Partnership Tax Allocations under Sections 704(b) and 704(c)

Author: James R. Hamill

Per the IRS Education Provider Standards this course must be COMPLETED by 12/31/2028 to receive credits. NOTE: Go to My Professional Profile in your CCH CPELink account settings to ensure your name, and PTIN number; matches your PTIN card

One of the key advantages of the partnership form is the flexibility provided by use of the so-called “aggregate” approach. One aspect of the aggregate approach is the ability to allocate items of income and loss by agreement. In effect the statute treats the income or loss as belonging to the partners rather than to the partnership, so it is then natural for the partners to decide how to allocate those items.

There are several restrictions imposed on the ability to allocate by agreement. First any agreement must have substantial economic effect. Second, an agreement may not apply to certain items of built-in gain or loss arising from contributions to the partnership or from admittance of a new partner.

Section 704(a) is the general rule allowing allocations by agreement. Section 704(b) limits agreed-to allocations to those with substantial economic effect. Section 704(c) governs allocations of built-in gains and losses. This course will cover all three of these provisions.

Section 704(b) has very detailed regulations to protect the integrity of agreed-to allocations. These regulations contain various safe harbor provisions that may be included in a partnership agreement. Allocations that follow one or more of these safe harbors may be called regulatory allocations.

More recently many partnerships have opted for allocations that follow hypothetical distributions as if the partnership liquidated at the end of each year. These are called “target” allocations and do not follow any safe harbor language found in the regulations. Whether regulatory allocations or target allocations are used, built-in gains and losses must nonetheless be allocated using the principles of Section 704(c). It is not a matter of Section 704(c) overriding the agreed-to allocations, instead the provisions deal with different issues.

This two-hour CPE course with nationally recognized tax expert and instructor James Hamill, CPA, Ph.D. will explain how to allocate items by agreement, whether that is done with regulatory or target allocations, and when Section 704(c) will otherwise apply to allocations involving items of built-in gain or loss.

Publication Date: April 2025

Topics Covered

• The general rule of Section 704(a)
• Allocations when interests vary during the year
• How to establish that allocations have economic effect
• What is meant by substantiality
• How target allocations differ from regulatory allocations
• The distinction between recourse and nonrecourse deductions
• How to maintain capital accounts to protect allocation clauses
• Use of tax and book basis capital to track and make Section 704(c) allocations
• Reporting unrecognized Section 704(c) gains and losses on a K-1 form
• Special tax issues that may need to be addressed

Learning Objectives

• Identify the general rules for partnership allocations
• Determine when partners may agree to special allocations
• Identify language used to protect agreed-to allocations
• Identify "target" allocations
• Determine gains and losses subject to Section 704(c) allocations
• Explain when Section 704(a) applies and when Section 704(c) applies to allocations
• Explain how the use of "book" and "tax" capital can help properly make partnership allocation decisions
• Identify the number of negative tests related to insubstantiality
• Identify the number of safe harbors for target allocations
• Identify the first step in the targeted allocation approach

Level
Intermediate

Instructional Method
Self-Study

NASBA Field of Study
Taxes (2 hours)

Program Prerequisites
Basic understanding of partnership tax allocations.

Advance Preparation
None