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VideoDigital Assets and Section 704(c): Allocation Considerations for Partnerships
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Digital Assets as Partnership Contributions
Using digital assets in the formation of businesses can create unexpected tax complexity. Although the tax law defines digital assets as personal property, many industry participants use them as currency. This, coupled with the fees and delays associated with converting digital assets to fiat currency through the traditional banking system, often leads entrepreneurs to contribute crypto assets in kind to new business ventures rather than contributing cash.
For businesses structured as partnerships, these in-kind contributions can complicate how taxable income is allocated among the partners, especially when the assets carry built-in gain or loss at the time of contribution.
How Section 704(c) Applies to Contributions
Under Section 721(a), a contributor of property to a partnership does not recognize gain or loss upon contribution. Instead, the partnership steps into the contributing partner’s shoes by taking the contributor’s original cost basis in the property. When the partnership sells the contributed asset, it will use this "carryover" cost basis to calculate its taxable gain or loss upon sale. The difference between the contributor’s cost basis and the fair market value (FMV) on the contribution date represents the "built-in" gain or loss that must be taken into account in allocating among the partners under Section 704(c) and the applicable regulations.
These rules apply to all types of contributed property, but digital assets have some practical characteristics that can make Section 704(c) allocations particularly challenging.
Why Digital Assets Create Unique Tax Challenges
One of the practical challenges in applying Section 704(c) to digital asset contributions is that taxpayers often don’t have the tax basis of their digital assets readily available.
A contributor’s history with digital assets may go back many years, and it may involve exchanges and other institutions that no longer exist. As a result, the underlying records needed to substantiate basis are often difficult or impossible to obtain.
Another challenge stems from the disconnect between how digital assets are used in practice and how they are treated for tax purposes. Digital asset enthusiasts tend to treat digital assets as currency, whereas the tax law views them as personal property. In transactions between industry participants, digital assets are often spent directly rather than converted to U.S. dollars first. This results in transactions that include both an ordinary expense element and a capital gain or loss component.
When these assets have been contributed to a partnership, the capital gain component must be further analyzed to distinguish between gain that was "built in" at contribution and gain that accrued afterward.
Partnership Contribution and Allocation Outcomes
To illustrate, suppose Tom and Matt are bitcoin developers starting a business, “Partnership TM,” to create new bitcoin software wallets. They require some start-up capital to acquire new computer equipment and cover ongoing expenses.
On January 1, 2025, Tom contributes $100,000 in cash. Matt, having bitcoin readily available and knowing that many vendors and contractors in the digital assets industry accept bitcoin as payment, contributes one bitcoin with an FMV of $100,000. Matt’s cost basis in the bitcoin was $30,000, and his acquisition date was October 31, 2023.
By the end of 2025, Partnership TM spent all of Matt’s contributed bitcoin on various expenses at an average value of $115,000. For simplicity, assume this was the partnership’s only activity during the year.
Summary of activity and resulting allocations
| Partnership TM | Beginning of Year | Income/(Expense) | End of Year | ||||
|---|---|---|---|---|---|---|---|
| Book | Tax | Book | Tax | Book | Tax | ||
| Assets | Cash | 100,000 | 100,000 | 100,000 | 100,000 | ||
| Bitcoin | 100,000 | 30,000 | (100,000) | (30,000) | – | – | |
| Partners' Capital | Tom | 100,000 | 100,000 | (50,000) | (50,000)1 | 50,000 | 50,000 |
| Matt | 100,000 | 30,000 | (50,000) | 20,0002 | 50,000 | 50,000 | |
| Income Statement | Ordinary Expense | (115,000) | (115,000) | ||||
| LT Cap Gain | 15,000 | 85,000 | |||||
1 Tom's tax allocation = 50% of ordinary expense + 50% of partnership gain on BTC.
2 Matt's tax allocation = 50% of ordinary expense + 50% of partnership gain on BTC + 100% of built-in gain on BTC.
Tax outcomes from the example
This scenario results in the following tax outcomes for the year:
- Partnership TM reports a taxable net loss of $30,000, consisting of $115,000 of ordinary expense and $85,000 of long-term capital gain ($115,000 FMV of bitcoin spent, less Matt’s carryover tax basis of $30,000).
- Of the $85,000 capital gain, $70,000 was "built in" at the time of contribution and is allocated directly to Matt. The remaining $15,000 of gain that accrued in the hands of the partnership is allocated evenly between Tom and Matt.
- The partners evenly split $115,000 of ordinary expense.
As a result, Matt is allocated net taxable income of $20,000, while Tom is allocated a net taxable loss of $50,000. This difference reflects the $70,000 of gain that was built into Matt’s contributed bitcoin. Comparing the beginning and ending balance sheet accounts, as shown in the table, illustrates how the special allocation of this amount eliminates disparities between book and tax values for both Matt and the partnership.
Applying Section 704(c) in More Complex Scenarios
The example above simplified certain conditions that are not always the case in practice. Specifically, it assumes that the original cost basis and acquisition date of the contributed property are known and that the total gain realized by the partnership exceeds the amount of built-in gain at the time of contribution. Under these assumptions, the "traditional" Section 704(c) allocation method can be applied relatively easily. If either assumption does not hold, determining the amount and tax character of the gain becomes more complex, and alternative Section 704(c) allocation methods may need to be considered.
One potential complication would be if the original acquisition date were in 2024 rather than October 31, 2023, as used in the example. The 2023 date makes it clear that any expenditure of bitcoin in 2025 results in long-term rather than short-term capital gain. However, a 2024 date would require that each transaction be analyzed separately to determine the proper tax character. This underscores the importance for taxpayers using digital assets to consistently track their cost basis and holding period.
Key Takeaways
Maintaining complete and consistent documentation is critical when contributing digital assets to a partnership. Considerations include:
- Tracking cost basis and acquisition dates for all contributed digital assets
- Documenting FMV at the time of contribution using a consistent, supportable methodology
- Coordinating tax reporting early in the entity formation process to support accurate Section 704(c) allocations
Weaver Can Help
Whether you are an entrepreneur forming a new digital asset business or an investor who needs help with reconciling your trading history, Weaver works with clients to address potential tax complications. Contact us to learn how we can support your planning and reporting needs.
Authored by David Hensley
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