Allocations Flashcards
To become an expert.
What is the ceiling rule?
The partnership may not allocate to the partners more of any tax item than the partnership has actually realized.
Is the same 704(c) method required for all of the partnership’s property?
No. Section 704(c) methods are elected on a property-by-property basis (i.e., the partnership can apply different methods for different property).
What does 704(c) require?
Any BIG or BIL on contributed property must be taken into account by the partnership using any reasonable method. This applies to both sales and depreciation of 704(c) property.
What is the traditional method under 704(c)?
Tax depreciation is allocated to noncontributing partners up to the amount of their share of book depreciation.
Any remaining tax depreciation is allocated to the contributing partner(s).
If the ceiling rule limits allocations, you stop there.
This is the most favorable method for the dirty contributor.
Example:
A and B form partnership AB.
A contributes property with FMV $100 and basis of $60
B contributing $100 cash.
The contributed property has a 10-year recovery period using the straight-line method. Thus, the book depreciation is $10 per year and tax depreciation is $6 per year.
Under the traditional method, B will be allocated tax depreciation up to the full amount of his book depreciation ($5) and A will receive the rest ($1).
If the adjusted basis of the property had been $40, then only $4 of tax depreciation would exist, and thus the partnership is limited by the ceiling rule from allocating to B the full amount of his book depreciation. So, under the traditional method, he would get $4 and A would get none, and then you would stop.
What is the traditional method with curative allocations?
This allows special allocations of similar actual tax items to counteract the ceiling rule limit (but they must actually exist and be of the same character).
This cures the ceiling rule limitation over the remaining life of the property.
This method most favors the non-contributing partners by correcting ceiling rule limitations as quickly as possible (but it is limited to there being available items).
Example:
A and B form partnership AB.
A contributes property with FMV $100 and basis of $40
B contributing $100 cash.
The contributed property has a 10-year recovery period using the straight-line method. Thus, the book depreciation is $5 per year and tax depreciation is $4 per year.
The ceiling rule under the traditional method would limit B’s allocation of tax depreciation to $4, which is $1 less than his book depreciation.
Under the curative method, the partnership can specially allocate an additional $1 of tax depreciation from a similar asset to “cure” the shortfall.
How does the remedial method work?
If tax items are not sufficient to allocate book allocations to noncontributing partner, then “notional” tax items are allocated to noncontributing partner and offsetting notional tax items are created and allocated to contributing partner
Unlike the curative method, this method is not limited by the availability of actual items.
The BIG/BIL asset is hypothetically divided into 2 assets, one with book value equal to tax basis and life equal to actual remaining useful life, and a BIG/BIL asset with $0 tax basis, with a life equal to the useful life as if the asset were net.
Since book basis in excess of tax basis is recovered over 15 years, this provides for recovery over a longer period of time.
This favors the non-contributing partners without regard to available items but may correct ceiling rule limitations over a longer period of time.
So this is actually better for the dirty contributor than the traditional with curative allocations.
For a dirty contributor, what is the optimal order of preference for 704(c) allocations?
Traditional, then remedial (because it corrects ceiling rule distortions over a longer period), then curative (because it correct distortions completely over the life of the asset).
For a non-contributing partner, what is the optimal order of preference for 704(c) allocations?
Curative (because it corrects distortions completely over the shortest period of time, i.e., the life of the asset, although it is limited to actual available similar items).
Remedial (because it corrects over a longer period of time but is not limited to available items).
Traditional (because it does not fully correct).
What method appears most often in partnership agreements?
Traditional - because the non-contributing partners are willing to make this concession to the contributing partner.
What are special allocations?
Special allocations are allocations that differ from the partners’ respective interests in partnership capital.
Are special allocations respected?
They are if they have substantial economic effect. If they don’t, then allocations will be made in accordance with partnership interests.
What is the SEE standard trying to get at?
Whether an allocation is consistent with the underlying economic arrangement.
Usually the concern is allocations of deductions and losses (rather than income).
What is the requirement for substantial economic effect?
Does it have economic effect?
Basic test
Alternative test
Economic Equivalence test
Is it substantial?
No shifting tax consequences
No transitory allocations
What is the basic test for SEE (the Big 3)
Capital accounts have to be maintained in accordance with 1.704-1(b)(2)(iv).
Upon liquidation, distributions have to be made in accordance with positive capital account balances.
If a partner has a deficit capital account after liquidation of their interest, he is unconditionally obligated to restore it by the later of the end of the year or 90 days from liquidation.
What is the alternate test to the basic test?
If the agreement doesn’t have a requirement to restore deficit capital account balances, it will still pass if it has a Qualified Income Offset provision.
This requires that if a partner has a deficit capital account balance as a result of certain unexpected events, the partnership has to allocate him income sufficient to eliminate that deficit as quickly as possible.
What are “shifting” allocations?
At the time the allocation becomes part of the agreement, there is a “strong likelihood” that the capital accounts of partners will be unaffected (because of equal and offsetting allocation in the same year). 1.704-1(b)(2)(iii)(b).
Example: Partnership has 1231 losses and capital losses for year. Partnership allocates losses to partners based on whether they can take those losses. Each partner’s C.A. will look the same as if losses were prorated evenly.
What are “transitory” allocations?
Agreement provides for “possibility” over 2 or more taxable years that original allocation will be largely offset by one or more offsetting allocations and “strong likelihood” at time allocations become part of agreement that capital accounts will emerge unaffected (compared to if no special allocations).
Example: PP has steady income. A has expiring NOLs, B and C highly taxed. So PP allocates 100% of income to A in year 1 (to use NOL) and 100% of income for years 2 and 3 to B and C.
What is a reverse 704(c) allocation?
Partnership property may be revalued (“booked up”) upon certain events, for example:
○ Contribution of property or money to the partnership
○ Liquidation of the partnership
○ Distribution that changes a partner’s interest in the partnership
The book up adjusts the book value but not the tax basis of the property
The difference between book value and FMV at time of book up is treated as if it were a newly-contributed Section 704 property
Allocations with respect to the booked up layer of value are called “reverse 704(c) allocations”
A partnership may have multiple book up layers from multiple book up event
Different 704(c) methods may be chosen for each property for each layer.
What is a nonrecourse liability?
A liability that is secured only by the underlying property.
Do partners bear the economic risk of loss for property secured by non-recourse debt?
No. If the value of the property decreases, they can just have the lender foreclose.
Partners only bear risk of loss to the extent of cash invested or recourse debt.
Can allocations of deductions attributable to non-recourse debt have substantial economic effect?
No, because the partners do not bear the risk of loss on the value of the property.
If property secured by non-recourse debt is sold or foreclosed upon, can the partnership have income?
Yes. The amount of gain will be equal to the relief of liability (i.e., the amount of the loan) less the property’s basis. If the property has been depreciated, for example, there will be gain.
What is “partnership minimum gain”?
The amount of gain that the partnership would realize if it disposed of assets subject to non-recourse debt for no consideration other than satisfaction of debt (i.e., the amount of the loan less the property’s basis).
What creates partnership minimum gain?
1) The adjusted basis of encumbered property is reduced below the amount of the liability (i.e., depreciation deductions).
2) The amount of a non-recourse liability is increased in excess of adjusted basis (i.e., a refinancing).
