Partnership Code Sec. 704(b) Capital Account Maintenance Permitted Adjustments Can Track Partners Economic Arrangements

February 2014 Partnership Code Sec. 704(b) Capital Account Maintenance Permitted Adjustments Can Track Partners Economic Arrangements By James R. Hamill James R. Hamill discusses the benefits of a partnership maintaining Code Sec. 704(b) book capital accounts, either in isolation or in addition to one of the other available methods and how those capital accounts should be maintained. Introduction With the growth in the use of limited liability companies (LLCs), partnership tax filings have increased ed df from 2,165,000 in 2001, the first year that Form m10 1065 filings exceeded Form 1120 filings, to more than 3.5 million in 2012. 1 Any boiler plate partnership or LLC agreement ement contains a definition of how capital accounts will be maintained and often determines partners rights to assets upon liquidation by reference to the capital accounts. Beginning with 2004 tax filings, Schedule e K-1 now requires that the partnership identify the method used to report capital accounts. Nonetheless, the professional tax literature pays surprisingly little attention to the determination of partners capital accounts and why one method may be preferred to another. Most practitioners are familiar with the requirement that Code Sec. 704(b) capital accounts be maintained to satisfy the safe harbor for economic effect under Reg. 1.704-1(b). Code Sec. 704(b) capital accounts also facilitate compliance with the deemed in accordance with the partner s interest test for nonrecourse deductions that cannot satisfy the economic effect test and with Code Sec. 704(c) and James R. Hamill, CPA, Ph.D., is the Director of Tax Practice at Reynolds, Hix & Co., P.A. in Albuquerque, New Mexico. reverse Code Sec. 704(c) allocations. The Schedule K-1 reporting now lists four options to maintain capital accounts, including Code Sec. 704(b) book, 2 GAAP, tax basis and other, which must be specified. While it has become quite common to see references ence to the maintenance nce of Code Sec. 704(b) capital al in operating agreements, there seem to be few practitioners who are aware of how wto satisfy the language of the agreement with respect to capital account maintenance. Because the safe harbor for economic effect requires that Code Sec. 704(b) capital accounts be maintained throughout the full term of the partnership, 3 failure to maintain Code Sec. 704(b) capital accounts for any year cannot be corrected by subsequent year adjustments. This article will discuss the benefits of a partnership maintaining Code Sec. 704(b) book capital accounts, either in isolation or in addition to one of the other available methods and how those capital accounts should be maintained. Understanding the Code Sec. 704(b) capital account provisions helps a practitioner to understand both the tax and economic effects of a variety of partnership transactions. Therefore, this article will analyze capital account maintenance, both on a Code Sec. 704(b) and tax basis, in the context of specific transactions that a practitioner would encounter for partnership clients. It will include an TAXES THE TAX MAGAZINE 2014 J.R. Hamill 35

Partnership Code Sec. 704(b) Capital Account Maintenance analysis of how Code Sec. 704(b) capital accounts are adjusted to reflect the economics associated with a contribution to an existing partnership in exchange for an interest, a distribution of property, including both liquidating and nonliquidating distributions, 4 a transfer of a compensatory profits interest, a partnership Code Sec. 1031 exchange with boot, Code Secs. 734 and 743 basis adjustments, a Code Sec. 708(b)(1)(B) termination and the grant or exercise of noncompensatory options to acquire a partnership equity interest. Why Maintain Code Sec. 704(b) Capital Accounts? As noted above, the most significant reason to maintain Code Sec. 704(b) capital accounts is to satisfy the safe harbor for economic effect, either under the three requirements test or the alternate test for economic effect. 5 Code Sec. 704(b) capital accounts are also required to meet the safe harbor that allows allocations of nonrecourse deductions as specified in the agreement to be deemed to be in accordance with the partners interests. 6 Finally, the use of Code Sec. 704(b) capital assists in tracking Code Sec. 704(c) and reverse Code Sec. 704(c) allocations. ons. 7 In addition, Code Sec. 704(b) capital can help partners rs understand and track the economics of a variety of partnership transactions. s. Because Code Sec. 704(b) capital al accounts were developed eloped to comply with the economic effect test, they are edesigned, as best one can, to track the economics of the arrangement among the partners. The effectiveness of the Code Sec. 704(b) capital accounts in tracking true economics has been criticized, including the inability of the provisions to track economics on a real-time basis. 8 But the Code Sec. 704(b) book capital accounts defer valuation restatements intended to better reflect the current economic arrangement until they are supported by arm s-length bargaining, so that it is the lack of objective evidence to support annual restatements that prevents tracking the economic arrangement on a real-time basis. Moreover, those who want to avoid the Code Sec. 704(b) capital accounts must both rely on the subjective partner s interest in the partnership (PIP) test for allocating partnership items and adopt some alternative capital account structure which itself would be subject to criticism. While it may be comforting to many partners to see a specific division of assets upon liquidation, rather than a 36 reference to distributions following Code Sec. 704(b) capital, avoiding a safe harbor economic effect test introduces uncertainty into the allocation process. 9 Thus, the Code Sec. 704(b) capital account provisions are most useful for tax purposes to permit allocations to be respected under a safe harbor. Because Code Sec. 704(b) capital account revaluations intended to better reflect the economics of the partnership must, by necessity, wait until some arm s-length transaction provides sufficient evidence to justify the adjustment, it is certainly true that Code Sec. 704(b) capital cannot reflect the economics of the partnership on a real-time basis. Certain transactions permit adjustments that, arguably, allow the capital to be restated to true-up the economics for a moment in time. However, even in such circumstances, the values assigned to partnership properties must be based on a rough justice approach that ignores valuation adjustments typically used for lack of marketability and lack of control because the effect of such discounts is not subject to bargaining between the parties. In spite of these limitations, the Code Sec. 704(b) capital accounts best reflect the economics of the partners arrangement when compared to available alternatives. For this reason, maintenance of Code Sec. 704(b) capital, alone or in conjunction with other methods, may be done for nontax economic c reasons in addition to the tax allocation benefits. But any economic benefits are more likely to be a by-product of the tax motivations for keeping Code Sec. 704(b) capital. Capital Account Maintenance Provisions The basic structure of the Code Sec. 704(b) capital account maintenance provisions is that partnership assets will be recorded at fair market value (FMV). Contributed properties are debited at FMV, associated liabilities that are either assumed by the partnership or taken subject to the debt are credited to the Code Sec. 704(b) accounts, so that the partner s initial capital account is reflected as the amount of money and the FMV of property contributed, net of any associated liabilities. When assets are distributed by the partnership, the assets are credited at FMV so the associated debit to the distributee partner s Code Sec. 704(b) capital is also at FMV of the distributed property. Where the distributed property is not already reflected at date-of-distribution FMV, it is then necessary to adjust the value that the

February 2014 property is carried at to its FMV immediately before distribution. Where appropriate, based on arm slength bargaining, asset values may also be adjusted during the life of the partnership for other permitted events with an offsetting adjustment to the partners Code Sec. 704(b) capital. The key to use of such adjustments is the existence of a transaction that requires the partners to bargain at arm s length with adverse interests to support adjustments to the values of partnership properties. As noted earlier, Code Sec. 704(b) capital account maintenance rules were created in connection with the regulations defining when an allocation satisfies the substantial economic effect test. Proper maintenance of Code Sec. 704(b) capital is required to meet both of the safe harbors for economic effect, whether the partners decide to use the three requirements or the alternate test, 10 and also to satisfy the safe harbor by which nonrecourse allocations are deemed to be in accordance with the partners interests. When used for these purposes, the partnership agreement must require that distributions in liquidation of a partner s interest be made in accordance with Code Sec. 704(b) capital. 11 It is the partner s desire to see adjustments to his or her capital for the purpose of securing rights to partnership assets that creates the adverse e interests ts that justify use of arm s-length bargaining between en the partners as establishing FMV. 12 If the partnership rsh agreement does not make distributions in liquidation based on Code Sec. 704(b) capital, such as where the partnership pchooses target t allocations to determine the amounts that each partner will receive, the use of agreements between the partners as the means of establishing FMV for purposes of Code Sec. 704(b) capital account maintenance becomes suspect. Many partnership agreements use target allocations to avoid complying with the three-requirements or the alternate test for economic effect, and such a partnership may not even maintain Code Sec. 704(b) capital. 13 Failure to maintain Code Sec. 704(b) capital will prevent the partnership from relying on a regulatory safe harbor, but allocations may still be made in accordance with the partner s interest in the partnership. This article recognizes that most partnerships that choose to use Code Sec. 704(b) capital do so to comply with a safe harbor provision, but the article will also note situations where Code Sec. 704(b) capital may be used to best illustrate the economic arrangement between the partners. Partnerships relying on target allocations may still require Code Sec. 704(b) capital to track the economics of the arrangement, and the target allocations will then adjust that capital to match the distributions made. At the time the Code Sec. 704(b) regulations were written, it was generally easy to identify the scope of arrangements classified as a partnership. Recent introduction of Series LLC statutes in many states raises the issue of whether each economically independent series should maintain its own Code Sec. 704(b) capital even if the entire series files a single Form 1065. Because the purpose of the Code Sec. 704(b) capital account provisions is to reflect the economic arrangement between the parties, it seems most consistent with that purpose that each economically independent series should maintain its own Code Sec. 704(b) capital accounts. Because partnership capital account maintenance may be done to achieve more objectives than satisfying a safe harbor for economic effect, a partnership may maintain multiple sets of capital accounts. Even where a partnership maintains Code Sec. 704(b) capital to comply with a safe harbor provision, that partnership is not required to use Code Sec. 704(b) capital on the tax return. 14 While Code Sec. 704(b) capital may best reflect the underlying economic arrangement among the partners, tax-basis capital may be more useful to a partner receiving a Schedule K-1 because it can be used to track the basis of the partner s interest. Property Contributions in Exchange for an Interest at Partnership Formation When property is contributed at formation of the partnership, and Code Sec. 704(b) capital is the basis for determining partners rights to assets for distributions in liquidation of the partner s interest, the arm s-length bargaining between the partners that results in an agreed-to FMV for contributed assets should be accepted for Code Sec. 704(b) capital. Each property partner will have an incentive to advocate for the highest possible value to be assigned to his contributed property to establish a greater right to assets of the partnership. Conversely, other partners should be expected to argue for the lowest possible value to be assigned to property contributed by other partners. Partnership agreements often include a schedule of agreed value contributed by each partner. This schedule should include a statement of value for each item of contributed property, although the partners often do not specify value in that much detail. However, failure to specify value for each item TAXES THE TAX MAGAZINE 37

Partnership Code Sec. 704(b) Capital Account Maintenance of property may lead to difficulty in making future allocations that are subject to Code Sec. 704(c). 15 38 Example 1. Ally and Sarah form the AS partnership with each contributing $500,000 of value. Ally contributes money, and Sarah contributes an unencumbered parcel of undeveloped land with a tax basis of $300,000 and an agreed FMV of $500,000. The partnership agreement satisfies the alternate test for economic effect and states that all items of income, gain, deduction and loss will be allocated 50 percent to each partner. 16 The partnership also maintains tax-basis capital accounts to assist in tracking the tax basis of partners interests and facilitating Code Sec. 704(c) allocations. The date-of-contribution capital is shown in Chart 1 (with 000s omitted from this and all subsequent examples). Chart 1. Ally Sarah Ally Sarah Contributed Value 500 500 500 300 The disparity between the Code Sec. 704(b) and tax-basis asis capital represents the built-in gain attributable t ble to Sarah s land, and this disparity between een value ea and basis is subject to Code Sec. 704(c) principles. ples The maintenance of both Code Sec. 704(b) and tax capital helps to distinguish the allocations location subject to Code Sec. 704(c) principles ple from those allocations subject to the general rule that partners may agree how to allocate items provided that agreement has substantial economic effect. For example, the Code Sec. 704(b) capital tracks the economic arrangement between the partners, and any allocation that cannot be reflected in the Code Sec. 704(b) capital accounts cannot have economic effect. This point can be illustrated by continuing our example with the assumption that Sarah s contributed land is later sold for $600,000 (we will assume that no other adjustments have been made to the capital accounts before the sale). The sale of Sarah s property will result in a Code Sec. 704(b) book gain of $100,000 ($600,000 amount realized minus $500,000 book basis) and a tax gain of $300,000 ($600,000 $300,000 Code Sec. 723 tax basis). The $100,000 gain that can be recorded in the Code Sec. 704(b) capital accounts represents an economic gain to the partnership, and this amount can then be allocated by agreement as it can satisfy the economic effect test. The balance of the gain that must be reported by the partnership on its tax return, $200,000, cannot be reflected in the Code Sec. 704(b) capital because it does not reflect economic gain realized by the partnership. 17 Because the $200,000 gain cannot be reflected in Code Sec. 704(b) capital, any allocation of that $200,000 gain cannot have economic effect. 18 The effect of the sale in the capital accounts is shown in Chart 2. Chart 2. Ally Sarah Ally Sarah Contributed Value 500 500 500 300 Sale of Land 50 50 50 250 Post-Sale 550 550 550 550 Because the Code Sec. 704(b) capital accounts reflect the date-of-contribution economic arrangement between the partners by recording all asset values at agreed-to FMV, the only gains that can be reflected in the Code Sec. 704(b) capital are those that economically accrued after formation. While Code Sec. 704(a) allows partners to allocate items of the partnership by agreement, ent, it is only the gain reflected in the Code Sec. 704(b) capital that can nbesa said to be a gain of the partnership. The balance of the tax gain, $200,000 in the above example, is an item to be reported by the partnership but does not represent an item of (economic) gain of the partnership. Code Sec. 704(a) allows partners to agree how to allocate items of the partnership but not items that economically arise before the partnership is formed. This is the distinction between the general rule of Code Sec. 704(a) and the exception of Code Sec. 704(c). The Code Sec. 704(b) capital accounts are the easiest way to track allocations subject to each provision. 19 Code Sec. 704(c) requires that the disparity between book and tax values be resolved as quickly as possible, which means that depreciation allocations with respect to contributed Code Sec. 704(c) property must use the principles of Code Sec. 704(c). As the depreciation allocations reduce the disparity between book and tax values, the allocations of gain from the sale of contributed

February 2014 property must also be adjusted, a process made easier to track by use of Code Sec. 704(b) book and tax-basis capital accounts. Example 2. Ally and Sarah form the AS partnership with each contributing $500,000 of value. Ally contributes money, and Sarah contributes an item of five-year recovery property with a tax basis of $300,000 and an agreed FMV of $500,000. The partnership agreement satisfies the alternate test for economic effect and states that all items of income, gain, deduction and loss will be allocated 50 percent to each partner. The partnership also maintains tax-basis capital accounts to assist in tracking the tax basis of partners interests and Code Sec. 704(c) allocations. The property contributed by Sarah is depreciated at the rate of 20 percent per year for both book and tax 20 and is sold at the beginning of the third year for $350,000. Depreciation deductions for Code Sec. 704(b) book purposes are based on the recorded FMV of the property. 21 For simplicity of illustration, no depreciation is claimed for the year of disposition. The capital from formation through the date of sale is shown in Chart 3. Chart 3. Code Sec. 704(b) Tax Basis Ally Sarah Ally Sarah Contribution 500 500 500 300 Depreciation 2 years <100> <100> <100> 0> <20> Pre-Sale Capital 400 400 400 280 Sale 25 25 25 145 Ending 425 425 425 425 This analysis shows that the built-in gain of $200,000 attributable to Sarah s contributed property is subject to Code Sec. 704(c) both with respect to the annual depreciation deductions as well as the gain from sale. Code Sec. 704(b) book depreciation is based on contributed FMV while tax depreciation is based on the partnership s carryover basis in the contributed property. Book depreciation is split equally pursuant to the agreement, while tax depreciation is allocated first to Ally to match her share of book depreciation, 22 and then to Sarah. For the two years that depreciation is claimed, Ally is allocated $80,000 more tax depreciation deductions than Sarah. When the property is sold, the Code Sec. 704(c) gain allocation to Sarah is $120,000, which is the contributed gain of $200,000 reduced by the differential depreciation for the first two years. The pre-sale capital balances show the amount that is subject to Code Sec. 704(c) as the $120,000 difference between Sarah s Code Sec. 704(b) and tax-basis capital. Property Contributions in Exchange for an Interest Post-Formation When money or property is contributed to the partnership in exchange for an interest at some time after formation of the entity, the amount contributed and the percentage interest received will allow the partners to infer the value of partnership properties at the time of the new contribution. Arm s-length bargaining should establish the fair payment required for the interest to be received, and that payment should also reflect the net asset value of partnership properties. It could be argued that the amount paid for the interest cannot readily be used to determine the value of properties because the interest value would be expected to be discounted by factors such as lack of marketability and lack of control. While this is certainly true, even ignoring the factors that may justify a discount for the value of the interest allows the partnership to better reflect the economic omic arrangement ent between the partners. Further, there is no objective way to incorporate valuation discounts into a revaluation of the properties. Discounts are not bargained by the partners, and if an outside expert is used to establish a discount, there may be a conflict of interest between the partner responsible for hiring that expert and one or more other affected partners. For example, when money or property is contributed to an existing partnership for an interest, the existing partners could seek an expert to support a high discount to inflate the implied value of partnership properties so that more preadmittance capital is shifted to them. So when an interest is acquired by contribution, the Code Sec. 704(b) capital accounts may be restated to reflect the value implied by the contribution but absent any discounts. This restatement is optional, but it assists the partnership in making reverse Code Sec. 704(c) allocations to reflect any inherent gain or loss that existed before the new interest is acquired. 23 If the restatement is not done, the partnership is still TAXES THE TAX MAGAZINE 39

Partnership Code Sec. 704(b) Capital Account Maintenance required to follow Code Sec. 704(c) principles with respect to any pre-admittance gains and losses. The restatement simply facilitates this analysis. Example 3. Ally and Sarah form the AS partnership, with each contributing $500,000 in exchange for a 50-percent interest. All contributions are made with money. The partnership agreement satisfies the requirements for the safe harbor for the alternate test for economic effect, and all items are allocated 50 percent to each partner. The partnership uses the contributions to purchase $1,000,000 of undeveloped land to be held for investment. Three years after formation, Katie offers to join the partnership by contributing money for a one-third interest. The amount to be paid by Katie is the subject of arm s-length bargaining where Katie would like to contribute the smallest amount, and Ally and Sarah would like her to contribute a much larger amount. The parties agree that Katie will contribute $800,000 for a one-third interest in all items. Katie s contribution implies that the value of all partnership properties, after her admittance, is $2,400,000 (so that her contribution properly reflects one-third of the total value). Because this amount includes Katie s $800,000 monetary contribution, tion, the land purchased by the AS partnership must be worth $1,600,000 0 at the time of Katie s admittance. tance The epartnership may now adjust the value of the land upward from its current Code Sec. 704(b) $1,000,000 value to $1,600,000. The offsetting credit entry of $600,000 is made to the Code Sec. 704(b) capital accounts of Ally and Sarah based on how they have agreed to share the economic gains associated with the land. Therefore, each partner has a $300,000 adjustment made to her capital. The Code Sec. 704(b) and tax-basis capital accounts then appear as shown in Chart 4. Chart 4. Initial Formation 500 500 500 500 Katie Admittance 800 800 Restatement 300 300-0- -0- -0- -0- Ending Capital 800 800 800 500 500 800 40 While the entries are fairly simple, they also tell a story. First, the restatement causes the Code Sec. 704(b) capital of each partner to be equal, reflecting their revised economic agreement by which each owns one-third of the partnership. Second, the $300,000 disparity between the Code Sec. 704(b) and tax-basis capital of both Ally and Sarah reflect their respective shares of the appreciation in the value of partnership properties that occurred from the date they formed the entity through the date that Katie was admitted as a new partner. This book-tax disparity is subject to Code Sec. 704(c), and the reverse Code Sec. 704(c) allocations when the land is sold will distinguish the gain that occurred when Ally and Sarah were the only partners from any gain or loss that occurs when there are three partners. To illustrate, assume that the land is later sold by the partnership for $1,900,000. The Code Sec. 704(b) gain, measured relative to the restated value of the land, is $300,000 ($1,900,000 $1,600,000). The gain to be shown on the tax return is $900,000 ($1,900,000 $1,000,000 cost basis). Book and tax gain are then allocated as shown in Chart 5. Chart 5. Code Sec. 704(b) Tax Basiss Ally Sarah Katie Ally Sarah Katie Initial Formation 500 500 500 500 Katie Admittance 800 800 Restatement 300 300 Sale of Land 100 100 100 400 400 100 Ending Capital 900 900 900 900 900 900 Only $300,000 of gain, the amount that can be reflected in the Code Sec. 704(b) capital, can be allocated among the three partners by agreement and satisfy the economic effect test. The remaining tax gain of $600,000 must be allocated using the principles of Code Sec. 704(c), and this reverse Code Sec. 704(c) gain, which reflects appreciation in the land value from date of formation through the date that Katie was admitted as a new partner, must be allocated between Ally and Sarah based on how they have agreed to share that gain. The example reflects a 50/50 split of the gain,

February 2014 but Ally and Sarah may agree to an allocation other than 50 percent each, and that allocation can have economic effect because it can be reflected in the Code Sec. 704(b) capital. If their agreement with respect to this gain was something other than 50 percent each, that agreement would have been reflected in the allocation of the restatement and later matched by an allocation in the tax-basis capital. Post-Formation Contribution by an Existing Partner for an Interest Example 3 shows an optional restatement when a new partner joins the partnership by contribution of money or property in exchange for an interest. The new partner scenario is the simplest to demonstrate, as the post-contribution value of partnership properties implied by the contribution is simply the FMV of the contribution divided by the percentage interest acquired by the contribution (in Example 3, $800,000 divided by one-third). If the contribution is made by an existing partner, the calculation of implied value is a bit more difficult as it is based on the change in the partner s rs percentage interest. 24 It is necessary to measure e the partner s share of capital both before and after his new contribution to determine er the value implied by the incremental interest est received eived in exchange for the new contribution, on, which requires e a four-step calculation. The four-step calculation is a generalized form of determining the implied value of partnership properties and can also be used to determine value in the preceding example. The following example will illustrate the four steps. Example 4. Ally, Sarah and Katie form the ASK partnership, with each partner contributing $500,000 of money in exchange for a one-third interest in all items. The partnership satisfies all requirements of the alternate test for economic effect. The partners use their cash contributions to purchase $1,500,000 of undeveloped land. Three years after formation, Ally contributes $400,000 additional cash in exchange for increasing her interest in partnership capital from one-third to 40 percent. The partnership will restate the value of the land to reflect the value implied by Ally s second contribution. This value is determined as follows: Step 1 Ally s share of capital, including any change in value after formation, immediately before the new contribution is: A pre = 500 + 0.333(X 1,500), where X is the value of partnership assets before the second contribution. Ally s Code Sec. 704(b) capital will be adjusted only if the value (X) is different than the 1,500 value currently reflected in Code Sec. 704(b) capital. Step 2 Ally s share of total capital after the second contribution is: A post = 400 + A pre =.40 Total Capital This step adds Ally s new contribution (400) to her restated pre-contribution capital and sets her post-contribution capital equal to 40 percent of the total post-contribution capital (both computed post-revaluation). Step 3 Total Capital after the second contribution = 1,900 + (X 1,500). This shows total capital is the total amount contributed (1,900) adjusted for the revaluation. Step 4 Determine X by substitution from above, where we can substitute Ally s share of capital after the second contribution as the numerator (substituting step 1 into step 2), total capital after the second contribution o as the denominator and set that quotient equal to.40, the agreed share of capital that nowbelongs to Ally: 900 + 0.333X 500 =.40 400 + X Then simplifying, 160 +.4X = 400 + 0.333X 0.067X = 240 X = 3,600 Therefore the value of the land immediately before Ally s second contribution is $3,600,000, which requires a book up of $2,100,000 from its original $1,500,000 value. This is shared onethird by each of the original partners, and capital accounts then appear as shown in Chart 6. TAXES THE TAX MAGAZINE 41

Partnership Code Sec. 704(b) Capital Account Maintenance Chart 6. Initial Formation 500 500 500 500 500 500 Ally Contribution 400 400 Restatement 700 700 700-0- -0- -0- Ending Capital 1600 1200 1200 900 500 500 42 Several issues stand out based on the ending capital accounts. First, the Code Sec. 704(b) capital has been restated to a total value of $4,000,000, and Ally s share of that total is 40 percent ($1,600,000/$4,000,000), consistent with the revised agreement among the partners. Second, there is a total book-tax disparity of $2,100,000 ($4,000,000 $1,900,000) which reflects the change in value of the land from the date of formation through the date that Ally s interest increased. This amount is subject to a reverse Code Sec. 704(c) allocation where each partner will be allocated $700,000 (the book-tax disparity for that partner). The prechange appreciation is shared equally; any post-change appreciation is shared in the revised 40/30/30 ratios. The restatement recorded in this transaction actio may become part of a larger Code Sec. 704(c) allocation as interests change in future years, including ng the possibility of admitting a new partner in exchange for a contribution. As noted above, the four steps shown in Example 4 to determine the value of partnership p properties before the new contribution is a generalized ed form that could also be applied to Example 3, as shown here: Step 1 Katie s share of capital, including any change in value after formation, immediately before the new contribution is: K pre = 0 + 0 (X 1,000), where X is the value of partnership assets before the second contribution. Step 2 Katie s share of total capital after the second contribution is: K post = 800 + K pre = 0.333 Total Capital Step 3 Total Capital after the second contribution = 1,800 + (X 1,000) Step 4 Determine X by substitution from above, where we can substitute Katie s share of capital after the second contribution as the numerator (again substituting step 1 into step 2), total capital after the second contribution as the denominator and set that quotient equal to 0.333: 800 800 + X Then simplifying, = 0.333 266.67 + 0.333X = 800 0.333X = 533.33 X = 1,600 This restated value of partnership properties is the same as was obtained in Example 3 but where a new partner is the one making the contribution the computation can be shortened by the method shown in that earlier example. Effect of Distribution of Property As noted earlier, the economic-based capital accounts record property contributions at FMV but also record distributions at FMV. Where values are not reflected at FMV immediately before distribution, either because the value changed during the partnership s holding period or changed relative to any pre-distribution restatements, teme it is necessary to restate the value of the distributed properties pe immediately mediate before e the distribution. ibuti How this adjustment occurs generally er depends on two issues. First, to what extent any changes in value have already been reflected by prior restatements. Second, whether the partnership restates the value only of the property actually distributed or whether all partnership properties are restated. As is the case with contributions, the partnership needs an objective measure of FMV, generally determined by agreement between the partners who are dealing at arm s length and with adverse interests. Where Code Sec. 704(b) capital is the basis for rights to assets upon liquidation, partners should have sufficient adverse interests to support an agreed value as reflective of FMV. If a partner is to receive a property distribution that does not liquidate his interest, the distributee partner has an incentive to argue that the distributed property has a small value. This is so because the value assigned will reduce his capital and thereby reduce his rights to future distributions. This leads the distributee partner to argue for a small reduction in his Code Sec. 704(b)

February 2014 capital. 25 In contrast, the other partners should be expected to argue for assignment of a large value to the distributed property, reducing the distributee partner s capital by a larger amount and protecting their interest to future distributions relative to the partner receiving the current distribution. However, the partners do not generally have adverse interests with respect to the value of any partnership properties that are not the subject of the current distribution. Therefore, when the distribution is not in liquidation of the distributee s interest, a restatement is permitted only for the distributed property. This is done through a deemed sale adjustment, or DSA, in which the distributed asset is deemed sold for its FMV with the resultant (book only) gain or loss charged to all partners Code Sec. 704(b) capital based upon their agreement. The property is then removed from the partnership at its restated FMV with the offset to the capital account of the partner receiving the distribution. 26 If the distribution liquidates the interest of the partner, the partners must first agree to the value of the entire interest held by the partner who will be liquidated. Once that total value is determined, the partners must agree which assets will be distributed to satisfy the partner s rights to the total assets of the partnership. p. The distributee again has an incentive to argue that t each asset received has a small value, as st that will justify receipt eipt of additional properties rt to equal the total agreed value of his interest. es Other partners have an incentive to argue the opposite, po so that asmaller number of distributed properties pert es will satisfy their obligation to the liquidated partner. Unlike the nonliquidating ng scenario, it is possible to restate the value of all l partnership assets, again through the DSA, because the partners have determined by arm s-length bargaining the total value of partnership properties. It is not mandatory to revalue all partnership assets in a distribution in liquidation of a partner s interest, but the full restatement should permit Code Sec. 704(b) capital to better reflect the economic arrangement between the partners, including continuing partners. The following example will present a base fact pattern that will be used to show how a DSA may be used in a nonliquidating distribution, and the same facts will be used in the next example to add a variation of a complete liquidation of the partner s interest with a DSA applying to all partnership properties. Example 5. Ally, Sarah and Katie form the ASK Partnership with each partner contributing $500,000 in exchange for a one-third interest in all items of the partnership. The partnership agreement complies with the alternate test for economic effect. The partnership uses the contributed funds to purchase a parcel of land for $1,500,000 and subsequently replats the land into 15 equal-sized lots. At the time of the replat, the partners do not believe that any lot is more valuable than any other, so they assign a $100,000 value to each lot. The intent of the partners is to passively hold the land until a bulk sale to a developer can be arranged. Three years after formation, Katie decides that she would like to build her residence on one of the lots, and she negotiates with Ally and Sarah to receive a distribution of a single lot, with the understanding that the distribution will reduce her interest in the partnership below one-third. The three partners negotiate the value of the lot, and all agree that it is worth $160,000. Because the distribution is not in liquidation of Katie s interest, there is no arm slength bargaining to establish the total value of partnership properties, nor is there any bargaining with respect to the value of any parcel other than the one to be distributed. The distributed lot is revalued at $160,000, with the $60,000 debit entry offset by a $20,000 adjustment to the Code Sec. 704(b) book capital of each partner, based on their agreed-to split of economic gain from the property. Code Sec. 704(b) capital accounts are then reflected in Chart 7. Chart 7. Initial Formation 500 500 500 500 500 500 Deemed Sale 20 20 20 Distribution -0- -0- <160> -0- -0- <100> Ending Capital 520 520 360 500 500 400 The aggregate values of the Code Sec. 704(b) and tax-basis capital remain equal, with book first adjusted upward by $60,000 but then reduced by $160,000, and tax reduced by the original $100,000 cost of the distributed lot. Katie takes a carryover basis in the distributed lot, 27 so there is no Code Sec. 734 adjustment to the basis of undistributed partnership properties even if the partnership has a Code Sec. 754 TAXES THE TAX MAGAZINE 43

Partnership Code Sec. 704(b) Capital Account Maintenance 44 election in effect. The tax basis of her interest and her tax-basis capital are both reduced by the $100,000 assigned to the distributed lot. 28 Katie will bear the potential $60,000 taxable gain if the distributed lot is sold by her after the distribution for its current FMV. Katie s Code Sec. 704(b) capital is $160,000 less than both Ally s and Sarah s, which reflects the value that she has already extracted by way of the distribution. 29 While not required as part of the analysis of this example, it is instructive to consider what happens when remaining partnership properties are disposed of in a taxable transaction. That is, we should be able to reconcile the economics shown in the Code Sec. 704(b) capital with the ultimate tax result to each of the partners. To illustrate, assume that each of the 15 lots is valued at $160,000, so that total partnership value is $2,400,000 before the distribution. Post-distribution, the partnership has remaining $2,240,000 of value ($160,000 14 lots), with a tax basis of $1,400,000 ($100,000 for each of the 14 remaining lots). A taxable disposition would create $840,000 of book and tax gain. Because there is no Code Sec. 704(c) issue (none of the remaining properties has a disparity in book ok and dtax values), Code Sec. 704(b) book gain would be allocated $280,000 to each partner. Tax gain will follow the Code Sec. 704(b) book gain under the economic c effect test. Capital accounts co would then appear pe ras shown nin Chart 8. Chart 8. Capital, from above 520 520 360 500 500 400 Sale remaining lots 280 280 280 280 280 280 Ending Capital 800 800 640 780 780 680 From this analysis we see that available partnership assets ($2,240,000 sale proceeds) will be distributed $800,000 each to Ally and Sarah and $640,000 to Katie. Katie s reduced distribution reflects the value she earlier received from the property distribution. Each partner will have a separate tax effect attributable to receipt of a liquidating distribution of cash sale proceeds, with Ally and Sarah each reporting an additional $20,000 capital gain from a distribution in excess of tax basis ($800,000 $780,000). Thus, Ally and Sarah report a total gain of $300,000 each, $280,000 from a K-1 item and $20,000 on Schedule D from a deemed exchange of their partnership interest. Katie has a $40,000 capital loss from receipt of a $640,000 cash distribution (determined by her Code Sec. 704(b) book capital) in exchange for an interest with a tax basis of $680,000. Katie then reports a net gain of $240,000, which is the $280,000 K-1 item net of the $40,000 Schedule D loss item. Katie s overall gain is $60,000 less than both Ally and Sarah because she still has the distributed lot with a FMV that exceeds basis by $60,000 ($160,000 $100,000). The $60,000 gain is deferred in the distributed lot and if Katie disposes of that lot in a taxable transaction her overall gain will be the same as Ally and Sarah. Obviously this expanded analysis assumes facts beyond a simple distribution of one lot, but it illustrates that over the life of the investment the tax consequences to each partner will match the economics shown through the Code Sec. 704(b) capital accounts. Matching allocations of taxable gain and loss to economic benefits and detriments is the essence of the Code Sec. 704(b) economic effect test, and this matching is reflected in the Code Sec. 704(b) capital accounts. counts 30 Example 6. The facts are the same as in Example 5 except Katie wants to receive one-third of the value of partnership properties in complete liquidation of her interest in the ASK partnership. In this case, the partners will have to negotiate the total value of partnership properties to reach an agreement as to what value Katie is entitled to for her one-third interest. The partners will also need to negotiate the value of specific lots to be distributed to match the value of Katie s interest. Ally, Sarah and Katie agree that each of the 15 lots is now worth $160,000, so that the total value of partnership properties is $2,400,000. Katie will be given title to five of the 15 lots, with a total value of $800,000. Because the partners have reached an arm s-length agreement of the value of all partnership properties, they are able to use a deemed sale adjustment to restate the value of every lot. They agree to restate all lot values, and the Code Sec. 704(b) capital accounts are adjusted as shown in Chart 9.

February 2014 Chart 9. Initial Formation 500 500 500 500 500 500 Deemed Sale 300 300 300 Distribution -0- -0- <800> -0- -0- <500> Ending Capital 800 800-0- 500 500-0- Katie substitutes the basis of her interest ($500,000) for the basis of the distributed properties, so she has a potential gain of $300,000 in the distributed properties that is deferred until she disposes of one or more of the lots in a taxable transaction. The tax basis of undistributed properties has not changed, so Ally and Sarah will each (ultimately) recognize a $300,000 gain when all of the remaining properties are disposed of by the partnership. Again, there is no Code Sec. 734 adjustment (if the partnership had a Code Sec. 754 election) because Katie s substituted basis is the same basis as the distributed properties had to the partnership. Code Sec. 734 Adjustments In the preceding examples, there were no Code Sec. 734 adjustments to the tax basis of undistributed ibuted properties p es as a result of the facts of the example. A Code Sec. 734 adjustment occurs only when the partnership has a Code Sec. 754 election in effect, and the adjustment can be used to maintain the Code Sec. 704(b) book and tax-basis capital accounts in balance over the life of the partnership. Unlike the Code Sec. 704(b) restatements shown above, which did not affect tax-basis capital, Code Sec. 734 adjustments are made to the tax basis of undistributed partnership properties when a distributee partner recognizes gain or loss from the distribution or when the basis of the distributed property to the partner is more or less than the partnership s basis in that distributed property. 31 Therefore, Code Sec. 734 adjustments may be made to the tax-basis capital of the partners, to offset the adjustment made to the asset side of the balance sheet. If the distribution giving rise to a Code Sec. 734 adjustment occurs because of a liquidating distribution, the adjustment is made only to the capital account of the partner whose interest was liquidated. If the adjustment arises from a nonliquidating distribution, it is made to the capital accounts of all partners based on how they would share any gains and losses from the property subject to the adjustment. 32 Example 7. Ally, Sarah and Katie form the ASK partnership with each partner contributing $500,000 of money. The partnership satisfies the alternate test for economic effect and all items will be shared equally by the three partners. The partnership uses the funds to purchase $1,500,000 of property, and the partnership generates $1,500,000 of operating income in its first five years of operations. For simplicity of illustration, it is assumed that all profits of operations are retained as cash and that no cost recovery adjustments have been made to the partnership property. As a result, at the end of the fifth year of operations, the partnership holds property with a Code Sec. 704(b) book and tax basis of $1,500,000 and money of $1,500,000, and partners Code Sec. 704(b) book and tax-basis capital is $1,000,000 each, or $3,000,000 in total. Katie wants to liquidate her interest at the end of the fifth year, and the three partners negotiate a cash buyout of $1,400,000 for Katie s one-third interest. The buyout price implies a total net FMV of partnership assets se of $4,200,000, 000 which consists sts of $1,500,000 of money and $2,700,000 of property. The property is currently carried on the books at $1,500,000, so a $1,200,000 restatement is possible before the liquidating distribution. The partners have agreed to restate the value of all partnership properties using the values implied by the agreement with Katie. 33 The capital accounts will appear as shown in Chart 10. Chart 10. Initial Formation 500 500 500 500 500 500 Operations 500 500 500 500 500 500 Deemed Sale 400 400 400 Distribution -0- -0- <1400> -0- -0- <1400> Ending Capital 1400 1400-0- 1000 1000 <400> TAXES THE TAX MAGAZINE 45

Partnership Code Sec. 704(b) Capital Account Maintenance 46 At this point, the partnership still holds property valued at $2,700,000 (the value implied by the redemption price) and money of $100,000 ($1,500,000 the distribution to Katie). The total assets of $2,800,000 are shared economically $1,400,000 to each of the continuing partners, as is reflected in the restated Code Sec. 704(b) capital accounts. The tax-basis capital of the continuing partners remains at $1,000,000 each, reflecting the unrealized gain of $400,000 attributable to each partner. Katie s Code Sec. 704(b) capital is zero, as she no longer has any right to assets of the partnership, but note that Katie s tax-basis capital ends at a negative number. This figure reflects the $400,000 Code Sec. 731 gain that Katie recognizes from receipt of a distribution of money in excess of the basis of her partnership interest. If the partnership has a Code Sec. 754 election in effect, or makes one for the year of the distribution, a $400,000 positive Code Sec. 734 adjustment will be made to the tax basis of undistributed properties. This adjustment will also be made to the tax-basis capital, with the adjustment made to Katie s capital only, because it arises from a distribution in liquidation. The Code Sec. 734 adjustment, t which is a debit entry to the tax basis of partnership p properties, is offset by a credit to Katie s tax-basis capital and results in a zero balance in her tax-basis capital at year end, matching the Code Sec. 704(b) capital. See Chart t11. Chart 11. Initial Formation 500 500 500 500 500 500 Operations 500 500 500 500 500 500 Deemed Sale 400 400 400 Section 734 Adj. 400 Distribution -0- -0- <1400> -0- -0- <1400> Ending Capital 1400 1400-0- 1000 1000-0- A Code Sec. 734 adjustment may also be made when the basis of the distributed property to the partner is different than the basis of that property to the partnership. That adjustment can be positive or negative, and the effect on tax-basis capital will again be as an offsetting entry to the adjustment made to the basis of undistributed partnership property. The DSA and the removal of the asset from the Code Sec. 704(b) books will reflect the entire effect of the distribution on the economic arrangement between the partners. The Code Sec. 704(b) capital should match the post-code Sec. 734 adjustment tax-basis capital of the liquidated partner as she should report tax consequences matching her Code Sec. 704(b) economic benefits and burdens over the life of her ownership interest in the partnership. Example 8. The facts are the same as in Example 6 except the total value assigned to the 15 lots is $1,800,000 and at the time of the liquidating distribution to Katie the partners agree that not all lots have the same value. Katie agrees to take four lots with an agreed value of $600,000 in liquidation of her interest. The four distributed lots have a tax basis to the partnership of $400,000. The partnership has a Code Sec. 754 election in effect for the year of the distribution. A DSA is recorded for all partnership properties, resulting in a bookup of $300,000 ($1,800,000 $1,500,000) immediately prior to the distribution. The four distributed lots are removed from the Code Sec. 704(b) accounts at their restated FMV of $600,000 0 and from the tax basis books at the partnership s $400,000 basis. Katie s basis in the distributed lots is $500,000, the substituted basis of her partnership interest. 34 Before considering the effect of the Code Sec. 734 adjustment, undistributed partnership properties have a FMV of $1,200,000 ($1,800,000 $600,000 distribution) and a tax basis of $1,100,000 ($1,500,000 $400,000 distributed basis). There is a negative Code Sec. 734 adjustment to the basis of undistributed partnership properties because the basis of the distributed property in Katie s hands exceeds that of the partnership by $100,000. 35 The entry made to the tax basis books to reflect this Code Sec. 734 adjustment to remaining partnership properties is shown in Chart 12. Chart 12. Katie Capital 100 Undistributed Property 100

February 2014 Partnership capital accounts, post-distribution and after the Code Sec. 734 adjustment, are shown in Chart 13. Chart 13. Initial Formation 500 500 500 500 500 500 Deemed Sale 100 100 100 Distribution <600> <400> Section 734-0- -0- -0- -0- -0- <100> Ending Capital 600 600-0- 500 500-0- The Code Sec. 734 adjustment zeroes out Katie s tax-basis capital, and the Code Sec. 704(b) revaluation creates a $200,000 total disparity between the FMV and tax basis of undistributed properties. The properties have a FMV of $1,200,000 and after the negative $100,000 Code Sec. 734 adjustment have a tax basis of $1,000,000. This disparity is also reflected in the excess of the Code Sec. 704(b) capital over the tax-basis capital of the remaining partners. The Code Sec. 734 adjustment allows the book-tax disparity to reflect only the share of unrealized gain in partnership p assets that belongs to Ally and Sarah ($100,000 0,000 each). Katie s $100,000 000 share is deferred er d in the four lots received e in the liquidating gdistri- bution n($ ($600,000 FMV in excess of $500,000 substituted basis). Code Sec. 743 Adjustments Code Sec. 743 adjustments occur when the partnership has a Code Sec. 754 election in effect, and a partner acquires an interest by purchase from another partner. For this purpose, a purchase includes inheritance of a partnership interest. Code Sec. 743 adjustments must be accounted for by the partnership provided the transferee partner timely notifies the partnership of the transfer, 36 but the adjustment itself belongs only to the purchasing partner. As a result, no adjustments are made to the common basis of partnership properties so that no adjustment is made to partnership capital. 37 The purchaser simply steps into the shoes of the seller with respect to capital and may also succeed to any inherent Code Sec. 704(c) items reflected as a disparity between Code Sec. 704(b) book and tax capital. 38 This is so because, unlike a Code Sec. 734 distribution adjustment, the mechanism giving rise to the Code Sec. 743 adjustment occurs outside of the partnership. 39 Code Sec. 705(a)(2)(B) Items Code Sec. 705(a)(2)(B) items are expenditures of the partnership that are not deductible in computing taxable income and not properly charged to capital. They are items that have a permanent effect on the basis of partnership assets without a corresponding current or future effect on taxable income. 40 That is, items capitalized to property that may be recovered through future cost recovery deductions or as reductions in gain from sale are not Code Sec. 705(a)(2)(B) items, which are instead permanent book-tax differences. Examples would include nondeductible premiums paid on partnership owned life insurance, expenses related to the production of tax-exempt income, disallowed related-party losses and the 50-percent disallowance for meals and entertainment. The Code Sec. 704(b) capital reflects the economic effect of these expenditures, and the items would fully reduce the economic-based capital. This is similar to the adjustments that would be made to a corporation s earnings and profits, which is used to determine the corporation s oratio economic ability ity to pay a dividend. Code Sec. 705(a)(2)(B) items can create permanent book-tax differences that will not automatically adjust themselves at liquidation of the partnership. Without any explicit guidance, the partnership may need to adopt self-help measures such as charging off some asset account against tax-basis capital at liquidation to avoid a lingering positive tax-basis capital account when a partner s interest is liquidated. Example 9. Ally and Sarah form a partnership, each contributing $100,000 in exchange for a 50-percent interest in all items of the partnership. During the life of the partnership, net income of $400,000 is reported for book and tax purposes, and $20,000 of meals and entertainment expense is incurred. The capital accounts appear as shown in Chart 14 immediately after each partner receives a liquidating distribution of $290,000 (an equal division of the $380,000 income net of the meals plus the original $200,000 capital). TAXES THE TAX MAGAZINE 47

Partnership Code Sec. 704(b) Capital Account Maintenance Chart 14. Ally Sarah Ally Sarah Initial Formation 100 100 100 100 Operating 200 200 200 200 Income Meals & <10> <10> < 5> < 5> Entertainment Distribution <290> <290> <290> <290> Ending Capital -0- -0-5 5 48 The partnership was required to make some debit entries to reflect the nondeductible meals and entertainment in the tax basis books. That is, cash was credited for $20,000, a tax deduction was debited for $10,000, and there was a balancing entry. If the partnership created a fictional asset account, that account could be eliminated with a credit entry at liquidation with the offsetting debit made to the capital accounts of both Ally and Sarah to zero out their tax-basis capital. Code Sec. 708(b)(1)(B) Terminations A partnership terminates under Code Sec. 708(b)(1)(B) when there e has been a sale or exchange of 50 percent or more eo of the interests in capital and profits within a 12-month period. In such a case, a deemed ed transaction tion occurs cur in which the old partnership transfers s its assets to a new partnership in exchange for all of the interests of the new partnership, and the old partnership then liquidates idat by distributing the interests of the new partnership to its partners, which includes the purchasing partner. 41 A strict application of the mechanics of the Code Sec. 704(b) capital account maintenance rules would require a restatement of the value of all properties when they are contributed to the new partnership in this assets-over transaction. However, because this transfer is merely a deemed transfer, and the actual transaction is a purchase of a partnership interest, the Code Sec. 704(b) capital of the selling partner is simply transferred to the purchasing partner, and no adjustments are made to partner capital. 42 Guaranteed Payments A guaranteed payment is one that is determined without regard to the income of the partnership. 43 It is treated as if made to a nonpartner because, unlike items of the partnership, the partner s right to the payment is not subject to entrepreneurial risk. The partnership reports the payment as a separately stated item on the K-1 of the recipient and deducts the payment subject to the general tax rules applicable to deduction or capitalization of partnership items. Because the payment is made to the recipient partner in a nonpartner capacity, it does not affect the capital account of any partner except through the effect of the deduction of the item by the partnership. 44 In this sense, it is treated the same as if the payment had actually been made to a third party. Transfer of a Profits Interest as Compensation A partnership may grant a profits-only interest as compensation for services, with the service provider avoiding a taxable event at grant. Once the service provider becomes a partner, he is subject to the normal distributive share rules with respect to any income allocable to the profits interest. This means that if the partnership s income is Code Sec. 1231 gain or long-term capital gain, what was intended to be compensation income may instead be recognized by the partner at tax-favored rates. Of course, the partnership loses a deduction for the putative compensation as a price for granting the compensatory profits interest holder the benefit of flowthrough treatment en for the character of the item. The other partners benefit only through a reduction of their share of the flowthrough income item, with the benefit efit determined at rates applicable to net capital gains if the service provider s gains are taxed at the favorable rates applicable to such gains. Rev. Proc. 93-27 defines a profits interest by reference to what the partner would receive if the partnership liquidated at the date of grant. To be a profits interest, the recipient of the interest must not be entitled to any assets if the partnership were to liquidate on the date of grant. 45 This liquidation approach to valuation may require a restatement of the value of partnership properties if there is an inherent gain with respect to partnership assets at the date of grant of the award. Reg. 1.704-1(b)(2)(iv)(f)(iii) makes the grant of the compensatory interest one of the permitted revaluation events for purposes of the Code Sec. 704(b) capital account maintenance rules. Example 10. Ally and Sarah form the AS partnership, with each contributing $500,000 of money in exchange for a 50-percent interest in all items of the partnership. The partnership agreement

February 2014 satisfies the alternate test for economic effect. The partnership uses the contributed money to purchase a tract of undeveloped land for $1,000,000. The partners intent is to hold the property for appreciation. Three years later, after Ally and Sarah believe the property has appreciated, they decide that they would like to enhance the land s value with partnership-level development activities. Because they are not experienced in real estate development, they approach Katie with an offer to help supervise all development work in exchange for a 20-percent interest in future development profits. To ensure that Katie s share of profits relates only to gains that occur after the date of the award of the profits interest, the parties have to agree on the date-of-award value of the property. Katie would be expected to argue for a relatively small value to provide a lower base for measuring future profits, and Ally and Sarah would argue for a large value, creating adverse interests. If they settle on an agreed value of $1,800,000 at the date of the award, the partnership can restate the value of the land by $800,000 and then define Katie s profit award to be based on Code Sec. 704(b) capital values. This justifies no current income to Katie by use of a liquidation valuation of her interest, tb t, because Code Sec. 704(b) capital is the basis for partners rights to distributions ib s in liquidation. The capital accounts would then appear ar as shown in Chart 15. Chart 15. Initial Formation 500 500 500 500 Restatement 400 400-0- -0- -0- -0- Ending Capital 900 900-0- 500 500-0- If the partnership later sells the property for $3,000,000, the development gain would be $1,200,000, which is split in a 40/40/20 ratio using Code Sec. 704(b) capital values. The tax gain is $2,000,000, which includes a reverse Code Sec. 704(c) allocation for the economic gain that accrued before Katie s admittance and a postgrant economic gain that is split among all three partners. The reverse Code Sec. 704(c) item was reflected in the earlier restatement and creates a disparity between Ally and Sarah s Code Sec. 704(b) and tax-basis capital. Ignoring any other capital account adjustments for ease of exposition, the capital accounts after sale of the land and immediately before distribution of proceeds of sale will appear as shown in Chart 16. Chart 16. Initial Formation 500 500 500 500 Restatement 400 400-0- -0- -0- -0- Sale @ 3000 480 480 240 880 880 240 Ending Capital 1,380 1,380 240 1,380 1,380 240 The restatement at the time of Katie s admittance helps to clarify that Katie s profit share is computed on a base asset value of $1,800,000. Katie s award is then ultimately worth 20 percent of $1,200,000, or $240,000. This gain is reported in the year of sale of the land based on the character of income determined at the partnership level. Tax Credits Tax credits generally have no effect on partnership capital, either er for Code Sec. 704(b) or tax-basis capital. Credits do not create e an economic omic benefit independent of tax consequences nces and therefore do not adjust Code Sec. 704(b) capital. Because tax credits have no effect on Code Sec. 704(b) capital, an allocation of tax credits cannot have economic effect. 46 Certain tax credits may reduce the tax basis of the property that gives rise to the credit, and any recapture of such credits may increase the basis of that property. 47 Where the credit affects the tax basis of the property, the offsetting entry will be to the partners tax-basis capital accounts, based on how they share the credit. Code Sec. 1031 Boot Gain Allocations: Interaction with Code Sec. 704(c) Code Sec. 1031 provides for nonrecognition of gain or loss when property held for investment or trade or business use is exchanged for property of a like kind also to be held for investment or trade or business use. If non-like-kind property is received as part of the exchange, the taxpayer recognizes gain measured by TAXES THE TAX MAGAZINE 49

Partnership Code Sec. 704(b) Capital Account Maintenance the lesser of the gain realized on the exchange or the FMV of non-like-kind property received. The basis of the replacement property is most simply computed on the Form 8824 as the cost basis of the replacement property minus the gain deferred on the exchange. 48 If the relinquished property had unrealized Code Sec. 704(c) gain, and the partnership recognizes a portion of the realized gain as a result of the receipt of boot in the exchange, an issue arises with respect to the timing of the recognition of the Code Sec. 704(c) gain. Specifically, must Code Sec. 704(c) gain be recognized first, to the extent of the boot received, or may the boot gain be attributed to economic gains realized after the contribution that created the Code Sec. 704(c) gain with the result that it can be shared by all partners under the economic effect test? The Code Sec. 704(b) capital account analysis is the easiest way to track the nature of the boot gain recognized and to which partner(s) that gain should be allocated, as shown in the following example. Example 11. Ally and Sarah form the AS partnership, with Ally contributing $1,000,000 of money and Sarah contributing undeveloped land with an agreed FMV of $1,000,000 and a tax basis of $600,000. 000 All items are agreed to be shared 50 percent tb by each partner and the partnership satisfies the requirements emen for the alternate test for economic om effect. Three years after formation, the partnership p sells Sarah s contributed land for $2,000,000. The funds are held in aco Code Sec. 1031 qualified descrow, and the partnership uses a qualified intermediary to facilitate an exchange. e. The partnership timely identifies and receives $1,800,000 of qualifying replacement property and $200,000 of boot from the exchange. The partnership has a $1,400,000 realized gain ($2,000,000 $600,000 basis) and a $200,000 recognized gain from the exchange. The partnership has $1,000,000 of economic gain realized from the sale ($2,000,000 $1,000,000 date-of-contribution FMV), 49 and that gain may be reflected in the Code Sec. 704(b) capital accounts. Notwithstanding the existence of unrealized Code Sec. 704(c) gain with respect to Sarah s contributed property, the $200,000 boot gain may be allocated 50 percent to each partner. This gain can be reflected in the Code Sec. 704(b) capital accounts, as shown in the capital account analysis, so that the tax gain may be allocated to both partners consistent with an economic benefit realized by each (see Chart 17). 50 Chart 17. Ally Sarah Ally Sarah Contributed Value 1000 1000 1000 600 Sale of Land 500 500 100 100 Post-Sale 1500 1500 1100 700 The tax basis of the replacement property is $600,000, creating a deferred gain of $1,200,000. The deferred gain belongs $400,000 to Ally and $800,000 to Sarah, which is reflected in the disparity between each partner s Code Sec. 704(b) book and tax-basis capital. There are no examples, or discussion, in the Code Sec. 704(b) regulations that relate to the Code Sec. 1031 partial recognition transaction shown above. However, the regulations do permit following the principles of the regulations in situations where specific guidance is lacking. 50 Also, an allocation can have economic effect where it can be reflected in the Code Sec. 704(b) capital accounts, and the regulations do have an example where a post-formation economic loss is allocated to all partners, even where the property sold has Code Sec. 704(c) gain potential. 51 The capital account entries shown above reflect ect the full economic profit realized from the sale in the Code Sec. 704(b) capital and create a book-tax disparity for both partners. However, Sarah s disparity remains $400,000 higher than Ally s, which allows us to continue to track the built-in gain from her formation transfer. Although it may also be argued that the book gain should be $200,000, matching the tax gain, the conclusion that the taxable gain can be split by agreement under the economic effect test will not change. The principles of the Code Sec. 704(b) regulations seem to support reflecting the full economic gain realized by the sale in the Code Sec. 704(b) capital accounts because the end result best reflects the current economic position of the partnership and states the value of the replacement property based on arm s-length bargaining with the seller of that property. Debt-for-Equity Exchanges When a partnership enters into an exchange of a debt instrument held by a creditor of the partnership for equity issued by the partnership, the exchange is

February 2014 generally governed by Code Sec. 721. The creditor recognizes no gain or loss on the exchange and acquires a tax basis in the partnership interest by substituting the basis of the debt instrument exchanged. 52 However, the partnership may recognize cancellation-of-debt (COD) income to the extent the FMV of the interest transferred in the exchange is less than the principal balance of the debt. Any COD income is allocated to those partners who were partners at the time of the discharge. If the creditor has not previously been a partner, no COD income is allocated to the creditor; if the creditor were a partner, COD income would be allocated to the creditor partner based on the interest held prior to the exchange. 53 Any loss realized by the creditor as a result of the exchange is impounded in the basis of the partnership interest. While such a loss appears like a Code Sec. 704(c) item in the partnership capital accounts, the property contributed is extinguished by the exchange and the deferred loss cannot be recognized until the creditor partner disposes of the interest. Example 12. Ally and Sarah form a partnership with each contributing $500,000. They borrow $2,000,000 00,00 from Katie and purchase $3,000,000 of real property. rty When the partnership p is in default on payments on Katie s debt, and the principal balance is still l $2,000,000, 2000,0 the ep parties agree that Katie will exchange her debt instrument for 60 percent of the equity of the partnership. p. The parties agree that the equity transferred ed to Katie has a FMV of $1,500,000. The exchange results in $500,000 of COD income that is allocated to Ally and Sarah. Katie has a realized loss on the exchange of $500,000 that is not recognized pursuant to Code Sec. 721. Katie s basis in her partnership interest becomes $2,000,000. The exchange that establishes $1,500,000 as the value of a 60-percent interest implies total partnership value is $2,500,000 ($1,500,000/.6). Because Katie s debt instrument is cancelled by the exchange, and does not become an asset of the partnership (as contributed property typically would be), the implied value of the real property is $2,500,000, or $500,000 less than it is currently carried on the Code Sec. 704(b) books. A revaluation of the property is then permitted. The capital account entries are shown in Chart 18. Chart 18. Initial Formation 500 500 500 500 Debt-for-Equity 1500 2000 Restatement <250> <250> COD Income 250 250-0- 250 250-0- Ending Capital 500 500 1500 750 750 2000 This analysis shows total Code Sec. 704(b) capital of $2,500,000, of which Katie owns 60 percent, and Ally and Sarah each own 20 percent. Ally and Sarah each have a reverse Code Sec. 704(c) allocation of a $250,000 loss, which reflects the decline in value of the property before Katie was admitted as a partner. When the land is disposed of in a taxable transaction, this loss will be allocated to Ally and Sarah. Katie s tax-basis capital exceeds her book basis capital by $500,000, but since her debt instrument was extinguished as part of the exchange, there is no Code Sec. 704(c) property the sale of which would allow her to recognize this built-in loss. Instead, Katie s realized but unrecognized loss on the debtfor-equity exchange will be recognized when she sells her partnership interest or receives es a liquidating distribution io from the partnership that would allow a loss under Code Sec. 731. For example, if the partnership property were sold for its restated value of $2,500,000, with liquidating distributions following Code Sec. 704(b) capital, the following entries would be made as shown in Chart 19. Chart 19. Pre-Sale 500 500 1500 750 750 2000 Sale @ 2500 0 0 0 <250> <250> 0 Distribution <500> <500> <1500> <500> <500> <1500> Post- Liquidation -0- -0- -0- -0- -0-500 Katie s unrecovered $500,000 tax basis will be recognized as a capital loss when the partnership liquidates. TAXES THE TAX MAGAZINE 51

Partnership Code Sec. 704(b) Capital Account Maintenance Noncompensatory Option: Grant and Exercise In addition to the grant of an equity interest in exchange for services, which may include the grant of options to acquire equity, partnerships can grant noncompensatory options to acquire interests. The noncompensatory option (NCO) provisions apply to call options, warrants, 54 convertible debt instruments and convertible equity. The grant of an NCO is generally treated as a open transaction, so there is no immediate tax effect to the NCO holder or to the partnership. The amount paid to the partnership in exchange for grant of the NCO is debited to the partnership books (however they may be maintained), and the offsetting credit is to a premium account. Although neither of these entries affects partnership capital, the grant of the NCO is a permitted revaluation transaction. Any unrealized gain or loss with respect to partnership properties belongs to the existing partners, and the revaluation allows the capital accounts to reflect the value attributable to capital represented by existing interests to prevent a shift of pre-grant gains and losses to the recipient of an NCO. The NCO holder has no capital account at this time because he is not yet a partner, so any restatement tju just affects the capital accounts co of existing partners. Upon exercise ercis of the NCO, the transfer of the option exercise e price in exchange e for an interest est is not a taxable event pursuant to Code Sec. 721. 55 The new partner s capital al account, cou for both Code Sec. 704(b) book and tax, is the sum of the amount previously paid for grant of the NCO (which is now moved from a premium account to partner capital) and the strike price paid to acquire the interest. Exercise is also a revaluation event, which allows the Code Sec. 704(b) capital accounts to reflect the value of partnership properties pre-exercise and also creates a Code Sec. 704(c) layer for the pre-exercise gain or loss. The NCO partner will be entitled to a Code Sec. 704(b) capital account adjustment to reflect his share of appreciation from the date of grant through the date of exercise. The NCO holder s Code Sec. 704(b) capital, postadjustment, should then reflect his date-of-exercise proportionate share of total Code Sec. 704(b) capital. The revaluation must take into account the effect of any prior revaluation that occurred at grant of the NCO. 56 The revaluation must also adjust the FMV of partnership properties, either up or down, to reflect the share of that FMV represented by other NCOs outstanding at exercise. This is because outstanding NCO holders have secured, through the call feature of the NCO, a right to some of the partnership asset value. If the FMV of the outstanding NCOs exceeds the option premium paid by the holders, the value of partnership properties is reduced in the revaluation. If the FMV of the outstanding NCOs is less than the option premium paid by the holders, the FMV of partnership properties is increased. 57 Example 13. Ally and Sarah form the AS partnership with each contributing $500,000 of money. The partnership satisfies the requirements for the alternate test for economic effect. The partnership uses the contributed capital to purchase $1,000,000 of undeveloped land. At a time when the land is valued at $1,500,000, the AS partnership grants an option to Katie to acquire a 25-percent interest in exchange for paying an exercise price of $500,000. Katie pays an option premium of $40,000 for the right to exercise the option at any time within the next three years. When the land has appreciated to $2,020,000, Katie exercises the option. Capital account entries will l be made as shown in Chart 20. Chart 20. Initial Formation 500 500 500 500 Grant Revaluation 250 250 Exercise -0- -0-540 -0- -0-540 Exercise 210 210 100-0- -0- -0- Revaluation Ending Capital 960 960 640 500 500 540 The entries in the example require more explanation that can be provided by the one-sided entries shown to the capital accounts. When the option is granted to Katie, the partnership makes the entry to its Code Sec. 704(b) and tax basis books as shown in Chart 21. 58 52

February 2014 Chart 21. Cash 40,000 Option Premium 40,000 The land is revalued to its date-of-grant value of $1,500,000, with the capital accounts of Ally and Sarah adjusted to reflect how they would share the gain attributable to the appreciation shown in Chart 22. Chart 22. Land 500,000 Ally capital 250,000 Sarah capital 250,000 This entry is to reflect the pre-grant appreciation, which economically belongs to Ally and Sarah. At exercise of the option, the date that Katie becomes a partner, Katie s capital account is credited for the option exercise price as well as the option premium (which is eliminated from the books by this entry) previously paid in Chart 23. Chart 23. Cash 500,000 Option Premium 40,000000 Katie capital 540,000 The land is again revalued, this time by $520,000, to its date-of-exercise -exe value of $2,020,000. The offsetting credits reflect how the partners share in the economic gains associated with this appreciation. Katie is entitled to some of the appreciation because, during the period she held an open option position, the option conferred an economic right to a share of the appreciation in the value of the property. Following exercise, Katie holds a 25-percent interest in partnership capital, Ally holds 37.5 percent, and Sarah also holds 37.5 percent. Total capital will be $2,560,000, the sum of the value of the land ($2,020,000) and the $540,000 cash received from the grant and exercise of Katie s option. Katie s share is $640,000 (25 percent), and Ally and Sarah s share is $960,000 (37.5 percent) each. The restatement of the land then must adjust economic-based capital to lead to these respective interests and is then shown in Chart 24. Chart 24. Land 520,000 Ally capital 210,000 Sarah capital 210,000 Katie capital 100,000 The land has a Code Sec. 704(b) book basis of $2,020,000 and a tax basis of its original cost of $1,000,000. When sold, there is $1,020,000 of Code Sec. 704(c) gain to allocate, with $920,000 allocated to Ally and Sarah and $100,000 to Katie. Katie s share is based on her sharing in the appreciation as a result of her option position, which provided her with some measure of equity ownership during the period the option was open. A call option allows the holder to share in appreciation in the underlying asset subject to the option right, without risk of loss beyond the amount paid to acquire the option position, an economic right that justifies the payment of the option premium. The above example is more complicated than the previous ones because the revaluation must recognize the economic position of the option holder from date of grant through date of exercise. If the partnership holds multiple properties, and one property is sold between the grant date and exercise date, the revaluation and adjustment to the capital of the option holder are even more complicated. This is so because the disposition of the asset prior to exercise prevents the partnership from using a revaluation to record the option holder s share of the post-grant gain attributable to the property that was disposed. To correct this, the NCO regulations provide for a capital account reallocation using corrective allocations. Corrective allocations result in a capital shift from existing partners to the option partner to reflect the option holder s share of post-grant economic gains that had been allocated only to the partners holding interests at the date of sale. 59 The correction is to effectively true-up the tax allocations with the overall economic arrangement of the TAXES THE TAX MAGAZINE 53

Partnership Code Sec. 704(b) Capital Account Maintenance partners. The option partner then ends up with the proper amount of post-grant gain that would have occurred had the property disposed of instead been held until the option partner became a legal owner of the interest. 60 Conclusion Partnership Code Sec. 704(b) capital accounts are generally used when the partnership agreement is drafted to satisfy one of the safe harbors for economic effect and the safe harbor to deem allocations of nonrecourse deductions to be in accordance with the partners interests. The economic effect test is satisfied when tax deductions are allocated to the partner who bears the economic detriment associated with the deduction, and taxable income is allocated to the partner who enjoys the economic benefit associated with the income. The purpose of the Code Sec. 704(b) capital accounts is to show the economics of the partners arrangement, so that it is possible to track the benefits and detriments associated with tax allocations. Code Sec. 704(b) capital is also useful in tracking Code Sec. 704(c) allocations, which are generally measured by the disparity between Code Sec. 704(b) and tax-basis capital and permitted revaluations to Code Sec. 704(b) capital allow the partnership to also track reverse Code Sec. 704(c) allocations. Finally, where Code Sec. 704(b) capital is used to reflect partnership economics, it is easier to understand a variety of other partnership-related tax issues arising from transactions undertaken for economic reasons. Where tax allocations must follow associated economic benefits and burdens, capital accounts that reflect the economic arrangement can be crucial to properly allocating the tax consequences of a transaction. This article reviews those transactions most commonly encountered by the tax adviser and illustrates how to make the required capital account adjustments. 1 2012 IRS SOI Tax Statistics, Table 21. S corporations remain the most popular entity ty type, with 2012 Form 1120S filings approximating proxim g45 4.5 million. 2 Code Sec. 704(b) book refers to the capital account maintenance e rules found in Reg. 1.704-1(b)(2)(iv), which are often incorporated rated by reference in a partnership agreement. ent. The term can be confusing because practitioners often think of financial accounting principles when the term book is used. However, since Treasury Regulations are drafted for tax purposes, book is instead defined as a shortened reference to Code Sec. 704(b) book, which assists in applying tax principles to partnership allocations. 3 Reg. 1.704-1(b)(2)(ii)(b). 4 In partnership convention, the terms liquidating and nonliquidating refer to whether the distribution terminates the interest of the distributee partner. The partnership itself may continue to exist in either type of distribution. This contrasts with the entity-type approach of corporations where a liquidating distribution refers to one that terminates the corporate existence. 5 Reg. 1.704-1(b)(2)(ii)(b) and (d). 6 Reg. 1.704-2(e). Allocations of nonrecourse deductions cannot have economic effect because the economic detriment associated with the deductions is borne by the nonrecourse creditor. Thus, such allocations must be made in ENDNOTES accordance with the partner s interest in the partnership. Satisfying the safe harbor will allow the allocation specified in the agreement to be deemed to satisfy the partner s interest test. 7 Reg. 1.704-3(a)(3)(i) identifies es Code Sec. 704(c) property by a disparity between the property s Code Sec. 704(b) book ok value and that property s tax basis. Reg. 1.704-3(a)(6)(i) (i) similarly identifies reverse Code Sec. 704(c) property by reference to disparities created by revaluations permitted by Reg. 1.704-1(b)(2)(iv)(f). 8 See, for example, Simon Friedman, Noncompensatory Capital Shifts: Rethinking Capital Accounts, 107 TAX NOTES 597 (May 2, 2005), Doc 2005-6565, 2005 TNT 84-43. 9 For a review of factors used in measuring the partner s interest in the partnership, and the difficulties in applying those factors, see Reg. 1.704-1(b)(3), Vecchio, 103 TC 170, Dec. 50,027 (1994), J.R. Tobias Est., 81 TCM 1163, Dec. 54,245(M), TC Memo. 2001-37, and M.W. Ballantyne Est., 83 TCM 1896, Dec. 54,796(M), TC Memo. 2002-160, aff d CA-8, 2004-1 USTC 50,120, 341 F3d 802. 10 See Reg. 1.704-1(b)(2)(ii)(b) for a description of the three-requirements test and Reg. 1.704-1(b)(2)(ii)(d) for a description of the alternate test. 11 Where the distributions are based on ending capital balances, it is common to build up capital with allocations of gain from sale of partnership assets to match capital to the partners agreed-to allocations of money. This can create multiple tiers of gain allocation, often referred to as a layer cake approach, to reflect the agreed priority of cash allocations. The layer cake approach proac can be complicated cate as it must also consider any minimum m gain charge back or qualified income offset allocations. at It is wise to test how the layers match partners expected cash distributions in a variety of possible economic states of the partnership. 12 See Reg. 1.704-1(b)(2)(iv)(h). The use of Code Sec. 704(b) capital as the basis for liquidating distributions will generally create the adverse interests needed to use partner agreements with respect to FMV as acceptable for Code Sec. 704(b) capital account maintenance. There is a limited exception to the capital accounts determining rights to assets that may apply when a partner s interest is purchased at a price negotiated at arm s length. It is not clear to what extent this exception may be relied upon when the partnership is the purchaser. See Reg. 1.704-1(b)(2)(ii)(b). 13 To ensure that partners receive what their deal points state, Code Sec. 704(b) compliant agreements must rely on often complex gain allocation tiers to build up capital to match the partners agreement as to division of assets. These provisions, when written in a partnership agreement, 54

February 2014 can be confusing to partners expecting to see a clear statement of how assets will be distributed. Target allocation provisions seek to minimize confusion to the partners by a clearer statement of what each partner s share of assets will be and then use income and loss allocations to create capital accounts that match the distributions. However, target allocation provisions do not base liquidating distributions on Code Sec. 704(b) capital account determinations, so they do not comply with any safe harbor for economic effect. If the values assigned to partnership properties do not affect the amounts to be received by the partners upon liquidation, it is more difficult to argue that the agreed-to values are based on bargaining by parties with adverse interests. 14 The partnership may maintain multiple capital account records for different purposes. The examples in this article show both Code Sec. 704(b) and tax basis capital, and a comparison of those two capital accounts facilitates, among other items, tracking Code Sec. 704(c) allocations, as is also shown in the examples in Reg. 1.704-3. The IRS MSSP for partnership allocations notes that an examiner may see tax basis capital on a partnership return even if the partnership also has Code Sec. 704(b) capital to satisfy a safe harbor r for economic effect. 15 Reg. 1.704-3(a)(2) applies Code Sec. 704(c) on a property-by-property pert basis. However, Reg. 1.704-3(e)(2) allows items in the same Code Sec. 168 recovery period, other than real property, perty, to be aggregated. ated. Securities ies partnerships are also granted flexibility in aggregating for purposes of reverse Code Sec. 704(c) allocations. 16 The alternate test requires that the partnership will maintain Code Sec. 704(b) capital, that distributions in liquidation of a partner s interest will be made in accordance with Code Sec. 704(b) capital and that the partnership agreement contains a qualified income offset. See Reg. 1.704-1(b)(2)(ii)(d). 17 A sale of contributed property for its agreed-to value at date of contribution simply changes the type of asset recorded on the debit side of the balance sheet but does not affect the partnership s economic position. 18 See Reg. 1.704-1(b)(5), Example 14. 19 This is why the Reg. 1.704-3 examples all illustrate the application of Code Sec. 704(c) principles by using Code Sec. 704(b) and tax basis capital accounts. 20 This is assumed for ease of computations. Code Sec. 168(i)(7) will have the partnership step into the shoes of the the 1 contributing partner with respect to cost recovery conventions, including determination of the cost recovery year. 21 Reg. 1.704-1(b)(2)(iv)(g)(3). 22 Reg. 1.704-3(b)(1). 23 See Reg. 1.704-2(d)(4) for the effect of revaluations on computations of changes in partnership minimum gain (used to measure nonrecourse deductions and determine the timing and amount of minimum gain chargebacks). 24 The Code Sec. 704(b) regulations only use examples where the post-formation interest transfer is made to a new partner. See Reg. 1.704-1(b)(5), Examples 14 and 18. This is computationally simple, but it requires the practitioner to develop the analysis required for a transfer to an existing partner. 25 Partnership distributions of property are not taxable under the Code Sec. 731 distribution rules. In appropriate fact patterns, a distribution may cause a partner to recognize gain pursuant to a disguised sale under Code Sec. 707(a)(2) (B) or to accelerate recognition of Code Sec. 704(c) gain under Code Sec. 704(c) (1)(B) or 737. If any of these anti-abuse provisions apply, the distributee still has an incentive to argue for a low value to be assigned to the distributed property to reduce gain to be reported. 26 Reg. 1.704-1(b)(2)(iv)(e). 27 Code Sec. 732(a)(1). 28 Code Sec. 733(2). 29 This also illustrates the adverse interests involved in the partners negotiations of the value of the distributed lot. Had Katie been en able to negotiate a smaller le value, her capital would be closer in line to that of the other partners. 30 Reg. 1.704-1(b)(2)(ii)(a) includes a statement of fundamental principles. 31 Reg. 1.734-1(b)(1) and (b)(2). 32 Reg. 1.704-1(b)(2)(iv)(m)(4). 33 Because Katie is redeemed with money, there is no requirement to restate the value of any properties. However, the partnership may, in a liquidating distribution, choose to restate the value of undistributed properties because the arm slength bargaining required to determine the value of the liquidated partner s interest provides objective evidence of the value of all properties. 34 Code Sec. 732(b). 35 Reg. 1.734-1(b)(2)(ii). 36 Reg. 1.743-1(k)(2) and (k)(4). 37 Reg. 1.743-1(j)(1) and (j)(2). 38 See Reg. 1.704-1(b)(2)(iv)(l) and (b)(5), Example 13(ii) and 1.704-3(a)(7). 39 Reg. 1.704-1(b)(2)(iv)(m)(2) and (b)(5), Example 13(iii) and (iv). 40 Rev. Rul. 96-10, 1996-1 CB 138. 41 Reg. 1.708-1(b)(1)(iv). 42 Reg. 1.704-1(b)(2)(iv)(l). The only change is the new partnership is not bound by the consistency rules for the method of Code Sec. 704(c) allocations (Reg. 1.704-3(a)(2)). 43 Code Sec. 707(c). 44 Reg. 1.704-1(b)(2)(iv)(o). Of course, there may be a dispute as to the character of the payment as a guaranteed payment or perhaps a normal distribution. If the partnership wants the item to be treated as a guaranteed payment, it is important to make its status clear by agreement among the partners. 45 Rev. Proc. 93-27, 1993-2 CB 343. See also Proposed Reg. 1.704-1(b)(4)(xii) for other provisions that may, when the regulations are finalized, be required in the partnership agreement to use the liquidation valuation approach. 46 See Reg. 1.704-1(b)(5), Example 11(i). 47 Reg. 1.704-1(b)(2)(iv)(j). 48 Code Sec. 1031(d) is the official means by which the basis of replacement property is computed. The basis is the basis of the relinquished property increased by any gain recognized and the FMV of any boot property transferred and reduced by any loss recognized and the FMV of any boot property received. 49 This is the economic gain of the partnership measured relative to the agreed FMV of the property at date of contribution. 50 Reg. 1.704-1(b)(2)(iv)(r). 51 Reg. 1.704-1(b)(5), Example 14(iii). 52 Code Sec. 722. 53 COD income in a partnership is generally allocated to the partner(s) who enjoy the benefit efi of the debt discharge, under the general eral principles ples of the economic c effect test. However, the specific application of the economic effect test to COD income is beyond the scope of the analysis presented in this article. 54 Although people often use the terms interchangeably, or mix the definitions, warrants are generally defined to be dilutive because new partnership units would be issued upon exercise, whereas options are generally nondilutive because the option is to acquire an existing interest. 55 An NCO may be settled for cash rather than for an equity interest, and a cash settlement may create a gain or loss to the partnership measured by the difference between the amount paid at settlement and the amount received at grant. If the NCO lapses unexercised, the partnership will also have a gain for the option premium received at grant. These gains or losses will affect the capital of existing partners in the same manner as any item of gain or loss but are not an issue for this article, which is limited to discussion of Code Sec. 704(b) capital account TAXES THE TAX MAGAZINE 55

Partnership Code Sec. 704(b) Capital Account Maintenance adjustments to reflect the economics of partnership transactions. 56 See Reg. 1.704-1(b)(5), Example 31, for the adjustments made at grant and exercise of the NCO. 57 Reg. 1.704-1(b)(2)(iv)(h)(2). 58 The premium is paid for the right, but not the obligation, to exercise the NCO pursuant to its terms. The transaction is treated as open until the option is either exercised or allowed to lapse. The entry shown does not affect any partner s capital because the option premium is part of an open transaction. The premium will affect capital upon exercise or lapse of the option right. 59 Reg. 1.704-1(b)(2)(iv)(s)(3) and (s)(4). 60 See Reg. 1.704-1(b)(5), Example 32. This article is reprinted with the publisher s permission from the TAXES THE TAX MAGAZINE, a month ly journal published by CCH, a part of Wolters Kluwer. Copying or dis tri bu tion without the pub lish er s per mis sion is prohibited. To subscribe to the TAXES THE TAX MAGAZINE or other CCH Journals please call 800 449 8114 or visit CCHGroup.com. All views expressed in the articles and col umns are those of the author and not necessarily those of CCH. 56