Capital Contributions Clause: Cash, Property, Services, and §721

The Three Contribution Types

Partners contribute three categories of value to a partnership: cash, property, and services. Each has its own tax treatment, its own capital-account mechanics, and its own drafting requirements.

Cash. The simplest contribution. Cash contributed equals the capital account credit. Tax basis in the partnership interest equals the cash contributed. No gain or loss. No §704(c) issues. The drafting is just an exhibit listing amounts.

Property. Non-cash property contributions get the §721 nonrecognition treatment for both partner and partnership. The contributing partner’s tax basis carries over to the partnership; the contributing partner’s outside basis equals the contributed property’s tax basis (adjusted for liability shifts under §752). Capital account credit is the fair market value of the contributed property. The mismatch between tax basis (carryover) and book value (FMV) creates the §704(c) gain or loss that must be allocated back to the contributing partner on subsequent sale.

Services. Services contributions are not property contributions; §721 does not apply. The contribution is governed by §83 (compensation in property for services), with two flavours. If the service partner receives a capital interest (a slice of current liquidation value), they have ordinary income at the time of receipt equal to the value of the interest, and the partnership has a corresponding compensation deduction. If the service partner receives a profit-only interest (no current liquidation value, only a share of future profits), Rev. Proc. 93-27 provides safe-harbor non-taxable treatment subject to four conditions.

The §704(c) Trap: Pre-Contribution Built-In Gain

When property is contributed at a value different from its tax basis, §704(c) requires that the pre-contribution gain or loss be allocated back to the contributing partner. The purpose: prevent shifting of taxable gain to other partners through property contribution.

Example: Partner A contributes property worth $100,000 with a tax basis of $40,000 (built-in gain of $60,000). Partner B contributes $100,000 in cash. They form a 50/50 partnership. The partnership immediately sells Partner A’s contributed property for $100,000.

Without §704(c), the $60,000 of gain on sale would be split 50/50, allocating $30,000 to Partner B. §704(c) instead allocates the entire $60,000 of pre-contribution gain to Partner A. Partner B is not taxed on any of it. The partnership’s post-contribution gain (none in this example) would split 50/50 under the regular §704(b) allocations.

Three §704(c) methods exist: traditional (just allocates the gain on sale), traditional with curative (also adjusts tax depreciation in subsequent years), and remedial (creates notional offsetting allocations to prevent §704(b)/§704(c) imbalance). Each has tradeoffs; the choice depends on the contributed property type, the partnership’s tax position, and the partners’ expected exit horizon. Tax counsel should review.

Sample Capital Contributions Clause

The Service-Partner Tax Trap and the Rev. Proc. 93-27 Safe Harbor

The most expensive contribution mistake in partnership drafting is granting a service partner a capital interest without realising the partner has just incurred ordinary income tax on the value of that interest. A service partner brought in as a 25% capital-and-profit member of an LLC with a $1M post-money value has $250,000 of ordinary income on the grant date, taxed at marginal rates. The partner often does not have the cash to pay the tax. The cure is to grant a profit-only interest under Rev. Proc. 93-27 instead.

Rev. Proc. 93-27 provides that a profits interest in a partnership is not taxable on grant if four conditions are met:

• The profits interest does not relate to a substantially certain and predictable stream of income from partnership assets (e.g. high-quality debt securities, net leases on real estate);
• The partner does not dispose of the profits interest within two years of receipt;
• The profits interest is not a limited partnership interest in a publicly traded partnership;
• The partnership treats the partner as a partner from the date of grant for all tax purposes.

Rev. Proc. 2001-43 clarifies that the partner is treated as receiving the profits interest at the date of grant rather than at vesting, eliminating the need to make a §83(b) election in the partnership context. However, practitioners commonly file a protective §83(b) election anyway to lock in the §83(b) regime if the IRS challenges the safe harbor.

A profits interest gives the recipient a share of partnership profits going forward but no share of current liquidation value. If the partnership were dissolved on the day of grant, the profits-interest partner would receive nothing. This is the defining feature: it is an interest in the future, not the present.

Liabilities and the §752 Outside Basis Adjustment

When a partner contributes property subject to a liability that the partnership assumes (or takes the property subject to), the §752 rules adjust the contributing partner’s outside basis. The contributing partner is treated as receiving a deemed distribution equal to the partnership’s share of the contributed liability (which reduces outside basis), and the contributing partner’s share of the assumed liability is treated as a contribution (which increases outside basis). The net effect depends on the contributing partner’s share of the assumed liability.

Example: Partner A contributes real property worth $500,000 with a tax basis of $200,000, subject to a $300,000 mortgage. Partner A’s capital account is credited with $200,000 (the net contribution: $500,000 FMV less $300,000 liability assumed). Partner A’s outside basis is calculated as: starting basis $200,000 (carryover from property) + Partner A’s share of the $300,000 assumed liability less the full $300,000 liability transferred. If Partner A’s share of the assumed liability is 50% ($150,000), the net outside basis change is $200,000 + $150,000 - $300,000 = $50,000.

If the net deemed distribution exceeds the contributing partner’s outside basis, the excess is gain under §731(a). This is a real and frequently overlooked trap when leveraged property is contributed. Always model the §752 calculations before contribution, with CPA review.

Authoritative Sources

• IRC §721 (contribution of property to partnership). Cornell LII.
• IRC §723 (basis of property contributed to partnership).
• IRC §704(b) and Treas. Reg. §1.704-1(b)(2)(iv) (capital account maintenance).
• IRC §704(c) and Treas. Reg. §1.704-3 (allocations for contributed property).
• IRC §752 and Treas. Reg. §1.752-1 to -3 (treatment of liabilities).
• IRC §83 (property transferred for services). Cornell LII.
• Rev. Proc. 93-27 (profits interest safe harbor). IRS.
• Rev. Proc. 2001-43 (profits interest grant timing).

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