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:: Partnership - Audit Technique Guide - Chapter 3 - Contribution of Property with Built-in Gain or Loss - IRC section 704(c) (12-2002)   Chapter 3 - Table of Contents Introduction     Overview           Issue:  IRC section 704(c) And Non-Depreciable Property     Allocation Methods – Non-depreciable Property     Traditional Method         Traditional Method with Curative Allocations     Remedial Allocation Method        Issue:  IRC section 704(c) and Depreciable Property     Traditional Method         Traditional Method with Curative Allocations     Remedial Allocation Method        Method Summary         Issue:  IRC section 704(c) and IRC section 197 Intangibles     Issue:  Anti-Abuse Rule         Issue:  Effect of IRC section 704(c) On Partners’ Share of Non-Recourse Liabilities Issue:  “Reverse” 704(c) – Revaluations       Examination Techniques        Supporting Law         Resources    back to the top   Introduction When a partner contributes appreciated or depreciated property to a partnership, the property has an inherent built-in gain or built-in loss that accrued in the hands of the partner.  Thus, at the time of contribution, the property has a tax basis that differs from its fair market value.  As was discussed in Chapter 2, the property’s fair market value at the time of contribution is what is called the “book basis”.  This type of property is referred to as “704(c) property.” The goal of IRC section 704(c) is to prevent the shifting of tax consequences (gain, loss, and deductions) with respect to appreciated or depreciated property contributed by a partner to a partnership.  It upholds the assignment of income principle by requiring the contributing partner to be taxed on the portion of the gain or loss that accrued prior to the property’s contribution.  This chapter will cover: IRC section 704(c) in the context of non-depreciable property IRC section 704(c) in the context or depreciable property IRC section 704(c) in the context of amortizable property Impact of IRC section 704(c) on the sharing of non-recourse liabilities The Anti-Abuse Rule “Reverse” IRC section 704(c) which addresses re-valuations   Overview Prior to 1984, there was no special rule that a contributing partner had to be taxed on the gain or loss inherent in property at the time of contribution.  In 1984, Congress took action against partners’ ability to shift pre-contribution gain or loss among themselves and made IRC section 704(c) mandatory.  As a result, gain or loss inherent in contributed property must be allocated back to the contributing partner.  In the case of non-depreciable property, this can happen all at once when the property is sold.  On the other hand, gain or loss inherent in depreciable property will be recognized over time as depreciation deductions are allocated to other partners and away from the contributing partner, thereby increasing the contributing partner’s income. Final regulations for 704(c) were issued on December 21, 1993.  These regulations include an anti-abuse rule in Treas. Reg. section 1.704-3(a)(10).  A firm grounding in the basic operation of IRC section 704(c) is critical to understanding the proper allocation of gain, loss, and cost recovery pertaining to IRC section 704(c) property.  Additionally, IRC section 704(c) principles have an impact on a contributing partner’s share of partnership non-recourse debt. ISSUE:  IRC SECTION 704(c) AND NON-DEPRECIABLE PROPERTY Example 3-1 Adams and Miller form an equal partnership in which Adams contributes raw land with a tax basis of $10,000 and a fair market value of $50,000.  Miller contributes $50,000 of cash.  The land is IRC section 704(c) property because there is a $40,000 appreciation that occurred prior to its contribution to the partnership.  Its book basis is $50,000 and its tax basis is $10,000. If the partnership were to sell the land for $50,000, the entire gain would be allocated to Adams. If the land appreciated in the hands of the partnership and it were sold for $100,000, $50,000 would be split equally between Adams and Miller and the built-in gain of $40,000 would be allocated to Adams. Consistent with the assignment of income principles, Miller is only allocated a portion of the gain that accrued during the time that he owned the land via the partnership.  All of the built-in gain of ($40,000) that accrued prior to contribution is allocated back to the contributing partner. Allocation Methods – Non-depreciable Property Although straightforward in its aim of upholding the assignment of income principle and taxing the contributing partner on any built-in gain or loss, IRC section 704(c) becomes more intricate when there has been a tax gain but a book loss. Example 3-2 Taking the facts from the above example, if the land decreased in value to $30,000 and was sold, there would be a tax gain of $20,000 ($30,000 less tax basis of $10,000).  Following IRC section 704(c) principles, this gain would be allocated to Adams.  Miller, on the other hand, has suffered an economic loss but has no accompanying tax loss.  Remember that Miller bought an undivided interest in a partnership that owned land worth $50,000.  The land had a book basis of $50,000 and was sold for $30,000, resulting in a $20,000 book loss.  The problem here is that there is no tax loss to match Miller’s book (or economic) loss. How this problem is addressed depends on which allocation method the partnership elects. The regulations discuss three allocation methods: back to the top Traditional Method Traditional Method with Curative Allocations Remedial Method The traditional method with curative allocations and the remedial method, are designed to remedy the noncontributing partner’s lack of a tax loss allocation in the presence of an economic loss.  Under the traditional method, the noncontributing partner's lack of a tax loss to match his economic loss is not corrected until the partnership liquidates or that partner sell its partnership interest. Traditional Method This method focuses solely on taxing the contributing partner on his built-in gain.  The noncontributing partner is forced to wait until the partnership liquidates in order to get a tax loss to match his economic loss.  Instead of having a current tax loss, Miller has a loss which will only be recognized upon disposing of his partnership interest.  Under the traditional method, this result is caused by the ceiling rule, which states that tax items allocated to partners with respect to IRC section 704(c) property cannot exceed the total tax items associated with that property.  In other words, Miller is not allocated a tax loss in conjunction with his book loss because the partnership doesn’t have one to give him. back to the top Traditional Method with Curative Allocations A partner may not be willing to defer until tomorrow a tax loss associated with today’s economic loss.  Because the ceiling rule will not allow the partner to take a non-existent allocation, the regulations permit a partnership to elect curative allocations.  In making a curative allocation, a partnership looks at the tax items it has generated for the year and searches for one that is of the same character as the item that was limited by the ceiling rule.  If the partnership has such a tax item, that item is “borrowed” and then allocated in a manner for tax different than the manner in which it was allocated for book.  The result is that the noncontributing and the contributing partners are allocated offsetting items – the noncontributing partner receives a loss or a gain reduced from what he would normally have received, and the contributing partner receives the mirror opposite. Remedial Allocation Method Unlike the curative allocation method, the remedial method does not force the partnership to look for a tax item that truly exists.  Instead, the partnership simply invents what it needs – it manufactures whatever tax allocations the noncontributing partner needs to accompany his book allocations.  At the same time, it invents an offsetting item in the same amount as the fictional tax items and allocates it to the contributing partner.  Thus, any remedial allocations of loss to one partner will result in an offsetting allocation of gain to the other partner.  It is important to realize that in spite of their purely fictitious origins, remedial allocations are real for tax purposes.  They affect both the partners’ tax liabilities and their outside bases.  Since these allocations are created solely for tax purposes, they do not affect the partners’ book capital accounts. Example 3-3 In the Example 3-2, Miller has a $10,000 book loss with no accompanying tax loss.  Note that the book capital accounts are not affected by the remedial allocation.  Also, as a result of the remedial allocation, the tax capital and the book capital accounts are equal. back to the top ISSUE:  IRC SECTION 704(c) AND DEPRECIABLE PROPERTY Example 3-4 Al contributes equipment with a FMV of $100 and an adjusted basis of $40.  The equipment is 10-year depreciable property with a 5-year remaining life.  The partnership will depreciate it under the straight-line method.  Betty contributes $100 cash.  Under the partnership agreement, Al and Betty are equal partners.  The partnership’s book basis in the equipment equals the FMV of the property at contribution, $100.  The partnership’s tax basis in the equipment equals the contributing partner’s tax basis at the time of contribution, $40.  In Year 1, the equipment generates book depreciation of $20 and tax depreciation of $8. Note:  Without IRC section 704(c), Al and Betty, as 50/50 partners, would share the tax depreciation equally. Although Betty is the owner of half of the property’s fair market value (that is, half of $100), the depreciation deductions Betty receives over the remaining 5-year life, under a pro rata allocation of depreciation, deductions ($4 per year for 5 years, or $20) do not equal half of the property’s fair market value.  In terms of cost recovery, Betty would have been better off purchasing a one half interest in the property directly from Al.  The IRC section 704(c) allocation methods address this inequity between book and tax allocations. back to the top Traditional Method Under the traditional method, the noncontributing partner is allocated tax depreciation, to the extent of real tax depreciation available, up to his or her amount of book depreciation.  To the extent permitted by the ceiling rule, the noncontributing partner is treated as if he or she purchased an undivided interest in the contributed property. Example 3-5 Assume the same facts as in Example 3-4 except that the partnership uses the traditional allocation method.  The ceiling rule limits the allocation to $8 because that is the total partnership tax depreciation for the year. back to the top Traditional Method with Curative Allocations As was described earlier, if the traditional method with curative allocations is used then the partnership looks for another tax item of the same amount and character as the item limited by the ceiling rule.  This item must exist in the partnership’s tax house for that year; otherwise no curative allocation can be made.  If the partnership has such an item, it will further reduce Betty’s book/tax disparity. Example 3-6 Assume the same facts as in Example 3-5, except that the partnership has $4 of ordinary income to be allocated. The partnership uses the curative allocation method and allocates the entire $4 of income to Al.  Alternatively, if the partnership had $4 of deductions available, a disproportionate allocation of $4 of deductions could be made to Betty. Remedial Allocation Method When used in conjunction with depreciable property, the remedial method uses a special rule for calculating the amount of book depreciation.  It introduces a split depreciation scheme.  Recall that when property is transferred to a partnership, the partnership normally steps into the shoes of the contributing partner and continues to depreciate the property using the same method and the property’s remaining life.  Under the remedial allocation method, the portion of the book basis equal to the adjusted tax basis is recovered in this manner.  The remainder of the book basis (book basis less tax basis) is recovered as if it were a newly purchased asset placed in service at the time of contribution. Example 3-7 Al contributes equipment with a FMV of $100 and an adjusted basis of $20.  The equipment is 10-year IRC section 1245 property with a 5-year remaining life.  Betty contributes $100 cash.  Under the partnership agreement, Al and Betty are equal partners.  The partnership’s book basis in the equipment equals the FMV of the property at the time of contribution, $100.  The partnership’s tax basis in the equipment equals Al’s tax basis at the time of contribution, $20.  The partnership uses the remedial allocation method.  Assume that the partnership has no income. The tax basis portion of the equipment ($20) is depreciated over its remaining 5 year life.  The excess ($80) is depreciated as if it were a newly purchased asset.  In this example, it is depreciated over a 10-year life. The remedial allocation method totally eliminates Betty’s book/tax disparity each year because the partnership is able to manufacture exactly what is needed. The curative allocation method in the prior example only eliminates Betty’s book/tax disparity if the partnership actually has other income or deductions in the appropriate amount and character. back to the top Method Summary The most obvious difference between the traditional allocation method and the other two (curative allocations and remedial allocation methods) is that under the traditional method, the contributing partner can shift taxable income to other partners if the ceiling rule applies.  A high bracket taxpayer will thus favor the traditional method because there are no curative or remedial allocations to prevent income shifting. For depreciation or amortization purposes, the noncontributing partner may favor the traditional method with curative allocations.  This is because the excess book basis may be depreciated over a short remaining life.  In contrast, the remedial method will bifurcate the asset and start a whole new depreciation period for the “excess book basis asset” which may be a longer time period. It should be remembered that the partnership can use any reasonable method of making allocations.  The partnership is not limited to the three methods described in the regulations.  Whether or not a method will be considered to be “reasonable” will depend on whether or not the allocations cause the contributing partner to bear the tax benefits and burdens of the built-in gain or loss.  Allocations that are not consistent with the assignment of income doctrine would obviously not be reasonable. The choice of method may be made on a property-by-property basis Treas. Reg. section 1.704-3(a)(2). back to the top ISSUE:  IRC SECTION 704(c) AND IRC SECTION 197 INTANGIBLES Allocations of amortization deductions are made in accordance with IRC section 704(c) on contributed intangible assets with built-in gain or loss.  IRC section 197 was enacted in 1993 to simplify the law regarding the amortization of certain acquired intangibles.  It established a mandatory 15-year recovery period for assets such as goodwill, trademarks, franchises, licenses granted by governmental agencies, and customer-based intangibles.  Other assets, such as patents and copyrights, are amortizable under IRC section 197 if they are purchased as part of a trade or business. To properly apply the IRC section 704(c) allocation methods, it must first be determined whether the intangible asset contributed by the contributing partner is amortizable under IRC section 197.  The general definition of Section 197 intangibles is found in IRC section 197(d) and includes, in part, goodwill, going concern, patents, copyrights, and licenses.  The definition of an amortizable 197 intangible is found in IRC section 197(c)(1).  There are two requirements for a 197 intangible to be considered to be an amortizable 197 intangible:  Generally, the asset must be: Acquired by the taxpayer after August 113, 1993, and Held in connection with the conduct of a trade or business or an activity described in IRC section 212 Note that intangibles acquired by the contributor prior to the enactment of IRC section 197 are not amortizable IRC section 197 intangibles, (with the exception of a taxpayer making an election to apply the provisions of 197 to property acquired after July 25, 1991). There is an important exclusion from the definition of amortizable IRC section 197 assets that addresses certain self-created assets.  This is found in IRC section 197(c)(2).  If self-created, any of the following assets will be not be amortizable under IRC section 197:  goodwill, going concern value, workforce in place, business books and records, patents, copyrights, formulas, processes, designs, patterns, knowhow, format, customer-based intangibles, supplier-based intangibles, and other similar items.  (Note that governmental licenses, covenants not to compete, and franchises, trademarks, and trade names do not fall within the exclusion.) Allocation Methods for Amortizable 197 Intangibles In situations where the contributed asset was an amortizable IRC section 197 intangible in the hands of the contributor, the partnership may make either curative or remedial allocations of amortization.  It is important to note that this also applies to a zero-basis intangible that otherwise would have been amortizable to the contributing partner (that is, if the asset had basis). Example 3-8 XYZ Corporation owns and operates a broadcasting station which has been in business since 1985.  In January 1995, the corporation purchases additional licenses from the Federal Communications Corporation for $150,000 and began using them in the active conduct of the business.  These 1995 licenses are described in IRC section 197 and are amortizable over the mandatory 15-year recovery period.  In January 1997, when the licenses have increased in value to $500,000, XYZ forms an equal partnership with ABC Corporation to expand XYZ’s existing business operations.  XYZ contributes the licenses and ABC contributes $500,000 cash. Since the licenses are amortizable IRC section 197 intangibles in the hands of XYZ Corporation, the partnership may make either curative or remedial allocations to the noncontributing partner, ABC to amortize its share of the partnership’s licenses. Recall that the remedial method treats the excess of the book basis over the tax basis of the contributed property as if it were a newly created asset with a new holding period.  Under the remedial method, the partnership would treat the contributed property as if it were two assets, one with a basis of $130,000 (the original tax basis of $150,000 less accumulated amortization of $20,000), and the other with a basis of $370,000 (the difference between the tax basis of $130,000 and the book basis of $500,000).  The tax portion of $130,000 is amortizable over the remaining 13 years of its recovery period.  The built-in gain portion of $370,000 is treated as a newly purchased asset by the partnership and is amortizable for book purposes over a new 15-year period.  Thus in 1997, ABC receives a remedial allocation of amortization in the amount of $12,333 ($370,000/15 = 24,666/2 = 12,333). Example 3-9 Post 1993 Goodwill Ken starts a business in 1998.  In 2000 he forms a 50/50 partnership with Jose who contributes $1,000,000 cash.  The assets of Ken’s business consisted of equipment with a basis and a FMV of $300,000 and self-created goodwill with a zero basis and a FMV of $700,000.  The goodwill is not an amortizable IRC section 197 intangible in Ken’s hands because it is a self-created asset.  IRC section 197(c)(2).  However, if the goodwill had basis, it is the type of asset that otherwise would be amortizable to the contributing partner (goodwill acquired after the enactment of IRC section 197).  The partnership can make either curative or remedial allocations to Jose to amortize his share of the partnership’s goodwill.  Ken will receive no amortization deductions because he had a zero basis in the goodwill. Allocation Method for Nonamortizable IRC section 197 Intangibles For assets that were nonamortizable in the hands of the contributor, the partnership may make amortization allocations to the noncontributing partner only using the remedial method.  The contributing partner will be allocated remedial income and the noncontributing partners will be allocated matching remedial amortization deductions. Example 3-10 Pre 1993 Goodwill Ken starts a business in 1989.  In 1994, he forms a 50/50 partnership with Jose, an unrelated person, who contributes $1,000,000 cash.  The assets of Ken’s business consisted of equipment with a basis and a FMV of $300,000 and self-created goodwill with a zero basis and a FMV of $700,000.  The goodwill, in the hands of Ken, is not an amortizable IRC section 197 intangible because it was created prior to the enactment of IRC section 197.  The partnership can only use the remedial method to amortize Jose’s share of the partnership’s goodwill.  Ken will receive no amortization because the goodwill was not an amortizable IRC section 197 intangible in Ken’s hands. Anti-Churning Rules Remedial allocations may not, however, be made if the partner contributing the nonamortizable intangible and the noncontributing partners are related and the asset is subject to the anti-churning rules of IRC section 197.  The purpose of the anti-churning rules is to prevent taxpayers from transforming assets which were not of a character to be amortized prior to the enactment of IRC section 197 into amortizable assets by selling them to a related party.  Thus, the anti-churning rules may limit the amortizability of intangibles acquired by a partnership or from a partnership in a transaction involving related parties.   See the following example: Example 3-11 Ken starts a business in 1985.  Fortunately, the business is successful and earns profits in every year.  As of 1995, his business consists of two assets, equipment with a basis and a FMV of $300,000 and self-created goodwill with a basis of zero and a FMV of $700,000.  The goodwill is an IRC section 197 intangible, but it is not an amortizable IRC section 197 intangible in Ken’s hands because it was created prior to the enactment of IRC section 197.  In 1995, Ken forms a partnership with a corporation in which he is the sole shareholder.  Ken contributes his business to the partnership and the partnership adopts the remedial method for making allocations.  Because the noncontributing partner (the wholly owned corporation) is related to Ken and because the intangible was owned by the contributing partner prior to the enactment of IRC section 197, the partnership is unable to amortize the asset.  Thus, the corporation is prohibited from receiving remedial allocations of amortization. Prior to the enactment of IRC section 197, intangibles that had a determinable useful life and a tax basis were amortizable over their useful lives.  If these types of assets are sold between related parties, the anti-churning rules will not apply.  See the following example: Example 3-12 A publisher owns a subscription list (customer-based intangible) that has a determinable useful life, an ascertainable value, and a zero tax basis.  The list was created prior to the enactment of IRC section 197.   A partnership is formed with the publisher and the publisher’s subsidiary as partners.  In 2000, the publisher sells the customer list to the partnership and amortizes the list.  Even though this is a related party transaction, the partnership will be able to amortize the list because it was an asset of a character subject to amortization prior to the enactment of IRC section 197. Contrast the above example with the following: Example 3-13 A real estate management partnership has management contracts which were acquired prior to the enactment of IRC section 197.  The contracts have an indefinite life.  The partnership would like to be able to amortize the contracts under IRC section 197.  The partnership sells the contracts to a corporation which is wholly owned by the partnership.  In this case, the corporation will not be able to amortize the contracts because they were held by a related party prior to the enactment of IRC section 197 and because they were not of a character subject to amortization. back to the top ISSUE:  ANTI-ABUSE RULE The 704(c) regulations contain an anti-abuse rule in Treas. Reg. section 1.704 3(a)(10) which states that an allocation method is not reasonable if the contribution of property 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. Additionally, Treas. Reg. section 1.704-3(a)(2) states that it may be unreasonable to use one method for appreciated property and another method for depreciated property.  While IRC section 704(c) applies on a property-by property basis, 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. back to the top ISSUE:  EFFECT OF IRC SECTION 704(c) ON PARTNERS’ SHARE OF NON-RECOURSE LIABILITIES As was discussed in Chapter 2, a partner’s share of non-recourse liabilities is the sum of three amounts defined in Treas. Reg. section 1.752-3.  704(c) impacts the calculation of the second amount, and it can have an impact on the third amount, the excess non-recourse liabilities for partnerships using the optional method.  Treas. Reg. section 1.752-3(a)(3).  The IRC section 704(c) method is relevant only to the extent of "extra excess" IRC 704(c) amounts.  For a review of the basics of calculating a partner’s share of non-recourse liabilities, see Chapter 2. As seen in Revenue Ruling 95-41, the IRC section 704(c) allocation method employed by the partnership can affect the amount calculated under Treas. Reg. section 1.752-3(a)(2), which is the amount of any taxable gain that would be allocated to the partner under IRC section 704(c) if the partnership disposed of the property in full satisfaction of the liability.  In analyzing a hypothetical sale to determine this amount, it is necessary to make two calculations, one using the property’s tax basis and one using the property’s book basis.  The impact of the hypothetical sale on the partnership’s noncontributing partner must be taken into consideration. Revenue Ruling 95-41 gives an example of an equal partnership formed between A and B.  A contributes IRC section 704(c) property having a basis of 4,000 and a fair market value of $10,000.  The property is encumbered with $6,000 of non-recourse debt.  B contributes $4,000 cash.  Traditional Method: Partner A would be allocated $2,000 of gain from the hypothetical sale of the contributed property.  Therefore, A would be allocated $2,000 of non-recourse liabilities under Treas. Reg. section 1.752-3(a)(2) immediately after contributing the property.  Recall that under the traditional method, there are no offsetting allocations, so A’s gain (and therefore his liability share under Treas. Reg. section 1.752-3(a)(2)) is only $2,000. Remedial Method: Partner B, the noncontributing partner has a $2,000 book loss in the hypothetical sale.  Under the traditional method, B would not have a tax loss to accompany his book loss because the partnership has no tax loss to give him.  The remedial method, however, can manufacture a tax loss to allocate to B and the ceiling rule applies.  If this happens, a tax gain in an equal amount must be manufactured to allocate to A.  Thus, under the remedial method, A has not only a $2,000 hypothetical tax gain on the sale of the property but also A has a $2,000 hypothetical offsetting allocation of gain created by using the remedial method.  Thus, under the remedial method, since A would be allocated $4,000 of gain in the hypothetical sale, A will have a $4,000 share of the non-recourse liabilities under Treas. Reg. section 1.752-3(a)(2). Although a contributing partner may not look favorably on the prospect of being allocated notional items of income or gain under the remedial method during the partnership’s operating years, the remedial method does have the advantage of potentially increasing the contributing partner’s non-recourse liability share under Treas. Reg. section 1.752-3(a)(2). Traditional Method with Curative Allocations:  If the partnership were to use the traditional method with curative allocations, it would be able to make reasonable allocations to B to allow B to have a tax loss that more closely reflects his economic loss.  The hypothetical sale scenario, however, cannot shed light on what items the partnership might use for curative allocations.  Therefore, curative allocations are not taken into account in determining debt share under Treas. Reg. section 1.752-3(a)(2).  If the partnership used the traditional method with curative allocations, A would be allocated $2,000 of non-recourse liabilities for the Treas. Reg. section 1.752-3(a)(2) sharing layer. back to the top ISSUE:  “REVERSE” 704(c) – REVALUATIONS Consistent with the assignment of income doctrine, a new partner who pays a fair market value for a partnership interest should not be taxed on the built-in gain or loss that accrued in the partnership’s assets prior to the time of his arrival.  While IRC section 704(c) deals with newly contributed property, “reverse” IRC section 704(c) requires that the existing partners be taxed on the appreciation or depreciation that occurred prior to the admission of a new partner.  See Treas. Reg. section 1.704(a)(6). Assuming that the partnership is following the capital account maintenance rules, the entry of a new partner by contribution will ordinarily result in the restatement of the partnership’s book capital accounts to reflect the fair market value of partnership assets.  At this point, there will be a disparity between the book and tax capital accounts of the existing partners, analogous to the book/tax disparity of a partner who contributes property with a built-in gain or loss. All of the principles of IRC section 704(c) previously discussed are applied in this situation.  The difference from the prior examples is that it is the “existing partners” are in the same position as the “contributing partner” and the “new partner” is analogous to the “noncontributing partner”.  For example, the new partner will want to be allocated the amount of depreciation or amortization that he “paid” for; under the traditional method, the ceiling rule may prevent this. Examination Techniques Make a 3-year comparison of the balance sheet to identify newly contributed property. Review the partnership agreement not only for instances of contributed property, but also to ascertain what IRC section 704(c) allocation method is being used. Review appraisals of contributed property and decide in the beginning of the audit if an engineering referral should be made. Review the returns of all of the partners.  If the partnership is making remedial or curative allocations to the noncontributing partner, make sure that the contributing partner is picking up the offsetting allocations. Make sure that offsetting allocations are passed through to the contributing partner’s return. Issue Identification If intangibles have been contributed to the partnership, the examiner will want to review IRC section 197. If depreciable IRC section 704(c) property has been sold, the examiner should carefully review Treas. Reg. section 1.1245-1(e)(2)(iv) to calculate recapture.  Remedial and curative allocations can complicate the calculation of recapture. Check to see if the allocation method applied to a specific property is consistent from year to year Documents to Request Partnership Agreement Appraisals of contributed property Appraisal of value of partnership upon entry of a new partner Letter, memos, or minutes, or agreements pertaining to contributed property Schedule reflecting non-recourse liability sharing Interview Questions What property was contributed upon formation of the partnership? What property was contributed subsequent to formation? Have new partners entered this partnership?  If so, how was the purchase price determined? What IRC section 704(c) allocation method is in place? Supporting Law IRC section 704(c), IRC section 197, IRC section 1245, Treas. Reg. section 1.752 3 pertaining to the sharing of non-recourse liabilities and Revenue Ruling 95-41 Resources The Logic of Subchapter K, 2d Edition (2000), Laura E. Cunningham and Noel B. Cunningham Federal Income Taxation of Partners and Partnerships, Karen C. Burke Revenue Ruling 95-41: A Favorable Analysis for Allocating Partnership Non-recourse Debt, The Journal of Real Estate Taxation Allocation of Non-recourse Liabilities: IRS Takes Two Steps Forward, One Back, Journal of Taxation November 1995 Use and Abuse of Section 704(c), Laura E. Cunningham, 3 Fla. Taxation Revue 92 (1996) Blake Rubin and Andrea Macintosh, Exploring the Outer Limits of the Section 704(c) Partnership Built-in Gain Rule, Parts I, II, and III, 89 Journal of Taxation (September, October, and November 1998)

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