Partnership Stuffing Allocations: Some Further Thoughts
November 19, 2013
by Monte A. Jackel
I was fascinated this morning when I came across an article in Tax Notes Today by Andrew Needham, entitled The Problem With Stuffing Allocations. The basic premise of this very detailed and informative article is that stuffing allocations, a practice that is engaged in by varied funds investing heavily in securities, is not a valid allocation under the principles of sections 704(b) and 704(c) or any other provision of partnership tax law. For this purpose, stuffing allocations can be thought of as allocations to a retiring partner of tax gain to that partner so that the partner has no further gain or loss under section 731 on the liquidating distribution to that partner.
I have written previously both here and elsewhere that stuffing allocations do not have any economic consequences to the retiring partner as compared to a simple liquidating distribution and, as a result, some questions exist today about the viability of stuffing allocations. The retiring partner will, in either case, have the same amount of gain under either section 704 or 731 and will receive the same amount of cash or property in either case.
The Needham article enumerates and then refutes various arguments that have been made by others in support of stuffing allocations; namely, (1) that stuffing allocations complement securities partnerships and their use of the aggregation method permitted under Treasury regulation section 1.704-3(e)(3); (2) the value equals basis presumption precludes any attack on the validity of stuffing allocations; (3) stuffing allocations are a proxy for a section 754 election; (4) stuffing allocations achieve the same result as a tax free distribution of securities to the retiring partner; and (5) stuffing allocations do not have any detrimental effect on the fisc. The Needham article refutes these arguments this way:
1. It is not the purpose of section 704(c) to eliminate inside/outside basis disparities for the benefit of the continuing partners and this is what occurs with a stuffing allocation. Rather, a section 754 election is what is required in such a case.
2. The value equals basis rule is only a presumption and does not override compliance with section 704(c) principles.
3. The stuffing allocation is in most cases more beneficial than a section 754 election because the tax effect of a stuffing allocation is always immediate as compared with a section 754 election, where it may take years for a basis step-up to be recovered by the partnership.
4. The mere fact that an income allocation happens to produce the same tax result as a distribution of securities in kind does not make the allocation valid because a distribution is a different transaction than an allocation.
5. The main reason for undertaking stuffing allocations is to reduce the tax liability of the continuing partners following the withdrawal of a partner.
It is quite clear from the Needham article that the author of that article does not believe that stuffing allocations are consistent with the principles of section 704(c). However, although the author cites example 14 of Treasury Regulation section 1.704-1(b)(5) in three separate footnotes (notes 50, 64 and 83), the article does not analyze the implications of a specific subpart of that example as it relates to a securities partnership using an aggregation method under Treasury regulation section 1.704-3(e)(3).
The pertinent provisions that I would like to focus on here are subparts (i), (vi) and (vii) of example 14 of Treasury regulation section 1.704-1(b)(5). I have reproduced the text of those provisions in the Appendix at the end of this article. It is clear from these provisions that, in the case of a partnership that does not aggregate gains and losses from securities under Treasury regulation section 1.704-3(e)(3), the reverse section 704(c) gain in subpart (vii) of example 14 belonging to the redeemed partner ceases to be section 704(c) gain and is allocated to the continuing partners based on the partners’ interest in the partnership rule of Treasury regulation section 1.704-1(b)(3). In that example, the allocation under PIP was pro rata. The reverse section 704(c) gain of the other partner who continues in the partnership continues to be allocable to that partner when it is realized by the partnership.
In the case of a partnership that aggregates securities gains and losses under Treasury regulation section 1.704-3(e)(3), the tax gains and tax losses are allocated among the partners so as to reduce the book-tax disparities of the partners. As the Needham article points out, none of the examples under Treasury Regulation section 1.704-3(e)(3) illustrates what happens when one or more partners retire from the partnership. However, under the literal text of this particular regulation, tax gains in the year of the retirement of a partner would be allocated to reduce the book-tax disparities of all of the partners and tax gains and tax losses in periods following the retirement of a partner would also be required to be allocated so as to reduce the book-tax disparity of the partners which, in the latter case, could only be the continuing partners.
Thus, the required allocation when a partnership aggregates securities is to allocate the tax gains and tax losses so as to reduce the book-tax disparity of the continuing partners in periods following the retirement of a partner. This treatment appears to conflict with part (vii) of Treasury regulation section 1.704-1(b)(5), example 14, where the post-retirement reverse section 704(c) gain is first traced to any continuing reverse section 704(c) partners and any unallocated gain is then allocated under PIP. Since PIP can clearly be different than an allocation based on the book-tax disparities of the partners, there appears to be a conflict between these two sets of regulations in the case of a partnership that aggregates securities gains and losses.
This is not to say that stuffing allocations are a “slam dunk” in terms of being valid under current law. Nor am I saying that the converse is true, based on the regulations as they exist today. My point here is that the resolution of the issue under the regulations as they exist today is not, in my view, as clearcut as the Needham article would lead the reader to believe. Clearly, this is an area where the government should step in and issue guidance to clarify the area. Leaving things as they exist today would not be either wise or good tax policy.
(i) MC and RW form a general partnership to which each contributes $10,000. The $20,000 is invested in securities of Ventureco (which are not readily tradable on an established securities market). In each of the partnership’s taxable years, it recognizes operating income equal to its operating deductions (excluding gain or loss from the sale of securities). The partnership agreement provides that the partners’ capital accounts will be determined and maintained in accordance with paragraph (b)(2)(iv) of this section, distributions in liquidation of the partnership (or any partner’s interest) will be made in accordance with the partners’ positive capital account balances, and any partner with a deficit balance in his capital account following the liquidation of his interest must restore that deficit to the partnership (as set forth in paragraphs (b)(2)(ii)(b)(2) and (3) of this section). The partnership uses the interim closing of the books method for purposes of section 706. Assume that the Ventureco securities subsequently appreciate in value to $50,000. At that time SK makes a $25,000 cash contribution to the partnership (thereby acquiring a one-third interest in the partnership), and the $25,000 is placed in a bank account. Upon SK’s admission to the partnership, the capital accounts of MC and RW (which were $10,000 each prior to SK’s admission) are, in accordance with paragraph (b)(2)(iv)(f) of this section, adjusted upward (to $25,000 each) to reflect their shares of the unrealized appreciation in the Ventureco securities that occurred before SK was admitted to the partnership. Immediately after SK’s admission to the partnership, the securities are sold for their $50,000 fair market value, resulting in taxable gain of $30,000 ($50,000 less $20,000 adjusted tax basis) and no book gain or loss. An allocation of the $30,000 taxable gain cannot have economic effect since it cannot properly be reflected in the partners’ book capital accounts. Under paragraph (b)(2)(iv)(f) of this section and the special partners’ interests in the partnership rule contained in paragraph (b)(4)(i) of this section, unless the partnership agreement provides that the $30,000 taxable gain will, in accordance with section 704(c) principles, be shared $15,000 to MC and $15,000 to RW, the partners’ capital accounts will not be considered maintained in accordance with paragraph (b)(2)(iv) of this section.
….(vi) Assume the same facts as in (i) except that the partnership does not sell the Ventureco securities. During the next 3 years the fair market value of the Ventureco securities remains at $50,000, and the partnership engages in no other investment activities. Thus, at the end of that period the balance sheet of the partnership and the partners’ capital accounts are the same as they were at the beginning of such period. At the end of the 3 years, MC’s interest in the partnership is liquidated for the $25,000 cash held by the partnership. Assume the distribution does not give rise to a transaction described in section 707(a)(2)(B). Assume further that the partnership has a section 754 election in effect for the taxable year during which such liquidation occurs. Under sections 734(b) and 755 the partnership increases the basis of the Ventureco securities by the $15,000 basis adjustment (the excess of $25,000 over the $10,000 adjusted tax basis of MC’s partnership interest).
(vii) Assume the same facts as in (vi) except that the partnership has no section 754 election in effect for the taxable year during which such liquidation occurs….Following the liquidation of MC’s interest in the partnership, the Ventureco securities are sold for their $50,000 fair market value, resulting in no book gain or loss but a $30,000 taxable gain. An allocation of this $30,000 taxable gain cannot have economic effect since it cannot properly be reflected in the partners’ book capital accounts. Under paragraph (b)(2)(iv)(f) of this section and the special partners’ interests in the partnership rule contained in paragraph (b)(4)(i) of this section, unless the partnership agreement provides that $15,000 of such taxable gain will, in accordance with section 704(c) principles, be included in RW’s distributive share, the partners’ capital accounts will not be considered maintained in accordance with paragraph (b)(2)(iv) of this section. The remaining $15,000 of such gain will, under paragraph (b)(3) of this section, be shared equally between RW and SK.