IRS ADDRESSES ALLOCATION OF PARTNERSHIP'S NONRECOURSE LIABILITIES.

Rev. Rul. 95-41

ISSUES

How does section 704(c) of the Internal Revenue Code affect the allocation of nonrecourse liabilities under section 1.752-3(a) of the Income Tax Regulations?

FACTS

A and B form a partnership, PRS, and agree that each will be allocated a 50 percent share of all partnership items. A contributes depreciable property subject to a nonrecourse liability of $6,000, with an adjusted tax basis of $4,000 and a fair market value of $10,000. B contributes $4,000 cash.

LAW

Section 1.752-3(a) provides that a partner's share of the nonrecourse liabilities of a partnership equals the sum of the amounts specified in section 1.752-3(a)(1)-(3).

Section 1.752-3(a)(1) provides that the partner's share of the nonrecourse liabilities of a partnership includes the partner's share of partnership minimum gain determined in accordance with the rules of section 704(b) and the regulations thereunder. See section 1.704- 2.

Section 1.752-3(a)(2) provides that the partner's share of the nonrecourse liabilities of the partnership includes the amount of any taxable gain that would be allocated to the partner under section 704(c) (or in the same manner as section 704(c) in connection with a revaluation of partnership property) if the partnership disposed of (in a taxable transaction) all partnership property subject to one or more nonrecourse liabilities of the partnership in full satisfaction of the liabilities and for no other consideration.

Section 1.752-3(a)(3) provides that the partner's share of the nonrecourse liabilities of the partnership includes the partner's share of the excess nonrecourse liabilities (those not allocated under section 1.752-3(a)(1) and (a)(2)) of the partnership as determined in accordance with the partner's share of partnership profits. The partner's interest in partnership profits is determined by taking into account all facts and circumstances relating to the economic arrangement of the partners. The partnership agreement may specify the partners' interests in partnership profits for purposes of allocating excess nonrecourse liabilities, provided the interests so specified are reasonably consistent with allocations (that have substantial economic effect under the section 704(b) regulations) of some other significant item of partnership income or gain. Alternatively, excess nonrecourse liabilities may be allocated among the partners in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated.

Section 704(c)(1)(A) provides that income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the adjusted tax basis of the property to the partnership and its fair market value at the time of contribution.

Section 1.704-3(a)(3)(i) provides that the book value of contributed property is equal to its fair market value at the time of contribution and is subsequently adjusted for cost recovery and other events that affect the basis of the property.

Section 1.704-3(a)(3)(ii) provides that the built-in gain on section 704(c) property is the excess of the property's book value over the contributing partner's adjusted tax basis in the property upon contribution. The built-in gain is thereafter reduced by decreases in the difference between the property's book value and adjusted tax basis.

Analysis

Upon A's contribution of the depreciable property to PRS, there is $6,000 of section 704(c) built-in gain (the excess of the book value of the property ($10,000) over A's adjusted tax basis in the property at the time of contribution ($4,000)). As a result of the contribution, A's individual liabilities decreased by $6,000 (the amount of the nonrecourse liability which PRS is treated as having assumed). A's share of the partnership's nonrecourse liabilities is determined under section 1.752-3.

(1) First Tier Allocations:

Under section 1.752-3(a)(1), a partner's share of the nonrecourse liabilities of PRS includes the partner's share of partnership minimum gain determined in accordance with the rules of section 704(b) and the regulations thereunder. Section 1.704-2(d)(1) provides that partnership minimum gain is determined by computing, for each partnership nonrecourse liability, any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability, and then aggregating the separately computed gains. Pursuant to section 1.704-2(d)(3), partnership minimum gain is determined with reference to the contributed property's book value rather than its adjusted tax basis.

In contrast, section 704(c) requires that allocations take into account the difference between the contributed property's adjusted tax basis and its fair market value. Thus, because partnership minimum gain is computed using the contributed property's book value rather than its tax basis, allocations of nonrecourse liabilities under section 1.752-3(a)(1) are not affected by section 704(c). Moreover, because the book value of the property at the time of contribution ($10,000) exceeds the amount of the nonrecourse liability ($6,000), there is no partnership minimum gain immediately after the contribution, and neither A nor B receive an allocation of nonrecourse liabilities under section 1.752-3(a)(1) immediately after the contribution.

(2) Second Tier Allocations:

Under section 1.752-3(a)(2), a partner's share of the nonrecourse liabilities of the partnership includes the amount of taxable gain that would be allocated to the contributing partner under section 704(c) if the partnership, in a taxable transaction, disposed of the contributed property in full satisfaction of the nonrecourse liability and for no other consideration. If PRS sold the contributed property in full satisfaction of the liability and for no other consideration, PRS would recognize a taxable gain of $2,000 on the sale ($6,000 amount of the nonrecourse liability less $4,000 adjusted tax basis of the property). Under section 704(c) and section 1.704-3(b)(1), all of this taxable gain would be allocated to A. The hypothetical sale also would result in a book loss of $4,000 to PRS (excess of $10,000 book value of property over $6,000 amount of the nonrecourse liability). Under the terms of the partnership agreement, this book loss would be allocated equally between A and B. Because B would receive a $2,000 book loss but no corresponding tax loss, the hypothetical sale would result in a $2,000 disparity between B's book and tax allocations.

If PRS used the traditional method of making section 704(c) allocations described in section 1.704-3(b), A would be allocated a total of $2,000 of taxable gain from the hypothetical sale of the contributed property. Therefore, A would be allocated $2,000 of nonrecourse liabilities under section 1.752-3(a)(2) immediately after the contribution.

If PRS adopted the remedial allocation method described in section 1.704-3(d), PRS would be required to make a remedial allocation of $2,000 of tax loss to B in connection with the hypothetical sale to eliminate the $2,000 disparity between B's book and tax allocations. PRS also would be required to make an offsetting remedial allocation of tax gain to A of $2,000. Thus, A would be allocated a total of $4,000 of tax gain ($2,000 actual gain plus the $2,000 allocation of remedial gain) from the hypothetical sale of the contributed property. Therefore, if the partnership adopted the remedial allocation method, A would be allocated $4,000 of nonrecourse liabilities under section 1.752-3(a)(2) immediately after the contribution.

If PRS used the traditional method with curative allocations described in section 1.704-3(c), PRS would be permitted to make reasonable curative allocations to reduce or eliminate the difference between the book and tax allocations to B that resulted from the hypothetical sale. However, PRS's ability to make curative allocations would depend on the existence of other partnership items and could not be determined solely from the hypothetical sale of the contributed property. Because any potential curative allocations could not be determined solely from the hypothetical sale of the contributed property, curative allocations are not taken into account in allocating nonrecourse liabilities under section 1.752-3(a)(2). Therefore, if PRS used the traditional method with curative allocations, A would be allocated $2,000 of nonrecourse liabilities under section 1.752-3(a)(2) immediately after the contribution.

(3) Third Tier Allocations:

Following the allocation under section 1.752-3(a)(2), PRS has excess nonrecourse liabilities that must be allocated between A and B. Section 1.752-3(a)(3) provides several alternatives for allocating excess nonrecourse liabilities.

(a) First, PRS may choose to allocate excess nonrecourse liabilities in accordance with the partners' shares of partnership profits. The partners' interests in partnership profits are determined by taking into account all the facts and circumstances relating to the economic arrangement of the partners. The partners' agreement to share the profits of the partnership equally is one fact to be considered in making this determination. Another fact to be considered is a partner's share of section 704(c) built-in gain to the extent that the gain was not taken into account in making an allocation of nonrecourse liabilities under section 1.752-3(a)(2). This built-in gain is one factor because, under the principles of section 704(c), this excess built-in gain, if recognized, will be allocated to A. A's share of section 704(c) built-in gain that is not taken into account in making allocations under section 1.752- 3(a)(2) is, therefore, one factor, but not the only factor, to be considered in determining A's interest in partnership profits. The amount of the section 704(c) built-in gain that is not considered in making allocations under section 1.752-3(a)(2) must be given an appropriate weight in light of all other items of partnership profit. For example, if it is reasonable to expect that PRS will have items of partnership profit over the life of the partnership that will be allocated to B, PRS may not allocate all of the excess nonrecourse liabilities to A. Rather, the remaining nonrecourse liabilities must be allocated between A and B in proportion to their interests in total partnership profits.

(b) Second, the PRS partnership agreement may specify the partners' interests in partnership profits for purposes of allocating excess nonrecourse liabilities, provided that the interests specified are reasonably consistent with allocations (that have substantial economic effect under the section 704(b) regulations) of some other significant item of partnership income or gain. The partnership agreement provides that each partner will be allocated a 50 percent share of all partnership items. Assuming that such allocations have substantial economic effect, PRS can choose to allocate the excess nonrecourse liabilities 50 percent to each partner.

Section 704(c) allocations, however, do not have substantial economic effect under the section 704(b) regulations. See section 1.704-1(b)(2)(iv)(d). Accordingly, under this alternative, section 704(c) allocations cannot be used as a basis for allocating excess nonrecourse liabilities.

(c) Finally, PRS may choose to allocate the excess nonrecourse liabilities in accordance with the manner in which it is reasonably expected that the deductions attributable to the excess nonrecourse liabilities will be allocated. Because A and B have agreed to allocate all partnership items 50 percent to each partner, A and B each will be entitled to allocations of book depreciation of $5,000 over the life of the contributed property. The contributed property, however, has an adjusted tax basis of $4,000 and, regardless of the method used by the partnership under section 704(c), the entire $4,000 of tax depreciation over the life of the contributed property must be allocated to B. Therefore, PRS must allocate all of the excess nonrecourse liabilities to B if it chooses to allocate the excess nonrecourse liabilities in accordance with the manner that the deductions attributable to the excess nonrecourse liabilities will be allocated.

HOLDINGS

(1) Allocations of nonrecourse liabilities under section 1.752- 3(a)(1) are not affected by section 704(c).

(2) Allocations of nonrecourse liabilities under section 1.752- 3(a)(2) take into account remedial allocations of gain that would be made to the contributing partner under section 1.704-3(d). Allocations of nonrecourse liabilities under section 1.752-3(a)(2) do not take into account curative allocations under section 1.704-3(c).

(3) Allocations of nonrecourse liabilities under section 1.752- 3(a)(3) are affected by section 704(c) in the following manner:

(a) If the partnership determines the partners' interests in partnership profits based on all of the facts and circumstances relating to the economic arrangement of the partners, section 704(c) built-in gain that was not taken into account under section 1.752- 3(a)(2) is one factor, but not the only factor, to be considered under section 1.752-3(a)(3).

(b) If the partnership chooses to allocate excess nonrecourse liabilities in a manner reasonably consistent with allocations (that have substantial economic effect under the section 704(b) regulations) of some other significant item of partnership income or gain, section 704(c) does not affect the allocation of nonrecourse liabilities under section 1.752-3(a)(3) because section 704(c) allocations do not have substantial economic effect.

(c) If the partnership chooses to allocate excess nonrecourse liabilities in accordance with the manner in which it is reasonably expected that the deductions attributable to the nonrecourse liabilities will be allocated, the partnership must take into account the allocations required by section 704(c) in determining the manner in which the deductions attributable to the nonrecourse liabilities will be allocated.

DRAFTING INFORMATION

The principal author of this revenue ruling is Brian M. Blum of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Brian M. Blum at (202) 622-3050 (not a toll-free call).