PARTNERSHIP TAXATION:
PARTNERSHIP ALLOCATIONS
I.
RECOURSE ALLOCATIONS
A.
The Basic Rules of 704(b). A two part test for the validity of the allocations:
1.
2.
An allocation must first have an economic effect.
This means that the allocation must be consistent with the economic business
deal of the parties. 1.704-1(b)(2)(ii)(a).
Substantiality Test.
a.
b.
B.
There must be a reasonable possibility that the allocation will affect
substantially the dollar amts. to be received by the partners from the PS
apart from the tax consequences.
Insubstantiality results when the economic effect of an allocation is
likely to be eliminated by one or more allocations and the overall tax
liab. of the partners is reduced. 1.704-1(b)(2)(iii)(a).
The 3 tests for economic effect.
1.
The primary test. The "Big Three"
This is satisfied if the following is provided in the PS agreement:
a.
The capital accts. are maintained in accordance with the rules of 1.7041(b)(2)(iv).
(1)
The capital accts. are considered properly maintained only if
each partner's capital acct. is
(a)
Increased by the following: 1.704-1(b)(2)(iv)(a).
i)
The amt. of money contributed to the PS as well
as the FMV of property contributed (net of liab.
securing the property that the PS is considered to
assume under 752),
Allocations to the partner of PS income and
gain, including tax-exempt income.
ii)
(b)
Decreased by the following: 1.704-1(b)(2)(iv)(b).
i)
The amt. of money distrib. to the partner by the
PS as well as the FMV of the property distrib.
(net of liab. secured by the prop. that the partner
is considered to assume under 752).
Allocations of PS losses and deductions.
Allocations to the partner of PS expenditures
that are not properly deductible or chargeable to
a capital acct., i.e. gambling losses, bribes,
ii)
iii)
1
(2)
(3)
charit. contrib., syndication exp., etc.
The FMV reasonably agreed to among the partners in arm's
length negotiation will control if they have sufficiently adverse
interests. 1.704-1(b)(2)(iv)(k).
The FMV of the assets may be booked up on these occasions.
(a)
(b)
(c)
(d)
b.
c.
Contributions.
Distributions.
Profits Interests.
According to GAAP.
Upon liquidation, liquidating distributions must be made in accordance
with the positive capital acct. balances of the partners. 1.7041(b)(2)(ii)(b)(3).
If the partner has a deficit balance following a liquidation, the partner
must be unconditionally obligated to restore the deficit. Orrisch HELD:
The ct. decided that the Orrisches would not have been obligated to
contribute cash to the PS with respect to the losses if the PS later
dissolves.
EXAMPLE: A & B purchased a building for $100,000 agreeing to allocate all recourse deductions to B
with a gain chargeback to B.
Initial
Years 1-10: dep.
End Year 10
Sale for $100,000
End Balance
2.
A's capital B's capital
account
account
50,000
$50,000
$(100,000)
$50,000
$(50,000)
$100,000
$50,000
$50,000
Alternate Economic Effect (i.e. test for LP).
The PS agreement must satisfy four tests (the first two are identical to the
primary test).
a.
b.
c.
The capital accts. must be maintained in accordance with the rules of
1.704-1(b)(2)(iv).
Upon liquidation, liquidating distributions must be made in accordance
with the positive capital acct. balances of the partners.
An allocation must not create/increase a deficit in the partner's capital
acct. in excess of any limited deficit make-up provision.
(1)
(2)
If an allocation of loss does create/increase a deficit, the loss
must be reallocated in accordance with the other partners'
interests.
Expected contributions.
(a)
The partners must also reduce their capital accts. by
distributions reasonably expected in a later PS year in
2
(b)
(c)
which the loss allocation was made.
For purposes of an expected distrib., you must
"hypothetically" modify the capital accts. ahead of time.
This, however, may be netted by upward adjustments for
anticipated income and expected contributions.
COMPREHENSIVE EXAMPLE
Purchase of a building for $100,000. All allocations to B. Plus B issues a promissory note of $10,000
giving B a limited makeup provision of $10,000. Also, the PS expects to make a $30000 distribution to
each partner in year 6 by taking out a $60000 recourse loan. All other operating income and expenses
offset.
Initial
Years. 1-3: dep.
End Year 3
Distribution
Years 4-10: dep.
End Year 10
d.
A's capital
B's capital
B's "hypo"
account(GP) account(LP) capital account
$50,000
$50,000
$20,000
$(30,000)
$(30,000)
$50,000
$20,000
$(10,000)
$(30,000)
$(30,000)
$(70,000)
$(50,000)
$(10,000)
The agreement must also include a qualified income offset. (QIO).
Treatment of unexpected distributions. 3 steps.
(1)
(2)
First, the distribution to the partners.
Second, the QIO.
(a)
(b)
(3)
An LP who unexpectedly receives a distrib. which
causes the capital account to go negative (or in excess of
a limited makeup provision) must be allocated items of
future income/gain to eliminate any remaining deficit as
quickly as possible.
The allocation from the other partners must be in accord
with the other partners' interest, and comes from
ordinary income first.
The remaining income or losses from all of the other activities
must be allocated according to the other partner's interest in the
partnership.
3
EXAMPLE: Unexpected distribution in year 6 of $60,000 from a recourse loan taken out. The PS has
$150,000 operating income and expenses.
Initial
Years 1-5 yrs:
End Year 5
Year 6: distribution
QIO
Remaining
loss
Year 7-10: dep.
End Year 10
3.
II.
A's capital B's capital
account
account
(GP)
(LP)
$50,000
$50,000
$(50,000)
$50,000
$0
$(60,000)
$60,000
$(70,000)
$(40,000)
$(60,000)
$0
Economic Effect Equivalence (if neither of the above tests is met).
Allocations are deemed to have economic effect if the PS agreement, as
interpreted by reference to the applicable state law, ensures that a liquidation of
the PS will produce the same economic results as if the Big 3 were satisfied.
1.704-1(b)(2)(ii)(i).
NONRECOURSE ALLOCATIONS
This requires a separate test because the NR deductions never have economic effect.
A.
The safe harbor rule with respect to NR deductions.
1.
2.
The PS must maintain capital accounts; liquidate in accordance with the capital
accounts; and provide a QIO.
For the 1st tax yr. of NR ded'n and thereafter, the NR ded'n must be allocated in a
manner reasonably consistent with allocations (having substantial economic
effect) of some other significant PS item attributable to property securing the NR
liab. of the PS.
a.
b.
3.
4.
B.
For example, if the recourse deductions/operating income is allocated on
a 80/20 basis with a later switch to 50/50, then
The NR allocation includes any amount between these two numbers.
A MGC is required for all nonrecourse deductions.
All of the other allocations must be valid under 704(b).
Important definitions.
1.
PS Minimum Gain.
This is the amt. of gain the PS would realize if it disposed of each of its
properties subject to a NR liability for no consideration other than satisfaction of
4
2.
debt, i.e. the excess of NR liab. over the AB of the property. 1.704-2(d)(1).
NR Deductions
Deductions which relate to the net increase in PS minimum gain.
EXAMPLE: Building (5 yr. life) bought for $20 and $80 of NR debt. The building is depreciated to $60,
but its FMV is still $100. They share everything equally.
Initial
Year 1: recourse deds
End Year 1
Years 2-5: nonrecourse deds
End Year 5
GP
LP
$10
$(10)
$0
$(40)
$(40)
$10
$(10)
$0
$(40)
$(40)
Basis NR liab. MG
$100 $80
$(20)
$80
$80
$(80)
$0
$80
Increase
(Decrease)
$0
$0
$0
$80 $80
$80
EXAMPLE: Same as above, except that GP contributes $5 and LP contributes $15. Recourse ded'ns are
allocated in that ratio with a later "flip" to 50/50. NR ded'ns are allocated 30% to GP and 70% to LP.
Initial
Year 1: recourse deds
End Year 1
Years 2-5: nonrecourse deds
End Year 5
3.
4.
GP
LP
$5
$(5)
$0
$(24)
$(24)
$15
$(15)
$0
$(56)
$(56)
Basis NR liab. MG
$100 $80
$(20)
$80
$80
$(80)
$0
$80
Increase
(Decrease)
$0
$0
$0
$80 $80
$80
Partner's share of MG.
The premise of the regs. is that NR ded'n may reduce a partner's cap'l acct. below
0 to the extent of the partner's share of MG, because they will be recaptured and
charged back to the partner to whom they were allocated.
Minimum Gain Chargeback.
a.
For any tax yr. in which there is a net decrease in a partner's share of
MG, that partner must be allocated, by a provision called a MG
chargeback, income and gain equal to the net decrease in the partner's
share of MG. 1.704-2(f)(1).
(1)
(2)
b.
A decrease can occur when property subj. to NR debt is
disposed.
A decrease can also occur when the principal amt. on a NR liab.
is reduced, or converted from NR to Recourse.
MG Chargeback applies to both GPs and LPs.
5
EXAMPLE: Same as above except the building is disposed after the 3d year.
GP
LP Basis NR liab. MG Net MG
$5
$15 $100
$80
$0
$(5) $(15) $(20)
$0
$0
$0
$80
$80
$0
$(12) $(28) $(40)
$40
$4
$12
$28 $(40)
$(80) $(40)
$(40)
$0
$0
$0
$0
$0
Initial
Year 1: recourse deds
End Year 1
Years 2-3: nonrecourse des
Year 4: sale
End balance
c.
Exceptions.
If a partner contributed capital to the PS to pay its NR debt.
(1)
(2)
That partner's share of MG will decrease, but the capital
contribution increases his capital acct. equal to the decrease in
MG.
Therefore, a partner is not subject to a MGC to the extent that the
decrease in the partner's share of the MG is attributable to the
partner's own capital contribution that was used to pay off the
PS's NR debts. 1.704-2(f)(3).
EXAMPLE: Same as above except that GP contributes $30 to pay off $30 of NR debt in year 4.
Operating income and operating expenses both equal $20.
Initial
Year 1: recourse deds
End Year 1
Years 2-3: nonrecourse deds
End Year 3
Year 4: Contribution
MGC
Remedial recourse deds
End Year 4
GP
$5
$(5)
$0
$(12)
$(12)
$30
LP Basis NR liab. MG Net MG
$15 $100
$80
$0
$(15) $(20)
$0
$0
$80
$80
$0
$(28) $(40)
$40
$40
$(28)
$40
$80
$40
$(30) $(30)
$7
$(27)
$(20)
$20
$(10)
$(9) $(21)
$20
$50
$30
6
EXAMPLE: Same as above, but operating expenses and income now equal only $5.
Initial
Year 1: recourse deds
End Year 1
Years 2-3: nonrecourse deds
End Year 3
Year 4: contribution
MGC
Remedial deds
End Year 4
Year 5: nonrecourse deds
MGC
End Year 5
(3)
C.
GP
LP Basis NR liab. MG Net MG
$5
$15 $100
$80
$0
$(5) $(15) $(20)
$0
$0
$0
$80
$80
$0
$(12) $(28) $(40)
$40
$40
$(12) $(28)
$40
$80
$40
$30
$(30) $(30)
$5
$(25)
$(20)
$20
$(10)
$(7) $(23)
$20
$50
$30
$(6) $(14) $(20)
$20
$(2)
$2
$20
$(15) $(35)
$0
$50
$50
If nonrecourse debt is changed into recourse debt.
There is no MG chargeback to the extent the P's EROL
increases. 1.704-2(f)(2).
Distrib. of NR Liab. Proceeds allocable to the increase in minimum gain.
Because there are no NR ded'n in this scenario, the PS is unable to allocate MG to a
partner to whom the corresponding NR ded'n were allocated.
1.
2.
Essentially, the excess MG is assigned automatically to the distribution because
the increase in the NR liability cannot produce income.
Therefore, the distribution is treated as carrying out part of the MG.
EXAMPLE: GP and LP each contribute $10 cash. Building (5 yr. life) bought for $20 and $80 of NR
debt. The building is depreciated to $0, but its FMV at the end of 5 years was $180. The partners borrow
an additional $100 NR in year 6 and distribute equally.
End Year 5
Year 6: distribution
End Year 6
III.
GP
$(40)
$(50)
$(90)
LP
Basis NR liab. MG Net MG
$(40)
$0
$80 $80
$(50)
$0
$100 $100
$100
$(90)
$0
$180 $180
ALLOCATIONS WITH RESPECT TO CONTRIBUTED PROPERTY 704(c)
A.
Introduction
1.
2.
B.
704(c) operates solely on tax allocations.
Technically, it narrows the book/tax disparity.
General allocation principles.
7
1.
An item of G/L with respect to property contributed by a partner to a PS shall be
shared among the partners so as to take acct. of the variation between the AB of
the property to the PS and its FMV at the time of contribution. 704(c)(1)(A).
a.
Precontribution G/L must be allocated back to the contributor.
(1)
(2)
b.
2.
The Service will generally accept a valuation determined at arm's length
if the partner's interests are sufficiently adverse. 1.704-1(b)(2)(iv)(h).
Allocations with respect to built-in G/L are made under 1 of 3 methods.
a.
b.
c.
C.
If the property's book value is greater than its AB, the difference
is "built-in gain," and
if the AB exceeds BV, the difference is "built-in loss."
1.704-3(a)(3)(ii).
Traditional method. 1.704-3(b).
Traditional method with curative allocations. 1.704(3)(c).
Remedial method. 1.704-3(d)
Sales and exchanges of contributed property: 704(c) allocation methods.
1.
Traditional method
a.
Requirements
(1)
(2)
b.
This generally requires a PS to allocate any built-in G/L to the
contributing partner. 1.704-3(b)(1).
The difference between the BV and its tax basis requires the PS
to keep two sets of books.
Ceiling Rule Limitations
(1)
(2)
This rule states that the total tax G/L allocated to the partners
may not exceed the tax G/L realized by the PS. 1.704-3(b)(1).
This rule, however, can result in shifting of tax burden and
tax/book disparities could result because the partner may not be
able to "book up" any disparity.
EXAMPLE: GP contributes $100 cash. LP contributes land with $50 basis and $100 FMV. It is
eventually sold for $70.
Initial
Gain on sale
GP
LP
Tax Book Tax Book
$100 $100 $50 $100
$(15) $20 $(15)
8
$100 $85
Final
2.
Traditional method with curative allocations.
a.
This allows the PS to make reasonable "curative allocations" of other PS
tax items of income, gain, loss, or deduction to correct the distortions of
the ceiling rule. 1.704-3(c)(1).
(1)
(2)
b.
3.
$70 $85
A curative allocation is an allocation made solely for tax
purposes that differ from the PS allocation of the corresponding
book item.
As such, a curative allocation has no economic effect.
Disadvantage: this only corrects in the year of distortion if the PS has
enough recognized tax gain.
Remedial method
a.
b.
This allows the PS to restore its books by creating a tax G/L of the
appropriate type needed to offset the ceiling rule distortions. These do
not affect the capital accounts. 1.704-3(d)(1).
If a tax/book disparity results, the PS may make a remedial allocation to
the noncontributing partner equal to the full amt. of the disparity and a
simultaneous offsetting remedial allocation to the contributing partner.
1.704-3(d)(1).
EXAMPLE: Same as above except without the purchase and sale of a security.
Initial
Gain (loss) on land
Remedial Allocation
End balance
4.
D.
GP
Tax Book
$100 $100
$(15)
$(15)
$85
$85
Planning aspects
The partner's may choose the traditional method if the contrib. partner is in a high
tax bracket because it understates the contrib. partner's gain and defers the
noncontributing partner's use of a deduction.
Depreciation of contributed property
1.
LP
Tax Book
$50 $100
$20 $(15)
$15
$85
$85
Traditional method.
a.
The Steps.
9
(1)
(2)
(3)
b.
Allocate the book depreciation according to the PS interest.
Then, allocate tax depreciation to the non-contributing partner to
the extent of book depreciation.
Finally, allocate any leftover depreciation to the contributing
partner. 1.704-3(b)(1) and -3(b)(2)
Effect of the ceiling rule: The partners tax depr. deductions cannot
exceed the PS total tax depreciation deductions.
EXAMPLE: GP contributes $100 cash, and LP contributes building (10 yr. property) with $50 basis and
$100 FMV.
Initial
Year 1: dep.
End Year 1
2.
E.
Traditional method with curative allocations.
If elected, the PS may make a curative allocation to the noncontributing partner
of the depreciation deduction not allowed under the ceiling rule to correct the
distortion. 1.704-3(c).
Other applications of 704(c).
1.
2.
3.
IV.
PS Basis
GP
LP
in Bldg Tax Book Tax Book
$50 $100 $100 $50 $100
$(5) $(5) $(5)
$(5)
$45 $95
$95 $50
$95
When a new partner is admitted, the PS may allocate built-in gains dormant in
the PS by revaluing PS assets along with corresponding upward adj. in the
partner's capital accts.
The rules of 704(c) should also come into play.
If revaluation is not elected a shift in income may occur, which the regulations
may treat as a gift or compensation to the new partner.
ALLOCATIONS OF PS LIABILITIES TO BASIS
A.
Recourse Liabilities.
1.
Economic Risk of Loss ("EROL")
A PS liability is recourse only to the extent that a partner or any person related to
the partner bears the EROL w/ respect to the debt. 1.752-1(a)(1).
a.
b.
In general, the partner bears the EROL to the extent the partner would be
ultimately obligated to pay the debt if all PS assets were worthless and
all PS liabilities were due and payable.
In order to allocate the EROL, the PS must go through a constructive
liquidation.
10
2.
Constructive Liquidation
The PS assets (including cash) are deemed worthless.
All PS liabilities become due and payable.
The PS disposes of assets in a taxable exchange for no consideration
(other than relief of NR liabilities).
d.
The PS allocates G/L among the partners and liquidates.
The regs. require the PS to constructively liquidate all assets.
e.
EXAMPLE: GP contributes $100 of cash and LP contributes $150 cash. A building was bought for $250
in cash and $750 recourse debt. They share all losses equally.
a.
b.
c.
CAPITAL ACCOUNTS
Prior to atom bomb
Loss after atom bomb.
Share of liab.
3.
GP
$100
$(850)
$(750)
BASIS
Contribution (§721)
Alloc. of liab. (§752(a))
LP
$150
$(150)
$0
GP
LP
$100 $150
$750 $0
The partner bears the EROL to the extent that she must contribute to the PS at
the time of the deemed liquidation.
a.
In determining the partner's pmt. obligation, all factual circumstances
must be taken into acct., including
(1)
(2)
(3)
b.
c.
Contractual obligations outside of the PS agreement. 1.752-2(b)
(3)(i).
Obligations imposed by the PS agreement, i.e. deficit restoration
obligations. 1.752-2(b)(3)(ii), and
The value of any property pledged (directly/indirectly) by the
partner to secure any PS liability. 1.752-2(h)(3) The value of
property pledged is deemed to be the value at the time it was
pledged.
The regs. assume that the recourse liab. will be paid by the partners to
the extent they are personally obligated to do so even if the partner's net
worth is less than the amt. of the obligation unless the facts and
circumstances indicate a plan to circumvent or avoid the obligation.
1.752-2(b)(6).
Broad General Rule with respect to limited partners.
Recourse debt is not allocated to a LP unless
(1)
(2)
The LP contributes a promissory note, pledges property as
security, or is otherwise obligated to contribute additional
amounts, and
is not entitled to reimbursement from the PS.
11
d.
The constructive liquidation is always based on book values.
EXAMPLE: GP contributes $200 to the PS, and LP contributes $300. The PS purchases a building with
$500 cash and $500 recourse debt. The partners share losses equally.
CAPITAL ACCOUNTS
Prior to atom bomb
Loss after atom bomb
Share of liab.
GP
$200
$(700)
$(500)
LP
$300
$(300)
$0
EXAMPLE: A and B contributed a building to the PS with a AB: 300,000; FMV: 800,000. C
contributed property with AB: 150,000 and FMV: 700,000 subject to 300,000 recourse debt.
Building 1
Building 2
300,000 800,000
150,000 700,000
TOTAL
450,000 1,500,000
Liab.
A
B
C
TOTAL
300,000
150,000
150,000
(150,000)
450,000
300,000
400,000
400,000
400,000
1,500,000
BASIS: C has $50,000 recognized gain and the PS has the option of increasing IB on the land by $50,000
Initial basis (§ 721)
Relief of liab. (§752(b))
Increase in liab. (§752(a))
End basis
B.
A
B
$150,000 $150,000
$100,000 $100,000
$250,000 $250,000
C
$150,000
$(300,000)
$100,000
$0
Nonrecourse Liabilities.
To the extent no partner bears the EROL, the liab. is classified as nonrecourse. These are
generally allocated according to the PS share of profits.
1.
The PS share of NR liab. is the sum of:
a.
b.
c.
The partner's share of MG (total MG determined by 704(b)).
In the case of NR liab. secured by contributed property, the amt. of gain
the partner would recognized under 704(c) if the PS disposed the
property in full satisfaction of the liability with no other consideration.
The partner's share of the remaining ("excess") NR liabilities, determined
in accordance with his share of PS profits.
(1)
Any specification of the partner's interests in the PS agreement
will be respected for 752 purposes if it is reasonably consistent
with an allocation of any other significant item of PS income or
gain which has substantial economic effect. 1.752-3(a)(3).
12
(2)
(3)
2.
Alternatively, excess NR liabilities may be allocated in
accordance with the manner in which it reasonably expected that
deductions attributable to those liab. will be allocated.
Absent any special allocation, the partners' interest in the PS
profits are determined by taking into acct. all facts relating the
partners' economic arrangement.
Partner's share of MG.
a.
The rule for allocation of NR liab. directly follows the rule for allocation
of the deductions and distributions attributable to those liabilities.
(1)
(2)
b.
The liabilities are first allocated in accordance with each
partner's share of MG, i.e. who gets the MG chargeback.
This rule reflects the fact that one of the principal purposes for
including PS liab. in the partners' OB is to support deductions
that will be claimed by the partners for items attributable to those
liable.
When the MG allocation is triggered.
(1)
(2)
(3)
The MG allocation rules is triggered by nonrecourse deductions.
The MG allocation rule is also triggered where MG results from
a distribution of the proceeds of a NR loan.
The distributee partner, to whom the MG is allocated under
704(b), is the partner to whom the NR liab. that generates the
MG will be allocated.
EXAMPLE: GP contributes $10,000 and LP contributes $90,000. The PS buys a building with
nonrecourse debt for $1,000,000. The building is depreciable over 10 years. The partnership agreed to
share nonrecourse and recourse deductions at 10:90 with a flip at year 10 to 50:50. They also agreed to
share the excess nonrecourse liabilities 50:50.
BASIS
Initial basis (§721)
Share of liab.
Beginning Year 1
Wash (50/50)
MG Liab.
Deduction
End Year 1
3.
GP
$10,000
$500,000
$510,000
$(50,000)
$10,000
$(10,000)
$460,000
LP
$90,000
$500,000
$590,000
$(50,000)
$90,000
$(90,000)
$540,000
Partner's share of 704(c) gain.
a.
To the extent of minimum 704(c) gain, the NR liab. secured by the
contributed property is allocated to the same partner to whom the built-in
13
b.
gain is allocated under 704(c).
There may also be built-in gain (as a result of NR liabilities in excess of
basis) which is neither 704(c) or MG, i.e. when a new partner joins and
book value is restated.
(1)
This "built-in" gain is treated the same as 704(c) gain under the
regs.
(2)
The prior partners are allocated the 704(c)-type gain which
would result if there were a sale of the property.
EXAMPLE: A and B contributed a building to the PS with a AB: 300,000; FMV: 800,000. C
contributed property with AB: 150,000
Initial basis (§721)
Relief of liab. (§752(b))
Increase in liab. (§704(c) MG)
Excess liab.
End basis
A
B
$150,000 $150,000
$50,000 $50,000
$200,000 $200,000
14
C
$150,000
$(300,000)
$150,000
$50,000
$50,000