What You Need To Know About IRC Section 704

Posted by admin on Nov 19, 2019 4:42:00 PM

In this post, we will discuss the rules and mechanics of alternative investment fund tax allocations.  Most alternative investment vehicles are structured as partnerships. Therefore, Subchapter K of the Internal Revenue Code (“IRC”), specifically IRC Section 704, provides the guidance and rules for tax allocations.

Throughout this post, I will make reference to “securities partnerships." The regulations define a securities partnership as a partnership in which at least 90% of the non-cash assets that constitute personal property (including stock and securities) are actively traded, and the partnership reasonably expects to perform a revaluation at least annually.  In practice, most hedge funds easily meet both these requirements. As such, they are subject to some special exceptions that will be discussed in depth throughout this post.

SECTION 704(b)

In general, the IRS allows for the partnership agreement to dictate the tax allocations. Sectionoffice buildings 704(b) and the corresponding regulations, however, require that, to be respected by the IRS, the allocations must have substantial economic effect.  This concept can be broken up into two parts.

Economic effect means that the “economic burden or benefit” that results from an allocation must be borne by the partner who received that allocation.  Economic effect is deemed to be achieved if the partnership agreement provides for the following:

  • Partner capital accounts are determined and maintained in accordance with regulations (discussed below)
  • Upon liquidation of the partnership, liquidating distributions are required to be made in accordance with each partner's positive capital account balance
  • Partners are required to restore a deficit balance in their capital account

Determining and maintaining capital accounts, ensuring capital account deficits are restored, and determining liquidation proceeds based on the capital account balance ensures that the allocations will have economic effect because the allocations ultimately will determine the proceeds each partner receives upon liquidating their respective partnership interest.

Substantial in this context is referring to the ability to shift tax consequences between the various partners.  Allocations will not be considered “substantial” if the “economic effect” of the allocation results in a situation where the shifting of tax consequences between partners results in a net tax decrease of one partner that is not offset by a net increase of another.  The concept of “substantiality” is a bit more complicated and subjective than “economic effect." However, there is an “after tax” component to the economic effect of the allocation that needs to be considered.


The capital account determination and maintenance rules are detailed in Treas. Reg 1.704-1(b)(2)(iv).  Each partner’s capital account is increased by money or the fair market value of assets contributed to the partnership as well as the allocations of partnership income and gain, and decreased by the money or fair market value of assets distributed as well as allocations of partnership losses or deductions.  Capital accounts tend to mirror GAAP and are typically used by fund investors to track the value of their investment, since they typically reflect the true economic value.

As detailed in part (f) of this Regulation section, capital accounts are adjusted for the revaluation of assets in certain situations. For example, capital accounts are adjusted to reflect the fair market value of the partnership assets.  For regular operating partnerships, this is permitted typically in connection with a new contribution of money or property, a distribution or liquidation, or the grant of a new partnership interest.  However, for securities partners, revaluations can be done at any time. 

It’s common practice for a hedge fund to revalue assets quarterly or monthly (typically referred to as break periods).  Each partner’s capital account balance is adjusted at each revaluation to reflect the respective interest in the fair market value of the fund’s assets (via a change in unrealized gain/loss).  Each partner’s share of the change in unrealized gain/loss is typically based on the partner's proportionate economic interest in the partnership.  The allocation of the change in unrealized gain/loss results in a difference between the partners' capital accounts and the respective tax basis since the “change in unrealized” does not have an impact on tax basis.  This is commonly referred to as “disparity” or “revaluation account.”

SECTION 704(c)

IRC Section 704(c) dictates the allocations when property with a built-in gain or loss is contributed to the partnership in a Section 721 transaction (i.e. tax free).  The objective of this Section is to prevent the shifting of tax consequences among the partners with built-in gain or loss property.  Section 704(c) states that allocations related to that property be allocated to partners “so as to take account of the variation between the basis of property to the partnership and its FMV at the time of contribution.”  Essentially, 704(c) operates to ensure realized gains and losses from built-in gain or loss property are allocated to the contributing partner.

A partnership need not have “contributed” built-in gain or loss property for Section 704(c) to apply.  The principals of 704(c) apply to property that has been revalued pursuant to 704(b) and have differences between book value and the adjusted tax basis that result from the revaluation.  Remember, as we discussed above, revaluation produces “book” gain or loss that impacts the capital accounts. However, it does not produce tax gain or loss.  This essentially creates a scenario in which assets have “built-in” gain or loss for purposes of Section 704(c) that need to be considered for allocation purposes.

When discussing the principals of Section 704(c) allocations, it is important to understand the following terms:

Forward Section 704(c) Allocations:  This refers to the allocation of future realized gains or losses dictated by unrealized gain or loss on contributed property.

Reverse Section 704(c) AllocationsThis refers to the allocation of future realized gain and loss dictated by unrealized gain or loss on revalued property.

For purposes of this post, we will focus on reverse 704(c).

The purpose of Section 704(c) is to remove or reduce the disparity between the capital account balances (i.e. book basis) and the adjusted tax basis of each asset.  As the entity revalues its assets on a periodic basis, the entity's book basis changes, while the tax basis remains the same.  When a gain or loss is eventually realized, that gain or loss should be allocated in proportion to each partner's relative disparity.  The effect is that the book-tax disparity will be reduced or removed.  See the example below:

Partnership ABC holds two stocks (Y and Z).  Partners A, B & C have the following tax basis and capital account balance for each of these investments:

After the last revaluation, both stocks had some depreciation.  The partnership sold both stocks and recognized a realized gain of $200 for Y and a realized loss of $(120) for Z. 

Stock Y Gain Allocation

Stock Z Loss Allocation

The first $(100) of realized loss would be allocated to Partner C and would remove his/her disparity.  Subsequently, there is no additional negative disparity that can be reduced or removed by allocating realized losses. Thus, the partners share the remaining $(20) equal to each partner’s economic interest in the partnership.


The example above reflects the requirement in the regulations that Section 704(c) be tracked on an asset by asset basis.  There is an exception in the regulations, however, for a securities partnership to aggregate all of its assets as opposed to tracking each asset separately.  The purpose of this exception is to reduce the administrative burden that would result in separately tracking each asset.  The idea is that each asset in a securities partnership is fungible and not separate and distinct from the other assets. 

Disparity on an Aggregate Basis (using example above)

Full Netting Approach: A partnership's realized gains and losses are netted at the end of each accounting period (break period).  The overall net gain or loss is allocated to partnerships with positive disparity (if net gain) or negative disparity (if net loss).

Full Netting Example (using example above)

In this example, the overall net gain is first allocated to the partners based on the relative positive disparity.  Because the realized gain did not result in fully removing the positive disparity, Partner C is not allocated any gains.

Partial Netting Approach: A partnership's net realized gains at the end of each accounting period (break period) are used to reduce positive disparity, while partnership net realized losses are used to reduce negative disparity.

Partial Netting Example (using example above)

In this example, the gains are allocated to the partners with positive disparity.  The loss is allocated to the partner with negative disparity until that disparity is removed. Subsequently, the partners share the losses based on their economic interest.

As this example shows, the benefit of the partial netting method is that it removes book-tax disparity at a faster pace.  It is, however, more likely to result in situations where partners with positive disparity (partners A & B in this example) are actually allocated realized losses, which further increases their disparity.


As with the aggregate method, securities partnerships also have the ability to special allocate realized gains and losses in certain situations.  Most partnership agreements will have a “stuffing provision” that provides the general partner the ability to specially allocate gains or losses to withdrawing partners.  When the fund makes a liquidating distribution to the partner equal to his/her capital account balance, there will typically be some book-tax disparity. The stuffing provision allows for the partnership to allocate realized gains or losses to the withdrawing partners equal to an amount that will align the tax basis to the liquidating proceeds.  The withdrawing partner will then not recognize gain or loss on the liquidation of his/her partnership interest (under section 731) because the tax basis is equal to the liquidation proceeds.

In a scenario where the fund is in an appreciated position, a redeeming partner will typically have a capital account balance in excess of his/her tax basis.  If there is a stuffing provision in place, the redeeming partner can be special allocated realized gains (if available) that would have otherwise been allocated to the remaining partners.  The redeeming partner is indifferent because, absent the additional realized gains allocated to that partner, he/she would be required to recognize gain on the liquidation of his/her partnership interest.  The remaining partners, however, benefit from the deferral of gain recognition that was instead allocated to the redeeming partner.  The reduction of the book-tax disparity achieved by the stuffing provisions falls in line with the principals of reverse 704(c) allocations.

Bottom Line: It is imperative that the General Partner ensures that proper accounting records are maintained and that the partnership agreement is thorough and complete.  This will allow the partnership to mitigate the risk of challenges to its allocations as well as allow the partnership to utilize the securities partnership exceptions that are provided in the code and regulations.



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