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Substantial Economic Effect in Allocation of Partnership Income

Understand the requirements and implications of the substantial economic effect in allocating partnership income among partners.

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Substantial Economic Effect in Allocation of Partnership Income

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  1. Chapter 6: Allocation of Partnership Income Among the Partners: The Substantial Economic Effect Requirement

  2. Introduction • A partnership does not pay tax. It allocates its income among its members, who then pay income taxes. • Partners must pay income tax on their allotted share of income whether or not the income is actually distributed to them. • This is called a partner’s “distributive share of partnership income”.

  3. Introduction Cont. • Generally, partnerships may allocate their income among the partners in any way the partners see fit, subject to the following limitations: • Code Sec. 704(b): Allocations must have “substantial economic effect”. • Code Sec. 704(c): Pre-contribution (“built-in”) gain or loss must be allocated to the partner(s) who contributed the property. • Code Sec. 704(e): limits the ability of family partnerships to allocate income derived from services provided by one partner to other partner-family members. • Code Sec. 706(d): prohibits partnerships from allocating income to partners that was earned by the partnership before such partners joined. • Chapter 6 focuses on the first restriction.

  4. The Partnership Agreement is a Legal Contract • The tax law looks to the partnership agreement to determine how the partners share in the economic benefits or detriments of partnership operations. • Partners generally must abide by the provisions contained in the partnership agreement unless such provisions are in violation of local or state law. • The agreement dictates how the partners have agreed to share profits and losses and how the partnership’s assets will be divided in case of the liquidation of the partnership or of a partner’s interest.

  5. The Partnership Agreement is a Legal Contract Cont. • An allocation has economic effect if it affects the amount of money or other assets to which the partner will be entitled upon leaving the partnership. • If the partnership agreement does not tie the partner’s rights at liquidation to the allocations he or she has received during the time he/she has been a member of the partnership, then those allocations will not have economic effect.

  6. The Partnership Agreement is a Legal Contract Cont. • If the allocation of partnership profits and losses provided for in the partnership agreement has “substantial economic effect, amounts allocated to partners will be valid for income tax purposes. • If it lacks “substantial economic effect” such an item must be reallocated among the partners in accordance with their economic interests, if any, in the item of income or deduction. • It is very important that the allocations provided in the partnership agreement have substantial economic effect or its equivalent if the partners wish to be certain of the validity of their tax allocations.

  7. General Requirements for Substantial Economic Effect • The “substantial economic effect” test is intended to ensure that: • If a tax deduction allowed for a partnership expense involves a possible economic risk of loss to the partnership itself, then that tax deduction is allocated to the specific partner who is most likely to bear the economic burden of that loss. • Taxable income is allocated only to partners most likely to enjoy the economic benefit from the transaction generating the taxable income. • The “substantial economic effect” test has two parts: • Does the agreement have “economic effect”? • If the agreement has “economic effect”, is that economic effect “substantial”?

  8. The First Requirement: “Economic Effect” • An agreement has “economic effect” if: • It has economic effect under the general rule; • It meets the alternate test for economic effect; or • It has economic effect equivalence. • These three rules govern the allocation of deductions that arise from contributions, those allowed because of borrowed funds for which one or more partners has personal liability for repayment, and the allocation of taxable income other than reversals of nonrecourse debt deductions.

  9. The First Requirement: “Economic Effect”– General Rule • To satisfy the economic effect requirement under the general rule three tests must be satisfied. • The partnership agreement (or local law) must provide that: • The partners’ capital accounts must be “properly maintained” in accordance with Code Sec. 24(b); • Liquidating distributions must be made in accordance with those capital accounts; and • Partners with a deficit balance in their capital accounts must be required to restore such deficit balances to the partnership upon liquidation of their interests.

  10. The First Requirement: “Economic Effect”– General Rule Cont. • Capital Account Maintenance Requirements • The regulations require the creation and maintenance of a separate set of investor capital accounts. • They are intended to reflect as accurately as possible the economic relationship between the partners. • The regulations require that capital accounts be increased by: • Cash contributions • The FMV of property contributed to the partnership by the partners (net of liabilities assumed) • Allocated items of book incomeand gain as determined under Code Sec. 704(b)

  11. The First Requirement: “Economic Effect”– General Rule Cont. • Capital accounts must be decreased by: • Distributions of cash from the partnership to a partner • The FMV of any property distributed to a partner (net of liabilities assumed) • Allocated expenditures that are not deductible in computing partnership income under Code Secs. 702 or 703 and are not properly chargeable to capital • Allocated items of book loss and deduction as determined under Code Sec. 704(b)

  12. The First Requirement: “Economic Effect”– Alternate Tests • If the partnership agreement does not meet the third requirement under the general rule, the “alternative” economic effect test can still be met if the partnership agreement contains a special capital account adjustment provision and a “qualified income offset”. • If these requirements are satisfied, an allocation to the partner will be considered to have economic effect to the extent that the allocation does not cause or increase a deficit balance in such partner’s adjusted capital account as of the end of the partnership tax year to which such allocation relates.

  13. The First Requirement: “Economic Effect”– Alternate Tests Cont. • Capital Account Adjustments • Special adjustments must be made to the partner’s capital account to prevent it from inadvertently falling below the partner’s limited deficit capital account makeup requirement. • The account must be reduced by: • Certain expected allowable depreciation deductions • Allocations of loss and deduction that are expected to be made to such partner under Code Sec. 704(e)(2) , 706(d) rules, and certain gain or loss deemed to occur under Code Sec. 751 • Distributions that, as of the end of such year, are “reasonably expected” to be made to such partner

  14. The First Requirement: “Economic Effect”– Alternate Tests Cont. • Qualified Income Offset Provision • In order for a special allocation to have economic effect under the alternate test, the partnership agreement must contain a “qualified income offset provision”. • This requires that a partner: • Who receives an adjustment, allocation, or distribution that is not “reasonably expected” and that • Results in a deficit capital account balance in excess of the partner’s limited deficit capital account make-up requirement • Will be allocated items of gross income and gain in an amount and manner sufficient to eliminate such deficit as quickly as possible.

  15. The First Requirement: “Economic Effect”– Equivalence • Where the partnership agreement does not satisfy the requirements of either the general test or the alternate test for economic effect, allocations which produce economic results which are identical to those that would have been produced if the agreement had been in compliance with the stated rules are deemed to have economic effect.

  16. “Substantial” Economic Effect of Partnership Allocations • Even if an allocation satisfies the requirements for “economic effect” it must be substantial to be recognized by the IRS. • Three tests must be satisfied in order for the economic effect of an allocation to be deemed substantial: • The “shifting allocations” test; • The “transitory allocations” test; and • The “overall tax effects” test.

  17. “Substantial” Economic Effect of Partnership Allocations– Shifting Allocations • The economic effect of an allocation is not substantial if, at the time the allocation becomes part of the partnership agreement, there is a strong likelihood that: • The effect of the allocation on the partners’ capital accounts for the current taxable year will not differ substantially from the changes in the partners’ respective capital accounts that would have occurred if the allocations were not followed, and • The total tax liability of the partners for the years of the allocations will be less than if the allocations were not contained in the partnership agreement.

  18. “Substantial” Economic Effect of Partnership Allocations– Transitory Allocations • The regulations provide that an allocation is not substantial if there is a strong likelihood that: • The original allocation will be substantially offset by an offsetting allocation in the current or a future tax year; and • The total tax liability of the partners for the years of the original and offsetting allocations is less than if the allocations were not made. • If these two conditions are met, the allocation lacks substantiality unless the taxpayer can prove that there was not a strong likelihood that the offset would occur at the time of the first allocation. • The regulations treat an original and offsetting allocation as substantial if at the point of the original allocation there is a strong likelihood that the offsetting allocation will not in “large part” be made within five years after the original allocation.

  19. “Substantial” Economic Effect of Partnership Allocations– Special Rule • The regulations provide a very important exception to the transitory allocations test for planned future allocations of partnership gain on the sale or disposition of partnership property. • Reg. § 1.704-1(b)(2)(iii)(c)(2) provides that for purposes of Code Sec. 704(b), the fair market value of partnership property is deemed to be equal to its book value. • Therefore future allocations of gain from the sale or other disposition of partnership property will not be sufficient to offset current allocations of depreciation or other items of income or expense. • Such future allocations do not violate the transitory allocations test.

  20. “Substantial” Economic Effect of Partnership Allocations– Overall Tax Effects • The economic effect of an allocation will not be substantial if: • The allocation may, in present value terms, enhance the after-tax economic consequences of at least one partner; and • There is a strong likelihood that no partner will suffer substantially diminished after-tax economic consequences, again in present value terms.

  21. Chapter 7: Allocation of Income and Deductions From Contributed Property: Code Sec 704(c)

  22. Introduction • Code Sec 704(c) requires special allocations that do not cause the partner to suffer nontax economic costs, in order to prevent the use of partnerships and LLCs as tax avoidance vehicles. • Applies whenever a partner contributes property to a partnership with a fair market value that differs from its tax basis. • The purpose of the statute is to ensure that gain or loss inherent in contributed property is allocated to the contributor and to allocate among the noncontributing partners only the gain or loss that accrues after the date of contribution.

  23. Introduction Cont. • Anti-Abuse Rule • An allocation method is not reasonable if the contribution of property and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability.

  24. Traditional Method– General • In general, the traditional method requires that when the partnership has income, gain, loss, or deduction attributable to Code Sec. 704(c) property, it must make appropriate allocations to the partners to avoid shifting the tax consequences of the built-in gain or loss. • For Code Sec. 704(c) property subject to amortization, depletion, depreciation, or other cost recovery, the allocation of these deductions must also take into account built-in gain or loss inherent in the property at the date of contribution.

  25. Traditional Method– General Cont. • In general, under the traditional method, tax deductions for depreciation, depletion, etc. with respect to contributed property are first allocated to the noncontributing partners to the extent of “book” allocations of these items. • Any remainder is then allocated to the contributing partner.

  26. Traditional Method– Ceiling Rule Limitation • Under the ceiling rule, total income, gain, loss, or deduction allocated to the partners for a taxable year with respect to a Code Sec. 704(c) property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year.

  27. Traditional Method With Curative Allocations • A partnership may make “curative” allocations to reduce or eliminate disparities between book and tax items of noncontributing partners. • A curative allocation is an allocation of income, gain, loss, or deduction for tax purposes that differs from the partnership’s allocation of the corresponding book item. • A partnership may allocate ordinary income away from the noncontributing partner (and to the contributing partner) to make up for an inability to allocate sufficient tax depreciation to the non-contributing partner.

  28. Traditional Method With Curative Allocations Cont. • To be reasonable, a curative allocation of income, gain, loss, or deduction must be expected to have substantially the same effect on each partner’s tax liability as the tax item limited by the ceiling rule. • A curative allocation is reasonable only to the extent that it does not exceed the amount necessary to avoid the distortion created by the ceiling rule for the current year and only if the items used have the same effect on the partners as the item affected by the ceiling rule.

  29. Remedial Allocations Method • A “remedial” allocation can be made whether or not the partnership has other items of income or loss available to allocate to the noncontributing partner(s). • Remedial allocations are tax allocations of artificial income, gain, loss, or deduction used to offset disparities attributable to the ceiling rule under Code Sec. 704(c).

  30. Remedial Allocations Method • A partnership may adopt the remedial allocations method to eliminate the disparities caused by the ceiling rule. • Under this method, the partnership makes a remedial allocation of income, gain, loss, or deduction to the noncontributing partner equal to the amount of the limitation caused by the ceiling rule and a simultaneous offsetting remedial allocation of deduction, loss, gain, or income to the contributing partner.

  31. Remedial Allocations Method Cont. • Under this method, if property is sold at a gain for tax but at a loss for book, the noncontributing partners may be allocated a tax loss and the contributing partner an offsetting larger gain than the reported tax gain from the sale. • Essentially, the ceiling rule limitation is ignored.

  32. Special Rules– Depreciation Methods • The use of different depreciation methods for book and tax does not provide the opportunity to avoid application of Code Sec. 704(c). • A special rule applies for calculating book depreciation when the remedial allocation method is used: • The portion of the book basis up to the tax basis is recovered in the same manner as the tax basis. • The remainder of the book basis is recovered using any available tax method and period for newly purchased property of the type contributed or revalued.

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