Rev. Rul. suggests strategic partnership failure to book-up.

• Author: Abrams, Howard E.
• Position: IRS Revenue Ruling 99-43

In Rev. Rul. 99-43, the Service ruled that a pair of allocations having economic effect was nevertheless invalid because it was not substantial. Even though the substantiality requirement is much less well-defined in the regulations than is the economic effect requirement, substantiality will come to play an increasing role in partnership allocations; because recently promulgated regulations under Secs. 743 and 755 now implicitly incorporate the detailed Sec. 704(b) "substantial economic effect" rules promulgated in Regs. Sec. 1.704-1(b). In particular, ordinary income recognized by an exiting partner under Sec. 751(a) can be reduced or eliminated if the partnership can ensure that his share of the unrealized appreciation in the partnership's ordinary income assets is small or even zero. This can be accomplished by carefully crafted special allocations, allocations that will have "economic effect" as defined in Regs. Sec. 1.704-1(b)(2)(ii) but may lack "substantiality" as defined in Regs. Sec. 1.704-1(b)(2)(iii).

Rev. Rul. 99-43 is important because it offers guidance beyond that contained in the "substantial economic effect" regulations. Further, while it held the allocations presented in the ruling invalid, it offered a roadmap for drafting equivalent tax allocations that should survive challenge. Finally, Rev. Rul. 99-43 suggests that eschewing capital account restatements may provide strategic tax advantages.

In Rev. Rul. 99-43, individuals A and B each contributed $1,000 to the general partnership PRS. Each partner was allocated 50% of profits and losses, and the partnership agreement provided that, if either partner contributed additional capital in the future, PRS would revalue its assets and restate capital accounts. Such revaluation and restatement is permitted (but not required) by Regs. Sec. 1.704-1(b)(2)(iv)(f) and (g).

The partnership purchased nondepreciable property for $10,000, using its capital of $2,000 as well as $8,000 borrowed from a bank. After one year, the value of the property fell to $6,000. As part of a workout with the bank, the loan was reduced to $6,000. A contributed additional capital of $500, which was used to pay currently deductible expenses. The partnership agreement was amended to provide that future items of profits and loss would be allocated 60% to A and 40% to B.

As a result of the workout, the partnership recognized $2,000 of cancellation of debt (COD) income for both book and tax purposes. The...