Transcript Chapters 6&7

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.)
• Generally, partnerships may allocate their income among
the partners in any way the partners see fit, subject to the
following limitations:
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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.
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.
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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:
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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:
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.
• 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.)
• 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.)
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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)
“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:
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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.
“Substantial” Economic Effect of Partnership
Allocations– Transitory Allocations
• The regulations provide that an allocation is not
substantial if there is a strong likelihood that:
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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.
“Substantial” Economic Effect of Partnership
Allocations– Transitory Allocations (Cont.)
 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.
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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:
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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.
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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.
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.
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.
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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.
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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.)
• 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– Nontaxable Dispositions
• When a partnership or LLC disposes of Code Sec.
704(c) property in a nontaxable exchange the
disposition does not trigger recognition of built-in
gain or loss under Code Sec. 704(c) using the
traditional method.
• Property received in the exchange, however, becomes
Code Sec. 704(c) property so that any built-in gain or
loss will be subject to Code Sec. 704(c) when it is
subsequently sold (or otherwise disposed of).