Calculating limited deficit restoration obligation when a partner is liable to partnership creditors.

• Author: Cassidy, Daniel J.

An allocation of income, gain, loss, deduction or credit by a partnership to its partners is respected as having substantial economic effect if either the general or alternative test of Regs. Sec. 1.704-1(b)(2) is met. The general test requires that (1) capital accounts be maintained in accordance with Regs. Sec. 1.704-1(b)(2)(iv); (2) liquidating distributions be made in accordance with the partners' positive capital account balances; and (3) partners be unconditionally obligated to restore negative capital account balances on liquidation. The alternative test keeps the first two requirements of the general test, but allows a qualified income offset to satisfy the third requirement for partners who do not have an unconditional obligation to restore negative capital account balances. A qualified income offset is a provision that requires loss allocations to be reallocated to other partners, to the extent that they cause or increase a deficit balance in a partner's capital account in excess of any portion of the deficit the partner is required to restore.

In the case of the alternative test, whether the allocation is respected depends on a determination of any negative capital account balance a partner is required to restore. Under Regs. Sec. 1.704-1(b)(2)(ii)(c), a partner's unconditional obligation to make a contribution to the partnership, whether imposed by the partnership agreement or by state or local law, will be treated as an obligation to restore the deficit capital account balance.

Rev. Rul. 97-38

Rev. Rul. 97-38 addresses the situation in which a general partner is required to make contributions to the partnership in the amount necessary to pay partnership creditors. Prior to this ruling, it was unclear what amount (if any) would be treated as an obligation to restore the partner's negative capital account. Therefore, it was not clear if certain allocations to partners had substantial economic effect.

To illustrate the confusion that previously existed, consider this situation. AB is a partnership in which A is a general partner with the obligation to contribute money to the partnership in an amount needed to pay creditors and B is a limited partner with no obligation to make additional contributions. A and B agree that no allocation will be made that causes or increases a deficit balance in...