The IRS recently issued regulations on allocation of built-in gains and losses on property contributed to a partnership. They contain methods that may be used to achieve a reasonable method consistent with the purpose of IRC Sec. 704(c). However, the price of flexibility may be the loss of simplicity. The authors provide the background for their issuance and, with extensive examples, lead us through the various methods that may be used.

In December of 1992, the IRS issued proposed regulations governing the allocation of built-in gains and losses on property contributed to a partnership. One year later, in December of 1993, the IRS issued final regulations under IRC Sec. 704(c), along with new temporary regulations that reflect changes to the 1992 proposed regulations. The final regulations adopted the same general approach as the 1992 proposed regulations--allowing taxpayers to allocate built-in gain or loss on property contributed to a partnership usin any "reasonable method." The final regulations, however, include some significant changes. The most significant change relates to the methods identified as methods that would generally be considered reasonable methods. Th new regulations eliminate the deferred sale method included in the 1992 propose regulations and include temporary regulations that contain a revised version of the deferred sale method, referred to as the remedial allocation method. In addition, the new temporary regulations provide special aggregation rules for securities partnerships.

Historical Perspective

IRC Sec. 721 generally provides that no gain or loss will be recognized on the contribution of property to a partnership in exchange for an interest in the partnership. If property is contributed to a partnership in exchange for a partnership interest, the basis of the property in the hands of the contributin partner will carry over to the partnership, and the partner will have a basis i his or her partnership interest equal to the basis in the property contributed. As a result of this nonrecognition treatment, it is possible for the gain or loss with respect to the contributed property to be transferred from the contributing partner to the partnership, as demonstrated by the following example.

Example 1: Contribution of Built-In Gain Property. Individuals A and B form partnership AB. In exchange for their one half interests in the partnership, A transfers $1,000 cash, and B transfers property worth $1,000 with an adjusted basis to her of $200. The partnership takes the property contributed by B with carryover basis of $200. A's basis in his partnership interest is $1,000, while B's basis in her partnership interest is $200, the basis of the property she contributed to the partnership. A and B agree to share profits and losses equally. Assuming the partnership sells the property for $1,000, the gain of $800 recognized by the partnership would be allocated $400 each to A and B. As result of this allocation, A's basis would be $1,400, and B's basis would be $600. If the partnership liquidates and distributes its $2,000 cash equally to and B, A would recognize a loss of $400 and B would recognize a gain of $400 on the liquidation. If B had sold the property herself and contributed the cash proceeds of $1,000 to the partnership, she would have realized a gain of $800 o the sale. By contributing the property to the partnership, she still realizes the same $800 gain ($400 gain on sale and $400 gain on liquidation). However, the timing and character of the gain will be substantially affected. Under thes circumstances, B has managed to defer recognition of $400 of gain until liquidation of the partnership, and has the potential to change the character o the gain from ordinary income to capital gain. Similarly, A has been taxed on $400 of gain (on the sale of the property) despite the fact he realized no economic benefit, and the offsetting loss is deferred until liquidation of the partnership. In addition, the gain recognized on the sale of the property may b ordinary income, while A's loss on liquidation of the partnership will be a capital loss.

IRC Sec. 704(c)

Congress was aware of the potential for abuse illustrated by the above example in 1954 when it first implemented Subchapter K of the IRC. Under the 1954 Code, the partnership agreement could provide such built-in gains and losses could be allocated among the partners to reflect the differences in the basis and fair market value of the property. Such an allocation was, however, not required. Th regulations issued under then IRC Sec. 704(c)(2) regarding such allocations adopted an approach that limited the amount of gain or loss that could be allocated to the contributing partner to the actual gain or loss realized by th partnership. This limitation is known as the "ceiling rule" under the traditional method of allocation. The ceiling rule also applies to limit deductions such as depreciation that may be allocated to the contributing partner.

The Deficit Reduction Act of 1984 amended IRC Sec. 704(c) to make the allocatio of built-in gains and losses mandatory, rather than elective. As a result, the present IRC Sec. 704(c)(1)(A) provides that "income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution...."

Example 2: Application of IRC Sec. 704(c). Assume the same facts as Example 1, except the transaction is subject to the provisions of IRC Sec. 704(c). The built-in gain on the sale of the property contributed by B in the amount of $80 would be allocated completely to B upon the sale of the property by the partnership. As a result, B's basis in the partnership would be increased to $1,000, the same as A's. Upon a liquidation of the partnership and a distribution of $1,000 each to A and B, neither would recognize any gain or loss.

The Conference Committee Report for the Deficit Reduction Act of 1984 stated taxpayers may rely on the old regulations, relating to the old IRC Sec. 704(c)(2), until new regulations could be issued. Accordingly, allocations of built-in gains or losses with respect to contributed property after 1984 were subject to the limitations of the ceiling rule under existing regulations.

The Ceiling Rule

The regulations issued under the old IRC Sec. 704(c)(2) provided that "...total depreciation, depletion, or gain or loss allocated to the partners is limited t a "ceiling" which cannot exceed the amount of gain or loss realized by the partnership or the depreciation or depletion allowable to it." The application of the ceiling rule in certain situations caused distortions with respect to th timing and character of gain or loss recognized by the partners. These distortions are best explained through the use of examples.

Example 3: Ceiling Rule Applied to Built-In Gain. Assume A and B form the AB partnership. A contributes $500 cash and B contributes property worth $500 with an adjusted basis of $100. The partnership later sells the property contributed by B for $400. Under IRC Sec. 704(c), the gain on the sale in the amount of $30 is allocated to B only, increasing her basis in the partnership to $400. However, for book purposes, a loss of $100 was realized by the partnership, and is allocated equally to A and B. Thus, both A and B would have a book capital account balance of $450 after the sale of the property. If the partnership liquidates and distributes $450 cash to each partner, A will recognize a loss upon liquidation of $50, while B will recognize a gain upon liquidation of $50. The total gain recognized by B with respect to the entire transaction was $350 ($300 on the sale and $50 on the liquidation). However, the gain that was inherent in the property when it was contributed to the partnership was $400. B transferring the asset to the partnership and applying the ceiling rule to limi the amount of gain allocated, B was able to defer recognition of $50 of gain until the partnership liquidated and avoid recognition of $50 of the built-in gain altogether. In addition, the gain on the sale of the property by the partnership may have been converted from ordinary income to capital gain upon liquidation of the partnership.

Example 4: Ceiling Rule Applied to Built-In Loss. Assume X and Y form the XY partnership. X contributes $100 cash and Y contributes property worth $100 with an adjusted basis of $200. XY sells the property for $120. The partnership recognizes a loss of $80 on the sale of the property, all of which is allocated to Y, reducing her basis in the partnership to $120. However, the partnership realized a book gain of $20 on the sale, which will be allocated equally betwee X and Y. After the sale, both X and Y will have book capital account balances o $110. If the partnership liquidates and distributes $110 each to X and Y, X wil recognize a gain of $10 and Y will recognize a loss of $10 upon liquidation. Th total loss recognized by Y with respect to the transaction is $90 ($80 loss on the sale of the property and $10 loss upon liquidation). However, the loss inherent in the property when it was contributed to the partnership was $100. Y was able to defer recognition of a portion of the loss until the property was sold, and the other portion of the loss until the partnership was liquidated. I addition, the character of the loss on the property may have changed from capital loss before it was transferred to the partnership, to ordinary loss in the hands of the partnership. Similarly, if the loss on the sale was ordinary, the character might have been changed to capital loss upon liquidation of the partnership.

Example 5: Ceiling Rule Applied to Depreciable Property. D and P form the DP partnership. D transfers depreciable property with an adjusted basis of $50, a fair market value of $200, and a remaining life of five years, and P transfers cash of $200. With P's $200 cash contribution to the partnership, she has, in effect, purchased an undivided one-half interest in the property contributed by D. Ordinarily, P would be entitled to depreciation on $100 of the property (her one-half interest) over five years, which would amount to $20 per year (assumin straight- line depreciation for the sake of simplicity). Under IRC Sec. 704(c), the tax depreciation would be allocated 100% to P, to correct the book and tax differences of the two partners as quickly as possible. However, because the partnership's basis in the property is only $50, the tax depreciation allowable is only $10 per year. The partnership cannot allocate $20 per year in depreciation to P and treat D as though he received $10 of income each year. As demonstrated in the above examples, the application of the ceiling rule in certain situations can cause distortions with respect to the timing and character of gains and losses to be recognized by partners that contribute appreciated property, as well as by the non-contributing partners. The discrepancies generally involve deferred recognition of gain or loss caused by shifting of either all, or a portion of the built-in gain to another partner, followed by a corresponding reversal at a later date.

In some instances, the distortions caused by the ceiling rule are incidental an catch the parties involved by surprise because the partners did not anticipate the results actually achieved through a given transaction. In other cases, the distortions stem from intentional abuses of the ceiling rule to the advantage o the partners involved. The ceiling rule may allow partners in different tax brackets to manipulate the amount of income allocated to each, and it may allow partners that contribute property to convert ordinary income into capital gain and to defer the recognition of some or all of the gain until the partnership liquidates. These distortions are indicative of the type of abuses Congress sought to prevent by making the allocation of built-in gains and losses mandatory in 1984. Accordingly, these distortions are the primary target of the final and temporary regulations under IRC Sec. 704(c).

The New Regulations

Generally, the final and temporary regulations allow greater flexibility than the pre-1992 rules regarding allocations of built in gains and losses on contributed property. The new regulations are primarily concerned with eliminating the possibility for manipulation of built-in gains and losses that was available under the old rules as a result of the "ceiling rule," which limited the amount of gain or loss that could be allocated to a contributing partner to the actual gain or loss realized by the partnership on a subsequent sale of the property and also provide further guidance to taxpayers with respec to allocations under IRC Sec. 704(c).

Under the new regulations, the partnership may allocate the built in gain or loss using "any reasonable method that is consistent with the purposes of IRC Sec. 704(c)." The 1992 proposed regulations provided three methods of allocatio that would generally be considered reasonable: the traditional method, the traditional method with curative allocation, and the deferred sale method. The final regulations, along with the new temporary regulations, generally adopted the traditional method and the traditional method with curative allocations, with minor changes. However, the new regulations replace the deferred sale method entirely, and implement the new remedial allocation method in its place.

Traditional Method

The traditional method described in the final regulations is basically the same method prescribed in the original pre-1992 IRC Sec. 704(c)(2) regulations, with a few modifications designed to address situations not covered in the original regulations. A significant addition to the regulations provides that if a partnership disposes of IRC Sec. 704(c) property in a nonrecognition transaction, the property received (to the extent it is substituted basis property) will be treated as IRC Sec. 704(c) property with the same amount of built in gain or loss that was inherent in the property disposed of by the partnership. The traditional method preserves the ceiling rule, and thus is not intended to be used in situations that would still result in book-tax disparities when used. The final regulations state that, "If a partnership has no property the allocations from which are limited by the ceiling rule, the traditional method is reasonable when used for all contributed property." Thus, in situations where allocations are limited by the ceiling rule, such as those described in examples 3, 4, and 5, the traditional method will not be considere a reasonable method.

Traditional Method with Curative Allocations

The second method specifically described as a reasonable method under the new regulations is the traditional method with curative allocations. A curative allocation is defined as "an allocation of income, gain, loss, or deduction for tax purposes that differs from the partnership allocation of the corresponding book item." In laymen's terms, a curative allocation is an allocation of gain, loss, or deduction to remedy any disparities caused by the ceiling rule under the traditional method.

The final regulations provide certain restrictions with respect to the amount and type of allocation that may be used. A curative allocation will be considered reasonable provided the amount of the allocation does not exceed the amount required to offset the discrepancy caused by the ceiling rule. The 1992 proposed regulations provided that if there were insufficient items of partnership income, gain, loss, or deduction to properly offset the effect of the ceiling rule, additional curative adjustments could be made in subsequent taxable years, provided the total amount of the adjustments did not exceed the total amount necessary to offset the effect of the ceiling rule. The final regulations generally do not allow curative allocations to be made in a subsequent year, with one exception. If, at the time the property is contribute to the partnership, the partnership agreement provides for curative allocations to be made over a reasonable period of time (such as the property's economic life), such allocations will be allowed.

There are also restrictions on the type of allocation that will be considered reasonable under the new regulations. Generally, a curative allocation must consist of items of income, gain, loss, or deduction that would have the same effect (with respect to character) on the partners as the items of income, gain loss, or deduction that would be affected by the ceiling rule. For example, where the ceiling rule affects the amount of depreciation allowed to a partner, a curative allocation consisting of an item of capital gain would not be a reasonable allocation.

The following examples demonstrate the traditional method with curative allocations as it applies to the previous examples regarding the ceiling rule (examples 3, 4, and 5 above).

Example 6: Built-In Gain With Curative Allocation. Assume the same facts as in example 3. Under the traditional method with curative allocations, upon the sal of the property, B will be allocated $400 of gain, and both A and B will receiv a subsequent allocation for their share of the loss recognized by the partnership ($50 each). The original allocation under IRC Sec. 704(c) was the gain realized by the partnership in the amount of $300. Under the new regulations, the additional allocation of gain in the amount of $100 made to B carries the same character as the $300 gain realized on the sale. This curative allocation corrects the distortion caused by the ceiling rule, and allows A to share in the economic loss the partnership realized as a result of the decline in value of the property after it was contributed to the partnership. If the gain on the sale of the property was capital gain, the allocation of ordinary income to correct the difference caused by the ceiling rule would be considered an unreasonable allocation. Similarly, limiting the amount of gain allocated to B to the $300 realized and allocating $50 of capital loss to A to reflect his share of the economic loss on the sale would not be a reasonable allocation because it does not account for the additional $100 of built-in gain when the property was contributed to the partnership.

Example 7: Built-In Loss With Curative Allocation. Assume the same facts as in example 4. In this case, under the proposed regulations, the original built-in loss in the amount of $100 will be allocated to Y, and the subsequent gain realized by the partnership will be allocated equally to X and Y ($10 each). Th original IRC Sec. 704(c) allocation to Y was a loss in the amount of $80. The curative adjustment is an additional allocation of $20 of loss, of the same character as the original $80 loss. This will restore the book-tax differences caused by the contribution of the built-in loss property. The $20 appreciation in the value of the property that occurred after it was contributed to the partnership will be shared equally by X and Y. As in the previous example, if the loss on the sale of the property were a capital loss, a curative allocation of $20 of ordinary loss to Y would not be considered a reasonable allocation. Similarly, limiting the amount of loss recognized to Y to $80 and allocating $1 of gain to X, to reflect his share of the economic gain, will not constitute a reasonable allocation because it fails to account for the total built-in loss o $100.

Example 8: Depreciable Property With Curative Allocation. Assume the same facts as in example five. In this example, P was only allowed to be allocated depreciation deductions in the amount of $10 per year as a result of the ceilin rule, despite the fact her contribution of cash to the partnership was effectively a purchase of an undivided one-half interest in the property contributed by D. Under the traditional method, it was stated the partnership could not allocate $20 of depreciation to P and $10 of income to D each year. Under the traditional method with curative allocations, this would be precisely the curative adjustment that would be made. Allocating $10 of income to D each year will increase his basis in the partnership to $100 after five years (disregarding all other transactions). Similarly, allocating $20 of depreciatio deductions to P each year will reduce her basis in the partnership to $100 afte five years, thus removing the book-tax differences originally caused by the contribution of IRC Sec. 704(c) property. In this case, an allocation of capita gain to D would not be considered reasonable, since the curative adjustment to is an allocation of depreciation deductions, which are ordinary deductions.

The Deferred Sale Method

The 1992 proposed regulations included a third--the deferred sale method--that was specifically identified as a reasonable method. This method takes its roots from the rules governing consolidated returns and intercompany transactions. Under those rules, if a member of an affiliated group that files a consolidated return sells property to another member of the group in a transaction treated a a "deferred intercompany transaction," the purchasing corporation receives a cost, or fair market value basis in the property, but the gain or loss that would be recognized by the selling corporation is deferred. As the purchasing corporation takes depreciation or depletion deductions with respect to the property, the selling corporation recognizes a portion of the deferred gain or loss to the extent of those deductions. Immediate recognition of the deferred gain or loss is also triggered if the property is sold to party that is not a member of the group, or if either the selling corporation or the purchasing corporation ceases to be a member of the group.

Under the deferred sale method of allocating built-in gains and losses with respect to property contributed to a partnership, the contribution to the partnership is treated as a sale of the property to the partnership. The partnership takes a cost, or fair market value basis in the property, but the gain or loss that would be recognized by the contributing partner is deferred. The partner's basis in the partnership will be the adjusted basis in the property contributed. As the partnership takes cost recovery deductions with respect to the property in excess of the deductions that would be allowable if the partnership took the property with a carryover basis, the contributing partner must recognize a proportionate share of the deferred gain or loss on th contributed property. In addition, the 1992 regulations provided other events would also trigger recognition of deferred gain or loss by the contributing partner.

The following example illustrates the application of the deferred sale method t the facts of example 5.

Example 9: Deferred Sale Method With Depreciation. Assume the same facts as in example 5. Under the deferred sale method, D would be treated as though the depreciable property was sold to the partnership for $200. The partnership woul have a basis in the property of $200, and D would have a deferred gain of $150 and a basis in the partnership of $50. To the extent the partnership takes depreciation deductions in excess of the amount that it would be allowed if it had transferred basis ($50) in the property, D must recognize a portion of the deferred gain. Thus, in the first year, the depreciation allowable (again assuming straight line for simplicity) would be $40. However, had the partnership taken the property with a carryover basis of $50, the depreciation allowable would be only $10. The difference of $30 must be recognized by the contributing partner, D, as deferred gain and will correspondingly increase his basis in the partnership to $80. Similarly, D must recognize $30 of the deferre gain for each of the five years that the property is depreciated. At the end of the five-year period, all $150 of deferred gain will be recognized, and D will have a basis in the partnership of $200 (not accounting for the fact his one-half share of the tax depreciation each year will reduce his basis accordingly).

Remedial Allocation Method

As previously stated, the final regulations do not include the deferred sale method as a specifically identified reasonable method. Instead, new temporary and proposed regulations were issued that replace the deferred sale method with the remedial allocation method, which is generally intended to be a simplified version of the deferred sale method.

The remedial allocation method requires the partnership to make allocations tha achieve substantially the same result as would be achieved under the deferred sale method. Generally, a remedial allocation is an allocation of income or gai to one partner, accompanied by an offsetting allocation of loss or deduction to the remaining partner(s). A remedial allocation is required in cases where the ceiling rule results in an allocation for book purposes with respect to a noncontributing partner that differs from the corresponding allocation for tax purposes. The amount of the remedial allocation should be whatever amount is necessary to eliminate the effect of the ceiling-rule limitation. None of the allocations made using the remedial allocation method have any effect on the book capital accounts of the partnership.

As with the rules regarding allocations under the traditional method with curative allocations, remedial allocations must consist of the same type of income or expense item as the item that was limited by the ceiling rule. For example, if the item limited by the ceiling rule is capital gain from the sale of contributed property, the remedial allocation to the contributing partner must consist of capital loss from the sale of that property and the offsetting remedial allocations to the remaining partners must consist of capital gain fro the sale of that property.

The remedial allocation method includes specific provisions regarding the determination of book allocations. Temporary Reg. Sec. 1.704- 3T(d)(2) provides that the portion of the partnership's book basis in contributed property equal to the adjusted tax basis at the time of contribution is recovered (i.e., depreciated) using the same recovery method used to recover the partnership's adjusted tax basis, but over the property's remaining recovery period. The remaining portion of the partnership's book basis in the contributed property i recovered using the recovery method and the recovery period applicable for newl purchased property placed in service at the time of contribution. The following examples illustrate the determination of book items under this method, as well as the general operation of the remedial allocation method as it applies to the examples used previously.

Example 10: Book Allocation Under Reg. Sec. 1.704-3T(d)(2). Depreciable propert with an adjusted basis of $20,000 and a value of $60,000 is contributed to the ACE partnership. The property is depreciable using the straight line method. Th remaining recovery period at the time of the contribution to the partnership is six years. The recovery period for newly acquired property of this type is 20 years. The partnership's book basis in the property is $60,000. The portion of the partnership's book basis equal to the adjusted basis at the time of contribution ($20,000) will be depreciated over its remaining recovery period o six years using the straight line method. The remaining portion of the partnership's book basis ($40,000) will be depreciated over the new recovery period (20 years) using the straight line method.

Example 11: Remedial Allocation Method with Built-In Gain. Assume the same fact as in example 3. Upon a sale of the property contributed by B for $400, the partnership would realize a book loss of $100, while the tax gain would be $300 All of the tax gain would be allocated to B, while the book loss would be allocated $50 to A and $50 to B. Partner A, the noncontributing partner, would thus be allocated a $50 loss for book purposes and would have no gain or loss allocated for tax purposes. This will result in a discrepancy in the amount of $50 between A's book allocation and tax allocation. Accordingly, under the remedial allocation method, the partnership must allocate $50 of tax loss to A (treated as a loss from the sale or exchange of the asset contributed by B), with a corresponding allocation of $50 of tax gain to B (treated as a gain from the sale or exchange of the asset contributed by A). Such an allocation properl reflects the economic reality of the transaction. A originally had a $400 gain inherent in the contributed property that would have been recognized if A had sold the property to the partnership. A shared equally in the loss of $100. Thus, A's net gain on the transaction should be $350, which is the result using the remedial allocations.

Example 12: Remedial Allocation Method with Depreciation. Assume the same facts as in example 5. In addition, assume the recovery period for similar property acquired and placed in service at the time the property was contributed to the partnership is 10 years, and the applicable recovery method is straight line. The portion of the partnership's book basis in the property equal to the property's original adjusted basis ($50) will be depreciated over the property' remaining life at the time of the contribution (five years), resulting in tax depreciation of $10 per year, all of which would be allocated to P under Reg. Sec. 1.704- 3(b)(1), |See Reg. Sec. 1.704-3T(d)(1). The remaining portion of th partnership's book basis ($150) will be depreciated over the new recovery perio of 10 years, for total annual book depreciation of $25 (tax depreciation $10 plus additional depreciation of $15) The book depreciation would be allocated $12.50 each to D and P. As a result, P, the noncontributing partner, will have difference of $2.50 between the book depreciation ($12.50) and the tax depreciation ($10) allocated to P. Under the remedial allocation method, the partnership must allocate an additional $2.50 of tax depreciation to P to eliminate the difference between the book and tax amounts. In addition, the partnership must make a corresponding allocation of income to D in the amount o $2.50. The type of income allocated to D must be the same type of income that i generated by the property being depreciated.

As with the other methods of allocating built-in gain or loss on contributed property, any allocations made under the remedial allocation method will only b considered reasonable to the extent they equal the amount necessary to offset the effects of the ceiling rule limitation.

Additional Provisions in the New Regulations

The new regulations allow taxpayers to apply different methods of allocation with respect to different items of Sec. 704(c) property. However, the same method must be applied consistently by both the partners and the partnership to each item of contributed property from year to year, and the use of different methods for different items of property is subject to the anti-abuse rules contained in the new regulations. In general, the anti-abuse rules provide that an allocation, or combination of allocations, will not be considered reasonable if the allocations are made "with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability. The anti-abuse rule in the final regulations was modified relative to the 1992 proposed regulations which gave the IRS broad powers to make adjustments if it determined that a taxpayer's allocations were not reasonable. In addition, the new temporary regulations regarding the remedial allocation method indicate that the IRS will not require taxpayers to use the remedial allocation method if the method used by the taxpayer is not considered a reasonable method by the IRS. As such, the nature of adjustments made by the IRS when it determines that a taxpayer's allocations are not reasonable will likely depend on the specific facts of each case.

Due to the complexity of the various methods for allocating built-in gains and losses, the new regulations provide a de minimis rule, which allows certain partnerships to disregard Sec. 704(c) altogether. If 1) the aggregate fair market value of all the property contributed during the year does not differ from the aggregate adjusted tax basis of the property by more than 15% of the aggregate basis, and 2) the total amount of such discrepancy does not exceed $20,000, the partnership may choose not to apply the allocation rules of Sec. 704(c). This rule was changed slightly from the 1992 proposed regulations.

The final regulations reflect further changes regarding the ability of taxpayer to aggregate property for purposes of applying the aggregation rules. The general rule under the 1992 proposed regulations was that the allocation rules had to be applied, with limited exceptions, to each individual item of contributed property. The only specific exception was for depreciable property. This exception is also included in the final regulations--allowing the aggregation of all property, other than real property, that is included in the same general asset account. In addition, the final regulations allow aggregatio of all property with a basis of zero (other than real property), and inventory items, if the taxpayer does not use the specific identification method for accounting for inventory. The inventory exception does not apply to securities or other similar investments. In addition to these changes in the final regulations, new temporary regulations were issued that provide special guidelines for the application of Sec. 704(c) to securities partnerships.

There were a few other changes in the final regulations, including provisions that require coordination between Sec. 704(c) adjustments and adjustments made under Reg. Sec. 1.743-1(b) and 1.751-1(a)(2), and clarification of the fact that, in the event a partnership transfers Sec. 704(c) property to a corporatio under Sec. 351, the built-in gain or loss will be reflected in the partnership' basis in the stock received.

Despite the many changes discussed above, the final regulations generally follo the same principles as the 1992 proposed regulations. The overriding objective is to give taxpayers the flexibility to choose the most appropriate method for their situation. This can result in uncertainty, since taxpayers may not be sur that the method they choose will be considered reasonable by the IRS. However, it allows taxpayers to choose from the methods identified in the regulations, o to create their own method, to provide the most effective and efficient method of tracking built-in gains and losses. The IRS has indicated that it will issue private letter rulings to make a determination as to whether a taxpayer's proposed method is reasonable. Accordingly, if taxpayers want certainty regarding an allocation method other than one identified in the regulations, they should request a ruling from the IRS.

David E. Zinneman, CPA, is a Tax Associate at Deloitte & Touche, Chicago. Rodge A. Bolling, Esq., is Director, Graduate Tax Program, at Northern Illinois University.