CHAPTER 6: ALLOCATION OF
PARTNERSHIP INCOME AMONG THE
PARTNERS: THE SUBSTANTIAL
ECONOMIC EFFECT REQUIREMENT
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”.
INTRODUCTION CONT.
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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.
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•
Chapter 6 focuses on the first restriction.
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.
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.
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.
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.
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•
The “substantial economic effect” test has two parts:
1.
2.
Does the agreement have “economic effect”?
If the agreement has “economic effect”, is that economic
effect “substantial”?
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.
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•
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.
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:
1.
2.
3.
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.
THE FIRST REQUIREMENT: “ECONOMIC
EFFECT”– GENERAL RULE CONT.
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Capital Account Maintenance Requirements
–
The regulations require the creation and
maintenance of a separate set of investor capital
accounts.
•
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They are intended to reflect as accurately as possible the
economic relationship between the partners.
The regulations require that capital accounts be
increased by:
1.
2.
3.
Cash contributions
The FMV of property contributed to the partnership by
the partners (net of liabilities assumed)
Allocated items of book income and gain as determined
under Code Sec. 704(b)
THE FIRST REQUIREMENT: “ECONOMIC
EFFECT”– GENERAL RULE CONT.

Capital accounts must be decreased by:
1.
2.
3.
4.
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)
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.
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:
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•
•
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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
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:
–
1.
2.
3.
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.
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.
“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:
1.
2.
3.
The “shifting allocations” test;
The “transitory allocations” test; and
The “overall tax effects” test.
“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.
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“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.
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•
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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.
“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.
“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.

CHAPTER 7: ALLOCATION OF
INCOME AND DEDUCTIONS FROM
CONTRIBUTED PROPERTY: CODE
SEC 704(C)
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.
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INTRODUCTION CONT.
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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.
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.
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.
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.
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 noncontributing partner.
TRADITIONAL METHOD WITH CURATIVE
ALLOCATIONS CONT.
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•
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.
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).

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.
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.
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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