704(c) Curative Allocations Explained
E and F form partnership EF and agree that each will be allocated a 50 percent share of all partnership items, with EF making section 704(c) allocations using the traditional method with curative allocations. E contributes equipment with an adjusted tax basis of 4,000 and a book value of 10,000, giving E a section 704(c) built-in gain of 6,000; the equipment has 10 years remaining and is depreciated straight-line. F contributes 10,000 of cash, which EF uses to buy inventory that it sells in year one for a 700 gain of income.
Under the traditional method of paragraph (b), each partner would be allocated 350 of book and tax sales income and 500 of book depreciation, and the 400 of available tax depreciation would all be allocated to F. Because of the ceiling rule, F ends the first year with book capital of 9,850 but tax capital of 9,950 — a 100 disparity between F’s book and tax accounts.
Because the anticipated inventory income has substantially the same effect on the partners’ tax liabilities as income from E’s contributed equipment, EF may make a reasonable curative allocation under paragraph (c): it allocates E an additional 100 of tax sales income (450 to E, 250 to F), eliminating the 100 disparity so both partners close at 9,850 of tax capital. By contrast, allocating all of the tax sales income to E (700 to E, 0 to F) is unreasonable under paragraph (c)(3)(i) because the allocation exceeds the amount necessary to offset the disparity caused by the ceiling rule.
