Special Allocations and §704(c)

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Under §704(a) the partnership agreement controls each partner’s share of income, gain, loss, deduction and credit. Under §704(b) an allocation that lacks substantial economic effect is disregarded and the item is reallocated according to the partners’ interests in the partnership, judged on all the facts (the Reg. §1.704-1(b)(3)(ii) factors on the Partnership Defined page). A pro rata allocation needs no analysis. The moment an agreement says “depreciation shall be allocated 90% to A,” this page applies.

Step 1: Economic Effect

Reg. §1.704-1(b)(2)(ii)(b). An allocation has economic effect if, and only if, throughout the partnership’s term the agreement requires all three:

1. Capital accounts determined and maintained under the rules in Step 3;
2. Liquidating distributions made in accordance with positive capital account balances; and
3. A deficit restoration obligation (“DRO”): a partner with a negative capital account after liquidation of the interest must unconditionally restore it, by the end of the tax year or within 90 days of liquidation if later.

The logic: a partner who receives a deduction must bear the economic loss it represents. If the deduction reduces his capital account, liquidation follows capital accounts, and he must make up any deficit, then he really did bear it. Read the agreement for those three clauses before honoring any allocation that is not pro rata.

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Step 2: The Alternate Test

Reg. §1.704-1(b)(2)(ii)(d). Most LLC members will not sign an unlimited DRO.

Without a DRO, allocations still have economic effect to the extent they do not create or increase a deficit capital account beyond what the partner is obligated to restore (including notes contributed and unconditional future contribution obligations, Reg. §1.704-1(b)(2)(ii)(c)) — provided the agreement contains a qualified income offset: a clause that if a partner unexpectedly receives an adjustment, allocation or distribution that drives his capital account negative, he is allocated income and gain as quickly as possible to eliminate the deficit. Allocations of nonrecourse deductions are governed by the separate rules of Reg. §1.704-2 (minimum gain chargeback), which the Operations page touches.

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Step 3: Capital Account Maintenance

Reg. §1.704-1(b)(2)(iv). These are book capital accounts at fair market value, not tax basis.

• Increase for money contributed, the fair market value of property contributed (net of liabilities the partnership assumes), and the partner’s distributive share of income and gain, including tax-exempt income.
• Decrease for money distributed, the fair market value of property distributed (net of liabilities assumed by the partner), and the partner’s share of loss and deduction, including nondeductible expenses.
• Revaluations (“book-ups”) are permitted on contributions, distributions and the grant of interests for services (Reg. §1.704-1(b)(2)(iv)(f)).
• Capital accounts may be negative. They are not the same as outside basis (no liabilities in them) and not the same as the tax-basis capital reported on Schedule K-1 Item L since 2020, which is a third number.

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Step 4: Substantiality

Reg. §1.704-1(b)(2)(iii). Economic effect is substantial if there is a reasonable possibility the allocation will substantially affect the dollar amounts the partners receive, independent of tax consequences.

It is not substantial if, when the allocation goes into the agreement, (1) the after-tax economic consequences of at least one partner may be enhanced, and (2) there is a strong likelihood that no partner’s after-tax consequences will be substantially diminished. Two named failures: shifting allocations (allocations in the same year that leave capital accounts where they would have been but lower total tax) and transitory allocations (an allocation offset by another within five years with the same result). The test looks at the partners’ tax situations — brackets, NOLs, exempt status — as they stand when the allocation is adopted.

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Step 5: The Two Regulation Examples

Reg. §1.704-1(b)(5), Example 1 — Anne and Bob. Each contributes $40,000. The agreement allocates all cost recovery deductions to Anne, but liquidation is 50/50 regardless of capital accounts and there is no deficit restoration. The allocation lacks economic effect: Anne does not bear the economic loss the deduction represents, because on liquidation she gets half regardless. Reallocated 50/50 under the partners’ interests. Fix: liquidate by capital accounts and add a DRO or a qualified income offset.

Example 5 — the tax-exempt interest. Proper capital accounts and a DRO, but the agreement allocates 80% of the tax-exempt interest to the partner in the top bracket and 100% of the taxable interest to the partner in the 15% bracket, with the amounts chosen so each partner’s capital account comes out about where a 50/50 allocation would have put it. Economic effect, yes; substantial, no — one partner’s after-tax position improves and nobody’s gets worse. Reallocated.

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Step 6: Targeted Allocations

Not in the course; added because it is what the agreements on our desks say. (check)

Most LLC agreements drafted in the last twenty years do not use the three clauses of Step 1. They provide instead that liquidating distributions follow a waterfall (return of capital, then a preferred return, then a split), and that income and loss are allocated each year in whatever amounts are necessary to make each member’s capital account equal what that member would receive if the partnership sold everything at book value and liquidated under the waterfall — “targeted” or “forced” allocations. These do not meet the literal economic-effect test (liquidation does not follow capital accounts; the capital accounts follow the liquidation), and the IRS has not issued regulations on them, but they are generally understood to allocate in accordance with the partners’ interests in the partnership, which is the §704(b) fallback anyway. For the desk: compute the hypothetical liquidation at year end, allocate to hit the targets, and keep the computation. Software does not do this for you.

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Step 7: §704(c) — Contributed Property

The partnership takes the contributor’s basis (§723) but books the property at fair market value. The difference is the contributor’s problem.

• Built-in gain property (FMV over basis at contribution): on a later sale, the precontribution gain is allocated to the contributing partner; only post-contribution appreciation is shared under the agreement (§704(c)(1)(A)). Sam contributes land, basis $10,000, FMV $32,000; the partnership sells it for $35,000: $22,000 to Sam, the other $3,000 split by the agreement. (The course exam keys all $25,000 to Sam; that is wrong.)
• Built-in loss property (basis over FMV): the loss is allocated only to the contributing partner, and for everyone else the partnership’s basis is treated as FMV at contribution (§704(c)(1)(C)). If the contributor leaves, the loss leaves with him; the other partners never get it.
• Character carries over for five years: inventory stays ordinary, a capital asset with a built-in loss stays capital (§724).
• The seven-year rules: if the contributed property is distributed to another partner within seven years, the contributor recognizes the remaining built-in gain (§704(c)(1)(B)); if the contributor receives other property within seven years, he recognizes the lesser of the remaining built-in gain or the excess of the property’s value over his outside basis (§737). Both are on the Distributions and Basis pages.

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Step 8: Depreciable §704(c) Property

Reg. §1.704-3. Book depreciation is on FMV; tax depreciation is on the carryover basis. The methods decide who gets the shortfall.

• Traditional method: tax depreciation goes first to the noncontributing partners, up to their share of book depreciation; the contributor gets what is left. The ceiling rule limits the allocation to the tax depreciation that actually exists, so the noncontributors can come up short.
• Traditional with curative allocations: the shortfall is cured with allocations of other tax items of the same character.
• Remedial method: the partnership creates offsetting notional items — extra deduction to the noncontributors, matching income to the contributor — so the ceiling rule never bites.

The method is chosen property by property and must be reasonable; it is usually fixed in the agreement. Worked (Reg. §1.737-1(e)): Fred contributes Property F, basis $20,000, FMV $30,000, ten-year straight line; Greg contributes land worth $30,000; Hal contributes $30,000 cash; equal thirds. Book depreciation $3,000 a year, $1,000 each; tax depreciation $2,000 a year, all to Greg and Hal under the traditional method. After three years Property F has a book value of $21,000 and a tax basis of $14,000, so Fred’s remaining built-in gain is $7,000, down from $10,000. If Greg’s land is then distributed to Fred in liquidation when Fred’s outside basis is $20,000, the §737 gain is the lesser of the $10,000 excess distribution or the $7,000 remaining built-in gain: $7,000. The lesson: the §737 and §704(c)(1)(B) amounts are the remaining book-tax gap, which depreciation shrinks.

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Step 9: Reporting

• General allocation percentages and any specially allocated item are disclosed on Schedule K and each K-1; a special allocation that does not follow the general ratios is shown separately with a statement.
• K-1 Item M: did the partner contribute property with a built-in gain or loss? If yes, attach a statement with the property, the contribution date and the built-in amount.
• K-1 Item N: the partner’s share of net unrecognized §704(c) gain or loss at the beginning and end of the year.
• K-1 Item L: tax-basis capital, which is neither the §704(b) book capital account nor outside basis. Keep all three.
• Schedule B asks whether the partnership is a §721(c) partnership (a U.S. contributor of built-in-gain property with a related foreign partner and 80% related ownership); if so, the gain-deferral method of Reg. §1.721(c)-3 or immediate gain recognition.

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Questions at the desk

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Written for the Tax Shop desk from my continuing-education course notes; figures are for the 2026 tax year unless stated. Items marked (verify) are to be confirmed against primary sources before they are relied on. Private reference, not client advice.