In episode 49 of How Tax Works, Matt Foreman discusses hobby losses, which are a significant and often underappreciated limitation on the ability to deduct losses based on the taxpayer’s profit motive.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 43rd episode of How Tax Works. I’m Matt Foreman. In this episode, I’ll talk about allocations under 704C of the internal Revenue Code. How Tax Works is meant for informational entertainment purposes only. This may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make.

Matthew Foreman [00:00:40]:
Before we get started, let’s go through some administration. New episodes every two weeks. The next episode is going to talk about common mistakes and misconceptions under Section 1202 of the Internal Revenue Code. QSPs mistakes. Whoops. Whoops, whoops. They’re big. They tend to be really big.

Matthew Foreman [00:00:55]:
If you saw this, as I said discussed before, this was also a webinar topic. I talked about this for an hour. It’s interesting because it’s in the future from when I talk from when I’m recording this, but it’ll be in the past from when I I’m when it’s being released. So that’s kind of interesting. Back to the future in a way. If you have any questions, comments, or constructive criticisms, you can email me at my FRB email address, which you can find via your favorite search engine. Again, you know, I’m going to request if you have any ideas for webinar or podcast topics. Happy to do it.

Matthew Foreman [00:01:22]:
I get these requests on LinkedIn where they’re like, you know, do you want to share and swap podcast guests? And I don’t have podcast guests, so don’t suggest that or suggest it and I’ll ignore it. Really. The. The choice is yours. You know, this is, this is your world, so I’m just living in it. The overview for this is pretty simple. On. On 704C, I’m going to talk about generally partnership tax, why this matters.

Matthew Foreman [00:01:43]:
Talk about depreciation because that’s sort of the core of 704C issues allocation of depreciation under section 704. So traditional with c. Traditional talk about the ceiling rule, traditional method with curative allocations and the remedial method. There are other reasonable methods I can talk about that. That’s interesting one. And what is the best method for each partner? And the answer is whatever I tell them to take. Right? That’s the best method. So partnership tax, part of the good and the bad, good for taxpayers, makes it hard from a technical standpoint is partnership tax is incredibly Flexible contributions to a partnership are generally tax free.

Matthew Foreman [00:02:17]:
Section 720 21. Unless the property that’s contributed is subject to liabilities that exceed the basis of the contributed property, or the tech contribution is a disguised sale, or the contribution or the partnership is an investment company for tax purposes. I’m going to assume that none of these exist here. Makes it easier if they do. You can just stop listening. We’ll move on. Contributed party retains most of the tax characteristics, almost all from the contributing partner. You get a transfer or carryover tax basis for one, both inside and outside basis.

Matthew Foreman [00:02:47]:
Not going to talk about what those are. Kind of will a little bit later really for another day. I talk about a lot in the one on revenue ruling 995 and 996, which is a while ago, the book basis is reset to the fair market value which is what creates this issue. And you have a step in the shoes methodology for depreciation method and period. Why is this so big? I always talk about part sale, part contribution. But this is the sort of thing that happens in a revenue ruling 995 transaction. Either a sale or. Or.

Matthew Foreman [00:03:15]:
Or post f reorg and then revenue rule 99.5. So basically it’s a situation when the idea sort of conceptually is either that the asset is split into two assets. There’s a sale portion owned by the partnership and the depreciation or amortization is allocated to the partners who were partners before the sale. And the contributed portion is owned by the contributing partner, a continu con continuation of their interest. The other situation is where two partners come together and one contributes an asset that has either been depreciated or has increased in value since they bought it. They may not have appreciated it yet or. And the other one puts in cash. This is where it is.

Matthew Foreman [00:03:50]:
We get really different types of assets. The allocation of assets that are subject to the part sale, part contribution or they have different basis. It’s governed by 704C, which is complex in concept, but the actual application is doubly or tripoli or quadruply complex. The method of allocation is a negotiated point in operating agreements for joint ventures or after a business is purchased and rollover, there is a common situation, right? The common situation that I run into a lot is after an f reorg the part sale, part rollover into a new LLC that is taxed as a partnership, right? People call that oh, it’s an f reorg. It has a lot more than an f re Org going on. But people call it an f reorg. So that’s fine. So depreciation, okay.

Matthew Foreman [00:04:28]:
Depreciation is an economic concept that reflects the decline in an asset’s value over an asset’s useful life due to an ordinary wear and tear of the asset, passage of time, change in capacity or other physical environmental factors. Depreciation therefore curse for the entirety of the assets useful life and only ends in the entire when the underlying assets were zero is really important. A lot of assets actually technically never depreciate to zero. They are never worth nothing. However, we’re going to assume that the asset drops to zero. Very important. A lot of times it’s real estate. Real estate very rarely drops to zero simply because you don’t.

Matthew Foreman [00:05:06]:
You generally can’t depreciate land. As I’ve discussed and I make jokes about. There are situations where that’s not true but we’re just going to pretend that’s that’s true here. There’s a lot of methods makers modified accelerated cost recovery systems or acres. Right. Accelerated cost recovery systems. There’s bonus and there’s straight line. I’m going to pretend only straight line exists for two reasons.

Matthew Foreman [00:05:26]:
One, it’s simpler and, and two, it’s simpler. You might say Matt, those are the same. And I said great, you’re listening. Allocation of depreciation under 704c. So this is kind of a general discussion rather than a really specific discussion and I think it’s an important one. Depreciation is generally allocated based on the partnership agreement or if not in there, the partner’s interest in the partnership. Pip 704C says that depreciation must be allocated in a manner that allocates the maximum amount of depreciation the non contributing partner as a mechanism to minimize built in gain between partners. Right.

Matthew Foreman [00:06:01]:
So 704c if you contribute something that’s worth 100 as a basis of 50, the first $50, if the partnership were to sell it the next day, the first $50 of gain goes back to you. Okay. And that’s really important. So this basically would even it out. An asset with built in gain is any asset which is a fair market value that exceeds its tax basis due depreciation or depreciation ramonization allocable. The allocation method must be two things. The partnership consists one, the partnership consistently uses a single reasonable method for each method for each individual item of contributed property and to the overall combination of methods must be reasonable. This is why the other reasonable method exists.

Matthew Foreman [00:06:42]:
Get to that in a second. There are four methods that are allowed. Well, there are three methods that are identified traditional, traditional curative allocations and remedial. But any reasonable method is permitted. You can theoretically make it up. So there are five steps that are generally done under any allocation under 704C. I’m going to first talk about the traditional method. Step one, calculate the tax allocations.

Matthew Foreman [00:07:07]:
Step two, calculate the book allocations. Right. These are both for depreciation. I’m assuming depreciation here. Although amortization is generally 15 year. Straight lines, the same idea. Allocate the book amounts according to the partnership agreement. Allocate the tax amounts in the non contributing partners up to their share of the book amount.

Matthew Foreman [00:07:22]:
And then step five, allocate the residual tax amounts, if any, to the contributing partner. Right. So it goes to non contributing first, then contributing people. Get this wrong, they’ll be like 50, 50, partnership, 50, 50. Not the case. So here’s the example. Alma and Barry formed Acme partnership. Alma contributed printer, $500, fair market value, $300 basis for half and Barry contributed 50, $500 cash for 50 bucks.

Matthew Foreman [00:07:49]:
The printer is depreciated over 14 years. We’re pretending here. That’s kind of a long time for a printer. And there are 10 years remaining, which makes my math really easy. Reminder only straight line. So five steps. The tax allocations is $300 over 10 years, $30 a year, and the book allocations $500 over 10 years, $50 a year. So what happens in this mechanism, right, is the book allocations are 25 each, 50 divided by 2 makes it pretty easy.

Matthew Foreman [00:08:17]:
And then the tax allocations are going to be $25 to Barry and $5 to Alma. Right. So Barry’s book allocation is 25. He’ll get the first $25 of tax allocations. So that’ll equal itself out. Alma will get the remainder. So even though she’s a $25 book allocation, she’s gonna have a $5 tax allocation eventually. That’ll even itself out.

Matthew Foreman [00:08:40]:
I’m going to talk about the ceiling rule. I’m going to do that after we come back from the music break. So the searing rule is not. Is not really a rule, it’s more of a result. I don’t get to choose the names. I promise you, if I did, they’d be much more fun because I’m the kind of guy who calls a podcast how tax works. So the ceiling rule, what the function, what it does is it limits a non contributing partner’s total tax appreciation to the amount of that partner’s book tax allocation. Right? So that can cause a Distortion between the non contributing partners tax depreciation allocation and their book allocation due to the limited amount of tax depreciation that may be available.

Matthew Foreman [00:09:39]:
So let’s go through some math, right? Similar last one. Alma and Berry form. And I just want to point this out. This was a webinar that I did back in November. Highly recommend you either see it. I can send you a link. If you email me. I can send you a link so you can watch it.

Matthew Foreman [00:09:55]:
Or I actually have an article coming out in a Thomson Reuter publication. I can send you the link for that. Once that comes out, I think at some point it becomes freely available about 704C and these numbers and everything are in there. So I’m not changing it. I don’t think it’s necessary to be changed. And I’m kind of flying through this on purpose. Highly recommend the webinar. I actually thought it.

Matthew Foreman [00:10:15]:
It turned out pretty well and it’s fun to do and having the math in front of you will help you. Okay. So anyway. Almond Berry 5050 partnership Alma contributor, partner contributed printer with a $500 fair market value and a $200 basis. Previously it was 300, now it’s 200. You’ll see why. Barry again $500 cash, right? 50, 50. Printer is still 14 years, right.

Matthew Foreman [00:10:37]:
10 years remaining. And only straight line will be using these examples. So the tax allocation, $200 basis available over 10 years, $20 per year book allocation 500 bucks for 10 years, 50 per year. What’s going to happen is Barry has $25 of book depreciation but only gets $20 of tax depreciation, which means Alma gets no tax depreciation whatsoever. That ceiling rule, that extra $5 that he’s not getting there, that will sit until they sell the asset. And what ends up happening is ALMA will recognize extra gain, but basically the tax depreciation just doesn’t quite get there. So this is viewed as a problem. There’s quote unquote lost depreciation.

Matthew Foreman [00:11:19]:
The first way that that’s resolved is what’s called the traditional method which with curative allocations, okay, example is the same math. $500 fair market value printer, $200 basis, et cetera, et cetera. What happens here is because of the curative allocations, you take $5 of income from the business itself and it is reallocated to the contributing partner. So what ends up happening essentially is Barry only gets $20 of depreciation still from a tax perspective, but Alma gets an additional allocation. So let’s say There’s a total of $10 of income. What happens is the entire $10, instead of 5 and 5 between Alma and Barry, the entire $10 is allocated to Alma because a loss of a $5 deduction is. Is equal to $5 of. Is sort of the corollary.

Matthew Foreman [00:12:18]:
It’s the opposite of getting a $5 income. So by allocating five extra dollars of income to Alma, it’s the same as giving an extra $5 deduction to Barry. Ends up being the same nets itself out. So by the partnership reallocating the partnership revenue, not gain and not income. And this is important. I just use the word income. It’s actually revenue. It’s before you get to income, you’ll mitigate the ceiling rule.

Matthew Foreman [00:12:41]:
To be reasonable curative allocation cannot exceed the amount required to offset the distortion caused by the ceiling rule or else it’ll lack substantial economic effect. I’ll talk about that at some point later. That’s probably gonna be a webinar too. I think 704B is really interesting there. And generally curative allocations are reasonable if they’re made in the current taxable year. Or you can use them in a. You know, you use them and it mitigates the issue in a prior year, but it’s only for a reasonable period of time afterwards. So the economic.

Matthew Foreman [00:13:11]:
The property’s economic useful life or generally one year. Right. One year after. So say, for example, you have a $5 single problem. You have no income, no revenue whatsoever that that year, the next year you can allocate an extra $5 of revenue to. To the partner who would not have received that extra deduction, who got the benefit of it in order to allocate it to sort of do it. So it doesn’t need to be year over year. A lot of my clients are businesses that have profit and have revenue.

Matthew Foreman [00:13:35]:
At least have revenue. So this is not a huge issue. Curative really works well. Going to get some music in here and then we’re going to go to remedial and bring it on home with other reasonable methods. All right. The remedial method. I call this the let’s make up revenue method. Fights happen over which one I don’t know.

Matthew Foreman [00:14:11]:
Not convinced they totally. It totally matters between the curative and remedial. But I’ll talk about both because I think they’re important. The. The remedial method essentially creates an income and offsetting loss. Out of thin air. The income loss offset each other. So the net effect on the partnership is actually zero.

Matthew Foreman [00:14:28]:
Example. Right. Alma and Barry Alma again, 500 fair market value and a $200 basis. Barry contributes $500 of cash. Ten years remaining on the depreciation and there’s no partnership revenue. Right. The steps. Right.

Matthew Foreman [00:14:43]:
All the same, three to five. Right. So how do you allocate it? So what happens is the $20 of depreciation goes solely to Barry and then there’s an additional deduction. What happens is the remedial allocation is has to be enough to $5 again in order to push the income from Alma to Barry. You just don’t need the revenue. Other reasonable methods. The first rule of reasonable allocation methods under 704C is you don’t use. You don’t use other reasonable methods.

Matthew Foreman [00:15:12]:
Right. I’m not convinced there’s actually other reasonable methods other than the three. I think the overall method or the combination of methods is actually the any reasonable method. So because you can choose which method to use on different pieces of property, which is kind of bananas to me, kind of makes me think. But I think it’s really important to note that if you’re doing something where like doing it one way really pushes a lot of income to one partner and doing it another way really pushes income to another partner and you can do capital versus ordinary or you can do state allocations as it matters. I actually think that’s unreasonable and I think that’s why the overall reasonable method is required. The, the overall method or combination of methods must be in this quotation marks reasonable based on the facts and circumstances and consistent with the purpose of 704C. That’s under treasury regulation 1.743 a2.

Matthew Foreman [00:16:01]:
So I think this is where the IRS comes back and this is their stick. Right. They’re saying look, don’t be a jerk, don’t do this. Just pick a method, generally use it. Which method is best for which partner. Right. The traditional method is best for partners who can contribute assets with built in gain because the ceiling rule limits the amount could potentially limit the amount of deduction that the other ones take and doesn’t increase their income. The traditional method with curative allocations requires sufficient revenue, not income, but revenue to use the full depreciation deduction that’s available.

Matthew Foreman [00:16:34]:
It’s better for the non contributing partner, but it does require available revenue. The remedial method is generally almost always the same result as the traditional method with cured allocations but doesn’t actually require revenue. It is best for the non contributing partner essentially no matter what. People get in fights over this. I have been in ones where I’VE suggested politely the curative. People are like, I want remedial. I’ve been on deals where I think the other side would want remedial or curative. I just threw in curative and they said we want traditional.

Matthew Foreman [00:17:09]:
That confused me. I’ve seen it happen. But I’m not one to point out others mistakes that’d be mean and rude and inappropriate for me to do. So, you know, the question is what can you negotiate? What can you do? If you’re just a partnership and the partnership’s making a decision, model out what you have to do. Again, you can do it on every asset. That’s different. I generally tell people to pick one and stick with it. For tax return preparers, they very much prefer me to tell them to pick one and stick with it.

Matthew Foreman [00:17:37]:
And I think that’s appropriate. All right, well, this was a shorter one, but I thought it was good kind of breeze through it again. The webinar highly recommend if you’d like. Happy to send you the the video of it. That was the 43rd episode of How Tax Works. Back in two weeks with the 44th where I’m going to talk about common mistakes and misconceptions under section 1202 of the Internal Revenue Code qualified small business stock exclusion. Happy New Year to everyone and yeah, looking forward to Great year for everyone. Thank you.