Immediately after the purchase, Partner A and Partner B form a new partnership (an upper-tier partnership, or UTP) with Partner A contributing its LTP interest and Partner B contributing $50 of cash, each in exchange for a 50% interest in the UTP.
Under this fact pattern, several questions emerge. First, how should Sec. 704(c) affect the UTP's income allocations? Second, how should the Sec. 743(b) adjustment be allocated at the UTP, and what effect, if any, should it have on the Sec. 704(c) allocations?
Sec. 704(c) allocations
At the LTP, the Sec. 704(c) allocations and the Sec. 743(b) deductions are straightforward. Each year, the LTP's depreciable property generates $20 of Sec. 704(b) deductions and $2 of tax deductions. As shown in the table, "LTP's Capital Accounts," below, each partner is allocated $10 (50%) of Sec. 704(b) deductions and $1 of tax deductions. The UTPalso receives $9 of Sec. 743(b) deductions ($45 ÷ 5 years = $9 per year), which offsets its share of the built-in gain.
At the UTP, the Sec. 704(c) allocations and interplay with the Sec. 743(b) deduction become less clear. In a tiered partnership context, Regs. Sec. 1.704-3(a)(9)states:
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.
Under these facts, it appears clear that the LTP has contributed forward Sec. 704(c) property that must be traced back to Partner A at the UTP level. Disregarding the Sec. 743(b) deductions for a moment, each year, Partner A and Partner B would each receive $5 (50%) of the Sec. 704(b) deductions associated with the forward Sec. 704(c) property, and Partner B, as the non-Sec. 704(c) partner, would receive $1 (100%) of the tax deductions. The next question is how the Sec. 743(b) deductions should be allocated between the UTP's partners.
Sec. 743(b) deductions
Regs. Sec. 1.743-1(h)(1) provides guidance on how to treat contributions of property to an LTP that has Sec. 743(b) basis adjustments and outlines that when a partnership (the upper tier) contributes to another partnership (the lower tier) property to which a basis adjustment has been made, the basis adjustment is also treated as contributed to the lower-tier partnership. However, the lower tier's basis in its assets attributable to the basis adjustment must be segregated and allocated solely to the upper tier and the transferee.
However, this rule does not apply to the fact pattern at hand, since the contributed LTP interest is not the adjusted property; instead, the adjusted property is the depreciable asset held by the LTP. Another regulatory provision must be applied.
Regs. Sec. 1.743-1(f) indicates that if a partner has a Sec. 743(b) basis adjustment associated with its partnership interest and then subsequently transfers that partnership interest, the transferor's Sec. 743(b) basis adjustment is determined without regard to the original Sec. 743(b) basis adjustment. More clearly stated, the original Sec. 743(b) basis adjustment associated with the partnership interest goes away, and a new Sec. 743(b) basis adjustment is calculated for the new partner. Applying this rule to the facts at hand, Partner A's Sec. 743(b) basis adjustment in the LTP goes away, and the UTP has a new Sec. 743(b) basis adjustment in the LTP. Because of this, the Sec. 743(b) basis adjustment at the LTP becomes common tax basis at the UTP.
At least two possible approaches can be used to treat the allocations in this situation. Under a literal reading of the rules outlined in Regs. Secs. 1.704-3 and 1.743-1, one approach would view the UTP's Sec. 743(b) deductions separately from its Sec. 704(c) allocations. This approach would compute the UTP's Sec. 704(c) allocations according to Regs. Sec. 1.704-3(a)(9) but would allocate the UTP's Sec. 743(b) deductions between the partners according to their sharing ratios. As shown in the table "UTP's Capital Accounts: Sec. 743(b) Deductions Allocated According to Partners' Sharing Ratios," below, this methodology results in distorted capital accounts because Partner B's share of the Sec. 743(b) deductions exceeds its ceiling limit amount.
Another approach would view the UTP's Sec. 743(b) deduction as part of its Sec. 704(c) allocations. Under this perspective, the Sec. 743(b) deductions would be treated as tax deductions from Sec. 704(c) property and allocated according to Sec. 704(c). As shown in the table "UTP's Capital Accounts: Sec. 743(b) Deductions Allocated to Partner B," below, this methodology allocates an amount of Sec. 743(b) deductions to Partner B that cures its ceiling limit. This corrects the capital account distortions created under the first approach.
Planning to avoid traps
As illustrated above, the tiered partnership rules under Secs. 704(c) and 743(b) can cause a trap for the unwary — a taxpayer who pays the full FMV for a partnership interest that has forward Sec. 704(c) property associated with it and who subsequently contributes it to another partnership may not receive the expected tax deductions. To avoid this result, taxpayers should consider structuring around the issue. For example, if at the time the LTP interest is acquired, it is known that the LTP interest will be contributed to a UTP, the UTP could be formed first, and it then could acquire the LTP interest.
EditorNotes
Annette B. 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 annette.smith@pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
