Overview and Background
A partners share of
partnership income, gain, deduction, loss or credit is determined
by the partnership agreement. This reflects the flexibility afforded
by Congress. The agreement may be oral or written, although an
oral agreement may cause evidentiary problems. IRC
Sec. 704(a)
Section 704(a) allows
the partners to choose how to allocate income and deductions.
The partnership agreement may provide different allocation ratios
for sharing items of income, gain, deduction, losses and credits
among the individual partners. When an allocation ratio differs
from the partner's profit and loss sharing ratio, or it differs
from a partners relative capital contribution, it is referred
to as a special allocation .
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Example
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The partnership agreement may stipulate
that partners A and B share equally in profits and losses,
except that partner A would be specially allocated 100
percent of the depreciation on a building owned by the
partnership. In this case, the partnership ordinary income
would be computed exclusive of depreciation on the building.
Partner A would report on his tax return 50 percent of
partnership income as well as all of the depreciation
on the building.
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If a partnership
agreement is silent and does not provide for a special allocation,
or if a special allocation is made and the allocation lacks
substantial economic effect, then a partner's distributive share
of profit or loss can be redetermined by the IRS in accordance
with the partner's interest in the partnership. Both of these
terms are discussed in detail in the remainder of this chapter.
IRC Sec. 704(b)
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Example
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A partnership agreement may require that
partners F and G share equally in profits and losses,
except that partner F would be specially allocated 100
percent of the depreciation on a building owned by the
partnership. If the building is later sold for a profit
of $50,000, and the gain is shared equally by F and G,
then either the allocation, or the profit on the building
would not be consistent with the underlying economic arrangement
of the partners. Thus, the IRS could redetermine the partner's
distributive share of income or gain according to what
the Service determines to be the partners' true interest
in the partnership.
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Generally, the agreement
between the partners can be modified to include special allocations
at any time during the year. However, the amendments must be
made on or before the due date (including extensions) of the
partnership return.
IRC Sec. 761(c)
The provisions of
the 704(b) apply to all allocations and not just to 'special"
allocations. These allocations include:
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Item
allocations: A separate allocation of an item of income, gain,
loss, deduction or credit (i.e., depreciation)
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Bottom
line allocations: An allocation of partnership net income
or loss to a partner is treated as an allocation to that partner
of each item used in computing the partnerships bottom line
income or loss. Reg.
Sec. 1.704(b)(1)(vii)
Substantial Economic Effect
Origin
The substantial economic
effect test was adopted by the Tax Reform Act of 1976 and is alluded
to in Section 704(b) of the Code. It is the sole measure for determining
whether allocations contained in the partnership agreement would
be respected. Unfortunately, the Code never defined substantial
economic effect and left the dirty work to the IRS through its
Regulations. Final Regulations undertaking this chore were finally
adopted and generally apply to partnership tax years ending after
April 30, 1986. In certain circumstances, the principles of Section
704(b) can be applied retroactively back to years beginning after
1975.
In satisfying statutory
framework of Section 704(b), the Regulations provide that for
an allocation to be respected for tax purposes, the allocation
must satisfy one of the following:
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Test
1: Have substantial economic effect; or
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Test
2: Be made in accordance with the partner's interest in the
partnership; or
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Test
3: Be deemed to be in accordance with the partner's interest
in the partnership (i.e., an economic equivalency test).
Reg.
Sec. 1,704-1(b)(1)(i)
Each of these tests
are protective measures, often referred to as safe harbors.
Origin of the Section 704(b) regulations
Except for minor exceptions,
the Regulations' version of the substantial economic effect test
employs the following theory-. If capital accounts are maintained
properly, if allocations are reflected in capital accounts, if
partnerships are liquidated according to capital accounts, and
if partners with deficits in their capital accounts are required
to restore the deficit, then the special allocation has economic
effect. Emphasis on the capital account was first established
in the early version of the Section 704 Regulations and the case
law of the times. Since the current Regulations have elaborated
on this basically straightforward theory, a discussion and basic
understanding of partners' capital accounts is necessary.
Defining a partner's capital account
Capital accounts are
generally created by partnership agreement and help determine
a partners rights to the money and property of the partnership
and often measure what a partner has put into a partnership. Because
capital accounts help determine amounts that a partner is entitled
to receive upon a sale or liquidation, it is important to ensure
the following points:
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Capital
accounts, as opposed to basis, can be negative,
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A
partner's share of liabilities is not reflected in the capital
account. Upon initial contribution, assets net of any liabilities
will be reflected in the capital accounts.
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Capital
accounts do not always reflect the true value of a partners
interest. Fluctuations in fair market value are not usually
reflected in the balances.
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Capital
accounts are a partnership accounting mechanism and not a
tax mechanism.
Capital accounts tests
According to early substantial
economic effect tests, capital accounts were the crux of special
allocation. This rule was established in the 1970 Tax Court decision
of Orrisch
v. Commissioner. (55 T.C. 395 (1970)).
The Tax Court recognized
that allocations may have economic effect if they affect the
partner's capital account balances, which in turn will determine
the amount that a partner may take out of the partnership. The
taxpayer in Orrisch, however, failed to have a valid
special allocation because he did not address liquidation
rights to capital nor how a partner with a negative capital
account balance would be treated. These explanations are
beyond the scope of this module.
Economic Effect Defined
For an allocation to
have substantial economic effect the Regulations require that
the allocation must first have economic effect, and second, the
economic effect must be substantial.
Reg. Sec. 1.704-1(b)(2)(i)
As a general rule, a special allocation of income, gain, loss
or deduction has economic effect if, throughout the full term
of the partnership, all three of the following requirements
are met:
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Requirement 1-Capital account maintenance:
Partners' capital accounts are maintained in accordance with
the rules found in the Regulations.
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Requirement 2-Liquidation proceeds: Proceeds
in liquidation must be distributed according to the positive
capital accounts balances of the partners.
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Requirement 3-Obligation to restore: Any partner
with a deficit capital account balance following the liquidation
of an interest in the partnership is unconditionally obligated
to restore that deficit. Reg.
Sec. 1.704-1(b)(2)(ii)(b)
Capital
accounts maintenance (Requirement 1) --
As discussed
in the previous subchapter, the foundation of special allocations
begins with an analysis of the capital account. Without a solid
capital account reflecting the economic arrangement of the partners,
a special allocation can not begin to pass the muster of the substantial
economic effect Regulations. The partnership must also maintain
the partners' capital accounts on a book basis rather than on
a tax basis. This means that contributions of property and distributions
must be reflected in capital at fair market value, rather than
adjusted tax basis. Reg.
Sec. 1.704-1(b)(2)(ii)(b)
To maintain a capital account on a book basis, a partner's
capital account is increased by:
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Money contributed to the partnership
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The fair market value of property contributed,
net of any liabilities
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Allocations of partnership income and gain
and decreased by:
- Partnership
distributions of money
- The fair market
value of property distributed, net of any liabilities
- Expenditures
that are nondeductible under Section 705(a)(2)(B) or are
syndication costs
- Allocations
of partnership deductions and losses Reg.
Sec. 1.704-1(b)(2)(iv)(B)
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NOTE
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For partnerships that issue audited financial
statements on a GAAP basis, the above capital account
rules will result in a third set of books that must be
kept by the partnership (GAAP, tax and now "book" according
to the Regulations).
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Liquidation proceeds
(Requirement 2) -- Upon
liquidation of the partnership, the liquidating distributions
must be made in accordance with the positive capital account balances
of the partners. In other words, whatever a partner's capital
account balance reflects on a book basis is what the partner should
be entitled to receive in a liquidation. The determination of
the partner's capital account balance is made after taking into
account all capital account adjustments for the partnership taxable
year during which the liquidation occurs.
Obligation
to restore (Requirement 3) -- The
final requirement for satisfying the economic effect involves
situations where a partner has a negative balance in his/her capital
account. Because a negative capital account indicates that the
partner is in debt to the partnership, the Regulations require
that the debt be satisfied. Accordingly, when a deficit exists,
the partner unconditionally must be obligated to restore the negative
balance by the later of:
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The
end of the taxable year of liquidation, or
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90
days after the date of the liquidation.
This requirement
can be satisfied by having the partnership agreement specify
that each partner unconditionally is liable to restore a deficit
account balance. If such a provision is not present in the partnership
agreement, state law will generally impose such a requirement
on the general partners. Reg.
Sec. 1.704-1(b)(2)(ii)(b)(3)
The alternate economic effect test
In many cases, limited
partners are reluctant to unconditionally obligate themselves
to make future cash commitments. When this happens, the partnership
fails Requirement 3 and the economic effect test can not be satisfied.
As a result of this conflict between general and limited partners,
the Regulations provide an alternate economic effect test that
treats a special allocation as if it has economic effect.
In order to use
this more flexible alternate test, Requirements 1 and 2 of the
economic effect test must be satisfied and all of the following
conditions must be fulfilled;
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The
partnership agreement must contain a qualified income offset.
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Partners
without obligations to restore deficits must not receive special
allocations that create deficit balances in their capital
accounts
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Partners
with limited obligations to restore, must not receive special
allocations that create deficits beyond the amount of their
limited obligations. Reg. Sec. 1.704-1(b)(2)(ii)(c) and
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In order to fulfill the conditions of this alternate test,
a qualified income offset must be present.
A qualified income
offset is a provision in the partnership agreement that states
that any partner with a deficit in his/her capital account,
as the result of unexpectedly receiving a distribution, must
be allocated items of future income or gain in an amount sufficient
to eliminate the deficit balance, In other words, to preserve
the economic effect theory, it requires partners with positive
capital accounts to shift income or gain that would ordinarily
be taxable to them to the partners with the deficit account
balances. Reg,
Sec. 1.704-1(b)(2)(ii)(d)
Partner's Interest in the Partnership
What the Regulations
have provided are three protective tests, or safe harbors, to
ensure that the special allocation will be respected. So far,
we have examined the first one (Test 1) for determining economic
effect. Test 2 and 3 allow a special allocation, which may not
have passed the muster of the economic effect test, to be respected
if it is made in accordance with a partner's interest in the partnership.
A partner's interest in the partnership
(Test 2) -- A
special allocation will be respected if it is made in accordance
with a partner's interest in the partnership. A partner's interest
in a partnership refers to the manner in which the partners have
agreed to share the economic burdens and benefits of each item
of income, gain, loss, deduction or credit. Because each item
can be treated separately, the partner's sharing arrangement for
any specific item may not necessarily match the overall economic
arrangement of the partners. When this occurs, many factors must
be examined to determine each partner's interest in the partnership
and whether allocations are made in accordance with that interest.
As one might expect, this test is very subjective and can not
always be reduced to mechanical calculations. As discussed below,
this is the test that the IRS uses when economic effect is not
present. Reg.
Sec. 1.704-1(b)(3)(i)
Deemed in accordance with a partner's
interest in the p'ship (Test 3) -- The
Regulations provide for an economic equivalency test that provides
that an allocation will be deemed to have economic effect if,
at the end of each tax year, a hypothetical liquidation would
produce the same results to the partners that would occur if all
the detailed requirements of the economic effect test (Test 1)
had been satisfied. The test has more affectionately been referred
to as the dumb-but-lucky rule. Reg.
Sec.1.704-1(b)(2)(ii)(i)
IRS determination
When a partnership allocation is not respected because it has
failed all three safe harbors, the partnership items are allocated
according to the partner's interest in the partnership as determined
by the IRS. In essence, the IRS performs Test 2 on a facts and
circumstances basis. The Regulations, however, contain a rebuttable
presumption that each partner has an equal interest in the partnership.
This means as a starting point, or until the IRS determines otherwise,
each partner has an equal share of profits and losses and the
burden of proof is on the taxpayer to show otherwise.
Reg. Sec. 1.704-1(b)(3)(i)
Fortunately, the
Regulations list several factors to consider in determining
a partner's interest in the partnership besides a pro rata allocation.
These factors include:
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Relative
capital contributions
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Interests
of the partners in economic profits
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Interests
of the partners in cash flows.
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Rights
to capital upon liquidation
Given the complexity
of many business transactions, the factors can not be applied
many times with certainty. Reg.
Sec. 1.704-1(b)(3)(ii)
Plain vanilla partnerships
with simple capital structures (one in which a partner has the
same capital and profits interest year after year) should ordinarily
satisfy the partner's interest in the partnership of Test 2
or the dumb-but-lucky (economic equivalency) rule of
Test 3.
Tests for Substantiality
Because capital accounts
are blind to the character of income and losses, the economic
effect of an allocation is substantial if there is a reasonable
possibility that the allocation will substantially affect the
dollar amounts that the partners will receive from the partnership,
independent of tax consequences. The terminology can be very misleading
because the word substantial does not necessarily connote what
we expect the term to represent.
Under the Regulations,
an allocation is not substantial if the following tests are
met:
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If
any partner's after-tax position, in present value terms,
may be improved by the allocation.
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There
is a strong likelihood that no partner's after-tax economic
position (again, in present value terms) will be substantially
worse as a result of the allocation. In other words, if the
U.S. Treasury is the only loser, the allocation may fail this
present value test. Reg.
Sec. 1.704-1(b)(2)(iii)
Unlike the more objective tests for economic effect, the rules
for substantiality are more subjective. The Regulations focus
on two specific rules to aid in determining substantiality.
The Regulations provide that in addition to the limitations
of the general rules, an allocation will fail the substantial
test if either of the following events occur:
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Event I- Shifting Allocations: Those allocations
that occur within the same year among partners who are taking
advantage of nonpartner attributes. (See Subchapter 5B).
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Event 2- Transitory Allocations-. Those allocations
that occur in different tax years. Generally it involves an
original allocation in one year and then an offsetting allocation
in a later year.
The overall-tax effect
rule
Even though an allocation
survives the gauntlet of the special rules that apply to shifting
and transitory allocations, it may run afoul of the overall-tax-effect
rule. Under the special rules, the focus is on the partner's capital
accounts. Under the overall-tax-effect rule, the allocation is
not considered substantial if no partners economic situation is
worse than it would be in the absence of the allocation. Generally,
for this rule to come into action, the partners must have significant
nonpartner attributes (i.e., tax credits, NOLS, etc.) that the
allocation scheme is hoping to exploit and must have avoided the
application of the above two events.
Special
rule -- Value equals basis In determining whether an
allocation is substantial, the Regulations presume that the
fair market value of partnership property equals the property's
adjusted basis. If the basis of a depreciated asset is zero,
the fair market value is presumed also to be zero for purposes
of the substantial test. Reg.
Sec. 1.704-1(b)(2)(iii)(c)
This presumption
may prove highly significant in passing the substantial test.
For example, an allocation of depreciation coupled with a gain
charge-back provision without the presumption may be considered
to be not substantial (insubstantial ). This is because depreciation
deductions do not always represent decreases in fair market
value. Thus, a $10,000 machine that is fully depreciated with
an adjusted basis of zero may have a value equal to $7,000.
It is presumed that the partner had no knowledge that the fair
market value would remain greater than the adjusted basis and
that the purposes of depreciation allocation was not to defer
taxes. By presuming that the value is equal to basis (both amounts
equal to zero), the partner had no knowledge of future gain
and the allocation will not be considered transitory.
Shifting Allocations
As a general rule, an allocation to a partner that has economic
effect will not be considered to be substantial if the allocation
only reduces the sum of the total income taxes payable by the
partners with a minimal non-tax capital impact to the partners.
The Regulations state that the economic effect of an allocation
is not substantial if there is a strong likelihood that:
-
The allocation will create a net decrease
in the partners' total tax liability.
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The increase and decrease to capital accounts
of the partners for the year will not be much different than
if the allocation had not been made.
The test is performed on an annual basis. Reg. Sec. 1.704-1(b)(2)(iii)(b)
Character allocations --
In many circumstances, a shifting allocation arises
as a result of character allocations . This type of shifting
occurs where the type of income allocated to each partner is
based on a desire to minimize the partners' overall tax liabilities.
Thus, a special allocation of Section 1231 losses away from
a partner with Section 1231 gains, and an offsetting allocation
of ordinary losses to that partner would be a character allocation.
Character allocations generally are not substantial.
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Example 1
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Partners X and Y form the XY partnership
and in their partnership agreement include provisions
that satisfy the economic effect test of the Regulations.
Partner X is in a high tax bracket and partner Y is in
a very low tax bracket. During the year the partners amend
their partnership agreement to allocate 90 percent of
all of the tax exempt income from municipal bonds to partner
X. Partner Y is to receive 90 percent of all taxable dividends.
At the time that the partnership agreement was amended
there was a strong likelihood that the partnership would
earn $20,000 of bond interest and $20,000 of dividend
income. While the allocations may have economic effect,
they are not substantial. This is because the sum of the
tax liabilities owed by the partners will be less than
it would have been without the allocation, and the capital
accounts will be increased the same (with or without the
allocation). Thus, the amount received by the partners
in the event of liquidation remains unchanged after the
amendment. In this allocation, the IRS is the only loser.
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Example 2
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If in the above example
the allocation had been made at the formation of the partnership
without any knowledge of income expectations, the allocation
would be deemed to be substantial . Even if the partnership
earns $20,000 in tax exempt interest and $20,000 of dividends,
the allocation was made at a time when there was no knowledge
of income, nor the strong likelihood that the tax liabilities
of the partners would be reduced.
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Planning
Unfortunately, 20/20
hindsight plays an important role in this analysis. If at the
end of the taxable year in which an allocation is made, it is
determined that the capital accounts are not substantially different
from what they would have been without the allocation, then
a rebuttable presumption exists that there was a strong likelihood
that the partners should have known this. Thus, unless the partners
choose to rebut with evidence, the allocation will be deemed
to not be substantial. Reg.
Sec. 1.704-1(b)(2)(iii)(b)
Transitory Allocations
While shifting allocations were designed to occur within the same
taxable year, transitory allocations involve allocations covering
multiple tax years. The objective, however, remains the same -
to reduce the tax liability of the partners without impairing
their capital structures. Transitory allocations are not substantial.
Reg. Sec. 1.704-1(b)(2)(iii)(c)
An allocation in one year is transitory where its offset will
be largely by allocations in other years and there is a "strong
likelihood" that:
-
The partners' respective capital accounts
with the allocations will not differ substantially from their
capital accounts without the allocations.
-
The resulting total tax liability of the partners
will be reduced. Similar to shifting allocations, the only
losing partner after a transitory allocation is the IRS.
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Example 3
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Partners C and D form the CD partnership and in their
partnership agreement include provisions that satisfy
the economic effect test of the Regulations. Partner
C is in a high tax bracket and partner D is in a very
low tax bracket. In three years C is expected to retire
and drop to a low tax bracket. The partnership agreement
allocates 90 percent of all of the tax exempt income
from municipal bonds to partner C. Partner D is to receive
90 percent of all taxable dividends. According to the
agreement, at the end of three years, D is to receive
90 percent of the tax exempt earnings and C is to receive
all the taxable dividends. Beginning in year seven and
thereafter, the partners are to split all income, gains
deductions and losses 50/50. At the time that the partnership
agreement was amended there was a strong likelihood
that the partnership would earn $20,000 of bond interest
and $20,000 of dividend income each year.
While the allocations may have economic effect, they are
not substantial. This is because the allocation was made
with the strong likelihood that the total tax liability
of C and D would be reduced, and the capital accounts
at the end of year six will be the same whether or not
the allocations are made. The presumption (which is rebuttable)
is that the partners had a foreseen knowledge of the decrease
in C's tax bracket and made an attempt to take advantage
of it. Since the allocation is not considered substantial
, it must be reallocated according to the partner's interest
in the partnership.
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Types of transitory allocations
There are generally
two types of transitory allocations:
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Gain chargebacks
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Income
chargeback
Gain
chargebacks --
Partnership
agreements commonly provide that partners who are allocated
loss or depreciation deductions must also be allocated the first
gain from the sale of the assets, up to the amount of the deductions.
Due to the value equals basis rule (discussed above), the IRS
respects most gain chargeback allocations as being substantial.
Reg.
Sec. 1.704-1(b)(2)(iii)(c)(2)
Income
chargebacks --
Partnership
agreements also commonly provide that partners that have been
allocated net taxable losses will be allocated the first net
taxable income, in later years, up to the amount of those losses.
The Regulations give less comfort to income chargeback than
in gain chargeback situations. The Regulations provide no guidance
with respect to income chargebacks that occur within five years.
Reg. Sec. 1.704-1(b)(5) Example 2
Five year rule transitory exception
-- If an allocation would ordinarily be considered transitory,
it will still pass muster under the substantial test if there
is a strong likelihood that the offsetting allocation, in large
part, will not be made within five years after the original
allocation.
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Example 4
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Partners C and D form the CD partnership and in their
partnership agreement include provisions that satisfy
the economic effect test of the Regulations. Partner
C is in a high tax bracket and partner D is in a very
low tax bracket. In three years C is expected to retire
and drop to a low tax bracket, The partnership agreement
allocates 90 percent of all of the tax exempt income
from municipal bonds to partner C. Partner D is to receive
90 percent of all taxable dividends.
Assume that the allocation will be made to partner C for
a period of five years and then begin to reverse to partner
D in year six. In this case, the allocation will not be
considered transitory because the offsetting allocation
was not made in large part within five years of the original
allocation (determined on a first-in, first-out basis).
However, it should be noted that it is this type of allocation
that may come within the scope of the overall-tax-effect
rule
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