Allocations of Partnership Income, Deductions, and Credits: An Introduction

• Pages: 75-108
• Author: James R. Repetti,William H. Lyons,Charlene D. Luke

75

Chapter Five

ALLOCATIONS OF PARTNERSHIP

INCOME, DEDUCTIONS, AND

CREDITS: AN INTRODUCTION

A. An Overview of the Code and Regulations

Up to this point, we have not had to worry about how a

partnership’s income, deductions, and credits (the partnership’s “tax

items”) are allocated among the partners. We have assumed, tacitly ,

that a 40% partner would report 40% of all the partnership’s tax

items. In fact, however, a partnership may allocate different portions

of its tax items to different partners. For example, partner A may

report 50% o f a partnership’s ord inary income but only 10% of i ts

capital gains, or partner B may be tax able on half of the taxable

income of a partnership’s New York office but only 10% of the taxable

income of its Washington office.

Section 704 governs allocations of a partnership’s tax items.

Section 704(a) provides that “the partnership agreement”

1

is the

starting point for determining allocations. Notwithstanding this

starting point, § 704(b) imposes impo rtant limitations on § 704(a),

and § 704(c) contains special rules for allocating tax items

attributable to property contributed to a partnership that has a tax

basis different from its fair market value.

2

Other rules may also limit

the freedom of partners to allocate tax items either directly or

indirectly.

3

Under the 1954 Code as originally enacted, § 704(b) said that a

partner’s distributive share of “any item of income, gain, loss,

deduction, or credit” was determine d by the partnership agreement

1

Section 761(c) defines the term “partnership agreement” for purposes of

subchapter K:

[A] partnership agreement includes any modifications of the partnership

agreement made prior to, or at, the time prescribed by law for the filing of the

partnership return for the taxable year (not including extensions) which are

agreed to by all the partners, or which are adopted in such other manner as

may be provided by the partnership agreement.

2

Section 704(c) is explored in Chapter 7.

3

See, e.g., § 737 and § 751. Also, § 199A(f)(4)(A) authorizes Treasury to issue

regulations that control the allocation of items relating to the 20% deduction in § 199A.

The regulations issued to date state that the “rules of subchapter K . . . apply in their

entirety for purposes of determining each part ner’s share” of items related to the

calculation of the 20% deduction. Reg. § 1.199A–1(e)(1). See also Reg. § 1.199A–6(b)(3)

(stating that the partnership is required to report the amounts needed for the § 199A

calculation that it has allocated to each partner on its Schedule K-1). See Chapter 1

note 13 for an overview of § 199A.

76

Allocations of Partnership Income, Deductions,

and Credits: An Introduction

Ch. 5

unless the “principal purpose” of a special or item allocation was

“avoidance or evasion of any tax.”

4

The regulations, with support in

the legislative history, did not take the reference to the tax-avoidance

“purpose” of a special allocation very seriously. Indeed, they

approved of a special allocation of tax-exempt interest, which is the

sort of thing that only tax -conscious partners are likely to do.

5

Instead of inquiring only into the taxpayers’ mo tives for a special

allocation, the regulations listed “factors” to be considered in

determining whether a special allocation was valid. By far the most

important of these factors was whether the allocation had

“substantial economic effect”; that is, whether the allocation might

actually have affected “the dollar amount of the partners’ shares of

the total p artnership income or loss independently of tax

consequences.”

6

In 1976, Congress rewrote § 704(b) to incorporate

the regulatory “substantial economic effect” standard into the statute

and to make clear that overall allocations ( such as “half the

partnership’s income to A”), as well as special allocations (such as

“10% of the partnership’s capital gain s to A”), are subject to the

statutory standard. In regulations finalized in 1985, Treasury re -

structured the substantial economic effect test into the two-part test

that still applies and is discussed below.

7

Under today’s version of the § 704(b) regulatory test, an

agreement allocating any partnership tax item, gain, loss, or

deduction will be valid if the allocation has “economic effect” and

passes a “substantiality test.” If either cannot be found—for example,

because an agreed-upon allocation lacks economic effect,

substantiality, or because there is no agreement at all —income is

allocated according to the “partner’s interest in the partnership,”

taking into account “all facts and circumstances.”

8

B. The “Substantial Economic Effect” Test

1. Introduction

Roughly speaking, an allocation has economic effect if it will

affect the wealth of the partners. Some kind of principle like this

must control allocations of partnership income. It would be absurd to

say that a partnership agreement allocating all of a pa rtnership’s

taxable income to partner D should be respected if the agreement also

4

Former § 704(b).

5

Former Reg. § 1.704–1(b)(2), Example (3) (1956).

6

Former Reg. § 1.704–1(b)(2) (1956).

7

Treas. Dec. 8065, 50 Fed. Reg. 53420 (Dec. 31, 1985). Of course, multiple other

adjustments have been introduced to the regulations since 1985.

8

A more specific approach for making allocations in line with the partner’s

interest in the partnership may apply. Reg. § 1.704–1(b)(3)(iii). This approach makes

use of a constructive, comparative liquidation and is illustrated in Example 5-7, below.

Sec. B

The “Substantial Economic Effect” Test

77

makes it clear that D and E will share equally in all the money and

property the partnership has and will get in the future. The

regulations under § 704(b) have, however, gone far beyond this

common-sense notion of “economic effect.” They have taken that

short statutory p hrase and built upon it a remarkably e laborate,

detailed, complex, and yet incomplete set of rules. These rules are so

difficult that only a handful of partnership-tax specialists will be able

to apply them. Garden-variety partnerships and limited liability

companies (small businesses advised by ordinary lawyers and

accountants) will seldom make allocations that satisfy all the

requirements for “substantial eco nomic effect” in the regulations.

Instead, their allocations will be judged by the “partner’s interest in

the partnership” standard, a very ambiguous standard that is

supposed to take into account “all facts and circumstances.”

You could think of the “substantial economic effect” rules, as

developed in the regulations, as a very complex safe harbor. This safe

harbor presents at least two threshold issues. First, the safe harbor

is complicated, and taxpayers may have difficulty understanding

what they have to do to comply with the rules. Second, complying

with the safe harbor rules may provide desired tax results but

undesired economic results. Thu s, particularly in relatively simple

situations, taxpayers may be willing to accept application of the

partner’s interest in the partnership test. In more sophisticated

situations, however, taxpayers may want to try to avoid having the

tax law interfere with their economic deal, while still hoping to enjoy

the be nefit of the safe harbor. A basic discussion of such attempts

appears in § B.5, below. Ne vertheless, to understand such

alternatives, you must first understand the concept of “substantial

economic effect.”

No introductory book can cover all the details of the “substantial

economic effect” regulations. Rather than attempt that task, we shall

describe the so-called “capital account” version of the test as it was

developed in the regulations and the case law under the former

version of § 704. With an understanding of that relatively

straightforward matter as background, you will be introduced to

some of the more important ways in which the current regulations

elaborate on that test. First, however, a brief description of partners’

capital accounts is necessary.

2. Capital Accounts

In many cases, the key to de termining a partner’s rights to the

money and property of a partnership is the partner’s capital account.

In general, the capital acc ount is supposed to reflect what a partner

is entitled to receive upon the liquidation of a partnership. Capital

accounts are created by the partnership agreement, and so the