§704(c): separate the gain that arrived from the gain earned together

Equal value does not mean equal tax basis

A contributes land with a $40,000 adjusted tax basis and $100,000 fair market value. B contributes $100,000 cash. Each supplied $100,000 of economic value, but the partnership did not pay $100,000 for A’s land. In a simple nonrecognition contribution without liabilities or special rules, the land retains its $40,000 inside tax basis. A’s initial outside basis is $40,000; B’s is $100,000.

For this illustration, §704(b) book capital begins at $100,000 for each partner. The $60,000 difference between the land’s value and tax basis is precontribution built-in gain. It is a timing and allocation problem, not a second asset or immediate cash payment. Write three numbers beside the land: tax basis $40,000, book value $100,000, built-in gain $60,000.

Draw the layers before allocating the sale

If the land is sold for $130,000, tax gain is $90,000: proceeds minus the $40,000 tax basis. Book gain is only $30,000: proceeds minus the $100,000 book value. The gains measure change from different starting points. Their $60,000 difference equals the built-in gain recorded at contribution.

Under the simple traditional-method example below, the original $60,000 gain stays with A. The partners share the subsequent $30,000 appreciation equally under the assumed valid economic arrangement. A receives $75,000 of tax gain and B $15,000. Allocating $45,000 to each instead would give B $30,000 of tax gain attributable to appreciation that existed before B joined the investment.

A useful layer diagram has a tax-basis floor at $40,000, a contribution-value line at $100,000, and a sale-price line at $130,000. The lower $60,000 layer belongs to the precontribution story; the upper $30,000 layer belongs to the joint-investment story. This explains the stated facts, not every form of §704(c) property.

Reconcile the sale to both sets of balances

Do not stop when the gain allocations add to $90,000. Add the tax allocations to outside basis: A reaches $115,000 and B reaches $115,000. Add the $15,000 book gain to each $100,000 book capital account: each also reaches $115,000. Meanwhile, the partnership holds $230,000 cash: B’s original $100,000 plus $130,000 sale proceeds. Every route reaches the same total.

This explains why equal economics can coexist with unequal taxable income. A started with a lower tax investment; the larger tax allocation catches up that historic difference. If all $230,000 cash were then distributed equally in this tightly bounded example, each would receive $115,000 against $115,000 outside basis. Debt, other assets, special distributions, or additional tax items require a fresh analysis.

Change one fact: the ceiling rule becomes visible

Now sell the land for $90,000 instead. There is a $50,000 tax gain but a $10,000 book loss. Equal book sharing gives each partner a $5,000 book loss. Under the traditional method, no actual tax loss from this sale exists to match B’s book loss. The ceiling rule limits allocations to the tax items the partnership actually has. All $50,000 tax gain goes to A in this example; B receives no tax gain or loss from the sale.

The mismatch is measurable: A’s tax basis becomes $90,000 and book capital $95,000; B’s tax basis remains $100,000 and book capital becomes $95,000. Both totals equal $190,000 cash, but each partner has a $5,000 book/tax disparity. A layer diagram cannot make this method-dependent issue disappear. Here the shortcut “give all historic gain to A and split the rest” no longer completes the analysis.

Methods and the boundaries of this lesson

Section 1.704-3 describes traditional, traditional-with-curative-allocations, and remedial methods. Curative allocations use appropriate actual tax items to address specified ceiling-rule distortions. Remedial allocations can create offsetting notional tax items within the regulatory system. The methods are not interchangeable labels; reasonableness and consistent application matter. This lesson identifies their purpose but does not calculate them.

Land keeps the example focused because no depreciation schedule is needed. Depreciable property adds annual cost-recovery differences. Built-in-loss property has a separate statutory restriction, and revaluations can create reverse-§704(c) layers. Distributions of contributed property and transfers of interests introduce other rules. Track contribution date, tax basis, book value, method, and subsequent adjustments for each asset instead of combining all assets into an unexplained gain bucket.