For
partnership allocations to
be respected, they must
either be made in accordance
with the partners’ interests
in the partnership or they
must meet the requirements
for the substantial economic
effect safe harbor. If
allocations do not have
substantial economic effect,
they will be reallocated
according to the partners’
interests in the
partnership.
This
chapter will describe:
Factors
considered in
determining the
partners’ interests in
the partnership
Economic effect
Substantiality
Allocation of items
attributable to
non-recourse debt
Allocation of tax
credits
This
chapter will summarize a
complex system of rules
which have been designed to
curb abuse. IRC section
704(b) was intended to stop
partners from allocating
deductions based on purely
tax rather than economic
consequences. The rules
governing partnership
allocations (IRC section
704(b) and its accompanying
regulations) has been
criticized as being some of
the most difficult and
complex. Simple business
enterprises, which allocate
income and loss in a
straightforward and
consistent manner, should
not be unduly concerned with
the complexity of IRC
section 704(b).
Unlike S
corporations, which must
report all income and
expenses in proportion to
stock ownership,
partnerships provide the
flexibility of making
special allocations of
income, gain, loss, or
deductions among the various
partners. For example, a
partnership agreement may
allocate all of the
depreciation deductions to
one partner subject to the
limitations described
below. Additionally, a
partnership agreement may
specify that the partners
may share capital, profits,
and losses in different
ratios. Stated differently,
the sharing of profits does
not have to coincide with
the sharing of losses.
Because of
the flexibility inherent in
Subchapter K, partnership
agreements can be written to
reflect whatever economic
sharing arrangement and risk
sharing arrangement the
parties wish to execute.
For example, Partner A who
has skills goes into
business with Partner B who
has capital. Partner B
contributes $100,000 in
cash. A and B agree to
split the business profits
20/80 until B recovers his
entire investment;
thereafter profits are split
50/50. Special allocations
permit partners to assume
different levels of risk and
to set the timing of income
in accordance with their
preferences.
Such
flexibility comes with
strings attached. Partners
are not able to allocate tax
benefits among themselves in
a manner that is divorced
from their allocation of
economic profit or loss. A
partner who is economically
enriched by an item of
partnership income or gain
is required to shoulder the
associated tax burden.
Similarly, a partner who is
economically hurt by an item
of partnership loss will be
allocated the tax benefit of
the loss. The tax
allocations must ultimately
conform to the economics of
the partnership’s
transactions.
Even if the
tax allocations of income,
gain, loss, or deductions
clearly reflect the economic
sharing arrangement of the
partners, other statutory
provisions may come into
play:
IRC
section 704(c)
prescribes rules for
sharing allocations
pertaining to
contributed
property.
IRC
section 704(d)
prevents a partner
from deducting loss
if it exceeds the
basis of his
partnership
interest.
IRC
section 465 limits
deduction of
distributive share
of partnership loss
to amounts at-risk.
IRC
section 469 limits
deduction of
distributive share
of partnership loss
from passive
activities
An
allocation of partnership
income, gain, loss,
deduction, or credit will be
respected if it meets any
one of the following tests:
is
made in accordance
with the partners’
interests in the
partnership, or
has
substantial economic
effect, or
is
considered to be
made in accordance
with the partners’
interest in the
partnership under
the special rules of
Treas. Reg. section
1.704-1(b)(4).
The last
category covers allocations
of tax credits, percentage
depletion in excess of cost,
and deductions or losses
attributable to partnership
non-recourse liabilities.
The
following sections will
cover these three
tests by which
partnership allocations will
be respected.
A partner’s
distributive share of
income, gain, loss,
deduction, or credit is
generally determined by the
partnership agreement. The
term “partnership agreement”
is very broad and refers to
any agreement which has an
impact on the economic
sharing arrangement among
the partners or between one
or more partners and the
partnership Treas. Reg.
section
1.704-1(b)(2)(ii)(h). The
partnership agreement may be
oral or written. Any
document or oral agreement
which bears on the
underlying economic
arrangement of the partners,
is considered to be part of
the partnership agreement.
Examples of such documents
may be:
Loan and credit
agreements
Assumption
agreements
Indemnification
agreements
Subordination
agreements
Correspondence with
a lender concerning
terms of a loan
Guarantees
Emphasis: The
partnership agreement
encompasses more than just
the partnership agreement
document.
Determining
the Partner’s Interest in
the Partnership
The
partner’s interest in the
partnership test is a
subjective facts and
circumstances test. It
seeks to determine the true
economic sharing arrangement
of the partners based on all
of the facts and
circumstances (Treas. Reg.
section 1.704-1(b)(3)). The
regulations consider the
following factors to be
relevant but not exclusive:
a) the
partners’ relative
contributions to the
partnership
b) the interests of the
partners in economic profits
and losses
c) the interests of the
partners in cash flow and
other non-liquidating
distributions
d) the rights of the
partners to distributions of
capital upon liquidation
There is an
important interconnection
between the partners’
interest in the partnership
test and the substantial
economic effect test. The
two tests can be viewed as
two different roads leading
to the same destination.
Both seek to ensure that tax
allocations parallel the
partners’ economic
sharing arrangement.
Allocations will be
respected under either set
of rules. The economic
effect test is a mechanical
test governed by lengthy and
detailed regulations. In
contrast, the regulations
covering the partners’
interests in the partnership
test are short, simple, and
subjective.
The essence
of both tests is to tie the
tax allocations to the
partners’ economic sharing
arrangement.
The
substantial economic effect
test is actually a two-part
test. An allocation is
respected only if the
allocation has “economic
effect” and that economic
effect is “substantial”
Treas. Reg. section
1.704-1(b)(2)(ii).
Emphasis:
“Economic effect” and
“substantiality” are two
separate and different
inquiries. An allocation
could have economic effect
and still not be respected
due to insubstantiality.
The
economic effect test
provides a “safe harbor”.
Its advantage is that it is
mechanical and well
defined. It removes the
taxpayer from the
subjectivity surrounding the
partner’s interest in the
partnership test.
It is
important to bear in mind
that the economic effect
test does not apply to
non-recourse deductions or
other tax allocations such
as tax credits which do not
have a corresponding
economic allocation. The
term “non-recourse
deduction” refers to any
loss, deduction, or IRC
section 705(a)(2)(B)
expenditure attributable to
partnership non-recourse
liabilities. A non-recourse
liability is one in which
the lender’s only recourse
is to the property securing
the debt. Since the
partners have no economic
risk of loss with respect to
the debt, deductions based
on non-recourse deductions
do not fall within the realm
of substantial economic
effect.
It is
important to distinguish
between recourse and
non-recourse debt because
the substantial economic
effect test is only
applicable in the context of
recourse as opposed to
non-recourse debt. The
regulations contain a
separate “safe harbor” for
non-recourse deductions.
This will be discussed in
the section “Allocations
Attributable to Non-recourse
Deductions.”
Emphasis: If the
partnership is funding its
losses or deduction through
non-recourse debt, do not
evaluate allocations based
on substantial economic
effect.
Economic Effect
The way the
economic effect regulations
tie tax allocations to
economic benefits and
burdens is through the
capital accounts. For an
allocation to satisfy the
primary economic effect test
the partnership agreement
must, throughout the full
term of the partnership,
provide as follows:
Capital Accounts:
the partners must
maintain their
capital accounts in
accordance with the
rules contained in
Treas. Reg. section
1.704-1(b)(2)(iv).
Liquidation: upon
liquidation of the
partnership, or any
partner’s interest
in the partnership,
liquidating
distributions are
required in all
cases to be made in
accordance with the
positive capital
account balances of
the partners.
Unlimited Deficit
Restoration: upon
liquidation, a
partner with a
deficit in his
capital account has
an unconditional
obligation to
restore the amount
of the deficit.
It should
be emphasized that the first
requirement focuses on the
maintenance of book or
economic capital accounts.
The purpose of the capital
account maintenance rules is
to ensure that the
underlying economic
arrangement of the partners
is clearly reflected.
Analysis of the book capital
accounts is intended to
reveal the contribution
obligations and the
liquidation rights of the
partners. If a partnership
satisfies the primary
economic effect test, then
upon liquidation, a partner
is entitled to any positive
amount in his capital
account balance or is
obligated to restore a
deficit capital account.
A partner
is treated as obligated to
restore the deficit balance
in his capital account to
the extent of any
unconditional obligation of
the partner to make
subsequent contributions to
the partnership by the
partnership agreement or by
state or local law.
Hal, a high
bracket taxpayer, and Larry,
and a low bracket taxpayer
form a general partnership
in which they agree to
allocate all of the
depreciation deductions to
Hal. Everything else is
allocated equally. The
partnership agreement
contains the three
requirements for the primary
economic effect test. They
each contribute $50,000 and
obtain a recourse debt of
$900,000. They purchase a
building for $1,000,000.
Their opening balance sheet
is as follows:
Building
1,000,000
Recourse Debt
900,000
Capital – Hal
50,000
Capital – Larry
50,000
Assets
1,000,000
Liabilities &
Capital
1,000,000
The
partnership’s income and
expenses except for
depreciation are equal.
Only interest is paid on the
debt. A $50,000 loss due to
depreciation expense is
allocated to Hal per the
agreement. Thus, at the end
of Year 1, Hal’s capital
account is reduced to zero.
At the end of Year 2, Hal’s
capital account is a
negative $50,000.
Scenario
A:
The
partnership sells the
building for $1,100,000 and
liquidates at the beginning
of Year 3. Since the
building’s adjusted basis is
$900,000, the gain is
$200,000 ($1,100,000 less
$900,000). Hal and Larry
split the gain equally, each
receiving $100,000:
Capital
Hal
Capital
Larry
Beginning
(50,000)
50,000
Allocated Gain
100,000
100,000
Totals
50,000
150,000
Upon liquidation of the
partnership, Hal and Larry
would receive the amounts in
their capital account
balances, $50,000 to Hal and
$150,000 to Larry. Hal has
borne the economic burden of
the depreciation deductions
since his proceeds upon
liquidation are reduced by
that amount. Thus, the
special allocation of all
depreciation to Hal has
economic effect.
Scenario B:
The
partnership sells the
building for $800,000 and
liquidates at the beginning
of Year 3. The sale
produces a loss of $100,000
($800,000 less adjusted
basis of $900,000). The
loss is split equally.
Capital
Hal
Capital
Larry
Beginning
(50,000)
50,000
Allocated Loss
(50,000)
(50,000)
Totals
(100,000)
0
Because Hal
is a general partner, under
state law Hal is required to
restore the negative amount
in his capital account in
order to pay the lender
($800,000 sales proceeds
plus $100,00 from Hal). The
allocation of depreciation
to Hal has economic effect.
Larry’s liquidating
distribution was based on
his positive account balance
and Hal was obligated to
restore his capital account
deficit.
The
facts are the same as in
Example 6-1, but Hal is
a limited partner, who
is not obligated to
restore any deficit in
his capital account.
Therefore, the
partnership agreement
fails to satisfy the
third requirement of the
primary economic effect
test. Accordingly, the
special allocation of
depreciation to Hal
would not have economic
effect.
For
purposes of IRC section
704(b), the partnership
agreement includes all
agreements among the
partners or between the
partners and the
partnership. Thus,
although the
responsibility of the
partnership’s debt may
appear to be shared
equally among the
partners, it is
important to be alert to
the impact of side
agreements or
guarantees.
Alternate Test for Economic
Effect
The primary
test for economic effect
requires all of the partners
to have an unconditional
deficit restoration
obligation. They must make
contributions to restore
negative capital accounts,
if any, upon the
partnership’s liquidation.
This requirement obviously
presents a problem for
limited partners who wish to
limit their obligations to
make additional capital
contributions.
The
alternate economic effect
test addresses this
situation. Under the
alternate test, the first
two requirements of the
primary test for economic
effect must be met (capital
accounts must be maintained
in accordance with the
regulations and positive
capital account balances
must be respected upon the
partnership’s liquidation).
However, an unlimited
deficit restoration
obligation is not required.
Instead, the regulations
require that the partnership
agreement contain a
“qualified income offset”,
sometimes called a “QIO
provision.”
The
regulations state that the
partnership agreement
contains a qualified income
offset if it provides that a
partner who unexpectedly
receives certain
adjustments, allocations, or
distributions will be
allocated items of income
and gain in order to
eliminate a prohibited
deficit balance as quickly
as possible. If necessary,
the partner will be
allocated gross income or
gain.
In summary,
partners who are not
required to restore negative
capital account balances
cannot be allocated items
that would create a negative
capital account beyond their
obligation to restore. The
QIO provision is intended to
eliminate any unexpected
deficit balance in a
partner's capital accounts.
The QIO provision is
especially important in the
context of partnership
non-recourse debt, which
will be discussed later in
the chapter.
Economic Effect Equivalence
The
economic effect equivalence
test is also known as the
“dumb-but-lucky” rule.
Treas. Reg. section
1.704-1(b)(2)(ii). This
provision can protect
allocations based on
unsophisticated but
unabusive partnership
agreements from falling
outside the parameters of
the economic effect safe
harbor. If a partnership
agreement fails to include
the three requirements
needed to satisfy the
economic effect test, its
allocations can, in many
instances, still be
respected. For this to
happen, it has to be shown
that a liquidation of a
partnership at the end of
the year in which the
allocation in question takes
place, would produce the
same results that would
occur if the three
requirements of the primary
economic effect test had
been met.
Example
6-3
Joe, a
real estate developer
and Sara, a physician,
form a partnership to
operate an apartment
building. Sara is a
limited partner who
contributes $100,000 to
be used as working
capital and guarantees
$100,000 of the
partnership’s $500,000
debt. Joe is a general
partner. Joe and Sara
want to cut expenses, so
they write their own
partnership agreement
without consulting an
accountant or attorney.
They agree that all of
the losses will go to
Sara, with future
profits being split
50/50. They are unaware
of the complex
provisions of IRC
section 704(b) so none
of the requirements for
meeting the primary
economic effect test or
the alternate economic
effect test are included
in their partnership
agreement.
At the
end of 5 years, the
partnership has
cumulative losses of
$50,000 which have been
allocated to Sara. The
partnership liquidates,
repays the lender, and
distributes $50,000 to
Sara. The allocations
to Sara are valid
because they produced
the same results as if
the partnership
agreement satisfied the
economic effect safe
harbor.
Obtain
not only the partnership
agreement, but also any
other documents which
describe the business
deal – letters, loans,
guarantees,
indemnification, that
is, any collateral
arrangement which could
affect a partner’s
rights and obligations.
Compare
the allocations in the
partnership agreement
with those actually made
on the tax return. If
there are differences,
ask for an explanation
and supporting
documents.
Determine the nature of
the partnership’s debt.
Pursue a substantial
economic effect analysis
only in the context of
recourse debt.
Review
the partnership
agreement for the three
requirements of economic
effect contained in
Treas. Reg. section
1.704-1(b)(2)(ii).
Before
proposing adjustments,
be sure to consider the
economic effect
equivalence test, the
“dumb but lucky” rule.
Some unsophisticated or
very old partnership
agreements might not
contain the three
requirements of economic
effect, but the
allocations might still
have economic effect
equivalence.
Supporting Law
IRC section
704(b)
Supporting Regulations:
Economic
Effect section
1.704-1(b)(2)(ii)
Alternate Test for
Economic Effect section
1.704-1(b)(2)(ii)(d)
Economic Effect
Equivalence section
1.704-1(b)(2)(ii)(i)
Partnership Agreement
Defined section
1.704-1(b)(2)(ii)(h)
Orrisch v. Commissioner,
55 T.C. 395 (1970)
In this case, the
partnership agreement was
amended to allocate all of
the depreciation on two
buildings to Orrisch. The
agreement provided that gain
on the sale of partnership
property would be charged to
Orrisch’s capital account to
the extent of the
depreciation allocations,
and the remainder shared
according to partnership
interests.
Although
the capital accounts were to
reflect a chargeback in the
event of a gain, the
allocation lacked
substantial economic effect
because the adjusted capital
accounts were not to provide
the basis for liquidating
distributions.
Additionally, Orrisch was
not required to make up his
capital account in the event
that the property was sold
at a gain less than the
allocated depreciation.
Goldfine v. Commissioner,
80 T.C. 843 (1983)
In this case, Goldfine, an
affluent attorney, and
Blackard, a real estate
developer formed a
partnership to own and
operate an apartment
complex. The partnership
agreement called for an
equal split of the proceeds
of any sales of partnership
property, cash distributions
on refinancing, or
liquidation. All of the
depreciation was allocated
to Goldfine, a high bracket
taxpayer, and all of the
income computed without
depreciation was allocated
to Blackard (who had net
operating losses from other
activities). The court
concluded the allocations
did not have substantial
economic effect and
commented that “Bargaining
for tax benefits does not
establish a business
purpose”.
Miller v. Commissioner,
T.C. Memo 1984-336
Allocations of all the
partnership’s depreciation
to Miller were found not to
have substantial economic
effect. The partnership
agreement made no provisions
for the special allocations
to be reflected in Miller’s
capital account and provided
that upon liquidation,
proceeds would be divided
based on ownership
percentages and not based on
capital account balances.
The court concluded that
Miller did not bear the
economic burden of the
depreciation deduction
allocations.
Martin Magaziner v.
Commissioner, T.C.
Memo 1978-205
In this case, the
partnership agreement called
for a substantial portion of
the interest and
depreciation deductions in
the early years of the
partnership to be allocated
to Magaziner, a dentist.
The property was sold at a
gain in Year 6 and Magaziner
received more than half of
the proceeds while the
taxable gain was divided
equally.
The court
concluded that the special
allocations to Magaziner did
not have substantial
economic effect since they
did not affect the dollar
amounts Magaziner received
from the partnership.
Even if an
allocation passes the
economic effect test, it
must still be considered to
be substantial. The
substantiality test is
designed to prevent abusive
allocations which are
motivated by the partners’
individual tax profiles.
Unlike the economic effect
test, the substantiality
test is not strictly
mechanical.
An
allocation is considered to
be substantial if there is a
reasonable possibility that
it will affect the amount of
money partners will receive
independent of tax
consequences. If a tax
savings occurs for one or
more partners in the
partnership and the economic
sharing arrangement is
unaltered, then the
allocation probably lacks
substantiality. It is
impossible to evaluate
substantiality without
knowing the tax profiles of
the partners receiving the
allocations. Thus,
analyzing allocations for
substantiality involves
looking beyond the
partnership return.
Emphasis: It is
impossible to evaluate
substantiality without
knowing the individual tax
profiles of the partners
involved.
Tests for Substantiality
The
regulations contain one
affirmative test and three
negative tests for
determining substantiality.
The affirmative test, which
is the general rule, states
that an allocation is
substantial if it has a
pre-tax dollar effect. In
other words, the allocation
affects the amount of money
to be received by the
partners independent of tax
consequences.
The three
types of insubstantial
allocations described in the
regulations are as follows:
“Some Help, No Hurt”
allocations
Shifting character
allocations
Transitory
allocations
“Some Help, No Hurt”
Allocations
This rule
is also known as the
overall-tax-effect rule.
This rule looks at the
partners as a group and
takes into consideration the
individual tax profiles of
the partners in determining
the overall tax effect of an
allocation. The rule states
that if the after-tax
economic consequences of at
least one partner will be
enhanced as a result of the
allocation, and no partner’s
after-tax economic
consequences will be hurt,
then the allocation lacks
substantiality. This is
true even if the allocation
may affect the actual dollar
amounts to be received by
the partners.
Example
6-4
Stewart
and Walt are partners in
a profitable partnership
which owns and manages
an apartment building.
They have split the
profits 50/50 since the
inception of their
partnership. Walt is
also a partner in a
shopping mall
partnership in which
Stewart is not
involved. Due to the
loss of several major
tenants, the shopping
mall partnership lost a
significant amount of
revenue and generated a
large pass-through loss
on Walt’s individual
return for the year
2000.
Prior
to filing their
apartment partnership’s
return for tax year
2000, Walt and Stewart
decide to amend the
partnership agreement to
allocate 100 percent of
the partnership’s income
to Walt. The amendment
is made knowing that
Walt’s loss from his
other partnership will
completely absorb the
special allocation of
income.
This
allocation is
insubstantial because it
exploits the different
outside tax profiles of
the partners in order to
get an after-tax benefit
for one of the partners
without hurting the
other partner.
Shifting Allocations
A shifting
allocation reduces the
partners’ overall tax
liabilities in a given year
without altering their
capital account balances.
In other words, while the
partners may be allocated
the same amount of income or
loss, the partners attempt
to select the character that
will interact in the most
favorable manner with their
own individual tax
profiles. A straightforward
example would be one in
which a partner with a large
net operating loss
carryforward is allocated
all of the partnership’s
taxable dividends while a
high tax bracket partner is
allocated an equal amount of
the partnership’s tax exempt
interest income. Since
capital account balances
reflect amounts and not
character, a pure capital
account analysis of this
situation would not indicate
that the allocation lacked
substantiality.
Example
6-5
D and M
are partners in
partnership DM. D also
owns another business
that has created a large
carryforward net
operating loss. M is a
high tax bracket
taxpayer. DM expects
income both from its
business operations and
from interest in
municipal bonds. The
partnership agreement
allocates all income
from interest in the
municipal bonds to M and
an equal amount of
income form DM's
business operations to
D. The remaining income
from business operations
is shared equally. D
will use his
carryforward net
operating loss to offset
the income allocation he
receives from DM. M is
also in a good tax
position because he is a
high tax bracket
taxpayer and is being
allocated tax-free
income. This
transaction lacks
substantiality because
there is no pre-tax
effect on the capital
accounts, yet there is
an after-tax advantage
to the special
allocation.
Transitory Allocations
Transitory
allocations occur over 2 or
more years. An allocation
is considered transitory
when an original allocation
is offset by a reversing
allocation in the future and
there has been a tax savings
for one or more partners.
In other words, if the
allocations taken as a whole
produce a wash in the
capital accounts, and there
has been a tax savings for
one or more partners, then
the allocations may be
considered to be transitory.
In
analyzing whether or not
allocations are transitory,
the regulations begin the
analysis when the suspect
allocations become a part of
the partnership agreement.
If, from the beginning,
there is a strong likelihood
that the allocations taken
as a whole will leave the
capital accounts unaffected,
and one or more partners has
a tax savings, then the
allocations will not be
respected.
Example 6-6
Rod and
Chris are partners in a
partnership which owns a
single tenant commercial
building. The tenant, a
financially sound
business, has given them
a ten-year lease.
Because Rod and Chris
wanted to entice the
tenant to their
building, they
structured the lease to
have a below market rent
in the first two years.
Rod is a high bracket
taxpayer who plans to
dispose of other real
estate at a gain over
the next 2 years. Chris
has a net operating loss
carryforward and would
not immediately benefit
from an allocation of
loss. The partners
agree that Rod will be
allocated the
partnership’s rental
losses in the first 2
years of the lease. Rod
will receive an income
chargeback in years
three and four, and
thereafter the partners
will split the income
50/50.
The
allocation of loss to
Rod during the first 2
years would probably be
considered to be an
insubstantial transitory
allocation. When the
allocation became part
of the partnership
agreement, there was a
strong likelihood that
the allocations would
produce a tax savings
for Rod and that the
allocations would
produce a wash in his
capital account.
The
regulations discuss three
instances in which
allocation which would
otherwise be deemed to be
insubstantial transitory
allocations will be
respected:
Riskiness
Five Year Rule
Value Equals Basis
Rule
Riskiness
Transitory
allocations hinge on
blending predictable future
events with taking advantage
of the partners’ individual
tax profiles. The level of
risk involved in the
partnership’s contemplated
business transactions have a
bearing on whether or not at
the outset there is a strong
likelihood that there will
be a tax savings with
capital accounts remaining
neutral.
As stated
in this chapter’s overview,
one of the reasons the Code
permits special allocations
is to provide entrepreneurs
with the ability to
apportion risk. If the
allocations produce a bona
fide shifting of
entrepreneurial risk from
one partner to the other,
rather than a mere tax
savings, the allocations
will be respected.
Example
6-7
Jim and
Marc form a partnership
to set up a new
Internet-related
business. Since Jim has
started other successful
technology related
businesses, he is a high
bracket taxpayer and
would like to be
allocated all losses
during the initial years
of the new partnership’s
business. The partners
agree that Jim will
receive all losses until
the partnership becomes
profitable. All profits
will be allocated to Jim
until he has recovered
his losses and then the
partners will share
equally in profits and
losses.
This
example differs from
Example 6-1 in that it
is unknown if the
business will be
successful. At the time
the allocations are made
a part of the
partnership agreement,
it cannot be said that
there is a “strong
likelihood” that the
capital accounts will be
left neutral or that Jim
will have a tax
savings. If the
business takes off in
the first year, Jim will
have more taxable
income. If the business
fails, the losses in
Jim’s capital account
will never be recovered.
If there is
a strong likelihood that the
offsetting allocations will
not be made within 5 years
of the original allocation,
the transitory allocation
may be respected. Treas.
Reg. section
1.704-1(b)(2)(iii)(c). The
5-year rule presumes that a
sufficient level of risk
exists for the allocations
to be considered
substantial.
Value Equals Basis
Offsetting
allocations can come from
income chargebacks or gain
chargebacks. A gain
chargeback occurs when gain
on the disposition of
partnership property is
allocated to the partner who
received earlier losses from
the property, generally the
partner who received
depreciation deductions.
The gain chargeback will
restore the decrease in the
partner’s capital account
caused by the original
allocations of depreciation.
Such a fact
pattern could be viewed as
transitory because it
involves original
allocations of loss which
are reversed by later
offsetting allocations from
gain on the disposition of
property, potentially
leaving the capital accounts
neutral. This situation,
however, is protected by the
value equals basis rule.
The value
equals basis concept
presumes that the property’s
basis is the maximum amount
of value that the
partnership can ever obtain
to pay a creditor. Thus,
although offsetting income
allocations could come from
the disposition of the
property that gave rise to
the original loss
allocations, the regulations
ignore this possibility and
assume, however
unrealistically, that the
value of the property will
never exceed its basis.
Therefore,
depreciation deductions are
presumed to reflect true
economic loss, regardless of
what is happening in the
real world. This
presumption protects
allocations of loss caused
by deprecation and later
offset by an allocation of
gain on the sale of property
from being attacked as
transitory allocations.
Examination Techniques
Obtain
and review the tax
returns or RTVUEs of the
partners to ascertain
the individual tax
profiles of the partners
Review
all amendments to the
partnership agreement ─
was the partnership
agreement amended after
the end of the taxable
year and before the
filing of the return?
Take
into account the
character of the special
allocation item
General Rule section
1.704-1(b)(2)(iii)
Some Help, No
Hurt section
1.704-1(b)(2)(iii)
Shifting
Allocations section
1.704-1(b)(2)(iii)(b)
Transitory
Allocations section
1.704-1(b)(2)(iii)(c)
Amendments
to partnership
agreements section
1.761-1(b)(4)(vi)
Revenue
Ruling 99-43 ─ The Service
ruled that partnership
special allocations lacked
substantiality under Treas.
Reg. section
1.704-1(b)(2)(iii). The
partnership allocated all of
its cancellation of
indebtedness income to the
insolvent partner who would
be able to exclude it from
his gross income. Book loss
from the revaluation of
partnership property lowered
the partners’ capital
accounts. These allocations
did not produce any net
effect on the partner’s
capital account but produced
an overall tax savings.
Allocations Attributable to
Non-recourse Deductions Test
The special
rules in Treas. Reg. section
1.704-1(b)(4) refer the
reader to Treas. Reg.
section 1.704-2 that covers
the rules pertaining to
non-recourse deductions.
As stated
previously, a non-recourse
debt is one in which the
lender can only look to the
property securing the debt,
and not to the partners, for
repayment. In a pure
non-recourse situation, the
lender can foreclose on the
property but cannot take
collection action against
the partners. The
non-recourse deduction rules
are particularly important
in connection with real
estate partnerships where
borrowing on a non-recourse
basis is a common business
practice.
The
proceeds from non-recourse
borrowing can be included in
the basis of depreciable
property. Depreciating
property secured by
non-recourse debt is one way
of creating non-recourse
deductions.
An
allocation of deduction or
loss which is attributed to
a non-recourse liability
cannot have economic effect
because no partner bears the
economic risk of loss.
The
regulations in section
1.704-2 provide a safe
harbor for allocating
deductions and loss
attributable to non-recourse
debt. The regulations have
two main goals. One is to
tie the partnership’s
allocation of non-recourse
deductions to other items in
the partnership which do
have substantial economic
effect. By doing this, the
regulations attempt to
establish a rational
relationship between the
partner’s economic interest
in the partnership and his
or her share of the
non-recourse deductions.
The second goal is to ensure
that partners who have
received non-recourse
deductions will also receive
an appropriate share of
minimum gain.
Partnership Minimum Gain
It is
impossible to understand how
non-recourse deductions are
properly allocated without
understanding the concept of
minimum gain. In evaluating
non-recourse deductions
minimum gain, as opposed to
economic effect, is the
focus. Minimum gain is
created as the partnership
claims deductions, typically
depreciation, that decrease
the partnership’s basis in
the property below the
balance of the non-recourse
debt securing the property.
Emphasis: A
partnership with
non-recourse debts and
negative capital accounts
has minimum gain.
Example 6-8
Assume
a partnership owes one
million dollars in
non-recourse debt which
was used to acquire
depreciable property for
one million. If the
partnership takes a
$200,000 depreciation
deduction, the basis of
the property is now only
$800,000. The amount by
which the debt exceeds
the basis, in this case
$200,000, is the amount
of the minimum gain.
The concept
of minimum gain came out of
a 1983 court case,
Commissioner v. Tufts.
In that case, a non-recourse
lender foreclosed on an
apartment building whose
fair market value had fallen
below the amount of the
outstanding debt. When a
borrower surrenders property
to a lender in exchange for
debt relief, the transaction
is treated as a sale or
exchange. The petitioner in
Tufts argued that the amount
realized was the fair market
value of the property. The
court determined that the
amount realized by the
borrower included the full
amount of the non-recourse
debt.
If the
basis of the property is
less than the outstanding
amount of the non-recourse
debt, there is a potential
taxable gain on the
disposition of the property
regardless of its fair
market value. This
potential gain is referred
to as the minimum gain.
Emphasis: Simply
put, minimum gain is the
spread between the
property’s basis and the
amount of non-recourse debt
encumbering the property.
Minimum
gain is created in the
following ways:
Deductions (generally
depreciation)
Refinancing of
non-recourse debt
Conversion of a recourse
debt to a non-recourse
debt
Minimum Gain Chargeback
Another key
to understanding
non-recourse allocations is
the concept of minimum gain
chargeback. The general
idea behind the minimum gain
chargeback is that a partner
who receives the tax
advantage of a deduction for
which he or she bears no
economic risk of loss (such
as depreciation deductions
generated by basis created
by non-recourse borrowing)
may bear a tax liability in
the future due to the
allocation of income. This
allocation of income is
called a “minimum gain
chargeback”. At the
appropriate time, income
must be allocated to the
partner who received the
corresponding non-recourse
deductions.
The
allocation of income to
partners who received
non-recourse deductions
–minimum gain chargeback ─
is triggered when there is a
decrease in minimum gain. A
net decrease in partnership
minimum gain occurs when
Debt is
repaid
Taxable
disposition of the
property encumbered by
the debt
A
non-recourse liability
is converted to a
recourse liability
Emphasis: Minimum
gain chargeback refers to
the allocation of income to
partners who previously
received non-recourse
deductions. This occurs
when there is a decrease in
minimum gain.
Exceptions to the Minimum
Gain Chargeback Requirement
The general
rule is that a net decrease
in partnership minimum gain
creates a minimum gain
chargeback to the partners
who previously received the
non-recourse deductions.
There are, however,
instances in which a
decrease in minimum gain
will not necessitate a
chargeback. The most common
ones are:
If
the amount of
non-recourse debt
decreases because it
was converted to
recourse debt for
which partners will
bear the economic
risk of loss, then
the partners will
not be subject to a
minimum gain
chargeback. If the
debt is converted to
recourse with
respect to some
partners, but not
others, then the
partners who do not
assume any economic
risk of loss, as
defined in the 752
regulations will be
allocated minimum
gain. Future
allocations will be
evaluated using the
substantial economic
effect rules.
If
a partner
contributes his or
her own money to pay
down the
non-recourse debt or
increase the basis
of the property,
minimum gain will
decrease but no
chargeback is
necessary. In this
case, the partner
has “restored” her
prior non-recourse
deductions with her
own money; therefore
an allocation of
minimum gain is not
necessary.
Safe Harbor Allocation of
Non-recourse Deductions
Allocations
of non-recourse deductions
will be deemed to be made in
accordance with the
partners’ interests in the
partnership if the following
requirements are met:
Book capital
accounts are
maintained in
accordance with the
economic effect safe
harbor rules,
liquidating
distributions are
made in accordance
with positive
capital account
balances, and the
partnership
agreement either
contains an
unlimited deficit
restoration
obligation or a
qualified income
offset.
The
manner in which the
partnership
allocates
non-recourse
deductions among the
partners must meet a
consistency
requirement. This
means that the
allocation of
non-recourse
deductions must be
made in a manner
similar to the
allocation of items
which do have
substantial economic
effect. Thus, a
partnership would
not be able to
allocate all
depreciation
deductions to one
partner while
allocating all other
items on a 50/50
basis.
The
partnership
agreement must have
a minimum gain
chargeback
provision.
All
other material
allocations and
capital account
adjustments under
the partnership
agreement are
recognized under the
regulations (safe
harbor or partners’
interests in the
partnership).
The second
requirement attempts to tie
the allocation of
non-recourse deductions to
other items in the
partnership which have
substantial economic
effect. For example, if the
partnership agreement splits
all of a partnerships items
of income, gain, and loss
50/50, it would be
inconsistent to allocate one
partner 90 percent of the
partnership’s non-recourse
deductions. Partners with
straightforward allocations
of economic profit and loss
will most likely allocate
their non-recourse
deductions along the same
lines.
If the
partnership agreement has a
more complex economic
sharing arrangement,
non-recourse deductions may
be allocated within a
certain range and still meet
the consistency
requirement. The example
given in Treas. Reg. section
1.704-2(m)(ii)-(iii)
articulates this point. If
a partnership has an initial
sharing arrangement between
a limited and a general
partner of 90:10 which
changes at the partnership’s
break even point to a 50:50
split, then allocating
non-recourse deductions on
any ratio between 90:10 and
50:50 will meet the
consistency requirement. An
allocation of 99:1, however,
would not be considered to
be consistent, with other
items which do have
substantial economic effect.
Definition of
Non-recourse
Liability section
1.704-2(b)(3)
Partnership Minimum
Gain section 1.704-2(d)
Safe Harbor
Requirements section
1.704-2(e)
Resources
Federal
Taxation of Partnerships and
Partners, William S. McKee,
William F. Nelson, Robert L.
Whitmire (Publisher: Warren,
Gorham & Lamont) (3rd Ed.
2001)
Federal
Income Taxation of Partners
and Partnerships, Karen C.
Burke (Publisher: West
Nutshell Series)
BNA Tax
Management 712-1st TM
“Treatment
of COD Income Under Sections
704 and 752”, The Tax
Advisor (May 1993)
“IRS
Provides Guidance on Special
Partnership Allocations of
COD Income”, The Tax Advisor
(December 1999)
“Allocations of Non-recourse
Debt Deductions”, The Tax
Advisor (October 1987)
“Non-recourse Debt
Regulations Resolve Most
Special Allocation Issues”,
The Journal of Partnership
Taxation (Spring 1987)
Allocation of Tax Credits
It is
impossible to evaluate
whether or not a tax credit
was properly allocated
without first understanding
the nature of the credit,
the nature of the debt being
used to finance the property
(recourse or non-recourse),
and the complex rules of IRC
section 704(b) concerning
economic effect,
substantiality, and the
allocation of non-recourse
deductions. A basic
understanding of the
principles presented in this
chapter is necessary in
order to determine if the
allocation of credits should
be respected.
The Tax
Code has numerous provisions
for tax credits. The
credits most commonly seen
in the partnership context
are the low-income housing
credit under IRC section 42
and the rehabilitation tax
credit under IRC section
47. The rehabilitation
credit is part of the
investment tax credit. Both
the investment tax credit
and the low-income housing
credit fall under the IRC
section 38, General Business
Credit.
The
regulations treat the
allocation of the investment
tax credit (which includes
the rehabilitation credit)
differently from other
credits. For this reason,
the allocation of the
rehabilitation credit will
be discussed separately.
Tax
Credits In General
In general,
tax credits do not impact
the partners' capital
account. They, therefore,
have no effect on the dollar
entitlements of the partners
in terms of cash
distributions or cash upon
liquidation. Thus, an
allocation of a credit
cannot have substantial
economic effect and must be
allocated according to the
partners’ interests in the
partnership.
There is no
specific, mechanical, safe
harbor for allocating tax
credits. The regulations
state that if a partnership
expenditure that gives rise
to a tax credit and also
gives rise to valid
allocations of loss or
deduction, then the credit
will be allocated in the
same manner as the loss or
deduction which decreases
the partners’ capital
accounts. The regulations
also state that identical
principles apply with
credits that arise from
gross receipts of the
partnership. Treas. Reg.
section 1.704 1(b)(4)(ii).
Example
6-9
Development Corp., a
real estate developer,
is a partner in a
low-income housing
partnership. The other
partner is an investment
partnership. Profits
and losses are split
50/50, with the
depreciation and low
income housing credit
specially allocated 99
percent to the
investment partnership
and 1 percent to
Development Corp. The
debt is recourse debt
from an unrelated lender
and both partners are
general partners.
Assume that the
partnership's allocation
of depreciation, 99
percent to the
investment partnership,
has substantial economic
effect under IRC section
704-1.
Since a
partnership expenditure
gives rise to the tax
credit (the building’s
qualified basis) and
also gives rise to a
valid allocation of
partnership deduction
(depreciation) which
reduces the capital
accounts, the allocation
of tax credit 99 percent
to the investment
partnership partner will
be respected.
In the
above example, the
allocation of credit is
respected because its
associated allocation of
depreciation deduction is
respected. The allocation
of credit parallels the
allocation of depreciation.
In
analyzing whether or not
credits are properly
allocated, it is critical to
determine if the “other
valid allocation” to which
the credit is tied is to be
analyzed using the economic
effect rules of Treas. Reg.
section 1.704-1(b)(2) or the
rules in Treas. Reg. section
1.704-2 concerning the
allocation of non-recourse
deductions.
In the
above example, if the debt
were non-recourse, the
depreciation deductions
would lack economic effect
to the extent that they were
attributable to the debt
because no partner bears the
economic risk of loss for
them. Non-recourse
deductions must be allocated
either in accordance with
the partners’ interests in
the partnership under Treas.
Reg. section 1.704-1(b)(3)
or under the safe harbor
non-recourse deduction
provisions under Treas. Reg.
section 1.704-2(e).
The second requirement of
the non-recourse deduction
safe harbor presents an area
of concern in evaluating the
allocation of a tax credit
in a non-recourse context.
This consistency requirement
stipulates that allocations
of non-recourse deductions
are allocated in a manner
that is reasonably
consistent with some other
“significant” partnership
item (other than a minimum
gain chargeback) having
substantial economic
effect. This item must be
attributable to the property
securing the non-recourse
debt.
Example 6-10
The
facts are the same as in
Example 6-9, but the
debt is non-recourse
debt. The partnership
agreement meets the
non-recourse debt safe
harbor under Treas. Reg.
section 1.704-2(e). The
partnership agreement
calls for allocating
depreciation in
accordance with the
allocation of a
significant partnership
item that has both
substantial economic
effect and related to
the property secured by
the non-recourse debt.
The allocation of the
credit in accordance
with the allocation of
depreciation will be
respected.
Banks often
become investors in low
income housing
partnerships. If a bank
acts as a non-recourse
lender in addition to being
a partner, the bank is
considered to bear the
economic risk of loss to the
extent that the liability is
not borne by another
partner. Treas. Reg.
section 1.752-2(c)(1).
Example 6-11
A real
estate development
corporation and a bank
form a partnership to
develop low-income
housing. The bank acts
as the lender and
provides non-recourse
financing. The
partnership agreement
calls for profits and
losses to be split
equally with all of the
depreciation and credit
being allocated to the
bank. In this case, the
special allocation of
depreciation and tax
credit to the bank would
be evaluated under the
economic effect rules
since the bank bears the
economic risk of loss.
As long as the
allocation of
depreciation to the bank
has substantial economic
effect, the allocation
of the credit will be
respected.
Rehabilitation
Credit
Unlike the
low-income housing tax
credit, the rehabilitation
tax credit does have an
impact on the partners’
capital accounts. The
partnership must reduce the
depreciable basis of the
building by the amount of
the rehabilitation tax
credit. Similarly, a
partner must reduce his
capital account by his
ratable share of the
rehabilitation tax credit.
The rule
for allocating the
rehabilitation tax credit is
found in Treas. Reg. section
1.46-3(f)(2). The general
rule is that each partner’s
share of the rehabilitation
costs is based on the
general profit ratio of the
partnership. This ratio
should reflect the partners’
real economic sharing
arrangement.
The
exception to the general
rule is that a special
allocation is possible if:
All
related items of
income, gain, loss,
and deduction with
respect to the
property are
specially allocated
in the same manner,
and
Such allocation is
made either in
accordance with the
partner’s interest
in the partnership
or has substantial
economic effect.
Example 3
in Treas. Reg. section
1.46-3(f)(3) discusses a
partnership engaged in the
business of renting
equipment whose cost
qualified for the investment
tax credit. Under the
partnership agreement, the
income, gain or loss on
disposition, depreciation
and other deductions
attributable to the
equipment are specially
allocated 70 percent to one
partner and 30 percent to
the other partner. The
conclusion is that if this
allocation is made in
accordance with the
partners’ interests in the
partnership or has
substantial economic effect,
the cost of the equipment
(and therefore the tax
credit) will be taken into
account 70 percent by one
partner and 30 percent by
the other partner.
These regulations do not
permit the flexibility of
separately allocating items
being generated by the same
property. It would
not be possible to sever the
depreciation and credits
from other items of
deduction or income being
generated by the same
property. All related items
of income gain, loss, and
deduction from a particular
property must be allocated
together. Additionally,
such allocation must meet
the other requirements of
IRC section 704(b).
A real
estate professional and
a bank form a
partnership to
rehabilitate and rent a
historic building making
equal contributions.
The bank is also acting
as the partnership’s
lender. The bank is to
receive 99 percent of
the depreciation
deductions and 99
percent of the
rehabilitation credit.
All other profits and
losses are to be split
50/50. The partnership
will maintain capital
accounts in accordance
with the regulations,
positive capital account
balances will be
respected upon
liquidation, and the
partnership agreement
contains an unlimited
deficit restoration
agreement. The debt is
recourse debt.
In this
example, the allocation of
the tax credit 99 percent to
the bank will not be
respected because a) it is
not in accordance with the
general profit sharing ratio
of the partnership and b)
the income, loss, and
deductions are not allocated
in the same manner. The
credit will be reallocated
in accordance with the
partners' interests in the
partnership (50 percent
each).
Examination Techniques
Credits in General
Determine the nature
of the credit.
Determine what
expenditure or
receipt is most
closely associated
with the creation of
the credit.
Review the
partnership
agreement to discern
the business deal
(partners’ interests
in the partnership)
or to verify that
the requirements for
substantial economic
effect are present.
Verify that the item
most closely
associated with the
credit is allocated
properly and that
the credit is
allocated in the
same manner.
Check to see if all
items being
generated by the
property (income,
gain, loss,
deduction) are
allocated in the
same manner.
Review the
partnership
agreement to discern
the business deal
(partners’ interests
in the partnership)
or to verify that
the requirements for
substantial economic
effect are present.
Supporting Law
Allocation
of Credits Treas. Reg.
section 1.704-1(b)(4)(ii)
Allocation of Section 38
Credits Treas. Reg. section
1.46-3
Resources
Corporate
Investment in the Low-Income
Housing Tax Credit,
The Journal of Taxation,
December 1993, Peter M.
Lampert
