Capital accounts and the alternate test for economic effect.

• Author: Einspahr, Michael R.

The most often overlooked and misunderstood limitation on the allocation of partnership losses is a limited partner's fair market value (FMV) (i.e., "book") capital account, and its impact on proper application of the alternate test for economic effect under Regs. Sec. 1.704-l(b)(2)(ii)(d).

Allocations of partnership loss to a limited partner must overcome many obstacles before they may be deducted. For example, Sec. 704(d)provides that a partner's distributive share of partnership loss will be allowed only to the extent of the adjusted basis of such partner's interest in the partnership at the end of the partnership year in which the loss occurred. In addition, Sec. 465 at-risk limitations and Sec. 469 passive loss limitations must be considered.

Before giving careful consideration to all these rules, practitioners should first examine whether the loss allocation is valid under Sec. 704(c) and Regs. Sec. 1.704l(b). According to Regs. Sec. 1.704-1(b)(1), these and other provisions may result in reallocation of partnership losses before the adjusted basis, at-risk basis, passive loss and other limitations would otherwise apply. Although several provisions of the Sec. 704(b)regulations can result in reallocation of partnership losses, the "alternate test for economic effect" in Regs. Sec. 1.704-1(b)(2)(ii)(d)may present the easiest tax planning opportunity to understand. Conversely, it contains many often overlooked pitfalls. General rules for economic effect Allocations are deemed to have economic effect if made in accordance with a partnership agreement that contains all three requirements of Regs. Sec. 1.7041(b)(2)(ii)(b). The first requirement is maintenance of "book" capital accounts in accordance with the rules of Regs. Sec. 1.704-1(b)(2)(iv). The second is that, on liquidation of the partnership or any partner's interest in the partnership, all liquidating distributions must be made in accordance with the partners' "book" capital accounts. The third requirement is that if a partner has a deficit "book" capital account balance on liquidation, such partner must unconditionally and without limit be obligated to restore the deficit to the partnership.

The alternate test for economic effect Limited partners would not be "limited" if they were subject to the third requirement of unlimited deficit restoration. For partners not obligated to restore deficit capital account balances, or obligated to restore only a limited dollar amount of...