IRS Provides Guidance on Special Partnership Allocations of COD Income.

AuthorFiore, Nicholas J.

A and B, both individuals, formed a general partnership, PRS. A and B each contributed $1,000 and also agreed that each would be allocated a 50% share of all partnership items. The partnership agreement provides that, on the contribution of additional capital by either partner, PRS must revalue the partnership's property and adjust the partners' capital accounts under Regs. Sec. 1.704-1(b)(2)(iv)(f).

PRS borrowed $8,000 from a bank and used the borrowed and contributed funds to purchase nondepreciable property for $10,000. The loan was nonrecourse to A and B, and was secured only by the property. No principal payments were due for six years, and interest was payable semiannually at a market rate.

After one year, the fair market value (FMV) of the property fell from $10,000 to $6,000, but the principal amount of the loan remained $8,000. As part of a workout arrangement among the involved parties, the bank reduced the principal amount of the loan by $2,000, and A contributed an additional $500 to PRS. A's capital account was credited with the $500, which PRS used to pay currently deductible expenses incurred in connection with the workout. All $500 of the currently deductible workout expenses was allocated to A. B made no additional capital contribution. At the time of the workout, B was insolvent within the meaning of Sec. 108(a).

A and B agreed that, after the workout, A would have a 60% interest and B would have a 40% interest in PRS's profits and losses.

As a result of the property's decline in value and the workout, PRS had two items to allocate between A and B. First, the agreement to cancel $2,000 of the loan resulted in $2,000 of cancellation of debt (COD) income. Second, A's contribution of $500 to PRS was an event that required PRS, under the partnership agreement, to revalue partnership property and adjust A's and B's capital accounts. Because of the decline in value of the property, the revaluation resulted in a $4,000 economic loss that had to be allocated between A's and B's capital accounts.

Under the terms of the original partnership agreement, PRS would have allocated these items equally between A and B. A and B, however, amended the partnership agreement (in a timely manner) to make two special allocations. First, PRS specially allocated the entire $2,000 of COD income to B, an insolvent partner. Second, PRS specially allocated the book loss from the revaluation, $1,000 to A and $3,000 to B.

While A receives a $1,000 allocation of book loss and B receives a $3,000 allocation of book loss, neither of these allocations results in a tax loss to either partner. Rather, the allocations result only in adjustments to A's and B's capital accounts. Thus, the cumulative effects of the special allocations is to reduce each partner's capital account to zero immediately following the allocations...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT