When a partner joins a partnership or limited liability company in exchange for a contribution of property—whether it’s land, inventory, intellectual property, securities, equipment, or anything other than cash—the Internal Revenue Code mandates special rules for allocating any gains or losses that are built into the property. Although the partnership operating agreement may call for equal allocations of all ordinary gains and losses, property contribution rules are substantially different. If there is a chance that anyone will be contributing property to your partnership, your operating agreement must contain provisions that comply with the Internal Revenue Code and Treasury Regulation guidelines on allocating built in gains and losses.

Section 704(c) of the Internal Revenue Code controls partnership allocations of built in gains and losses on contributed property. In a typical 704(c) transaction, a partner contributes an appreciated asset to a partnership—meaning the property appreciated in value after the partner purchased it, and the value was still appreciated at the time that the partner contributed the property to the partnership. Because of the appreciation, the partner’s tax basis—the purchase price adjusted for depreciation and amortization—is less than the fair market value. The partnership is interested in the value of the asset, not its tax basis, so the partnership will carry the property on its books at its fair market value. If the partnership were to turn around and sell the property immediately, it would recognize gain on the sale—measured as the difference between the sale price (fair market value) and the partner’s tax basis prior to contribution. To prevent the partnership from allocating these “built in gains” to non-contributing partners—particularly to low-tax-bracket partners—704(c) requires that all built in gains be allocated to the contributing partner.

For example, an incoming partner contributes a developed parcel of land to a partnership. The land has a tax basis of $1,000,000 and a fair market value of $1,500,000. The partnership records the property on its books at $1,500,000—its fair market value. The property has a tax basis of $1,000,000, and it has $500,000 of gain baked in upon contribution.

If the partnership sold the property right then, 704(c) would require the full $500,000 of gain to be allocated to the contributing partner. If the partnership held the property for a while before selling, and over that time the property appreciated further to $1,600,000, the partnership would allocate $500,000 to the contributing partner pursuant to 704(c). And the remaining $100,000 of gain would be allocated among all the partners as otherwise provided in the operating agreement. That’s because the additional $100,000 of gain accrued after contribution of the property. It was collective gain.

When the value of property declines after contribution, things get more complicated. If the contributed land declined in value to, let’s say, $1,300,000 before the partnership sold it off, $300,000 of taxable gain would be allocated to the contributing partner pursuant to 704(c). That is the remaining built-in gain. An additional $200,000 of book loss—because the property sold at a book loss of $200,000—would be allocated between the partners as provided in the operating agreement. At this point, the noncontributing partners would receive a book loss, but get no corresponding tax loss. That’s not a good deal for the noncontributing partner. And it is the policy of 704(c) is to avoid this outcome, called a book-tax disparity. Section 704(c) wants book and tax adjustments to match. There are several ways to fix the disparity. A full discussion of them is beyond the scope of this post. But perhaps the most common solution is to give the contributing partner a remedial tax allocation equal to the noncontributing partner’s share of the book loss, and give the noncontributing partner a corresponding tax loss.

In other words, if the partnership had just two partners with equal allocation rights, the $200,000 book loss would be allocated equally between them at $100,000 apiece. The noncontributing partner would be down $100,000 in book value, but not get any tax benefit out of the loss. To remedy the situation, the partnership would create an additional tax gain of $100,000 and allocate it to the contributing partner. It would then create a corresponding tax loss of $100,000 and allocate it to the noncontributing partner. At that point the contributing partner would have recognized taxable “built in gain” of $400,000, and the noncontributing partner would get a $100,000 tax and book loss. Assuming there was no other 704(c) property in the company, each partner’s book and tax capital accounts would be even.

The situation gets even more complicated if the contributed property is sold below both its fair market value and its tax basis. That is, if the partnership sold the property that was valued at $1,500,000 with a $1,000,000 tax basis for just $700,000. In that case—assuming again that there are two partners with equal allocation rights—the simplest approach would be to allocate the book loss evenly between the partners—$400,000 each—and allocate the entire $300,000 of tax loss to the noncontributing partner. Alternatively, under what is known as the “remedial method,” the partnership could allocate the full $300,000 of tax loss as well as an additional $100,000 of remedial tax loss to the noncontributing partner. This would give the noncontributing partner a full $400,000 of tax loss—equal to the partner’s one-half share of the $800,000 book loss on the drop from $1,500,000 to the sale price of $700,000. The contributing partner would receive an offsetting allocation of $100,000 in tax gain.