Tax allocations for securities partnerships.

• Author: Bellamy, Chris

Due to several factors, including the volume of trading, frequency of changes in partners' profit and loss (P&L)-sharing percentages and their entering and exiting a partnership, realized gains and losses cannot be allocated for tax purposes based on the partners' economic percentages in the period the gain or loss is recognized, without creating some inequity. This type of allocation would lack Sec. 704 "substantial economic effect" because the allocation of recognized gains or losses might not be consistent with the actual economic effect reflected in the allocation for book purposes.

Background

Securities partnerships are defined as either management companies or investment partnerships that make all of their book allocations in proportion to the nonmanaging partners' relative book capital accounts. Partners who provide management or investment advisory services can receive special allocations (such as management and incentive fees). A partnership is a management company if it is registered with the SEC as such under the Investment Company Act of 1940, as amended (15 USC Section 80a). An investment partnership is a partnership that makes revaluations at least annually and on the date of each capital restatement, and 90% of its noncash assets are deemed to be qualified financial assets. A qualified financial asset is any personal property (including stock), actively traded (as defined in Regs. Sec. 1.1092(d)-1) for purposes of the straddle rules.

Allocation Methods

Example: On Jan. 1, 2003, Partners A and B each contribute $500,000 in return for a 50% interest in securities partnership AB. AB uses the money to purchase X Corp. shares. At the first revaluation of the partnership's assets on March 31, 2003, the investment in X is valued at $2 million; the book value of A's and B's capital accounts is $1 million each. On April 1,2003, C purchases a 33% interest in AB for $1 million. ABC then uses C's $1 million to purchase shares of D Corp. On June 30, 2003, ABC sells its entire investment in X for $1.5 million and its investment in D for $200,000. The partnership recognizes a $500,000 gain on the sale of the X stock and an $800,000 loss on the sale of the D stock.

In the example, if realized gains and losses were allocated based on the partners' economic percentages for the period in which they were recognized, each partner would be allocated a $100,000 net realized loss; see Exhibit 1 on p. 473. Due to the timing or appreciation of the...