Contributions of Property to a Partnership—The Value of Understanding the Rules
The Tax Court, in its opinion in Foxman case, 41 T.C. 535, 551 (1964), gave its view on the complexity of the taxation of partnerships (which is found in Subchapter K of the Internal Revenue Code). It wrote, “The distressingly complex and confusing nature of the provisions of subchapter K present a formidable obstacle to the comprehension of these provisions without the expenditure of a disproportionate amount of time and effort even by one who is sophisticated in tax matters with many years of experience in the tax field. Its most complex provisions may confidently be dealt with by at most only a comparatively small number of specialists who have been initiated into its mysteries.”
One of the more difficult provisions of the taxation of partners and partnerships found in Subchapter K of the Code deals with partnership allocations that relate to certain property that has been contributed to a partnership. Clearly, when the rules are applicable, those partners (or their tax advisors) who understand these rules are at a distinct financial advantage as compared to those who are ignorant of them.
These rules apply whenever a partner contributes property to a partnership that either has a fair market value in excess of tax basis (i.e., appreciated property) or fair market value that is less than tax basis (depreciated property). It should be pointed out that these rules equally apply to limited liability companies that are treated as partnership for tax purposes (the vast majority of LLCs that are owned by more than one person are partnerships for tax purposes).
In addition, the rules can apply when a partner either contributes property to a partnership for an interest, or its interest is redeemed for property, at a time when the partnership owns either appreciated or depreciated property.
The purpose behind the rules is to prevent the tax gain (or loss) that is inherent in the contributed property from being shifted away from the contributor to the other partners. Under the rules, the inherent gain or loss must, as best as possible, be allocated back to the contributing partner as soon as possible. This is accomplished by making a special allocation when the contributed property is sold or, if it’s subject to depreciation or amortization, making special allocations of the tax depreciation or amortization so as cause the contributor to recognize the inherent gain or loss over the life of the asset.
The tax regulations give three methods of applying these rules. Each one can have a dramatic financial impact on the partners depending upon whether or not they are the property contributor. It is very important to point out that these allocations only impact the tax liabilities of the partners. They do not affect any partner’s economic share of the partnership. Thus, understanding these rules and being able to “crunch the numbers” up front can be tremendously valuable in evaluating which of the methods is the most beneficial.