The regulations under Sec. 704(b) provide a safe harbor under which the IRS will respect a partnership's allocations as having economic effect (Regs. Sec. 1.704-1(b)(2)(ii)(b)). The requirements of the safe harbor are that the partnership must maintain the partners' capital accounts in accordance with the Sec. 704(b) capital accounting rules, that upon liquidation, the partnership must make liquidating distributions in accordance with the partners' positive capital account balances, and that a partner is unconditionally obligated to restore a deficit capital account balance following a liquidation of the partner's partnership interest.
The capital account generally should reflect a partner's equity in the partnership. The Sec. 704(b) capital account maintenance rules require the partnership to credit a partner's capital account with the amount of cash or net fair market value (FMV) of property invested in the partnership. The capital account is further adjusted to reflect the partner's additional capital contributions, allocable shares of partnership income and loss, and any distributions of cash or other property. In addition, the capital account maintenance rules permit a partnership to revalue its assets and restate the partners' capital accounts to reflect each partner's economic share of the underlying assets at FMV, but only if the adjustments are made principally for a substantial nontax business purpose in connection with specific events. These events are commonly referred to as "revaluation events."
Regs. Sec. 1.704-1(b)(2)(iv)(f) permits a partnership to revalue its property in connection with: (1) contributions of money or property by a new or existing partner in exchange for a partnership interest; (2) distributions of money or property to a partner as consideration for a partnership interest; (3) the grant of a partnership interest in exchange for services; (4) the issuance of a noncompensatory option; and (5) under GAAP, if the partnership is a securities partnership (substantially all the assets of which are readily traded on an established securities market).
The enumerated revaluation events generally are considered to be events that change the economic entitlements of the partners. In other words, an adjustment to the capital accounts is warranted to "true up" the partners' capital accounts just prior to the change in economics by allocating to the partners any unrealized income, gain, loss, or deduction inherent in the partnership property that previously has not been reflected in the partners' capital accounts, based on their existing economic agreement. The Sec. 704(b) revaluation events also provide an objective mechanism for determining the current value of the partnership's assets.
Example: If a new partner contributes $10,000 for a one-third interest in the venture, and the parties are dealing at arm's length, the partnership assets should have an FMV of $30,000 immediately after the contribution, and it can be inferred that the assets had an FMV of $20,000 immediately before the new partner joined.
In this context, the FMV of the partnership assets corresponds to an objective determination of those values. Thus, another key consideration in whether a transaction should qualify as a revaluation event is whether the transaction is conducive to ascribing objectively verifiable FMVs to partnership assets. The revaluation of the partnership's assets must represent their true FMV, as would be negotiated at arm's length between unrelated parties.
When the IRS introduced the list of permissible revaluation events into the Sec. 704(b) regulations, the idea of a partnership revaluation was novel and viewed as potentially burdensome. Over time, the notion of revaluing partnership assets has become more prevalent, since valuing assets often is required for GAAP and other purposes, and the list of permissible revaluation events has grown. The IRS added issuance of partnership interests in exchange for services and the issuance of noncompensatory partnership options to the list in 2004 and 2013, respectively.
The IRS should consider expanding the list of revaluation events to include additional transactions that change the underlying economics of the partners' arrangement, if a reliable FMV for the revalued assets can be established in connection with them. In this regard, the IRS may wish to consider:
- A partner's sale of a significant partnership interest in an arm's-length transaction;
- A partnership recapitalization (adding this event was suggested in the proposed regulations under Sec. 751(b) (REG-151416-06) issued in 2014);
- A Sec. 1031 exchange of partnership property when the property exchanged represents substantially all the assets of the partnership; and
- In the context of tiered partnerships, requiring a lower-tier partnership to revalue its assets if an upper-tier partnership that holds a controlling interest (representing more than 50% of capital or profits) in the lower-tier partnership revalues its assets in connection with a revaluation event.
In addition, the IRS should consider expanding the current revaluation rule in Regs. Sec. 1.704-1(b)(2)(iv)(f)(5)(v)—which permits securities partnerships, substantially all the assets of which are readily tradable on established securities market, to revalue their property under GAAP—to include other partnerships whose assets may not be currently traded on an established exchange but which may have a reliable method for regularly adjusting the FMVs of their assets for GAAP purposes. Finally, the authors suggest that the IRS consider making some or all of the revaluation events mandatory under the Sec. 704(b) safe harbor.
While partners' capital accounts are not maintained in real time or systematically updated on a recurring basis to reflect changes in the underlying value of partnership property, revaluation events allow partnerships to adjust the partners' capital accounts to more accurately represent the partners' economic entitlements on the basis of current FMVs of partnership property. As stated above, an important consideration in identifying a proper revaluation event is whether the event will support the adjustments to the values of the partnership property based on arm's-length valuations. To the extent an event can establish a reliable FMV, it should be considered as a potential permissible or mandatory revaluation event, since a restated capital account adjusted to account for allocations of unrealized gain and loss items more accurately reflects the economic arrangement of the partners, based on the current FMV of the partnership's property. Thus, there may well be additional events beyond those listed above for which a revaluation based on objective factors establishing an FMV of the partnership assets is appropriate.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.