allocable share of the debt is $12.50: $25 share of total debt x

50 Disguised Sales - Exceptions Distributions of Operating Cash Flow A distribution of operating cash flow is presumed not to be part of a disguised sale unless the facts and circumstances clearly establish otherwise. Reg (b)(1). Partner s share of operating cash flow is the lesser of Partner s share of overall profits for the year of distribution or Partner s percentage interest in overall partnership profits for the life of the partnership. Notice that definition of operating cash flow is NOT the same as the partner s share of net profit for the year or GAAP cash flow. 49

51 Disguised Sales - Exceptions Reasonable Guaranteed Payments A reasonable guaranteed payment for the use of capital under section 707(c) is presumed not to be part of a disguised sale unless the facts and circumstanced clearly establish otherwise. Reg (a)(1)(ii). A guaranteed payment is reasonable if it does not exceed the safe harbor rate. Safe harbor rate is generally 150% of the highest AFR in effect at any time after the right to the guaranteed payment is established. 50

52 Disguised Sales - Exceptions Reasonable Preferred Returns A reasonable preferred return for the use of capital is presumed not to be part of a disguised sale unless the facts and circumstanced clearly establish otherwise. Reg (a)(2). A preferred return is reasonable if it does not exceed the safe harbor rate. Safe harbor rate is generally 150% of the highest AFR in effect at any time after the right to the preferred return is established. 51

53 Section 721 Exceptions Liability Shifts in Excess of Basis 52

54 Liability Shifts in Excess of Basis Section 731(a): a partner recognizes gain to the extent a distribution of cash exceeds partner s basis. Section 752(a): a partner s basis in its interest includes the partner s share of partnership liabilities. Section 752(b): a contribution of a liability to a partnership is treated as a distribution of cash by the partnership to the contributing partner. 53

55 Liability Shifts in Excess of Basis Property X FMV: 150 Debt: 100 Basis: 40 A B 50% 50% $50 Cash Liability Shift A s starting basis in pship: 40 Amount of debt assumed: (100) A s share of debt assumed: 50 Gain/Difference: (10) A s ending basis in pship: 0 54

56 Section 721 Exceptions Investment Company Exception 55

57 Investment Company Exception Section 721(a) does not apply to a transfer to a partnership that would be an investment company if it were a corporation. A transfer to an investment company occurs if: the transfer results in diversification of the transferor s interests, and the transferee is either: a RIC or a REIT, or any corporation more than 80 percent of the value of whose assets are held for investment and consist of stocks or securities. 56

58 Investment Company Exception Diversification Any transfer of non-identical assets to a newly formed entity ordinarily results in diversification Exceptions: Single transferor to a Newco Two or more transferors Each transferor transfers identical assets, unless nonidentical assets are insignificant, or Each transferor transfers a diversified portfolio of stock and securities (as defined in section 368(a)(2)(F)(ii)) Transfers to pre-existing companies? 57

59 Investment Company Exception Stocks and Securities include: cash, options, forwards, notional principal contracts, derivatives, or futures contracts, debt, foreign currency, stock in corporations (but look-thru if >50%) interests in RICs, REITS, publicly-traded p ships, or common trust funds (or other interests readily convertible into these interests), interests in precious metals (unless used or held in an active trade or business) Note that Reg (c) definition of stocks and securities is out-of-date. 58

60 Investment Company - Rev. Rul Google stock Cash For 89 percent of Newco For 11 percent of Newco Newco Diversification 59

61 Investment Company - Reg (c)(6) Diversified portfolio (utilities) Reg (a)(2)(F)(ii) Diversified portfolio (high tech) Reg (a)(2)(F)(ii) Newco No diversification 60

62 Rev. Rul and Reg (c)(6) Diversified portfolio Reg (a)(2)(F)(ii) Cash Newco Arguably no diversification as cash is the ultimate diversified asset 61

63 Investment Company - All-or-Nothing Google stock Diversified portfolio Newco Notwithstanding diversification of only one transferor, rules appear to require gain recognition by both transferors 62

64 Investment Company - Pre-existing Transferee B: transfers shares of IBM for 80 percent of X stock Shareholder A Newco Owns only Google stock Should result in diversification to B; any effect on A? Regulations and rulings address only transfers to Newco 63

65 Section 721 Exceptions Partnership Interests for Services 64

66 Partnership Interest for Services Rev. Proc Receipt of a profits interest for services provided to or for the benefit of a partnership is not a taxable event unless: Profits interest relates to a substantially certain and predictable stream of income (such as high-quality debt securities); Partner disposes of interest within 2 years of receipt; or Profits interest is an interest in a publicly traded partnership. 65

67 Partnership Interest for Services Definitions A capital interest is any interest that would give the holder a share of proceeds upon liquidation of the partnership. A profits interest is any interest other than a capital interest. To ensure service partner receives only a profits interest, book-up the capital accounts of the other partners prior to admission of the service partner 66

68 Partnership Interests for Services Rev. Proc Time for testing whether an interest is a profits interest is at time of grant even if the interest is non-vested. As a result, there is no tax effect when the interest vests. Requirements: Partnership and service provider treat the service provider as the owner of the interest from the date of grant; Service provider includes its share of partnership income; No deduction is taken (either by partnership or a partner) upon the grant or the vesting of the interest; and All other conditions of Rev. Proc are satisfied. Section 83(b) election: No election needed if Rev. Proc applies. 67

69 Partnership Interests for Services Proposed Section 721 Regulations Receipt of a vested or unvested profits interest is a taxable event to the employee under Section 83 BUT: a valuation safe harbor allows the employee/partner to treat the profits interest as having a FMV of $0. Partner must make a Section 83(b) election. Special forfeiture allocations of loss to the employee are required if an unvested profits interest does not vest. Partnership does not recognize any gain on transfer of a compensatory profits interest. 68

70 Section 721 Exceptions Deferred Intercompany Transactions 69

71 Deferred Intercompany Transactions Transactions between members of a consolidated group of corporations are generally disregarded for federal income tax purposes. Reg (c). For example, gain or loss is not recognized on a sale of property between members of the same consolidated group. Any gain or loss on the sale is deferred until the property is no longer held by a member of the consolidated group. Reg (d)(1). A contribution of the property to a partnership will trigger the deferred gain or loss. 70

72 Deferred Intercompany Transactions Asset X FMV 100 Basis 75 P S Asset X FMV 200 Basis 75 Parent sells Asset X to Sub for 100 in Year 1. No gain recognized by Parent. Sub subsequently contributes Asset X to Sub in Year 2. Parent recognizes deferred gain of $25 in Year 2. 71

73 Section 721 Exceptions Overall Foreign Losses 72

74 Overall Foreign Losses When a taxpayer disposes of property used predominately outside the US, the taxpayer is deemed to have foreign source income in an amount equal to the lesser of The gain/loss in the property or The remaining amount of overall foreign losses of the taxpayer Disposition includes a tax-free contribution to a partnership. Section 904(f)(3)(B)(i). 73

75 Section 721 Exceptions Section 481 Accounting Method Adjustment 74

76 481 Accounting Method Adjustments If a taxpayer with a net Section 481(a) accounting method adjustment ceases to engage in the trade or business to which the net adjustment relates, the balance of the net adjustment not previously taken into account is taken into account in the taxable year of the cessation. Rev. Proc , 5.04(3)(c)(i). The contribution of trade or business assets to a partnership is treated as a cessation of that trade or business for this purpose. Rev. Proc (3)(c)(ii)(E). 75

77 Section 721 Exceptions Acceleration of Advance Payments 76

78 Acceleration of Advance Payments Qualifying taxpayers may generally defer to the next taxable year the inclusion of advance payments for goods or services to the extent the advance payments are not recognized in revenues in the taxable year of receipt. Rev. Proc This deferral ends if the taxpayer's obligation with respect to the advance payments is satisfied or otherwise ends other than in- A transaction to which Section 381(a) applies, or Certain Section 351(a) transfers. Rev. Proc , 5.02(5)(b). 77

79 Section 721 Exceptions Section 337(d) Transactions 78

80 Section 337(d) Transactions Proposed 337(d) regulations address the tax consequences that can occur when a partnership, directly or indirectly, owns, acquires, or distributes the stock of a partner. Prop. Reg (d)-3(a). 79

81 Section 337(d) Transactions Deemed Redemption Rule: A partner recognizes gain when the partner increases its interest in its own stock in exchange for appreciated property. Distribution Rule: A partner is treated as redeeming its stock for a portion of its partnership interest (and recognizes gain, if any) if the partnership distributes stock of the partner to the partner. 80

82 Section 337(d) Deemed Redemption X Y Property Z FMV: 100 Basis: 10 50% 50% $100 of X Stock As a result of the contribution, X has economically exchanged 50% of Property Z for 50% of Y s cash. X is treated for tax purposes as exchanging: $50 of Property Z for $50 of X stock. X recognizes $45 of gain: $50 FMV of Property Z - $5 basis in Property Z 81

83 Section 337(d) Distribution Rule X Y $200 of X stock X s interest has $200 FMV and $50 basis X receives $200 of X stock in liquidation of its interest X recognizes $150 of gain: $200 FMV of X stock - $50 basis in X s interest 82

84 Basic Section 704(c) Rules 83

85 Statute: Section 704(c) Income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. Reality: You break it you bought it. 84

86 Section 704(c) Example 1 A B 50% 50% Asset A $100 FMV: $100 Basis: $ 60 Partner A contributes Asset A with $40 of pre-contribution built-in gain. Section 704(c) is intended to ensure that Partner A continues to bear the tax consequences of the $40 built-in gain (BIG) in Asset A. 85

87 Section 704(c) Section 704(c) achieves this result by allocating MORE tax gain to Partner A LESS tax depreciation to Partner A 86

88 Section 704(c) This result can create serious confusion for both taxpayers and tax professionals. Partners will normally expect tax gain and tax depreciation to be allocated according to their economic agreement. Tax professionals must deal with both 704(c) tax items and 704(b) book items in making allocations. This can be accomplished through a simple 4-step process. 87

89 Four Simple Steps Section 704(c) Calculate tax gain or tax depreciation Calculate book gain or book depreciation Allocate book items to partners according to their partnership agreement Allocate tax items to partners: Non-contributing partner: allocated tax items = book items Contributing partner: allocated the remaining tax items 88

90 Section 704(c) Example 1 A B 50% 50% Asset A $100 FMV: $100 Basis: $ 60 Partner A contributes Asset A with $40 of built-in gain. Property has two years of remaining straight-line depreciation. 89

91 Section 704(c) Example 1(a): Partnership sells Assets A for $110 Calculate tax gain: $50 ($110 sale - $60 tax basis) Calculate book gain: $10 ($110 sale - $100 book basis) Allocate book items to partners: $5 to A; 5 to B Allocate tax items to partners: $ 5 to B (tax gain = book gain for non-contributing partner) $45 to A (remaining $45 of tax gain to contributing partner) 90

92 Section 704(c) Example 1(b): Partnership depreciates Asset A Calculate tax depreciation $30 ($60 tax basis 2) (2-year straight line property) Calculate book depreciation $50 ($100 book basis 2) Allocate book items to partners (50-50 agreement) $25 to A $25 to B Allocate tax items to partners $25 to B (tax depreciation = book depreciation) $ 5 to A (remaining $5 of tax depreciation) 91

93 Section 704(c) Step 5 : The Ceiling Rule In Step 4, the non-contributing partner is allocated tax items = book items. This works well as long as the partnership has enough tax items. What happens if there are not enough tax items to allocate to the non-contributing partner? For example, what would happen in Example 1 if Asset A had only $20 of total tax depreciation in Year 1? This shortage of tax items is referred to as the ceiling rule. 92

94 Section 704(c) Three Options for Dealing with Ceiling Rule: Traditional: never fix it Curative: try to fix it with other tax items Remedial: always fix it with notional tax items 93