Use and Abuse of Section 704(c)

Abstract

It is basic to income taxation that each taxpayer should be taxed on his or her economic income and that only taxpayers who suffer economic losses should derive tax benefits therefrom. While these tenets are easily stated, they are difficult to enforce, particularly in the partnership setting where lines between the economic interests of partners are often blurred. The substantial economic effect rules of section 704(b) strive mightily to constrain partners' ability to shift income and losses in a manner inconsistent with the partners' economic arrangement. Nevertheless, when a partner contributes property to a partnership, the possibility exists that some of the gain or loss inherent in that property may be shifted from the contributor to the other partners. No gain or loss is recognized at the time of the contribution, and the partnership, as new owner of the property, takes the contributor's basis. Thus, upon any subsequent sale of the property, the gain or loss, including gain or loss inherent in the property when contributed, is generally treated as that of the partnership entity and, absent a special rule, would be divided amongst the partners.
This shifting of gain or loss was tolerated before 1984. Under section 704(c), partners were permitted to agree that the subsequent gain or loss would be reported by the contributing partner, but this treatment was never mandatory. Moreover, the regulations under section 704(c) contained rules constraining that agreement, the most significant of which came to be known as the "ceiling rule," providing that the gain or loss allocated to the contributing partner could not exceed the partnership's entire gain or loss on the sale. When the ceiling rule applied, precontribution gain or loss was effectively shifted to the noncontributing partners in spite of the partners' agreement to the contrary.