Final Regs Provide Rules on Allocations for Property Contributed to Partnership

 [4830-01-u]

 ACTION: Final and temporary regulations.

 SUMMARY: This document contains final regulations under section 704 of the Internal Revenue Code relating to allocations with respect to property contributed by a partner to a partnership. Changes to the applicable law were made by the Tax Reform Act of 1984 (the 1984 Act) and the Revenue Reconciliation Act of 1989 (the 1989 Act). The final regulations affect partnerships and their partners and are necessary to provide guidance needed to comply with the applicable tax law.

 EFFECTIVE DATE: These regulations are effective December 21, 1993.

 FOR FURTHER INFORMATION CONTACT: David Edquist at (202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

INTRODUCTION

This document adds section 1.704-3 to the Income Tax Regulations (26 CFR part 1) under section s 704(c)(1)(A) and 704(c)(3), and revises existing sections 1.704-1(b)(1)(vi), 1.704-1(b)(2)(iv), and 1.704-1(c). The IRS and Treasury are also contemporaneously issuing temporary regulations that address issues reserved in the final regulations.

BACKGROUND

 On December 24, 1992, the IRS published in the Federal Register a notice of proposed rulemaking (57 FR 61353) amending the Income Tax Regulations (26 CFR part 1) under section 704. These amendments were proposed to implement section 704(c) as amended by the 1984 Act and the 1989 Act. The notice provided rules relating to allocations reflecting built-in gain or loss on property contributed to a partnership. Comments responding to the notice were received, and a public hearing was held on April 16, 1993. After considering the comments and the statements made at the hearing, the IRS and Treasury adopt the proposed regulations as revised by this Treasury decision.

EXPLANATION OF PROVISIONS

GENERAL PRINCIPLES AND APPROACH

 The final regulations generally adopt the provisions of the proposed regulations with respect to property contributed with built- in gain or loss. Accordingly, under the final regulations, if a partner contributes property to a partnership, the partnership can use any reasonable method of making allocations so that the contributing partner receives the tax burdens and benefits of any built-in gain or loss.

 The final regulations specifically describe two reasonable methods of making allocations under section 704(c). These are the traditional method and the traditional method with curative allocations. The remedial allocation method is a third reasonable method that is permissible under the temporary regulations that are being issued in conjunction with these final regulations. In addition to these described methods, other reasonable allocation methods meeting the requirements of section 704(c) are also acceptable. Section 1.704-3(e) contains special rules and exceptions.

 The final regulations allow a partnership to use different reasonable allocation methods with respect to different items of section 704(c) property. However, the allocation method used for an item of section 704(c) property must be consistently applied to that item of property by both the partnership and the partners from year to year. In addition, the overall method or combination of methods used by the partnership must be reasonable under the facts and circumstances. In exercising its authority under section 1.704-3 to make adjustments if a partnership's allocation method is not reasonable, the IRS can make adjustments regardless of the provisions contained in the partnership agreement.

 The final regulations also provide special rules and exceptions that have been revised from those contained in the proposed regulations. These rules and exceptions apply regardless of the allocation method chosen by the partnership and include a de minimis rule for small disparities and an aggregation rule for certain property.

ADDITIONAL REASONABLE METHODS

 Comments were received requesting additional reasonable methods. Several comments requested that the "undivided interests method" contained in section 704(c)(3) prior to amendment by the 1984 Act be included specifically as a reasonable method. Under the undivided interests method, allocations of depreciation, depletion, or gain or loss with respect to undivided interests in property contributed to a partnership were determined as though the undivided interests had not been contributed to the partnership. After consideration, the IRS and Treasury have decided not to add the undivided interests method as a specific reasonable method described in the final regulations because it appears to be of very limited application. However, the use of this method in appropriate situations may be reasonable.

 The comments also suggested including as a specifically described reasonable method an allocation method used in the oil and gas industry. Under this method, each partner is, in essence, allocated all of the depreciation or depletion from each item of property the partner contributes to the partnership (or from property purchased with cash contributed by that partner). Upon disposition of the contributed property, remaining built-in gain or loss is allocated to the contributing partner, and any additional gain or loss is allocated according to the partnership agreement. The IRS and Treasury have also decided not to add this method as a specific reasonable method described in the final regulations because, although it may be common in the oil and gas industry, it does not appear to be a generally applicable method. However, the use of this method in appropriate situations may be reasonable. The IRS is considering issuing further guidance on this method.

 One comment suggested that the final regulations adopt as a safe harbor the use of the traditional method with a curative allocation of gain upon sale of the property. Under this approach, the anti- abuse rule would not apply to allocations following the safe harbor. Another comment suggested that the anti-abuse rule be deleted and that a curative allocation upon sale of the property be mandatory. Both of these suggestions would have required exceptions to the anti- abuse rule. The IRS and Treasury believe it is appropriate to require that all allocation methods satisfy the anti-abuse rule. Otherwise, the regulations might be interpreted as sanctioning allocation methods undertaken with a view to reducing substantially the present value of the partners' aggregate tax liability. Section 1.704-3(b)(2) Example 2 describes the use of the traditional method with a curative allocation of gain upon sale that is reasonable under the facts of that example.

SECTIONS 743 AND 751

 The final regulations provide that a partnership making adjustments under section 1.743-1(b) or 1.751-1(a)(2) must account for section 704(c) property in accordance with the principles of these regulations. The IRS will conform sections 1.743-1(b) and 1.751-1(a)(2) to incorporate the changes to section 704(c) made in the 1984 Act and the 1989 Act as well as these regulations.

TRANSFERS OF PARTNERSHIP INTERESTS

 The final regulations make explicit, in response to a comment, that if a contributing partner transfers the partnership interest, the remaining built-in gain or loss is allocated to the transferee partner.

TRANSFER OF PROPERTY UNDER SECTION 351

 If a partnership transfers an item of section 704(c) property together with other property to a corporation under section 351, in order to preserve that item's built-in gain or loss, the basis in the stock received in exchange for the section 704(c) property is determined as if each item of section 704(c) property had been the only property transferred to the corporation by the partnership.

THE ANTI-ABUSE RULE

 Comments requested clarification on the standard the IRS will apply in administering the anti-abuse rule. The final regulations provide an anti-abuse rule that has been revised to respond to concerns raised in comments and to target more specifically abusive transactions. The rule applies to all methods of making section 704(c) allocations, including the methods described in the final and temporary regulations. Under the rule, an allocation method (or combination of methods) is not reasonable if the contribution (or other relevant event) and the allocations with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability. Thus, the final regulations make clear that time- value-of-money concepts are relevant. In addition, the example of abusive curative allocations in the proposed regulations (proposed section 1.704-3(c)(4) Example 2, which is Example 3 in the final regulations) has been clarified to illustrate these governing principles.

 Some comments raised the concern that the IRS would use the anti-abuse rule to place taxpayers on the deferred sale method. To address this concern, the temporary regulations that describe the remedial allocation method (the revised deferred sale method) provide that in exercising its authority to make adjustments if a partnership's allocation method is not reasonable, the IRS will not require a partnership to use the remedial allocation method.

CURATIVE ALLOCATIONS

 The final regulations provide that curative allocations are reasonable only if they conform to certain limitations. For example, they may not exceed the amount necessary to offset the effect of the ceiling rule. In addition, the period over which the allocations are made is a factor in determining whether the allocations are reasonable.

 Under the proposed regulations, curative allocations could only be made using a tax item that would have the same effect on the partners as the tax item affected by the ceiling rule. Some comments requested clarification of this limitation. Accordingly, the final regulations provide that an allocation of a type that is not expected, at the time the allocation becomes part of the partnership agreement (or at the time the allocation is actually made if the partnership agreement is not sufficiently specific) to have substantially the same effect on each partner's tax liability as the tax item limited by the ceiling rule is generally not reasonable. However, when cost recovery is limited by the ceiling rule, gain from the sale of the contributed property may be used to make a curative allocation if provided in the partnership agreement in effect for the year of the contribution. The final regulations also provide additional examples of types of permissible and impermissible curative allocations.

 The proposed regulations provided that if a partnership did not have tax items sufficient in the amount and of the correct type to offset fully the effect of the ceiling rule, the partnership could choose to make the curative allocation in the next succeeding taxable year in which it had sufficient items. The final regulations generally do not permit these make-up curative allocations. The IRS and Treasury believe that those taxpayers that are concerned about this restriction can choose to use the remedial allocation method described in the temporary regulations. The final regulations provide that a curative allocation is not reasonable to the extent it exceeds the amount necessary to offset the effect of the ceiling rule either for the current taxable year or, in the case of a curative allocation upon disposition of the property, for a prior taxable year. However, a partnership may make curative allocations in a taxable year to offset the effect of the ceiling rule for a prior taxable year if they are made over a reasonable period of time, such as over the property's economic life, and are provided for under the partnership agreement in effect for the year of contribution.

THE REMEDIAL ALLOCATION METHOD

 After consideration of the comments received on the deferred sale method contained in the original proposed regulations, the IRS and Treasury have decided to repropose a revised deferred sale method, referred to as the remedial allocation method, and, during the comment period, have issued temporary regulations for current use by taxpayers. In the absence of specific published guidance, it is not reasonable to use a section 704(c) method in which the basis of property contributed to the partnership is increased (or decreased) to reflect built-in gain (or loss) and, except as provided in the temporary remedial allocation method regulations, it is also not reasonable for a partnership to create tax allocations of income, gain, loss, or deduction independent of allocations affecting the partnership book capital accounts.

SMALL DISPARITIES

 The proposed regulations provided that a partnership may disregard the application of section 704(c) to a partner's contributions of property in a single year if (1) for each item of contributed property, the fair market value does not differ from the adjusted tax basis by more than 15 percent of the adjusted tax basis, and (2) the total disparity for all properties contributed by that partner in that year does not exceed $10,000. One comment stated that the 15 percent test should be applied in the aggregate, rather than on each item of property. The final regulations adopt this comment. In addition, comments were received stating that the $10,000 limit was too small. Accordingly, the final regulations raise this limit to $20,000.

AGGREGATION RULES

 In general, the final regulations follow the proposed regulations and provide that, with certain exceptions, property generally may not be aggregated for purposes of making allocations under section 704(c). In response to comments, additional exceptions have been added so that certain other types of properties may be aggregated, such as all property (other than real property) that is included in the same general asset account, and all property with a basis of zero, other than real property. Each type of property must be separately aggregated. Under the final regulations, the IRS may issue additional guidance setting forth other assets for which aggregation is permissible. However, the final regulations clarify that any aggregation of property must also be reasonable under the anti-abuse rule.

 The IRS requested and received comments on whether securities partnerships should be able to aggregate built-in gains and losses upon restating their capital accounts. After consideration of the comments received, the IRS and Treasury have determined that further consideration is necessary in order to define securities partnerships broadly enough to offer useful guidance and narrowly enough to prevent abusive allocations. Accordingly, this portion of the final regulations has been reserved and a special rule is being separately proposed that permits aggregation of certain types of property for securities partnerships. However, in recognition of the fact that taxpayers need immediate effective guidance on aggregation by securities partnerships, the IRS and Treasury are contemporaneously issuing temporary regulations allowing aggregation under certain circumstances during the comment period.

CERTAIN TRANSACTIONS INVOLVING FOREIGN PERSONS

 The rules of the final regulations relating to dispositions of partnership interests and dispositions by partnerships apply to dispositions by both domestic and foreign persons. To the extent dispositions of property are also described in section s 367(a), 367(d), 897, 1248, or 1491, those section s also apply. Consistent with preserving U. S. taxing jurisdiction, additional requirements applicable to contributions of section 704(c) property and subsequent dispositions involving foreign persons may be issued in the future. Those requirements may include appropriate reporting and recordkeeping requirements. The IRS and Treasury welcome comments regarding the scope of any additional requirements, including whether those requirements should be applied retroactively.

EFFECTIVE DATE

 These regulations apply to property contributed to a partnership and to restatements pursuant to section 1.704-1(b)(2)(iv)(f) on or after December 21, 1993.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U. S. C. chapter 5) and the Regulatory Flexibility Act (5 U. S. C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these final regulations is David Edquist of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS IN PART 1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding a citation in numerical order to read as follows:

Authority: 26 U. S. C. 7805 *** Section 1.704-3 also issued under 26 U. S. C. 704(c). ***

Par. 2. Section 1.704-1 is amended by revising paragraphs (b)(1)(vi), (b)(2)(iv)(d)(3), and (c) to read as follows:

SECTION 1.704-1 PARTNER'S DISTRIBUTIVE SHARE.

* * * * *

(b) * * *

(1) * * *

(vi) SECTION 704(c) DETERMINATIONS. Section 704(c) and section 1.704-3 generally require that if property is contributed by a partner to a partnership, the partners' distributive shares of income, gain, loss, and deduction, as computed for tax purposes, with respect to the property are determined so as to take account of the variation between the adjusted tax basis and fair market value of the property. Although section 704(b) does not directly determine the partners' distributive shares of tax items governed by section 704(c), the partners' distributive shares of tax items may be determined under section 704(c) and section 1.704-3 (depending on the allocation method chosen by the partnership under section 1.704-3) with reference to the partners' distributive shares of the corresponding book items, as determined under section 704(b) and this paragraph. (See paragraphs (b)(2)(iv)(d) and (b)(4)(i) of this section.) See section 1.704-3 for methods of making allocations under section 704(c), and section 1.704-3T(d)(2) for a special rule in determining the amount of book items if the remedial allocation method is chosen by the partnership. See also paragraph (b)(5) EXAMPLE (13)(i) of this section.

* * * * *

(2) * * *

(iv) * * *

(d) * * *

(3) SECTION 704(c) CONSIDERATIONS. Section 704(c) and section 1.704-3 govern the determination of the partners' distributive shares of income, gain, loss, and deduction, as computed for tax purposes, with respect to property contributed to a partnership (see paragraph (b)(1)(vi) of this section ). In cases where section 704(c) and section 1.704-3 apply to partnership property, the capital accounts of the partners will not be considered to be determined and maintained in accordance with the rules of this paragraph (b)(2)(iv) unless the partnership agreement requires that the partners' capital accounts be adjusted in accordance with paragraph (b)(2)(iv)(g) of this section for allocations to them of income, gain, loss, and deduction (including depreciation, depletion, amortization, or other cost recovery) as computed for book purposes, with respect to the property. See, however, section 1.704-3T(d)(2) for a special rule in determining the amount of book items if the partnership chooses the remedial allocation method. See also EXAMPLE (13)(i) of paragraph (b)(5) of this section. Capital accounts are not adjusted to reflect allocations under section 704(c) and section 1.704-3 (e.g., tax allocations of precontribution gain or loss).

* * * * *

(c) CONTRIBUTED PROPERTY; CROSS-REFERENCE. See sections 1.704-3 and 1.704-3T for methods of making allocations that take into account precontribution appreciation or diminution in value of property contributed by a partner to a partnership.

* * * * *

Section 1.704-1T [Removed]

Par. 3. Section 1.704-1T is removed.

Par. 4. Section 1.704-3 is added to read as follows:

SECTION 1.704-3 CONTRIBUTED PROPERTY.

(a) IN GENERAL -- (1) GENERAL PRINCIPLES. The purpose of section 704(c) is to prevent the shifting of tax consequences among partners with respect to precontribution gain or loss. Under section 704(c), a partnership must allocate income, gain, loss, and deduction with respect to property contributed by a partner to the partnership so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution. Notwithstanding any other provision of this section , the allocations must be made using a reasonable method that is consistent with the purpose of section 704(c). For this purpose, an allocation method includes the application of all of the rules of this section (e. g. , aggregation rules). An allocation method is not necessarily unreasonable merely because another allocation method would result in a higher aggregate tax liability. Paragraphs (b), (c), and (d) of this section describe allocation methods that are generally reasonable. Other methods may be reasonable in appropriate circumstances. Nevertheless, in the absence of specific published guidance, it is not reasonable to use an allocation method in which the basis of property contributed to the partnership is increased (or decreased) to reflect built-in gain (or loss), or a method under which the partnership creates tax allocations of income, gain, loss, or deduction independent of allocations affecting book capital accounts. See section 1.704-3T(d). Paragraph (e) of this section contains special rules and exceptions.

(2) OPERATING RULES. Except as provided in paragraphs (e)(2) and (e)(3) of this section, section 704(c) and this section apply on a property-by-property basis. Therefore, in determining whether there is a disparity between adjusted tax basis and fair market value, the built-in gains and built-in losses on items of contributed property cannot be aggregated. A partnership may use different methods with respect to different items of contributed property, provided that the partnership and the partners consistently apply a single reasonable method for each item of contributed property and that the overall method or combination of methods are reasonable based on the facts and circumstances and consistent with the purpose of section 704(c). It may be unreasonable to use one method for appreciated property and another method for depreciated property. Similarly, it may be unreasonable to use the traditional method for built-in gain property contributed by a partner with a high marginal tax rate while using curative allocations for built-in gain property contributed by a partner with a low marginal tax rate.

(3) DEFINITIONS -- (i) SECTION 704(c) PROPERTY. Property contributed to a partnership is section 704(c) property if at the time of contribution its book value differs from the contributing partner's adjusted tax basis. For purposes of this section , book value is determined as contemplated by section 1.704-1(b). Therefore, book value is equal to 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. For a partnership that maintains capital accounts in accordance with section 1.704-1(b)(2)(iv), the book value of property is initially the value used in determining the contributing partner's capital account under section 1.704-1(b)(2)(iv)(d), and is appropriately adjusted thereafter (e.g., for book cost recovery under sections 1.704-1(b)(2)(iv)(g)(3) and 1.704-3T(d)(2) and other events that affect the basis of the property). A partnership that does not maintain capital accounts under section 1.704-1(b)(2)(iv) must comply with this section using a book capital account based on the same principles (i.e., a book capital account that reflects the fair market value of property at the time of contribution and that is subsequently adjusted for cost recovery and other events that affect the basis of the property).

(ii) BUILT-IN GAIN AND BUILT-IN LOSS. 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 upon contribution. The built-in gain is thereafter reduced by decreases in the difference between the property's book value and adjusted tax basis. The built-in loss on section 704(c) property is the excess of the contributing partner's adjusted tax basis over the property's book value upon contribution. The built-in loss is thereafter reduced by decreases in the difference between the property's adjusted tax basis and book value.

(4) ACCOUNTS PAYABLE AND OTHER ACCRUED BUT UNPAID ITEMS. Accounts payable and other accrued but unpaid items contributed by a partner using the cash receipts and disbursements method of accounting are treated as section 704(c) property for purposes of applying the rules of this section .

(5) OTHER PROVISIONS OF THE INTERNAL REVENUE CODE. Section 704(c) and this section apply to a contribution of property to the partnership only if the contribution is governed by section 721, taking into account other provisions of the Internal Revenue Code. For example, to the extent that a transfer of property to a partnership is a sale under section 707, the transfer is not a contribution of property to which section 704(c) applies.

(6) OTHER APPLICATIONS OF SECTION 704(C) PRINCIPLES -- (i) REVALUATIONS UNDER SECTION 704(b). The principles of this section apply to allocations with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues partnership property pursuant to section 1.704-1(b)(2)(iv)(f) (reverse section 704(c) allocations). Partnerships are not required to use the same allocation method for reverse section 704(c) allocations as for contributed property, even if at the time of revaluation the property is already subject to section 704(c) and paragraph (a) of this section . In addition, partnerships are not required to use the same allocation method for reverse section 704(c) allocations each time the partnership revalues its property. A partnership that makes allocations with respect to revalued property must use a reasonable method that is consistent with the purposes of section 704(b) and (c).

(ii) BASIS ADJUSTMENTS. A partnership making adjustments under section 1.743-1(b) or 1.751-1(a)(2) must account for built-in gain or loss under section 704(c) in accordance with the principles of this section.

(7) TRANSFERS OF A PARTNERSHIP INTEREST. If a contributing partner transfers a partnership interest, built-in gain or loss must be allocated to the transferee partner as it would have been allocated to the transferor partner. If the contributing partner transfers a portion of the partnership interest, the share of built- in gain or loss proportionate to the interest transferred must be allocated to the transferee partner.

(8) DISPOSITION OF PROPERTY IN NONRECOGNITION TRANSACTION. If a partnership disposes of section 704(c) property in a nonrecognition transaction in which no gain or loss is recognized, the substituted basis property (within the meaning of section 7701(a)(42)) is treated as section 704(c) property with the same amount of built-in gain or loss as the section 704(c) property disposed of by the partnership. If gain or loss is recognized in such a transaction, appropriate adjustments must be made. The allocation method for the substituted basis property must be consistent with the allocation method chosen for the original property. If a partnership transfers an item of section 704(c) property together with other property to a corporation under section 351, in order to preserve that item's built-in gain or loss, the basis in the stock received in exchange for the section 704(c) property is determined as if each item of section 704(c) property had been the only property transferred to the corporation by the partnership.

(9) TIERED PARTNERSHIPS. If a partnership contributes section 704(c) property to a second partnership (the lower- tier partnership), or if a partner that has contributed section 704(c) property to a partnership contributes that partnership interest to a second partnership (the upper-tier partnership), the upper-tier partnership must allocate its distributive share of lower-tier partnership items with respect to that section 704(c) property in a manner that takes into account the contributing partner's remaining built-in gain or loss. Allocations made under this paragraph will be considered to be made in a manner that meets the requirements of section 1.704-1(b)(2)(iv)(q) (relating to capital account adjustments where guidance is lacking).

(10) ANTI-ABUSE RULE. An allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse section 704(c) allocations) and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability.

(b) TRADITIONAL METHOD -- (1) IN GENERAL. This paragraph (b) describes the traditional method of making section 704(c) allocations. In general, the traditional method requires that when the partnership has income, gain, loss, or deduction attributable to section 704(c) property, it must make appropriate allocations to the partners to avoid shifting the tax consequences of the built-in gain or loss. Under this rule, if the partnership sells section 704(c) property and recognizes gain or loss, built-in gain or loss on the property is allocated to the contributing partner. If the partnership sells a portion of, or an interest in, section 704(c) property, a proportionate part of the built-in gain or loss is allocated to the contributing partner. For section 704(c) property subject to amortization, depletion, depreciation, or other cost recovery, the allocation of deductions attributable to these items takes into account built-in gain or loss on the property. For example, tax allocations to the noncontributing partners of cost recovery deductions with respect to section 704(c) property generally must, to the extent possible, equal book allocations to those partners. However, the total income, gain, loss, or deduction allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year (the ceiling rule). If a partnership has no property the allocations from which are limited by the ceiling rule, the traditional method is reasonable when used for all contributed property.

(2) EXAMPLES. The following examples illustrate the principles of the traditional method.

EXAMPLE 1. OPERATION OF THE TRADITIONAL METHOD -- (i) CALCULATION OF BUILT-IN GAIN ON CONTRIBUTION. A and B form partnership AB and agree that each will be allocated a 50 percent share of all partnership items and that AB will make allocations under section 704(c) using the traditional method under paragraph (b) of this section . A contributes depreciable property with an adjusted tax basis of $4,000 and a book value of $10,000, and B contributes $10,000 cash. Under paragraph (a)(3) of this section , A has built-in gain of $6,000, the excess of the partnership's book value for the property ($10,000) over A's adjusted tax basis in the property at the time of contribution ($4,000).

(ii) ALLOCATION OF TAX DEPRECIATION. The property is depreciated using the straight-line method over a 10-year recovery period. Because the property depreciates at an annual rate of 10 percent, B would have been entitled to a depreciation deduction of $500 per year for both book and tax purposes if the adjusted tax basis of the property equalled its fair market value at the time of contribution. Although each partner is allocated $500 of book depreciation per year, the partnership is allowed a tax depreciation deduction of only $400 per year (10 percent of $4,000). The partnership can allocate only $400 of tax depreciation under the ceiling rule of paragraph (b)(1) of this section , and it must be allocated entirely to B. In AB's first year, the proceeds generated by the equipment exactly equal AB's operating expenses. At the end of that year, the book value of the property is $9,000 ($10,000 less the $1,000 book depreciation deduction), and the adjusted tax basis is $3,600 ($4,000 less the $400 tax depreciation deduction). A's built-in gain with respect to the property decreases to $5,400 ($9,000 book value less $3,600 adjusted tax basis). Also, at the end of AB's first year, A has a $9,500 book capital account and a $4,000 tax basis in A's partnership interest. B has a $9,500 book capital account and a $9,600 adjusted tax basis in B's partnership interest.

(iii) SALE OF THE PROPERTY. If AB sells the property at the beginning of AB's second year for $9,000, AB realizes tax gain of $5,400 ($9,000, the amount realized, less the adjusted tax basis of $3,600). Under paragraph (b)(1) of this section , the entire $5,400 gain must be allocated to A because the property A contributed has that much built-in gain remaining. If AB sells the property at the beginning of AB's second year for $10,000, AB realizes tax gain of $6,400 ($10,000, the amount realized, less the adjusted tax basis of $3,600). Under paragraph (b)(1) of this section , only $5,400 of gain must be allocated to A to account for A's built-in gain. The remaining $1,000 of gain is allocated equally between A and B in accordance with the partnership agreement. If AB sells the property for less than the $9,000 book value, AB realizes tax gain of less than $5,400, and the entire gain must be allocated to A.

(iv) TERMINATION AND LIQUIDATION OF PARTNERSHIP. If AB sells the property at the beginning of AB's second year for $9,000, and AB engages in no other transactions that year, A will recognize a gain of $5,400, and B will recognize no income or loss. A's adjusted tax basis for A's interest in AB will then be $9,400 ($4,000, A's original tax basis, increased by the gain of $5,400). B's adjusted tax basis for B's interest in AB will be $9,600 ($10,000, B's original tax basis, less the $400 depreciation deduction in the first partnership year). If the partnership then terminates and distributes its assets ($19,000 in cash) to A and B in proportion to their capital account balances, A will recognize a capital gain of $100 ($9,500, the amount distributed to A, less $9,400, the adjusted tax basis of A's interest). B will recognize a capital loss of $100 (the excess of B's adjusted tax basis, $9,600, over the amount received, $9,500).

EXAMPLE 2. UNREASONABLE USE OF THE TRADITIONAL METHOD -- (i) FACTS. C and D form partnership CD and agree that each will be allocated a 50 percent share of all partnership items and that CD will make allocations under section 704(c) using the traditional method under paragraph (b) of this section . C contributes equipment with an adjusted tax basis of $1,000 and a book value of $10,000, with a view to taking advantage of the fact that the equipment has only one year remaining on its cost recovery schedule although its remaining economic life is significantly longer. At the time of contribution, C has a built-in gain of $9,000 and the equipment is section 704(c) property. D contributes $10,000 of cash, which CD uses to buy securities. D has substantial net operating loss carryforwards that D anticipates will otherwise expire unused. Under section 1.704-1(b)(2)(iv)(g)(3), the partnership must allocate the $10,000 of book depreciation to the partners in the first year of the partnership. Thus, there is $10,000 of book depreciation and $1,000 of tax depreciation in the partnership's first year. CD sells the equipment during the second year for $10,000 and recognizes a $10,000 gain ($10,000, the amount realized, less the adjusted tax basis of $0).

(ii) UNREASONABLE USE OF METHOD -- (A) At the beginning of the second year, both the book value and adjusted tax basis of the equipment are $0. Therefore, there is no remaining built-in gain. The $10,000 gain on the sale of the equipment in the second year is allocated $5,000 each to C and D. The interaction of the partnership's one-year write-off of the entire book value of the equipment and the use of the traditional method results in a shift of $4,000 of the precontribution gain in the equipment from C to D (D's $5,000 share of CD's $10,000 gain, less the $1,000 tax depreciation deduction previously allocated to D).

(B) The traditional method is not reasonable under paragraph (a)(10) of this section because the contribution of property is made, and the traditional method is used, with a view to shifting a significant amount of taxable income to a partner with a low marginal tax rate and away from a partner with a high marginal tax rate.

(C) Under these facts, if the partnership agreement in effect for the year of contribution had provided that tax gain from the sale of the property (if any) would always be allocated first to C to offset the effect of the ceiling rule limitation, the allocation method would not violate the anti-abuse rule of paragraph (a)(10) of this section . See paragraph (c)(3) of this section . Under other facts, (for example, if the partnership holds multiple section 704(c) properties and either uses multiple allocation methods or uses a single allocation method where one or more of the properties are subject to the ceiling rule) the allocation to C may not be reasonable.

(c) TRADITIONAL METHOD WITH CURATIVE ALLOCATIONS -- (1) IN GENERAL. To correct distortions created by the ceiling rule, a partnership using the traditional method under paragraph (b) of this section may make reasonable curative allocations to reduce or eliminate disparities between book and tax items of noncontributing partners. A curative allocation is an allocation of income, gain, loss, or deduction for tax purposes that differs from the partnership's allocation of the corresponding book item. For example, if a noncontributing partner is allocated less tax depreciation than book depreciation with respect to an item of section 704(c) property, the partnership may make a curative allocation to that partner of tax depreciation from another item of partnership property to make up the difference, notwithstanding that the corresponding book depreciation is allocated to the contributing partner. A partnership may limit its curative allocations to allocations of one or more particular tax items (e.g., only depreciation from a specific property or properties) even if the allocation of those available items does not offset fully the effect of the ceiling rule.

(2) CONSISTENCY. A partnership must be consistent in its application of curative allocations with respect to each item of section 704(c) property from year to year.

(3) REASONABLE CURATIVE ALLOCATIONS -- (i) AMOUNT. A curative allocation is not reasonable to the extent it exceeds the amount necessary to offset the effect of the ceiling rule for the current taxable year or, in the case of a curative allocation upon disposition of the property, for prior taxable years.

(ii) TIMING. The period of time over which the curative allocations are made is a factor in determining whether the allocations are reasonable. Notwithstanding paragraph (c)(3)(i) of this section , a partnership may make curative allocations in a taxable year to offset the effect of the ceiling rule for a prior taxable year if those allocations are made over a reasonable period of time, such as over the property's economic life, and are provided for under the partnership agreement in effect for the year of contribution. See paragraph (c)(4) Example 3(ii)(C) of this section.

(iii) TYPE -- (A) IN GENERAL. To be reasonable, a curative allocation of income, gain, loss, or deduction must be expected to have substantially the same effect on each partner's tax liability as the tax item limited by the ceiling rule. The expectation must exist at the time the section 704(c) property is obligated to be (or is) contributed to the partnership and the allocation with respect to that property becomes part of the partnership agreement. However, the expectation is tested at the time the allocation with respect to that property is actually made if the partnership agreement is not sufficiently specific as to the precise manner in which allocations are to be made with respect to that property. Under this paragraph (c), if the item limited by the ceiling rule is loss from the sale of property, a curative allocation of gain must be expected to have substantially the same effect as would an allocation to that partner of gain with respect to the sale of the property. If the item limited by the ceiling rule is depreciation or other cost recovery, a curative allocation of income to the contributing partner must be expected to have substantially the same effect as would an allocation to that partner of partnership income with respect to the contributed property. For example, if depreciation deductions with respect to leased equipment contributed by a tax-exempt partner are limited by the ceiling rule, a curative allocation of dividend or interest income to that partner generally is not reasonable, although a curative allocation of depreciation deductions from other leased equipment to the noncontributing partner is reasonable. Similarly, under this rule, if depreciation deductions apportioned to foreign source income in a particular statutory grouping under section 904(d) are limited by the ceiling rule, a curative allocation of income from another statutory grouping to the contributing partner generally is not reasonable, although a curative allocation of income from the same statutory grouping and of the same character is reasonable.

(B) EXCEPTION FOR ALLOCATION FROM DISPOSITION OF CONTRIBUTED PROPERTY. If cost recovery has been limited by the ceiling rule, the general limitation on character does not apply to income from the disposition of contributed property subject to the ceiling rule, but only if properly provided for in the partnership agreement in effect for the year of contribution or revaluation. For example, if allocations of depreciation deductions to a noncontributing partner have been limited by the ceiling rule, a curative allocation to the contributing partner of gain from the sale of that property, if properly provided for in the partnership agreement, is reasonable for purposes of paragraph (c)(3)(iii)(A) of this section even if not of the same character.

(4) EXAMPLES. The following examples illustrate the principles of this paragraph (c).

EXAMPLE 1. REASONABLE AND UNREASONABLE CURATIVE ALLOCATIONS -- (i) FACTS. E and F form partnership EF and agree that each will be allocated a 50 percent share of all partnership items and that EF will make allocations under section 704(c) using the traditional method with curative allocations under paragraph (c) of this section . E contributes equipment with an adjusted tax basis of $4,000 and a book value of $10,000. The equipment has 10 years remaining on its cost recovery schedule and is depreciable using the straight-line method. At the time of contribution, E has a built-in gain of $6,000, and therefore, the equipment is section 704(c) property. F contributes $10,000 of cash, which EF uses to buy inventory for resale. In EF's first year, the revenue generated by the equipment equals EF's operating expenses. The equipment generates $1,000 of book depreciation and $400 of tax depreciation for each of 10 years. At the end of the first year EF sells all the inventory for $10,700, recognizing $700 of income. The partners anticipate that the inventory income will have substantially the same effect on their tax liabilities as income from E's contributed equipment. Under the traditional method of paragraph (b) of this section , E and F would each be allocated $350 of income from the sale of inventory for book and tax purposes and $500 of depreciation for book purposes. The $400 of tax depreciation would all be allocated to F. Thus, at the end of the first year, E and F's book and tax capital accounts would be as follows:

 E                   F

 E                 F

 E                   F

EXAMPLE 2 CURATIVE ALLOCATIONS LIMITED TO DEPRECIATION -- (i) FACTS. G and H form partnership GH and agree that each will be allocated a 50 percent share of all partnership items and that GH will make allocations under section 704(c) using the traditional method with curative allocations under paragraph (c) of this section , but only to the extent that the partnership has sufficient tax depreciation deductions. G contributes property G1, with an adjusted tax basis of $3,000 and a fair market value of $10,000, and H contributes property H1, with an adjusted tax basis of $6,000 and a fair market value of $10,000. Both properties have 5 years remaining on their cost recovery schedules and are depreciable using the straight-line method. At the time of contribution, G1 has a built-in gain of $7,000 and H1 has a built-in gain of $4,000, and therefore, both properties are section 704(c) property. G1 generates $600 of tax depreciation and $2,000 of book depreciation for each of five years. H1 generates $1,200 of tax depreciation and $2,000 of book depreciation for each of 5 years. In addition, the properties each generate $500 of operating income annually. G and H are each allocated $1,000 of book depreciation for each property. Under the traditional method of paragraph (b) of this section , G would be allocated $0 of tax depreciation for G1 and $1,000 for H1, and H would be allocated $600 of tax depreciation for G1 and $200 for H1. Thus, at the end of the first year, G and H's book and tax capital accounts would be as follows:

 G                      H

 G                     H

 J                        K

 J                      K

(C) The property has only one year remaining on its cost recovery schedule even though its economic life is considerably longer. Under these facts, if the partnership agreement had provided for curative allocations over a reasonable period of time, such as over the property's economic life, rather than over its remaining cost recovery period, the allocations would have been reasonable. See paragraph (c)(3)(ii) of this section . Thus, in this example, JK would make a curative allocation of $400 of sales income to J in the partnership's first year (10 percent of $4,000). J and K's book and tax capital accounts at the end of the first year would be as follows:

 J                     K

(e) EXCEPTIONS AND SPECIAL RULES -- (1) SMALL DISPARITIES -- (i) GENERAL RULE. If a partner contributes one or more items of property to a partnership within a single taxable year of the partnership, and the disparity between the book value of the property and the contributing partner's adjusted tax basis in the property is a small disparity, the partnership may --

(A) Use a reasonable section 704(c) method;

(B) Disregard the application of section 704(c) to the property; or

(C) Defer the application of section 704(c) to the property until the disposition of the property.

(ii) DEFINITION OF SMALL DISPARITY. A disparity between book value and adjusted tax basis is a small disparity if the book value of all properties contributed by one partner during the partnership taxable year does not differ from the adjusted tax basis by more than 15 percent of the adjusted tax basis, and the total gross disparity does not exceed $20,000.

(2) AGGREGATION. Each of the following types of property may be aggregated for purposes of making allocations under section 704(c) and this section if contributed by one partner during the partnership taxable year.

(i) DEPRECIABLE PROPERTY. All property, other than real property, that is included in the same general asset account of the contributing partner and the partnership under section 168.

(ii) ZERO-BASIS PROPERTY. All property with a basis equal to zero, other than real property.

(iii) INVENTORY. For partnerships that do not use a specific identification method of accounting, each item of inventory, other than securities or similar investment interests (as defined in section 1.704-3T(e)(3)).

(iv) OTHER AGGREGATED PROPERTY. Types of property designated in guidance published in the Internal Revenue Bulletin.

(v) LETTER RULINGS. Other property as permitted by the Commissioner in a letter ruling.

(3) SECURITIES PARTNERSHIPS. [Reserved]

(f) EFFECTIVE DATE. This section applies to property contributed to a partnership and to restatements pursuant to section 1.704-1(b)(2)(iv)(f) on or after December 21, 1993.