Example. A and B invest $10,000 cash on January 1 in a securities partnership. On June 30, there is appreciation in the securities of $10,000. C then invests $15,000 for a 1/3 interest in the partnership. The investments are sold before December 31 reflecting a decline in value since June 30 of $6,000. During the year, the partnership had numerous securities transactions. There were losses on transactions amounting to $20,000, and gains on transactions amounting to $24,000, resulting in a net taxable gain of $4,000. A and B each enjoyed an increase in net asset value of $3,000 and C suffered a decline in net asset value of $2,000. The combined profit of A and B ($6,000) minus C's loss ($2,000) is equal to the overall partnership taxable gain ($4,000).

The Nature of the "Ceiling Rule"

The principles of the "ceiling rule" provide that only those items of gain or loss realized at the partnership level can be allocated among partners for tax purposes. The interpretation of this principle is not clear. If this is interpreted to mean net gains and losses recognized for the year (in the example, $4,000 net gain) problems result.

Applying this strict interpretation of the ceiling rule, even though C had an economic loss of $2,000, there would be no tax loss available to allocate to C. A and B would be allocated the $4,000 net gain, $2,000 each.

However, a more reasonable interpretation is to apply the ceiling rule on a transaction-by-transaction basis which solves the problem. In this case, there would be available for allocation for tax purposes up to $20,000 of losses and $24,000 of gains. Since the partnership actually recognized losses of $20,000, it might then be possible to allocate C his $2,000 loss and each to A and B a $3,000 gain without running afoul of the ceiling rule.

Support for the more reasonable interpretation is found in example (7) of the regulations. In this example, a partnership invests in an equal amount of municipal bonds and corporate stock. The partnership agreement allows the tax attributes of the bonds, including gain or loss, to be allocated in a different manner than the allocation of the tax attributes of the stock. There is no mention of any necessity of netting the gain or loss from the two sources if sold in the same year. Thus, it can be inferred that gains from one source can be allocated to some partners while losses from the other source can be allocated to other partners. This is so, even ff there is no overall gain or loss after netting the two. Although this example does not specifically deal with the ceiling rule, there is no more justification for requiring gains and losses to be netted when applying the ceiling rule than when the ceiling rule does not apply.

It's the Economic Arrangement That Counts

Furthermore, the complex set of rules and tests are designed to accomplish one goal: to insure that allocations of tax attributes follow the economic arrangement of the partners. Or, in the words of IRC Sec. 704(b), to insure that allocations have "substantial economic effect." In the securities partnership context, tax allocations that follow the appreciation or depreciation in the value of a partnership interest certainty follow the economic substance of the partner's arrangement. Limiting the allocation to the overall net gains (losses) at the partnership level, $2,000 to A and B, on the other hand, would cause tax allocations to differ from the economic reality of the investment results to the individual partners.

It Could Be Worse

The inequities that may arise if the gains and losses subject to the ceiling rule are computed on a net basis have been illustrated by the earlier example. Even though C's economic loss benefitted A and B by reducing their taxable gain from $3,000 each to $2,000 each, C has been deprived of the $2,000 loss for tax purposes. A worse result could occur if C were required to report a "phantom" gain. An allocation based on each partner's percentage interest in the partnership for the portion of the year he or she was a partner would, in the example, allocate the $4,000 net taxable gain 2/5 each to A and B ($1,600 each) who participated all year and 1/5 to C ($800) who participated only half of the year. Or an allocation based on year-end ownership would divide the taxable gain equally among A, B, and C ($1,333 each). In both cases C is allocated a taxable gain even though C sustained an economic loss of $2,000.

The IRS has at least once in the past applied the principles of the ceiling rule to a securities partnership. In Rev. Rul. 75-458, a partnership operated a nondiversified open-end investment company and invested in marketable securities. When new partners were admitted to the partnership, partnership assets were valued and the unrealized gains or losses were assigned to existing partners. When assets were sold, taxable gain or loss was allocated among the partners by taking into account the unrealized gain or loss that had previously been assigned to the partners and attributable to the assets sold. Even though the ruling does not specifically state that the ceiling rule prohibits this allocation, the principles of the ceiling rule are applied. The ruling states:

"Accordingly,sincethemethodof

allocationprescribedbythepart

-nershipagreementcouldresultin

somepartnersreportinggains

greaterthanthoseactuallyrealized

bythepartnershipandotherpan

-nersreportinglossesthatwere

neversustained,forfederalincome

taxpurposesthepartners'distribu

-tivesharesofgainorlossonthesale

ofpartnershippropertymaynot

bedeterminedunderthemethod

prescribed."

It should be noted that in the revenue ruling, the partnership owned only one asset: Partners A and B bought into the partnership for $2,000 each and the asset was purchased for $3,000. The asset appreciated to $9,000 and C was admitted for $5,000 at which time the $6,000 of unrealized appreciation was allocated equally between A and B under the partnership agreement. If the asset was sold for $6,000 (for a partnership gain of $3,000), under the partnership agreement, A and B should each have $3,000 of taxable gain and C should have $3,000 of taxable loss. However, the partnership had no transactions realizing a loss. The only transaction resulted in the $3,000 gain being realized. Therefore, under the facts of the ruling the allocation of gain to A and B and loss to C violated the principles of the ceiling rule. However, because only one transaction was involved in the ruling, there is no implication that partnership gains and losses during the year cannot be allocated on a transaction-by-transaction basis.

The Bookkeeping Gets Tricky

Accounting for each partner's share of gain and loss on a transaction- by-transaction basis can be quite cumbersome, especially if a number of partners are admitted or redeem their partnership interest during the taxable year. The examples in Reg. Sec. 1.704 (Examples 14, 15, and 16), illustrate an accounting method that allows gains and losses to be allocated in total rather than transaction-by-transaction and still avoids violation of the ceiling rule. Applying those regulations to the example discussed at the beginning of the article would be as per Figure 1.

By applying the foregoing accounting method, the ceiling rule may be avoided in all but very unusual circumstances in the vast majority of securities partnerships. Gains and losses may be allocated on a gross basis to eliminate the book/ tax disparity. To the extent the disparity is not eliminated in the current year, the disparity may be carried over to succeeding years.

By Cheryl Kemp, CPA, McGladrey & Pullen.