Partnership's allocation method satisfies sec. 704(b) and (c).

• Author: Penick, Barksdale

Typically, the IRS has bee unwilling to rule on whether allocations are "substantial' under Sec. 704(b) because the issue is inherently factual; see Rev. Proc. 87-35. Despite this ruling position the Service recently ruled in Letter Ruling 9540034 that a partnership' method of allocating items o income, gain, loss and deduction has substantial economic effect under Sec. 704(b). Prior to this ruling, the IRS issued only two other rulings relating to "substantiality" under Sec. 704(b) (Letter Rulings 9207027 and (TAM) 9219002).

In Letter Ruling 9540034, two companies formed a partnership to develop oil and gas properties and chose not to elect out of subchapter K. One company transferred an interest in a land lease to the partnership and another conducted the drilling operations. The partnership agreement provided that the Tax Matters Partner would maintain a fair market value (FMV) capital account and a tax basis capital account for each partner. Each partner's FMV capital account would be increased nd decreased in accordance with Regs. Sec. 1.704-1 (b) (2) (iv) (b). The partnership agreement required that liquidating distributions be made in accordance with the partners' positive FMV capital account balance Each partner was unconditional obligated to restore any deficit balance in its capital account following the partnership's liquidation Because the partnership agreement satisfied the three requirements for establishing economic effect contained in Regs. Sec. 1.704-1 (b) (2) the IRS found that the allocation would have economic effect.

In addition to ruling that the all cations would have economic effect, the Service determined that such economic effect would be "substantial. The partnership agreement apparently provided for...