Tax Consequences of Precontribution Gain in a Partnership

When a partner contributes property to a partnership, the concept of precontribution gain comes into play. This is governed by Section 704(c) of the Internal Revenue Code and addresses the difference between the property’s fair market value and the partner’s tax basis at the time of contribution. The purpose of these rules is to prevent the tax consequences of this built-in gain from being shifted from the contributing partner to the other partners. It ensures the partner who brings the appreciated asset into the partnership is the one who will be taxed on that appreciation.

This principle applies to property contributions under Section 721, where gain or loss is generally not recognized upon the transfer. The rules create a special accounting requirement for the partnership to track this potential tax liability, linking the built-in gain to its original owner.

Identifying and Calculating Precontribution Gain

The calculation of precontribution gain is the amount by which the fair market value (FMV) of the contributed property exceeds the contributing partner’s adjusted tax basis at the moment of contribution. The FMV is what the property would sell for on the open market, while the adjusted tax basis is typically the partner’s original cost for the property, adjusted for factors like depreciation. This difference represents an unrealized gain the partner would have recognized if they had sold the property.

For example, a partner contributes a parcel of land to a partnership. The partner’s adjusted tax basis in the land is $50,000. At the time of contribution, the land has an FMV of $120,000. The precontribution gain is calculated as $120,000 (FMV) minus $50,000 (adjusted basis), resulting in a $70,000 built-in gain that must be tracked.

This calculation creates a disparity between the partnership’s accounting records, often called “book” value, and its tax records. For book purposes, the partnership will record the land at its $120,000 FMV. For tax purposes, the partnership inherits the partner’s $50,000 adjusted basis, a concept known as a carryover basis. This $70,000 difference between the book value and tax basis is the precontribution gain that is tracked over time and reduced as the partnership allocates related income or gain back to the contributing partner.

Tax Consequences Upon Sale of Contributed Property

The most direct consequence of precontribution gain occurs when the partnership sells the contributed property. When such a sale happens, the tax rules dictate a specific order for allocating the recognized gain. The gain from the sale must first be allocated to the contributing partner to the extent of their remaining precontribution gain.

Using the previous example, the partnership holds land with a book value of $120,000 and a tax basis of $50,000, with a $70,000 precontribution gain. Suppose the partnership later sells the land for $150,000. The total gain recognized for tax purposes is $100,000 ($150,000 sale price minus $50,000 tax basis).

The first $70,000 of the tax gain, equal to the original precontribution gain, must be allocated entirely to the contributing partner. The remaining $30,000 of gain represents the appreciation that occurred while the partnership owned the property. This post-contribution gain is allocated among all partners, including the contributing partner, according to the profit-sharing ratios in the partnership agreement. This allocation is a tax-only concept and does not necessarily affect the actual cash distributions to the partners, and the character of the gain is determined at the partnership level.

Tax Consequences of Property Distributions

The tax code contains anti-abuse rules to prevent partners from circumventing precontribution gain recognition through property distributions. These rules generally apply if certain distributions occur within seven years of the initial property contribution. They create scenarios where the precontribution gain can be triggered even without a sale of the asset to a third party.

One scenario involves the partnership distributing the contributed property to a partner other than the one who originally contributed it. If this distribution happens within the seven-year window, the contributing partner must recognize their remaining precontribution gain as if the partnership had sold the property for its fair market value. For instance, if the land from our example were distributed to another partner in year four, the original contributing partner would have to recognize their $70,000 precontribution gain. This gain recognition increases the contributing partner’s basis in their partnership interest.

A second scenario occurs when the partner who contributed the appreciated property receives a distribution of other property (excluding cash in many cases) from the partnership. Under Section 737, if this distribution happens within the seven-year period, the contributing partner must recognize gain. The amount of gain recognized is the lesser of their remaining precontribution gain or the excess of the fair market value of the distributed property over the partner’s basis in their partnership interest.

Imagine the contributing partner has a $70,000 precontribution gain and a tax basis in their partnership interest of $50,000. If, in year five, the partnership distributes a different property with a fair market value of $80,000 to them, they would recognize gain. The gain would be the lesser of the $70,000 precontribution gain or $30,000 (the excess of the $80,000 property value over their $50,000 basis), so the partner recognizes a $30,000 gain.

Allocation Methods for Precontribution Gain

Treasury regulations provide partnerships with three methods to allocate income, gain, loss, and deductions associated with contributed property. These methods address the book-tax disparity over time, which is important for depreciable assets. The choice of method can significantly alter the timing and amount of taxable income allocated to each partner.

The Traditional Method allocates tax depreciation to the non-contributing partners up to their share of the book depreciation. A limitation of this method is the “Ceiling Rule,” which states that the total tax depreciation the partnership can allocate is limited to the tax depreciation it actually generates. This can create economic distortions if the asset’s tax basis is too low to provide non-contributing partners with tax deductions equal to their share of economic depreciation.

The Traditional Method with Curative Allocations allows the partnership to make “curative” allocations of other income or deduction items to correct for distortions caused by the Ceiling Rule. For example, if a non-contributing partner is shortchanged on tax depreciation, the partnership can allocate extra taxable income to the contributing partner or extra tax deductions to the non-contributing partner from another source.

The Remedial Allocation Method allows the partnership to create notional tax items if the Ceiling Rule creates a disparity. The partnership creates a remedial tax deduction to allocate to the non-contributing partner and a corresponding remedial income item to allocate to the contributing partner. These allocations are purely for tax purposes and ensure that non-contributing partners receive tax deductions that match their share of the book depreciation.