Choosing a 704(c) method can be confusing. There are 3 primary methods to choose from, and each can produce different economic outcomes. Careful evaluation and modeling are key to balancing the often-competing interests of partners.
One of the critical decisions partners must make when forming or operating a partnership is how to allocate tax items for property contributed by a partner that’s subject to a built-in gain or loss. This is where Section 704(c) of the Internal Revenue Code will apply. The purpose of Section 704(c) is to prevent the shifting of tax burdens among partners when property is contributed to a partnership with a fair market value that differs from its tax basis. This is achieved by allocating more tax gain to a contributing partner and/or less tax depreciation to the contributing partner. The chosen method affects the timing and the character of the tax allocations related to these unrealized gains and losses. It’s important to note when selecting a 704(c) method that there is no one-size-fits-all approach. Factors to consider include competing interests of partners, the fiduciary duty of managers to the partners, and whether tax distributions include 704(c) income allocations, among others.
Key differences between 704(c) methods
The Section 704(c) regulations provide three methods of addressing tax allocations: traditional, traditional with curative allocations, and remedial.
Traditional method
This method generally allocates the built-in gain/(loss) back to the contributing partner over a shorter time horizon (remaining useful life of contributed property) than the remedial method (discussed below). However, the traditional method applies what’s known as the ceiling rule. That rule limits the amount of built-in gain recognized annually through tax allocations based on the tax deductions or gain with respect to the contributed property.
Under this method, the noncontributing partner (or “cash partner”) may not receive all of the ordinary tax deductions they would otherwise be entitled to under the partnership’s operating agreement, due to the lack of tax deductions available to be allocated under the ceiling rule. To the extent a partners’ tax capital account becomes distorted by this disconnect between their shares of economic and tax deductions on an annual basis, or the built-in gain is unable to be fully recognized by the contributing partner because of the ceiling rule, it’s typically resolved in liquidation of the partners’ interests through capital gain or loss.
The traditional method is generally thought of as favorable for rollover members or property contributing partners, but this doesn’t always hold true. It’s the most favorable to property contributors for zero-basis property contributions, because no allocation is made until the property is disposed of. However, in situations where the ceiling isn’t reached, it can accelerate the recognition of the built-in gain as compared to the remedial method.
Traditional method with curative allocations
This method aims to correct the distortions caused by the ceiling rule in the traditional method by allocating other existing income or deduction of the same income tax character to make the cash contributor whole on their proportionate share of tax and economic deductions. This ensures that the tax consequences more closely align with the partners’ intended economic arrangements.
The curative method can also include other unique features to cure ceiling limitations, such as special allocations of gain on sale of 704(c) property. Generally, the curative method is considered favorable to the noncontributing partner based on both the period over which the built-in gain is recognized and the ability to cure distortions, provided the partnership has sufficient items to allocate.
Remedial method
This method goes a step further by creating notional items of income or deduction, for income tax purposes, to ensure the partners recognize the fair amount of ordinary income and deduction. It provides the most accurate reflection of the partners’ economic interests. Under the remedial method, if tax deductions or gain aren’t sufficient to make the cash contributor whole on their proportionate share of tax and economic deductions, fictional gross income and gross deductions are created and allocated to the partners.
The built-in gain is generally recognized over a longer period than under the other two methods, as a new useful life is created under this method for the excess of the fair market value over the tax basis. These notional items don’t create recapture allocations (Section 1245) in the event of a sale transaction in the way that the true depreciation or amortization expense allocations provided in the other methods would. This could result in a permanent tax saving to the noncontributing partner based on current tax rates.
However, because of this ability to create notional gross items, tax allocations can sometimes produce unusual or expected results such as the allocation of ordinary income to a contributing partner in a year in which the partnership produces an overall tax loss. When using this method, property contributing partners will want to consider negotiating for tax distributions that include the 704(c) income allocation.
So, which 704(c) method should I select?
There are various reasons partners might prefer a particular method. For example, the traditional method is favored by rollover members to defer gain longer, particularly with zero-basis goodwill. Cash investors might prefer the traditional method when tax distributions include 704(c) allocations to minimize tax distributions and keep more money in the company to fund growth. On the other hand, the remedial method is preferred by cash investors who greatly value tax deductions, as it avoids Section 1245 recapture on fictional deductions. However, the traditional method with curative allocations may be less desirable in some cases, as it uses the remaining tax life and could accelerate deferred gain recognition.
Partnerships will often benefit from modeling different methods and economic sharing arrangements when closing a transaction. It’s also recommended that the Section 704(c) method be documented in the operating agreement to avoid disputes and unwanted surprises among the partners. This can ensure you aren’t surprised for example by either a large remedial income allocation with no corresponding tax distribution or with a traditional method ceiling limitation that leaves you with a large capital loss on liquidation. As you can see, each partner may have a conflicting interest or benefit unevenly from a particular method. The choice of method typically hinges on key commercial negotiations among the partners to achieve the expected results and avoid tax surprises when closing a transaction.
