Partnership allocations may be subject to IRS reallocation.

• Author: Barranca, Steven C.

Partnerships can make special allocations of taxable income, gain, loss, deduction or credit to their partners. However, there are at least five sets of Sees. 704 and 706 rules that govern tax item allocation. The allocation of tax items is subject to IRS reallocation if it does not satisfy the Sees. 704 and 706 requirements.

Sec. 704(b) Allocation Rules

Sec. 704(a) generally requires the allocation of tax items to each partner in accordance with a partnership agreement. The simple interpretation of this provision is that Form 1065, U.S. Partnership Return of Income (and its accompanying Schedules K-1), must ultimately resemble the partners' economic sharing arrangements. However, Sec. 704(b) adds a measure of complexity. If the partnership agreement is either silent on sharing economic profits and losses, or not silent on sharing them but the allocation of tax items does not have substantial economic effect, under Sec. 704(b), the tax items must be allocated according to each partner's interest in the partnership (PIP). A PIP is determined by taking into account a partner's capital contributions and his share in the partnership's economic profits and losses and nonliquidating and liquidating distributions.

For taxpayers uncomfortable with the uncertainty of this approach, the regulations provide a complex safe-harbor provision called the "substantial economic effect" (SEE) rules, which test the degree of correspondence between an allocation of tax items and book (economic) items. An allocation of tax items will have substantial economic effect when it substantially corresponds to the manner in which partners share economic profits and losses. The SEE rules apply a two-part analysis that tests the economic effect of an allocation and then its substantiality. The economic-effect test requires (1) a partnership to maintain book capital accounts in accordance with Sec. 704(b) and (2) to make distributions in accordance with positive book capital accounts, and (3) the partnership agreement to contain a deficit restoration obligation (DRO) or a qualified income offset (QIO) provision.

The DRO and QIO eliminate negative capital accounts. The DRO eliminates negative capital accounts by requiring withdrawing partners to restore their negative capital accounts with capital contributions. The QIO eliminates negative capital accounts by requiring the partnership (under certain circumstances) to make a special allocation of income (even gross income) to partners with negative capital accounts until negative capital balances are eliminated. Also, the QIO generally disallows the allocation of taxable loss and deduction to partners to the extent such allocations create or increase a negative capital account balance. For QIO purposes, a partner's capital account is allowed to be negative to the extent of the...