Protecting Tax Deferral for A Contribution to A Partnership
March 06, 2017
Contributing Property to A Partnership
When a taxpayer (“Taxpayer”) sells a property (“Property”) with a fair market value (“FMV”) in excess of Taxpayer’s basis in Property in exchange for cash in an arm’s-length transaction, the amount of gain that he realizes on the sale is measured by the difference between the amount of cash received by Taxpayer over his basis for Property.
Because Taxpayer has terminated his investment in Property (by exchanging it for cash), he must include the gain realized in his gross income for the year in which the sale occurred.
If Taxpayer instead contributes Property to a partnership (“Partnership”) in exchange for an “equally” valuable equity interest therein, he will still realize a gain on the exchange, but such gain will not be recognized (i.e., it will not be included in Taxpayer’s gross income) because Taxpayer is viewed under the Code as continuing his investment in Property, albeit indirectly, through his partnership interest; thus, it would not be appropriate to tax him on the gain realized.
Preserving the Gain
As we saw last week, because the Code considers Taxpayer’s investment in Partnership as a continuation of his investment in Property, Taxpayer’s basis for his partnership interest will be the same basis that he had in Property. In this way, the gain realized by Taxpayer on his disposition of Property is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.
But what if Taxpayer does not dispose of his Partnership interest in a taxable transaction? What if he leaves it to his heirs with a stepped-up basis at his death? What if Partnership disposes of Property? To whom will the gain from a sale of Property be allocated?
Never fear, the Code and the regulations promulgated thereunder have foreseen this possibility and have accounted for it.
First of all, Partnership will take Property with a basis equal to the basis that Taxpayer had in Property at the time of its contribution to Partnership.
Thus, the gain inherent in Property at the time it is contributed by Taxpayer (the “pre-contribution BIG”) will also be preserved in the hands of Partnership.
You may ask, won’t this gain be allocated among all the partners, including Taxpayer, based upon their relative interests in Partnership? Simply put, no, and that is why it is imperative that any taxpayer who intends to contribute appreciated property to a partnership in exchange for a partnership interest therein should be aware of the tax consequences described below and should plan for them.
The Allocation of Pre-Contribution Built-In Gain
In order to prevent the pro rata allocation of the pre-contribution BIG among the contributing and noncontributing partners, and the resultant “shifting” of income tax consequences, the Code and the Regulations provide a set of rules with respect to the allocation of any pre-contribution BIG. These rules require that a partnership must allocate its income, gain, loss and deduction with respect to contributed property so as to take into account the pre-contribution BIG.
In general, these rules require that when a partnership has income, gain, loss or deduction attributable to a property that has pre-contribution BIG, the partnership must make appropriate allocations among its partners to avoid shifting the tax consequences of the pre-contribution BIG away from the contributing partner. (View it as a variation of the “assignment of income” doctrine.)
Thus, if Partnership sells Property and recognizes gain, the pre-contribution BIG on Property will first be allocated to Taxpayer as the contributing partner. Then, any remaining gain will be allocated among all of the partners in accordance with their relative interests in Partnership.
Allocating Depreciation Deductions
If Property is subject to depreciation, the allocation of the deductions attributable to the depreciation for tax purposes must take into account the pre-contribution BIG on Property. Specifically, the rules provide that the tax allocation of depreciation deductions to the noncontributing partners must, to the extent possible, equal the “book allocations” of depreciation deductions to those partners. This allocation rule is often referred to as the “traditional method.”
Partnership’s depreciation deduction for tax purposes will be determined by reference to Partnership’s starting basis in Property – the same basis that Taxpayer (as the contributor) had for Property – while its depreciation deductions for financial accounting (or “book”) purposes will be determined based upon Partnership’s book value for Property. A contributed property’s starting “book value” – the amount at which it is recorded on the partnership’s financial accounting records (its “books”) – is equal to its FMV at the time of its contribution.
Where the contributed property has pre-contribution BIG (as in the case of Property), its beginning book value (the property’s FMV) will exceed its basis for tax purposes. Thus, the effect of the above allocation rule, which “matches” the tax allocation of depreciations deductions to the noncontributing partners with the allocation of such deductions to such partners for book purposes, is to shift more of the partnership’s (Partnership’s) taxable income to the contributing partner (Taxpayer) by allocating more of its tax-deductible depreciation deductions to the noncontributing partners.
In this way, over time, an amount equal to Property’s pre-contribution BIG will have been allocated to the Taxpayer, at which point the special allocation rule will cease to apply.
In order to further ensure the intended result of the above allocation rules – i.e., to prevent the shifting of tax consequences with respect to pre-contribution BIG to the noncontributing partners – the special allocation rules provide yet additional rules that may be applied where, contrary to the above matching rule, a noncontributing partner would otherwise be allocated less tax depreciation than book depreciation with respect to the contributed property. (This will usually be the case when talking about appreciated property.) The effect of these so-called “curative” allocation and “remedial” allocation rules is to make up this difference, and to reduce or eliminate the disparity, between the book and tax items of the noncontributing partners. The rules thereby prevent the shifting of any portion of pre-contribution BIG to the noncontributing partners, thus ensuring that the tax consequences attributable to the pre-contribution BIG are visited upon the contributing partner.
Protecting the Contributing Partner
Although a taxpayer generally may contribute appreciated property to a partnership in exchange for an interest therein without incurring an immediate income tax liability, the application of the pre-contribution BIG allocation rules discussed above has the potential to immediately wipe away this deferral. For example, if Partnership decides to sell Property shortly after its contribution, Taxpayer (as the contributing partner) will not have enjoyed the benefit of tax deferral.
Moreover, Taxpayer may find himself in a situation where he must include the pre-contribution BIG in his gross income for tax purposes, but he has not received any cash with which to pay the tax, and he may not be in a position to compel Partnership to make the necessary cash distribution or to give him a loan.
What is Taxpayer to do?
For one thing, it would have behooved Taxpayer to retain a tax adviser who was familiar with the above allocation rules. Such an adviser would have advised Taxpayer to try to negotiate a period during which Partnership would not sell or otherwise dispose of the Property (except as part of a “tax-free” exchange).
Alternatively, the tax adviser might have counseled Taxpayer try to negotiate a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.
Insofar as the allocation of depreciation deductions pursuant to these rules is concerned, the tax adviser would likely have suggested that Taxpayer negotiate for the use of the “traditional method” so as to maximize the deferral period for “recognition” of the pre-contribution BIG, failing which he may have suggested the use of the “remedial allocation method” over the “curative allocation method,” as the former generally allows the book-tax difference (the excess of book value over tax basis) described above to be spread out over a longer period of time.
Bottom line: the foregoing options may not be available after Taxpayer has already contributed Property to Partnership. The time to consider these issues, to plan for them, and to negotiate ways to reduce any adverse impact is prior to making the contribution.