Reverse Allocations: More Than Meets the Eye

Transcription

1 Passthrough Entities/September October 2002 Reverse Allocations: More Than Meets the Eye By Howard E. Abrams 2002 H.E. Abrams Howard Abrams explains the intricacies of maintaining capital accounts for partners in cases of reverse allocations. Introduction The usual way to ensure that tax allocations have economic effect is to maintain capital accounts for each partner and then ensure that every tax allocation is accompanied by a corresponding book allocation that adjusts those capital accounts. Properly maintained capital accounts must be increased for the value of property and cash contributed to the partnership; decreased for the value of cash and property distributed by the partnership; and increased (or decreased) for allocations of income (or deduction). 1 Finally, liquidation proceeds must be distributed in accordance with final capital account balances. 2 For example, suppose that a partnership earns $100 of income, and suppose further that this item of income is allocated under the partnership agreement to partner P. If capital accounts are maintained properly, this allocation will result in a $100 increase in P s capital account. And if liquidation proceeds will be distributed in accordance with final capital accounts, then P will receive 100 dollars more at liquidation (if not before) by reason of the allocation. The upward capital account adjustment, in other words, ensures that the economic benefit (receipt of more dollars) follows the tax allocation (inclusion of more income). Because liquidating proceeds must be distributed in accordance with final capital account balances, it is the book allocations that define the economic relationships among the partners. The partners are free to allocate the partnership s economic gains and losses as they see fit; the requirement of economic effect mandates only that tax allocations follow book allocations. But this relationship between book allocations and tax allocations presupposes that book items and the corresponding tax items arise simultaneously. There are times, however, when book allocations must be made before the corresponding tax items occur and, when that happens, the requirement of economic effect requires that when the tax items Howard E. Abrams is a professor of law at Emory University and spent the academic year with the national office of Deloitte & Touche, LLP, as the Director of Real Estate Tax Knowledge. He is a member of the American Law Institute and the California Bar. 41

2 Reverse Allocations mature, they be allocated in the same way as the prior book items. This relationship between current tax allocations and prior tax allocations is enforced by the rules of Code Sec. 704(c)(1)(A). When property is contributed to a partnership, Code Sec. 704(c)(1)(A) requires that any unrealized appreciation or loss in the contributed property be allocated to the contributing partner. The regulations promulgated under Code Sec. 704(c)(1)(A) implement this mandate by requiring that the contributed property be booked into the contributing partner s capital account at current fair market value. 3 These regulations further provide that when the precontribution unrealized gain or loss is finally realized and recognized by the partnership, it must be allocated to the contributing partner. 4 Thus, Code Sec. 704(c)(1)(A) has two functions. First, it specifies that the contributing partner ultimately must receive the full value of the contributed property from the partnership the economic benefit of all unrealized appreciation cannot be shifted to other partners. Second, it imposes the requirement of economic effect on this precontribution unrealized gain or loss by demanding that the tax benefit or burden associated with this gain or loss must also be allocated to the contributing partner. Note that Code Sec. 704(c)(1)(A), by specifying how the unrealized appreciation is handled for book purposes, affects the economics of the venture and not merely its tax aspects. Thus, it ultimately affects how many dollars the contributing partner will receive upon liquidation of his interest in the partnership. This aspect of Code Sec. 704(c)(1)(A) does not speak to the economic effect requirement of Code Sec. 704(b). Rather, it responds to an assignment of income concern, something that the partners may on occasion wish to avoid. 5 Book items subject to Code Sec. 704(b) can be allocated however the partners desire, subject only to the requirement of substantial economic effect; thus, the partners have considerable flexibility in the allocation of such items. In contradistinction, book items subject to Code Sec. 704(c)(1)(A) must be made to the contributing partner; as to such allocations, the partners have no flexibility. There are circumstances when a partnership is permitted to revalue its assets and restate the capital accounts to reflect those values. 6 When this is done (called a partnership book-up ), the restatement and revaluation causes a book/tax disparity for the partners identical to a book/tax disparity caused by the contribution of appreciated or loss property. It should be unsurprising, then, that the regulations under Code Sec. 704(b) require the application of Code Sec. 704(c)(1)(A) principles to such book/tax disparities. 7 These mid-stream adjustments to the book value of partnership assets are most often made when new value is contributed to an ongoing partnership. If the new value takes the form of appreciated or loss property, Code Sec. 704(c)(1)(A) will apply to the contributing partner. 8 But whether or not the contributed property has built-in gain or loss, the principles of Code Sec. 704(c)(1)(A) will apply to the continuing partners if they elect to restate their capital accounts because of the contribution. 9 In such circumstances, application of Code Sec. 704(c)(1)(A) principles to the continuing partners are called reverse 704(c) allocations because they are made not to the contributing partner (as are true Code Sec. 704(c)(1)(A) allocations), but rather to all the other partners because of the contribution. Reverse allocations fall somewhere between allocations falling within Code Sec. 704(c)(1)(A) and those limited only by the general provisions of Code Sec. 704(b). While the partners have no flexibility with respect to Code Sec. 704(c)(1)(A) allocations and virtually complete flexibility with regard to most Code Sec. 704(b) allocations, partners once had, but no longer have, flexibility with respect to reverse tax allocations. That is, the partners have considerable flexibility in allocating the revaluation book gain or loss, but when in a subsequent year that book gain or loss becomes recognized for tax purposes, it must then be allocated among the partners as the prior book gain or loss was allocated. In the context of Code Sec. 704(b), book items and tax items occur simultaneously, while in the context of Code Sec. 704(c)(1)(A), book items occur prior to tax items. But the two provisions both operate to preserve economic effect by ensuring that tax allocations follow book allocations. Reverse allocations arise when book items precede tax items other than in connection with the contribution of appreciated property. This will occur whenever partnership assets are revalued and partnership capital accounts are restated to reflect the revaluation. In general, a partnership is permitted to book its assets to fair market value only in connection with the contribution of new equity to the partnership or 42

3 Passthrough Entities/September October 2002 in connection with the distribution of property (including cash) to a partner with respect to the partnership interest. 10 Optional Book-Ups Example. X and Y each contributes $50 to the XY partnership, and each becomes a 50-percent partner. The partnership purchases nondepreciable Blackacre for its cash of $100. After Blackacre increases in value to $140, Z is admitted to the partnership as a one-third Chart 1 partner in exchange for a cash contribution of $70. If the partnership elects to revalue Blackacre and restate its capital accounts upon the admission of Z, the books of the partnership will stand as is shown in Chart 1 (where CA refers to capital account and OB refers to outside basis). The capital accounts of the partners stand at $70 each, and that accurately reflects the equal onethird status of each partner. The book/tax disparity for X and Y results from the book-up: capital $50 $50 $50 $50 Starting Values Book-Up Admission of Z $70 $50 $70 $50 $70 $70 Total Blackacre $140 $100 Cash Chart 2 $70 $50 $70 $50 $70 $70 After Book-Up Allocations Under Code Sec. 704(c)(1)(A) Allocations Under Code Sec. 704(b) $80 $80 $80 $80 $80 $80 Total Cash $240 $240 Chart 3 $50 $50 $50 $50 $70 $70 No Book-Up Blackacre $100 $100 Cash $ 70 $ 70 accounts were increased to reflect the as-yet unrealized appreciation in Blackacre. As a result, the partners will be required to adopt one of the Code Sec. 704(c) methods the traditional method, the traditional method with curative allocations or the remedial allocation method with respect to the book/ tax disparity in Blackacre. 11 In particular, if Blackacre is subsequently sold for $140 or more, the first $40 of taxable gain must be allocated equally between X and Y to eliminate the book/tax disparity arising from the book-up. If, say, Blackacre is sold for $170, the books will show what is illustrated in Chart 2. The Economics of Booking-Up Suppose that the XYZ partnership discussed above elects not to restate its capital accounts on the admission of Z. As a result, the books of the partnership will read as is shown in Chart 3. The capital accounts do not accurately reflect the equality of the partners: Z s capital account is greater than that of X and of Y, suggesting (inaccurately) that Z s interest in the partnership is greater than that of the other two partners. However, there is no inflexible requirement that the capital accounts always reflect the partners relative interests in the partnership, and to ensure that the parties are treated fairly, the partners might agree simply that upon the disposition of Blackacre, the first $40 of gain will be divided equally between X and Y alone. That is, the parties can use a special allocation of dispositional gain in lieu of a book-up. If, for example, Blackacre is eventually sold for $170, the $70 of gain will be divided into two components: the first $40 of gain and the remaining $30 of gain. The 43

4 Reverse Allocations first $40 will be allocated $20 to X and $20 to Y, and the remaining $30 of gain will be allocated equally among the partners. As a result, the books of the partnership will reflect the equality of the partners, illustrated in Chart 4. In this circumstance, replacing the book-up with a special allocation of dispositional gain yielded the same net effect to the partners. But if the property had declined in value after the admission of Z, the special allocation might not be an effective substitute. For example, suppose again that Blackacre is worth $140 when Z is admitted to the partnership in exchange for Chart 4 $50 $50 $50 $50 $70 $70 No Book-Up Special Allocation of Tax Gain Allocations Under 704(c)(1)(A) $80 $80 $80 $80 $80 $80 Total Cash $240 $240 Chart 5 $70 $50 $70 $50 $70 $70 After Book-Up (2) 0 (2) 0 (2) 0 Book Loss Allocations Under 704(b) $68 $67 $68 $67 $68 $70 Total Cash $214 $214 Chart 6 $50 $50 $50 $50 $70 $70 No Book-Up Special Allocation of Tax Gain $67 $67 $67 $67 $70 $70 Total Cash $214 $214 cash of $70, but now assume that Blackacre is worth only $134 when eventually sold by the partnership. On that sale, there will be a taxable gain of $34, divided equally between X and Y. Assuming the partnership booked Blackacre to fair market value upon the admission of Z, the books will appear as shown in Chart 5. These books correctly reflect the equality among the partners. The $6 decline in the value of Blackacre arising after the admission of Z results in a capital account reduction of $2 per partner; as a result, an immediate liquidation will result in each partner receiving a cash distribution of $68. But suppose the partnership had elected not to book up Blackacre upon the admission of Z. In that case, the sale of Blackacre would produce a gain of $34 for both book and tax purposes, so the books would look like the numbers in Chart 6. These capital accounts indicate that if the partnership were now to liquidate, its cash of $214 would be distributed $67 to X, $67 to Y and $70 to Z. Thus, by failing to book up, the economics underlying the partnership have been compromised. The decline in value of Blackacre accruing after the admission of Z should be shared equally among all the partners, Z included. Without the book-up, though, it was shared only by X and Y. The great advantage that a book-up offers is that the partners capital accounts will accurately reflect the underlying economic relationships at all times, even if the partnership s assets turn around in value. If a partnership elects not to book up its assets upon the contribution of new equity and then one or more of its restated assets turn around in value, the partnership can preserve the economics among the partners by fashioning curative allocations with other items of income or deduction. 12 For example, suppose that the partnership elects not to book up Blackacre upon the admission of Z, that Blackacre is eventually sold for $134 and that in the same or in a subsequent year, the partnership has a deduction of $3 that would, under the partnership agreement, be allocated equally among the partners. If this deduction is, in fact, allocated entirely to Z for both book and tax purposes, the books of the partnership will read as shown in Chart 7. 44

5 Passthrough Entities/September October 2002 Just as the capital account problem can be cured by an extra allocation of loss to Z, so, too, the problem could be solved by an extra allocation of income to X and to Y. 13 However, these cures are dependent on having income or deduction with which to cure, just like the traditional method with curative allocations defined in the Code Sec. 704(c)(1)(A) regulations. 14 The self-help curative allocations have considerably more flexibility than those defined in the regulations, though, because these self-fashioned curative allocations can be made in any year or years, in any amounts and need not be made with income of the same character as that causing the book/tax disparity. 15 However, while these self-help curative allocations plainly satisfy the test for economic effect, they must also be tested against the requirement of substantiality. Suppose, for example, that the XYZ partnership includes two allocations with respect to the book/tax disparities caused by the decision not to book up when Z was admitted. First, the partners agree that the first $40 of book and tax gain realized on the disposition of Blackacre will be allocated only to X and Y, $20 to each. Chart 7 Second, they agree that if there is less than $40 of income realized on the disposition of Blackacre, all other partnership income will be divided equally between X and Y (and all partnership deductions will be allocated only to Z) until the shortfall from the disposition of Blackacre has been fully recovered. Because these allocations will be reflected identically in the partners capital accounts and outside bases, they have economic effect within the meaning of Code Sec. 704(b). 16 But to be valid, that economic effect must be substantial. Are these two sets of allocations shifting or transitory within the meaning of the substantiality regulations or do they in some other way violate the substantiality requirement? 17 The condemnation of both shifting and transitory allocations in the regulations emphasizes that pairs of allocations likely to have offsetting economic effects should be disregarded. For example, an allocation of excess deductions to one partner in year one followed by an offsetting allocation of income to the same partner in year two generally will be ignored. 18 Fortunately, the allocations used to mimic the economics of a partnership book-up are not shifting or transitive because they are not offsetting; rather, they are complementary. If there is sufficient gain from the disposition of Blackacre, $50 $50 $50 $50 $70 $70 No Book-Up Sale of Blackacre (3) (3) Curative Allocation of Loss $67 $67 $67 $67 $67 $67 Total Cash $211 $211 the second allocation will not be triggered. If there is no gain from the disposition of Blackacre, only the second allocation will be triggered. And if there is insufficient gain from the disposition of Blackacre, both allocations will be triggered to work in tandem, giving income to X and Y or loss to Z. In no sense are these two sets of allocations offsetting. To be sure, these allocations together come very close to mimicking an initial book-up of Blackacre upon the admission of Z, but it is hard to see how that fact alone could subject the allocations to challenge. 19 After all, booking assets to fair market value upon the contribution of new equity is expressly made optional. 20 However, using self-help curative allocations in lieu of a book-up can offer some aggressive tax opportunities, and in that context we will have to re-examine the limits of the substantiality doctrine. When Not to Book Up A partnership should elect not to book assets to fair market value upon the contribution of new equity whenever it wishes to shift some of the unrealized appreciation to the contributor of the new equity. For example, a cash-poor partnership could use the lure of a share of unrealized appreciation to attract a new investor. If, say, X and Y are equal partners in the XY partnership owning a single asset with adjusted basis and book value of $1,000,000, they might seek an infusion of cash to pay operating expenses. Even if the partnership s asset were worth $2,200,000, obtaining loans might be difficult. New investor Z might be willing to contribute cash of $500,000 for a full one-third share, and that can be accomplished only by eschewing a book-up when Z joins the venture. 45

6 Reverse Allocations If the partnership elects to book its asset to fair market value upon the admission of Z, the books of the partnership will read as in Chart 8. If, say, the asset is eventually sold for $2,500,000, there will be book gain of $300,000 and tax gain of $1,500,000. Even if the entire book gain is allocated to Z, Z s capital account will rise to only $800,000. And because liquidating distributions must be made in accordance with final capital account balances, 21 that means that if the partnership then liquidates, Z will receive only $800,000 of the partnership s $3,000,000, with X and Y each receiving $1,100,000. In effect, by booking the unrealized appreciation into X s and Y s capital accounts, that value is locked away from Z. But if the partnership had not booked the unrealized appreciation into the capital accounts upon the admission of Z, the books would be very different. If the asset were sold for $2,500,000 and the book and Chart 8 tax gain were allocated equally among the partners, the books would show that Z is, in fact, a full one-third partner. See Chart 9. The same technique could be used when admitting a new investor who takes an initial debt position with a right to convert to equity. In such circumstances, the investor generally seeks the rights of a creditor in case things turn out poorly, but desires the rights of an equity participant if things turn out well. If the debt is converted into equity, it is essential that the partnership not book its assets to fair market value for the investor to be treated as a full equity participant ab initio. For a more aggressive use of the option not to book assets to fair market value, consider the facts of Rev. Rul In that ruling, A and B each contribute cash of $1,000 to the general partnership PRS. Each partner is allocated 50 percent of profits and losses, and the partnership agreement provides that if either partner contributes additional capital in the future, PRS will revalue its assets and restate capital accounts. The partnership purchases nondepreciable property for $10,000, using its capital of $2,000 as well as $8,000 borrowed from a bank. After one year, the value of the property falls to $6,000. As part of a workout with the bank, (1) the loan is reduced by $2,000 to $6,000; (2) A contributes additional capital of $500; and (3) the additional capital contributed by A is used to pay currently deductible expenses and triggers a revaluation of the partnership s assets and a restatement of capital accounts. As a result of the workout, the partnership recognizes $2,000 of cancellation of indebtedness income (COI income) for both book and tax purposes. The partners agree to allocate this entire amount to B, who is insolvent. The partnership also has $4,000 of book loss resulting from the revaluation of its property, and the partners agree to allocate this loss, $1,000 to A and $3,000 to B. Fi- $500,000 $500,000 $ 500,000 $500, Starting Values 600, , Book-Up , ,000 Admission of Z $1,100,000 $500,000 $1,100,000 $500,000 $500,000 $500,000 Total Cash $500,000 $500,000 Property 2,200,000 1,000,000 Chart 9 $ 500,000 $ 500,000 $ 500,000 $ 500,000 $ 0 $ 0 Starting Values , ,000 Admission of Z 500, , , , , ,000 Sale of Asset $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 Total Cash $3,000,000 $3,000,000 46

7 Passthrough Entities/September October 2002 nally, the partnership allocates the entire $500 of book and tax deductions arising from the payment of workout expenses entirely to A. In tabular form, the capital accounts would look like Chart 10. As a result of these allocations, each partner s capital account is reduced to zero. Had the partners simply allocated both the COI income and the revaluation loss equally between the partners, capital accounts also would have been reduced to zero. But by allocating both the income and loss disproportionately, the partners attempt to allocate all the taxable COI income to the insolvent partner, thereby minimizing the partners joint tax liability without affecting the number of dollars either partner will receive upon liquidation. The ruling concludes that the disproportionate allocation of the COI income and the revaluation loss together constitute a shifting pair of allocations because there is a strong likelihood that they will have offsetting effects. The disproportionate allocation of COI income entirely to B has an immediate effect of increasing B s capital account and thereby increasing the number of dollars B will receive upon liquidation of B s partnership interest. The disproportionate allocation of the revaluation loss to B then reduces the number of dollars B will receive upon liquidation, thereby restoring the partners relative shares to equality. Of course, the revaluation loss will only affect the number of dollars that the partners will receive if the property in fact declines in value. But partnership property is conclusively presumed to have fair market value equal to current partnership book value under the value-equals-basis rule (discussed more fully below). Thus, when property is revalued for adjusting capital accounts, the value of the property is conclusively presumed to have declined to the restated value. 23 As a result, the diminution in value reflected in the bookdown is conclusively presumed to have occurred, so that the loss resulting from that book-down is conclusively assumed to offset the disproportionate allocation of COI. These two disproportionate allocations thus have offsetting effects and for that reason, fail the substantiality test. 24 While the conclusion of the ruling that the allocations are invalid seems inescapable, suppose the partnership agreement had provided that the partnership s asset would not be revalued when new capital was contributed by either partner. Thus, when the workout Chart 10 occurs, the only tax items to be allocated are the COI income and the $500 of current expenditures (this latter item plays no role in the analysis of the ruling or in the analysis that follows). Allocation of the COI to B has economic effect that is substantial and so should be valid (as should the allocation of the expense to A). To maintain the economics of the transaction, the partners must also agree that when the partnership s property is sold, the first $2,000 of loss will be allocated entirely to B. This is not a current allocation because no book or tax loss has yet been realized from disposition of the property. But a current allocation and a future allocation can together be invalid if there is a strong likelihood that they will have offsetting effects. Such pair of allocations are called transitory under the regulations. 25 Are the current disproportionate allocation of current COI income and the anticipated future disproportionate allocation of loss invalid as transitory? No. While the two allocations will have offsetting effects, the future loss allocation is not reasonably certain to occur because, under the value-equals-basis rule of Reg (b)(2)(iii)(c)(2), the future loss is conclusively presumed not to occur. The partnership s property is conclusively presumed to equal its current book value of $10,000. By electing not to revalue the partnership s property as part of the workout, the partners can cause the A B Explanation $ 1,000 $ 1,000 Starting Values 0 2,000 Allocation of COI Income (1,000) (3,000) Allocation of Revaluation Book Loss Capital Contribution by A (500) 0 Allocation of Expenses $ 0 $ 0 Total value-equals-basis rule to transmute what was an unstoppable sword in the hands of the government into an impassable shield in the hands of the taxpayer. The regulations provide that an allocation or set of allocations will lack substantiality as transitory if at the time the allocation (or allocations) becomes part of the partnership agreement, there is a strong likelihood that: 26 (1) The net increases and decreases that will be recorded in the partners respective capital accounts for such taxable years to which the allocations relate will not dif- 47

8 Reverse Allocations fer substantially from the net increases and decreases that would be recorded in such partners respective capital accounts for such years if the original allocation(s) and offsetting allocation(s) were not contained in the partnership agreement, and (2)The total tax liability of the partners (for their respective taxable years in which the allocations will be taken into account) will be less than if the allocations were not contained in the partnership agreement (taking into account tax consequences that result from the interaction of the allocation (or allocations) with partner tax attributes that are unrelated to the partnership). Chart 11 The special allocation of the COI income and the offsetting allocation of loss from the decline in the value of the partnership s assets will constitute a set of transitory allocations only if, at the time the allocations were placed into the partnership agreement, there was a strong likelihood that the partnership will incur a loss from the disposition of the property with which to offset the disproportionate allocation of the COI income. While you and I might think that there is a strong likelihood that the value of the partnership s asset will decline given that in fact it already has declined the regulations take a different tack. The regulations ignore with absolute certainty the true value of a partnership s assets in favor of the book value of those assets: the misnamed value-equals-basis rule provides that partnership property is conclusively presumed to be worth current book value 27 so that: there cannot be a strong likelihood that the economic effect of an allocation (or allocations) will be largely offset by an allocation (or allocations) of gain or loss from the disposition of partnership property. 28 A B Explanation $ 1,000 $ 1,000 Starting Values 2,000 Allocation of COI Income Capital Contribution by A (500) Allocation of Expenses 0 0 Gain (Loss) from Sale of Asset $ 1,000 $ 3,000 Total Note that if the AB partnership had attempted to offset its disproportionate allocation of COI income to B with offsetting operating profits (to A) or losses (to B), the pair of allocations could be subject to a recharacterization under the substantiality regulations. The IRS would argue that the operating profits or losses had a strong likelihood of arising, and it would fall to the taxpayer to provide otherwise. But by using only dispositional gain or loss, the partnership avoids the challenge entirely thanks to the valueequals-basis rule. The value-equals-basis statement in the regulations is remarkable, and it offers astute taxpayers great flexibility. For example, suppose in our earlier example of Z joining the XY partnership, the partnership owns not only Blackacre, but also Whiteacre. The partnership could refuse to book-up its assets (Blackacre and Whiteacre) upon the admission of Z, but then allocate all pre-admission unrealized gain in the assets exclusively to X and Y. Further, the partnership could provide that if upon the disposition of the first parcel there was insufficient gain to fulfill the special allocation, any shortfall would be made up with dispositional gain from disposition of the second asset. To be sure, if both parcels ultimately were sold for less than they were worth when Z joined the partnership, there will be an economic loss that cannot be shared with Z under this approach. But because cures can be made with any dispositional gain or loss (including the disposition of property purchased after Z joins the partnership), this could easily be a risk that X and Y are willing to take. Especially if it offers them significant advantages. Return to the AB partnership of Rev. Rul , and consider what happens if the partnership elects not to restate the capital accounts and the property turns around in value after the workout. For example, suppose one year after the workout, the property is sold for its then-current fair market value of $10,000. This sale produces no book gain or loss (because the value of the asset was not restated as part of the workout) and no tax gain or loss (because the property was purchased by the partnership for $10,000 and no depreciation was allowed or allowable). Thus, the capital accounts books of the partners will appear as illustrated in Chart 11. Because there has, in fact, been no offsetting disproportionate allocation of loss to B, B s capital 48

9 Passthrough Entities/September October 2002 account remains disproportionately high. This is not what the partners intended, and to prevent its occurrence, the partnership agreement should provide that if upon disposition of the property by the partnership there is less than $2,000 of loss, additional items of partnership income or loss will be allocated to restore capital accounts of the partners to parity. As indicated above, though, unless the self-help curative allocations are limited to dispositional gain and loss, the allocations risk challenge as transitory. Collateral Consequences of Booking-Up 29 A common provision in a partnership agreement is that the partners will be liable to restore capital account deficits in favor of third-party lenders, but not in favor of other members of the partnership. In general, allocations of deductions (other than nonrecourse deductions) from encumbered partnership property are allocated according to the substantial-economic-effect rules in Reg (b)(2). When partners lack an unlimited, unconditional capital account deficit restoration obligation, the substantial-economic-effect regulations permit such deductions to be allocated however the partners wish, so long as (1) the deductions are properly reflected in the partners capital accounts and (2) the deductions do not increase a capital account deficit beyond the partner s maximum obligation to fund a deficit out of additional funds. 30 A partner who is potentially liable to third-party creditors, but not to other partners is treated as having a limited deficit restoration obligation. The amount of that limited deficit restoration is computed by assuming the partnership sells all of its assets for their current book values and then the cash so raised is used to satisfy the partnership s creditors. If there are insufficient funds to satisfy all creditor demands, the partners would be required to contribute additional funds to the partnership, and the amount of such funds that a partner would be required to contribute under the hypothetical scenario is the partner s limited deficit restoration obligation. See Rev. Rul Note that under this standard, the greater the book value of the partnership s assets, the smaller the partner s limited deficit restoration obligation. And the smaller the partner s deficit restoration obligation, the fewer deductions that can be allocated to the partner. To be sure, if a book-up increases the partner s capital account, the amount of the partner s limited deficit restoration obligation will be less relevant because the increased capital account balance will be able to absorb allocations of deductions. But if the book-up is not in the same proportion as are shared losses, problems can result. For example, suppose P and Q form the PQ partnership by contributing $100 each. The partnership purchases depreciable property for $1,000, paying $200 down and the remainder in the form of a recourse note. The partners agree to allocate all depreciation to P, all operating income equally between P and Q, and gain from the disposition of assets 50 percent to P and 50 percent to Q after a special allocation of gain charging back all prior depreciation deductions. Each partner is obligated to restore a capital account deficit in favor of the third-party lender, but not in favor of the other partner. Assume the property generates $200 of depreciation each year and that the partnership has no other items of income or deduction. The first year s depreciation of $200 must be allocated equally between the partners, despite the partnership agreement providing the contrary, because that depreciation represents a reduction in the partners equity and so cannot generate a capital account deficit to one partner while maintaining a capital account surplus for the other. 32 However, the analysis is different for year two. In year two, there is again depreciation of $200, and that depreciation reduces the book value of the property to $600, an amount that is $200 less than the amount of the debt. Allocation of the entire depreciation to P will create a $200 capital account deficit to P. Further, because the property is conclusively presumed to equal its book value of $600, this capital account deficit of P is presumed under Rev. Rul to create a potential obligation from P to the third-party lender, and that obligation supports the capital account deficit caused by the allocation. In short, the allocation of the entire $200 depreciation in year two to P is valid. Assume, though, that the property is, in fact, worth $760 during year two, and assume that new partner R joins the partnership as a 20-percent partner in exchange for a cash contribution of $40. Assuming the partnership elects to restate its capital accounts upon the admission of R (with P and Q 49

10 Reverse Allocations each reducing their interests in the partnership to 40 percent), the capital accounts of the partnership, prior to the allocation of the depreciation in year two, will read as in Chart 12. There is now $200 of depreciation to be allocated for year two, and the parties want to allocate it entirely to P. Unfortunately, they cannot do so. Because R contributed fresh equity of $40, R must be allocated $40 of depreciation before any of the other partners can be allocated depreciation causing a capital account deficit. Thus, $40 of depreciation must be allocated to R whether the partnership restates the capital accounts or not. The remaining $160 of the depreciation also cannot be allocated exclusively to P because the book-up created positive capital accounts for P and Q and creates a conclusive presumption that the property is worth $760. That value, combined with the fresh cash of $40, means that under the rule of Rev. Rul , there is no obligation on the part of any partner to restore a capital account deficit (because the debt equals $800 and the book value of the partnership s assets also equals $800). Thus, the $160 remaining depreciation for year two cannot create a capital account deficit for any partner and so must be allocated $80 to P and $80 to Q. After accounting for the fresh equity contributed by R, what limited P s ability to claim Chart 12 depreciation was the book-up. By giving Q half the $160 book-up, the partnership was forced to give Q an equal dollar amount of depreciation. Had the property not been revalued, fully $160 of the depreciation in year two could have been allocated to P. 33 Multi-Layer Book-Ups If a partnership elects to book up its assets and it already owns an asset subject to a Code Sec. 704(c)(1)(A) or reverse Code Sec. 704(c) book/tax disparity, the bookup will create a second layer of book/tax disparity. This layer is independent of the first layer and can be addressed by any of the methods permissible under Code Sec. 704(c)(1)(A) without regard to the method used for the first layer. 34 For example, if P and Q form the PQ partnership with P contributing cash and Q contributing appreciated property, the partnership might elect to recover the unrealized appreciation in Q s property by using, say, the traditional method with curative allocations. If R subsequently joins the partnership by contributing cash and, if at that time the fair market value of the property previously contributed by Q is not equal to its current book value, the difference between the property s current fair market value and current book value could be addressed, say, by the remedial allocation method. P Q R Explanation $ 100 $ 100 $ 0 Starting Values (100) (100) 0 Year 1 Depreciation Admission of R Book-Up $ 80 $ 80 $ 40 Total The mechanics of multi-layer bookups are not difficult if two key points are kept in mind. First, each layer must be addressed independently of the other layers and, second, for each layer, one set of partners will always be entitled to tax depreciation equal to book depreciation while another set will pay for it. In the case of true Code Sec. 704(c)(1)(A) allocations, the noncontributing partners are entitled to tax depreciation equal to book depreciation while the contributing partner is not; in the case of reverse Code Sec. 704(c) allocations triggered by the contribution of new value to an ongoing partnership, the contributing partner is entitled to tax depreciation equal to book depreciation while the other partners are not. For example, assume X and Y form the XY general partnership, with X contributing cash of $10,200 and Y contributing depreciable property with adjusted basis of $6,000 and fair market value of $10,200. The property contributed by Y has five years remaining on its depreciation schedule; if newly placed in service, its basis would be recovered over seven years. Assume the partnership elects to depreciate this property using the straight-line method, and that the partnership will allocate depreciation equally between the partners except as required by application of Code Sec. 704(c)(1)(A). The partnership elects to address the Code Sec. 704(c)(1)(A) book/ tax disparity using the remedial allocation method. 35 Under Code Sec. 168(i)(7)(A), the partnership will continue (for tax purposes) to depreciate the property contributed by Y, using Y s depreciation schedule (the step-in-the-shoes rule). Thus, the property s inside basis of $6,000 will be recovered over five years at a rate of $1,200 per year. Under the remedial allocation method, the partnership recovers an equal 50

11 Passthrough Entities/September October 2002 amount of book value using the same schedule, but recovers the remainder of the property s book value as if newly placed in service. 36 Thus, the old piece of the property yields book and tax depreciation of $1,200 per year for years one through five; the new piece of the property yields no tax depreciation but book depreciation of $600 per year for years one through seven. Combining these two pieces, there is tax depreciation of $1,200 for the first five years, book depreciation of $1,800 during the first five years and $600 of book depreciation for years six and seven. X is entitled to tax depreciation equal to book depreciation each year, with Y s share of tax depreciation making up the shortfall. Thus, after one year, the books of the partnership look like Chart 13. Note that at this point the property has a book value of $8,400 and inside basis of $4,800. After one year, assume Z joins the partnership as a one-third partner Chart 13 in exchange for a cash contribution of $9,615 because the value of the property contributed by Y now equals $9,030. (Thus, X s and Y s interests in the partnership are each worth exactly $9,615 both before and after the admission of Z.) 37 The partnership elects to revalue its assets and restate the capital accounts as a result of the admission of Z, and it elects to use the remedial allocation method to address the reverse-704(c) issue caused by the asset book-up. The reverse Code Sec. 704(c) layer addresses the variation between the book value of the property immediately before Z joins (that is, $8,400) and the restated book value immediately thereafter (that is, $9,030). Thus, the amount of the reverse Code Sec. 704(c) layer is $630. Under the remedial allocation method, the property is now divided into three pieces the old piece having adjusted basis and book value of $4,800, recovered X Y CA OB CA OB Explanation $10,200 $10,200 $10,200 $ 6,000 Starting Values (900) (900) (900) (300) Depreciation $ 9,300 $ 9,300 $ 9,300 $ 5,700 Total Chart 14 Allocation of Tax Depreciation: Year 2 X s Share Y s Share Z s Share Total Old Piece $ (400) $ (400) $ (400) $ (1,200) New Piece (200) 400 (200) 0 Really New Piece (30) 0 Totals $ (585) $ 15 $ (630) $ (1,200) over the next four years; the new piece having a book value of $3,600 and a $0 adjusted basis, recovered over the next six years; and the really new piece having a book value of $630 and a zero adjusted basis, recovered over the next seven years (that is, over years two through eight). Combining these three pieces, we obtain the following results: For years two through five, there is book depreciation of $1,890 per year and tax depreciation of $1,200 per year. For years six through seven, there is book depreciation of $690 per year and no tax depreciation, and for year eight there is book depreciation of $90 and no tax depreciation. In each year, the book depreciation is shared equally among the partners because they have agreed to be equal partners. (See Chart 14.) Looking at the property layer by layer, the old piece of property has book value and adjusted tax basis 4,800, and the partners share both the annual book depreciation of $1,200 and annual tax depreciation of $1,200 equally over the next four years. The second layer (that is, the new piece ) has a book value of $3,600 and an adjusted basis of $0 and the partners share the annual book depreciation of $600 equally for the next six years. X and Z are entitled to tax depreciation equal to book depreciation (because this low-basis property was contributed by Y), so they are entitled to $200 per year of depreciation each. There is, though, no net depreciation allowable with respect to this layer, Chart 15 $ 9,615 $ 9,300 $ 9,615 $ 5,700 $ 9,615 $ 9,615 After Year 1 (2,520) (2,340) (2,520) 0 (2,520) (2,520) Years 2-5 Depreciation Years 2-5 Remedial Allocations $ 7,095 $ 6,960 $ 7,095 $ 5,760 $ 7,095 $ 7,095 Total After Year 5 51

12 Reverse Allocations so that Y must include a remedial allocation of income equal to the depreciation claimed by X and Z; that is, Y must include a remedial allocation of $400 of income each year for the next six years. Finally, with regard to the final layer (the really new piece ), there is annual book depreciation of $90, but no tax depreciation. Z is entitled to annual tax depreciation equal to book depreciation of $30 because this slice represents the reverse Code Sec. 704(c) book-up that increased the capital accounts of X and Y. However, because there is no tax depreciation from this layer, X and Y must have annual combined remedial allocations of income that offset Z s annual allocation of tax depreciation. Because X and Y had equal shares of the book-up, they must have equal remedial allocations of income from the third layer of $15 per year. Taking all three slices into account and multiplying these numbers by 4 to get the results for years two Chart 16 Allocation of Tax Depreciation: Year 6 through five yields partnership books as shown in Chart 15. In each of years six and seven, the book depreciation of $690 is allocated $230 to each partner. Because there is no tax depreciation, there is a remedial allocation of $230 of depreciation (per year) to Z, of which $200 is from the (new piece) 704(c) layer and $30 is from the (really new piece) reverse-704(c) layer. X should get a full tax share of the (new piece) 704(c) layer, or $200, less one-half of Z s remedial allocation from the (really new piece) reverse-704(c) layer, for a net depreciation allocation of $185. Because there is no tax depreciation to the partnership in this year, that means X receives a remedial allocation of deduction of $185. Y, therefore, must receive a remedial allocation of income of $230 + $185, or $415. See Chart 16 for a tabular form. Multiplying these numbers by 2 to get the results for years six and seven yields books for the partnership resembling Chart 17. In year eight, the book depre- X s Share Y s Share Z s Share Total New Piece $(200) $400 $(200) $ 0 Really New Piece (30) 0 Totals $(185) $415 $ (230) $ 0 ciation of $90 is allocated $30 to each partner. Because there is no tax depreciation, there is a remedial allocation of $30 of depreciation to Z as well as remedial allocations of $15 of income to both X and Y. (Thus, Z obtains a full tax share of book depreciation, and X and Y split paying for it.) The property is now fully depreciated both for book and tax purposes, and the book/tax disparities have been fully eliminated. (See Chart 18.) Mandatory Book Ups 38 There is one circumstance in which a partnership is required to revalue an asset and restate capital accounts. When property is distributed, the partnership is required to revalue the distributed property immediately before the distribution. 39 This mandatory revaluation ensures that the distributee s capital account is reduced by the full current value of the distributed property. It also may have the effect of creating book/tax disparities for the partners identical to that created by a routine application of the ceiling limitation. Chart 17 $ 7,095 $ 6,960 $ 7,095 $ 5,760 $ 7,095 $ 7,095 After Year 5 (460) 0 (460) 0 (460) 0 Years 6-7 Depreciation 0 (370) (460) Years 6-7 Remedial Allocations $ 6,635 $ 6,590 $ 6,635 $ 6,590 $ 6,635 $ 6,635 Total After Year 7 Chart 18 $ 6,635 $ 6,590 $ 6,635 $ 6,590 $ 6,635 $ 6,635 After Year 7 (30) 0 (30) 0 (30) 0 Year 8 Depreciation (30) Year 8 Remedial Allocations $ 6,605 $ 6,605 $ 6,605 $ 6,605 $ 6,605 $ 6,605 Total After Year 8 52

13 Passthrough Entities/September October 2002 For example, suppose P and Q are partners in the PQ partnership. Assume that Blackacre is distributed to P when Blackacre has an adjusted basis in the hands of the partnership of $6,000 and a current fair market value of $10,000. Assume further that the partners have agreed to allocate gain from the disposition of Blackacre 60 percent to P and 40 percent to Q while losses will be divided equally. Finally, assume that the partnership also has $10,000 in cash, so that each partner has an outside basis and capital account of $8,000. If Blackacre is distributed to P, 40 the books of the partnership will look like Chart 19. As to Q, the effect of the distribution is to increase Q s capital account by Q s share of the unrealized appreciation in Blackacre without an equivalent increase in Q s outside basis; thus, the distribution leaves Q with a capital account in excess of outside basis by $1,600. As to P, the effect of the distribution is to increase P s capital account by P s share of the unrealized appreciation in Blackacre and then to reduce P s capital account by the full book value of Blackacre (that is, by the adjusted basis of Blackacre plus Q s share of the unrealized appreciation plus P s Chart 19 share of the unrealized appreciation), for a net reduction equal to the adjusted basis of Blackacre plus P s share of the unrealized appreciation. Because P s outside basis is reduced only by the adjusted basis of Blackacre, P s capital account ends up lower than P s outside basis by Q s share of the unrealized appreciation in Blackacre; that is, by $1,600. Thus, the revaluation and distribution result in equal and offsetting book/tax disparities for the partners, book/tax disparities that cannot be eliminated because the property that caused the problem is no longer owned by the partnership. Can the partners elect to cure their book/tax disparities by resort to curative or remedial allocations? For example, could P be allocated a remedial $1,600 capital loss tax allocation while Q is allocated an offsetting remedial $1,600 capital gain allocation? Because use of curative or remedial allocations generally is elective, a partnership that does not wish to cure these book/tax disparities presumably is free to let them remain. But is a partnership that wishes to eliminate them authorized to do so? Surprisingly, the answer is not clear. Book/tax disparities caused P Q CA OB CA OB Explanation $ 8,000 $ 8,000 $ 8,000 $ 8,000 Starting Values 2, ,600 0 Revaluation of Asset (10,000) ( 6,000) 0 0 Distribution $ 400 $ 2,000 $ 9,600 $ 8,000 Total Chart 20 P Q CA OB CA OB Explanation $ 8,000 $ 8,000 $ 8,000 $ 8,000 Starting Values 2, ,600 0 Revaluation of Asset (2,000) 0 (2,000) 0 Sale for $6,000 $ 8,400 $8,000 $ 7,600 $ 8,000 Totals by the revaluation of partnership assets are to be resolved by resort to Code Sec. 704(c)(1)(A) principles. The same issue could arise if contributed property with a book/ tax disparity were distributed to a partner other than the contributing partner more than seven years after it had been contributed to the partnership. In such circumstances, what do the regulations under Code Sec. 704(c)(1)(A) provide? Nothing. While there is a paragraph covering nontaxable dispositions of Code Sec. 704(c)(1)(A) property, 41 the regulations assume that such dispositions will be exchanges in which the partnership acquires qualifying replacement property for the Code Sec. 704(c)(1)(A) property. In such circumstances, the regulations provide that Code Sec. 704(c)(1)(A) attaches to the qualifying replacement property, a reasonable enough result when there is replacement property. But when the Code Sec. 704(c)(1)(A) property is distributed under Code Sec. 731(a)(1), the transaction is tax-free to the partnership, yet it acquires no replacement property on the transaction. As to this transaction, the regulations are disappointingly silent; presumably the drafters simply did not consider this particular possibility. What should the answer be? Had Blackacre been sold rather than distributed to P, the unrealized gain would have been realized and recognized to the partnership and then passed through to the partners, with P picking up P s share of the gain and Q picking up the rest. Because of the distribution, though, P will include all of the gain in income when the property eventually is sold, even though P s capital account was only credited with a portion of it. And Q will never recognize any of the unrealized gain in Blackacre, even 53

14 Reverse Allocations 1 Reg (b)(2)(iv)(b). 2 Reg (b)(2)(ii)(b). 3 Reg (b)(2)(iv)(d)(1). 4 Reg (a)(1). 5 See discussion on page of this article. 6 See Reg (b)(2)(iv)(f) (g). 7 Reg (b)(2)(iv)(g)(1). 8 See generally Howard E. Abrams, Dealing With the Contribution of Property to a Partnership: Part I, BUS. ENTITIES, Nov.- Dec. 2000, at 16; Howard E. Abrams, Dealing With the Contribution of Property to a Partnership: Part II, BUS. ENTITIES, Jan.-Feb. 2001, at See generally Howard E. Abrams, Adding a New Cash Partner to an Operating Partnership: Part I, BUS. ENTITIES, Jan.-Feb. 2002, at 28; Howard E. Abrams, Adding a New Cash Partner to an Operating Partnership: Part II, BUS. ENTITIES, Mar.-Apr. 2002, at See Reg (b)(2)(iv)(f). 11 Reg (b)(2)(iv)(g). 12 Called self-help curative allocations, to distinguish them from curative allocations described in Reg (c). 13 For example, if the partnership had $6 of income, it could be allocated $3 to X and $3 to Y and, thereby, equalize the capital accounts at $ See Reg (c). 15 Compare Reg (c)(3) (limiting though Q s capital account already has been credited with Q s distributive share of it. Suppose Blackacre had been booked up to $10,000 and then declined in value back to $6,000. Assume that Blackacre had then been sold to a third party, producing a book loss of $4,000, but no gain or loss for tax purposes. After this sale, the partnership books would read as is shown in Chart 20. There is a book/tax disparity for each partner, equal in amount, but offsetting in sign. P s capital account exceeds P s outside basis by $400 while Q s capital account is less than Q s outside basis by the same amount. This is a conventional instance of the operation of the ceiling rule, 42 one the drafters of the Code Sec. 704(c)(1)(A) regulations anticipated, and there is no question that the book/tax disparities can be eliminated by curative or remedial allocations if the partners so choose. 43 And if the book/tax disparities are not eliminated, there is a timing mismatch for each partner because there was insufficient tax gain to offset the prior capital account book-up when Blackacre is sold. Thus, with the property giving rise to the book/tax disparity now gone from the partnership, the remaining book/disparities for the partners cannot be eliminated with a curative or remedial allocation. ENDNOTES the amount, timing and character of curative allocations). 16 See Reg (b)(2)(ii). 17 See generally Reg (b)(2)(iii). 18 See, e.g., Reg (b)(5), Example Indeed, under the value-equals-basis rule of Reg (b)(2)(iii)(c), the first allocation is ignored because dispositional gain caused by post-allocation appreciation is conclusively presumed not to occur. 20 Reg (b)(2)(ii)(f); but see Reg (b)(1)(iii) (iv). 21 Reg (b)(2)(ii)(b)(2). 22 Rev. Rul , CB 406. See generally Howard E. Abrams, Revenue Ruling Suggests Strategic Partnership Failure to Book-Up, THE TAX ADVISOR, Mar. 2000, at Reg (b)(2)(iii)(c). 24 See Reg (b)(2)(iii)(b). 25 Id. 26 Reg (b)(2)(iii)(c)(1) (2). 27 The value-equals-basis rule should more accurately be called the fair market value is presumed to equal book value rule. 28 Reg (b)(2)(iii)(c)(2). 29 This material is excerpted from Howard E. Abrams, Adding a New Cash Partner to an Operating Partnership: Part 2, supra note 9, at See Reg (b)(2)(ii)(d)(1) (2). 31 Rev. Rul , CB See generally HOWARD E. ABRAMS & RICHARD This is the precise situation that occurs when Blackacre is distributed rather than sold: there are equal and offsetting book/tax disparities for the partners that can only be eliminated by curative or remedial allocations because the property giving rise to the prior capital account adjustments is now out of the partnership. Thus, the distribution in fact works a timing mismatch for both partners identical to that created by a more traditional application of the ceiling rule limitation, and so I think the partnership should be permitted to eliminate the book/tax disparities by resort to curative or remedial allocations. L. DOERNBERG, ESSENTIALS OF UNITED STATES TAXA- TION, 3-56 to 3-57 (1999). 33 Of course, had this happened, P ultimately would be forced to recognize an offsetting amount of income. See, e.g., RICHARD L. DOERNBERG & HOWARD E. ABRAMS, FEDERAL INCOME T AXATION OF CORPORATIONS AND PART- NERSHIPS (3d ed. 2000), at Reg (a)(6)(i). 35 See generally Reg (d). 36 Reg (d)(2). 37 Prior to the admission of Z, there is cash in the partnership of $10,200 and property worth $9,030 for a combined value of $19,230. Because X and Y are each a 50-percent partner, they each have a partnership interest worth half of $19,230, or $ This material is based on RICHARD L. DOERNBERG & HOWARD E. ABRAMS, supra note 33, at Reg (b)(2)(iv)(e)(1). 40 This example assumes the distribution is not subject to Code Secs. 707(a)(2)(b), 704(c)(1)(B), 737 or 751(b). 41 Reg (a)(8). 42 See Reg (b)(1). 43 But see Reg (a)(2) for limitation on a partnership s discretion to choose among the various Code Sec. 704(c) methods in abusive situations. This article is reprinted with the publisher s permission from the JOURNAL OF PASSTHROUGH ENTITIES, a bi-monthly journal published by CCH INCORPORATED. Copying or distribution without the publisher s permission is prohibited. To subscribe to the JOURNAL OF PASSTHROUGH ENTITIES or other CCH Journals please call or visit 54