Paul L. Caron

Tuesday, October 21, 2014

Osofsky: Unwinding the Ceiling Rule

Leigh Osofsky (Miami), Unwinding the Ceiling Rule, 33 Va. Tax Rev. 63 (2014):

As is widely known, the so-called “ceiling rule,” which applies under the traditional method for section 704(c) allocations, can create the wrong tax result. Specifically, the ceiling rule can result in misallocations of income, gain, loss, and deduction to both a partner contributing property and to the noncontributing partners. Notwithstanding these predictable misallocations, the Treasury Department still permits application of the ceiling rule under section 704(c). This Article challenges longstanding assumptions regarding the operation of the ceiling rule in the context of section 704(c). Historically, Congress and partnership tax experts assumed that the ceiling rule is perfectly unwound on liquidation or sale of a partnership interest. This assumption still operates to some extent today. The assumption glosses over a significantly more complicated reality. This Article closely examines the history of section 704(c) and the interaction between the ceiling rule and the rules regarding sales and liquidations of partnership interests. Doing so reveals that when and to what extent the perfect unwinding assumption holds depends (perhaps to a surprising degree) on (1) a variety of relatively arbitrary facts regarding the assets held by the partnership on liquidation or sale, and (2) the unintended interactions of inordinately complicated partnership tax rules. In reaching this conclusion, this Article displays that the ceiling rule, which has always been part of the section 704(c) regime, is even worse than it is commonly thought to be.

Fully appreciating the extent to which the ceiling rule can perpetuate mistaxation long after the liquidation or sale of a partner’s interest in the partnership is important. As explained in this Article, the ceiling rule creates enormous complexity and planning opportunities that unjustifiably accrue to the well informed. The ceiling rule creates this complexity and these planning opportunities not in order to tax taxpayers appropriately. Instead, when it applies, the ceiling rule creates uncontrovertibly incorrect tax results. The ceiling rule thereby unnecessarily creates a mess of the fundamentally important section 704(c) partnership tax rules governing allocations with respect to contributed property. Despite the mess it makes of the section 704(c) regime, the ceiling rule has remained part of it for decades in part because of the mistaken and oversimplified assumptions regarding the unwinding of the ceiling rule, and the resulting perceptions of the limited impact of the ceiling rule. By debunking these long-held assumptions, this Article displays there is no reasonable justification to continue to retain the ceiling rule.

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