Chapter 5--Allocation of Partnership Income and Losses
What is a gain chargeback
A provision in a partnership agreement that provides that gains on the sale of an asset equal to the prior depreciation deductions taken shall be allocated to the partners in the same manner as the depreciation itself was allocated.
When you fail economic effect, the allocation goes to
who would get to keep the allocation based on the hypothetical liquidation
What decreases a partner's capital accounts?
i. the amount of money distributed to the partner ii. the FMV of property distributed to the partner (net of liabilities secured by the property that the partner is considered to assume or take subject to under 752) iii. allocations or expenditures of the partnership that can neither be capitalized nor deducted in computing taxable income iv. allocations of partnership loss and deduction Note: unlike AB in the partnership interest, a partner's capital account does not include that partner's share of liabilities
Example for economic effect equivalence test: A and B contribute $75k and $25k into the partnership respectively. The partnership maintains no capital accounts and the partnership agreement provides that all income, gain, loss, deduction, and credit will be allocated 75% to A and 25% to B. A and B are ultimately liable for 75% and 25% respectively of any debts of the partnership. Economic effect?
Although the allocations do not satisfy the requirements of the regular or alternative economic effect rules, the allocations have economic effect under the economic effect equivalence test 1.704-1b5
What are the four independent "substantiality tests"? and the general rules?
Four tests are the substantially affects dollar amounts test, the after-tax consequences text, the shifting tax consequences test, and the transitory allocations test. 1.7041b2iiia. Regs provide that the economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the partners independent of tax consequences. Allocation is NOT substantial if: i. the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation were not contained in the partnership agreement, and ii. there is a strong likelihood that the after-tax consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement
If partners have contributed 704c property to the partnership, the partnership will have to keep 2 sets of book.
First set will contain the book values of the partnership properties and the other will contain the tax values. The book items are allocated under 704b regs. Tax items, when they differ from the book items are allocated under 704c regs and generally must be determined so as to take account of the variation between the adjusted tax basis and the FMV of the contributed property.
A partnership has two equal partners A and B. It holds a property with a FMV of $20k and book value of $15k. It distributes the property to A. What must the capital account be adjusted for?
First, A's capital account is reduced for the full FMV of the property distributed. Second, the partner's capital accounts must be adjusted to the gain inherent in the distributed property. So FOR CAPITAL ACCOUNTS PURPOSES ONLY, the partnership recognizes the $5k of gain inherent in the property and allocates $2,500 of the gain to each partner's capital account. Thus, A's capital account is increased by $2500 and the decreased by $20k under T Reg. 1.704-1b2
If a partner contributes property with a tax basis of $7k and a FMV of $10k, the partnership's tax basis under 723 is..? Book value/book basis?
Tax basis is $7k and book value is the full FMV of $10k
A contributed land #1 to the AB partnership. A and B are equal partners. The land has a tax basis of 7k and a FMV of 10k. The partnership takes a tax basis in the property of 7k, A's tax basis in her partnership interest is increased by that amount and no gain or loss under 721a. What if the property is sold for 12k?
Tax gain is 12k-7k=5k and the book gain is 12k-10k=2k. The 2k of book gain is allocated equally to A and B, 1k each. Under 704c, the tax gain is allocated 4k to A and 1k to B. Why? 4k to A comes from 3k (FMV - tax basis when contributed) + 1k for the 50/50 split of the 2k remaining of the 5k of tax gain. So, the FMV - Tax basis is allocated to the contributing partner, then allocated accordingly, in this case they were equal partners so the 2k remaining is split evenly A: Formation: tax 7k ------ book 10k Gain: tax 4k ------------- book 1k Balance: tax 11k ---------book 11k B: Formation: tax 10k-----book 10k Gain: 1 tax-------------book 1k Balance: 11k tax-------book 11k
Partnership has 2 options for allocating partnership items to a partner when partnership interests change but the tax year of the partnership tax year does not close early with respect to any partner. The 2 methods?
The default method--the interim closing of the books, or it can elect to prorate the partnership items to the partners based on their varying interests in the partnership during the year
Alternative economic effect rules: T Reg. 1.704-1b2iid
Under this alternative, an allocation must meet the first 2 economic effect tests (keep capital accounts according to the rules and upon liquidation, pay to a partner any positive balance in his capital account), but instead of having an unlimited deficit restoration obligation, the third requirement is that the partnership agreement contain a qualified income offset provision. QIO provisions state that a partner's capital accounts won't go below 0, so they could get the deduction allocations until the 0 mark. It could go below zero, but then they would need to be allocated income to offset it. "The QIO provision essentially would state that in the event of an unexpected adjustment, that decreased an owner's capital below zero, the LLC will allocate items of gross income and gain to that owner as soon as possible to restore the capital." If this alternative test is met, an allocation will be treated as having economic effect if the allocation does not cause the partner to have a deficit capital balance or increase an already existing deficit capital account balance
Example to test whether allocations create a negative capital account balance under the alternate economic effect test: Partnership wants to allocate $8k of depreciation to a partner who does not have a deficit restoration obligation and falls within the alternate rules. The partner has a $15k balance in this capital account. Under the rules, the partnership must reduce his capital accounts for testing purposes for a $10k distribution expected to be made in a future year. That would temporarily give the partner a $5k balance in his capital account, meaning that only $5k of the $8k depreciation could be allocated to him. After that determination the $10k reduction for the future distribution is....
reversed, restoring the capital account to $15k and the it is reduced for the $5k of depreciation that may be allocated to the partner
Tax gain equals book gain equals
sell price - tax basis sell price - FMV
706c2B provides that the partnership's taxable year does not close with respect to a partner who...
sells or exchanges less than their entire interest in the partnership or whose interest is reduced
A and B are equal partners. A contributes depreciable equipment with a tax basis of 6k and a book value of 10k and B contributes 10k cash. The equipment is depreciated using the straight-line method at the rate of 10% per year. Tax depreciation is $600 per year and book depreciation is 1k per year. The book depreciation would be allocated equally between the partners, or $500 each. The tax depreciation would be allocated $500 to B. The balance $100 would be allocated to A. Now assume the property is sold at the end of Y2 for 9k. The tax basis is? and book value is? Tax gain is? Book gain is? How are they allocated?
tax basis is 4800 (6k-1200) and its book value is 8k (10k-2k). Tax gain of 4200 (9k-4800) and book gain of 1k (9k-8k). Book gain is allocated equally to the partners, or $500 each. Tax gain equal to book gain is allocated in the same manner as book gain--500 to each partner. Tax gain in excess of book gain, 3200 (4200-1000), is entirely allocated to A, the contributing partner. Notes***if the partnership sold the property immediately after it was acquired, the gain that would have been allocated to A is 4k. After 2 years, the gain allocated to A is $800 less than that, this is because the tax and book account were caught up by 2 years of preferential allocations of the tax depreciation to B. Each year, B received $400 more depreciation than A, or $800 over 2 years, hence there is less gain to be allocated to A under 704c1A on the sale
706c1 provides that the taxable year of the partnership is not closed as the result of...
the death of a partner, the entry of a new partner, the liquidation of a partner's interest in the partnership, or the sale or exchange of a partner's interest in the partnership. 706c2 provides significant exceptions to this general rule
If a partner does not have a deficit restoration obligation, but receives a downward adjustment to the capital account that gives the partner a negative capital account, it may be necessary to
to allocate a disproportionate amount of gross income of the partnership to such partner for such year so as to bring that partner's capital account back up to zero. 1.704-1b3i In Vecchio v. Commissioner, in applying the rule that the partner to whom an allocation is made must receive the related economic benefit or bear the related economic burden, the court reasoned that the partner receiving the disproportionate allocation on the sale should bear the economic burden of gain necessary to bring its capital account to zero to avoid the shifting of the economic burden of the prior losses that had been deducted by the partner to the other partners. Thus , the allocation to the partner of an amount sufficient to offset the prior deficit capital account was consistent with PIP
What is the purpose of 704c1a?
to eliminate the disparities between book and tax account
706a provides that a partner is required to include the partner's distributive share of the income, gain, loss, deduction, or credit of the partnership for the taxable year of
of the partnership ending within or with the taxable year of the partner. The partnership's tax year of a given partner will close early if the partner's entire interest is sold, exchanged, or liquidated. A partner's interest in the partnership can change during the tax year. A partner's percentage interest in the partnership can vary during the tax year if, for example, part of theirs or another partner's interest is sold or redeemed, if he or another partner contributes new capital to the partnership, or if the new partners enter the partnership. 706 addresses how partnership items of income, gain, loss, deduction or credit are to be allocated when partnership interests change
The Regs permit partnership to use any reasonable allocation method that takes into account the variation between the adjusted tax basis of property and it FMV at the time of contribution. 1.704-3a1. Regs give permission to use one of the 3 methods in the regs that gives them the best tax results. What're the 3 methods of allocation
traditional method--entity theory traditional method w/ curative allocations--not taught remedial method--aggregate theory
706c2A provides that the taxable year of the partnership closes with respect to a partner whose...
whose entire interest in the partnership terminates. This is only with respect to the partner whose interest terminates, not the other partners.
What is 704c property
contributed property that at the time of contribution has a book value that differs from its tax basis
Example: regular economic effect test Jan 1 Y1, A and B invest $10k each in the AB partnership. The partnership purchases equipment for $20k. The tax basis and book value of the equipment is $20k. Assume book depreciation deductions are $5k per year and the partnership has no debt. Further assume that the partnership breaks even on its operations except for depreciation deductions, and thus the partnership operates at a $5k book loss per year. Partnership agreement allocates all of the depreciation deductions to A. What happens with capital accounts in Y1? Assume at the beginning of Y2, the equipment is sold and the partnership is liquidated. To comply with the economic effect rules, the partnership must pay to each partner, the balance in their capital account. FMV of equipment is equal to book value, 15k. How is the sale distributed to A and B? What if the partnership agreement provides that upon liquidation, all partnership funds must be distributed equally?
At the beginning of Y1, A and B each has a capital account of $10k. As a result of the Y1 allocations, A's capital account is reduced to $5k and B's remains the same. The book value of the equipment is reduced to $15k. 5k to A and 10k to B. Then the allocation in Y1 would not have an economic effect. This is because A would not have borne the economic burden of the depreciation allocation--the allocation would not fully have had an economic effect on A. For the allocation of the full amount of depreciation to A to have economic effect, A's capital account must be reduced by that amount and A must be paid no more than the balance in the capital account on the partnership's liquidation (5k). If $7,500 was distributed to each partner, the regs would require that the allocation in Y1 be changed, and each partner would be allocated $2,500 of depreciation, giving each a capital account balance of $7,500. Regs can trump the provision of the partnership agreement. Go to 135-36 for a couple more examples.
704c depreciation example: A and B are equal partners. A contributes depreciable equipment with a tax basis of 6k and a book value of 10k and B contributes 10k cash. The equipment is depreciated using the straight-line method at the rate of 10% per year. Tax depreciation is $600 per year and book depreciation is 1k per year. The book depreciation is allocated equally between the partners, or $500 each. The tax depreciation is allocated $500 to B. The balance $100 is allocates to A. Why is this logical?
B essentially gave A 10k of credit for the equipment he contributed and should therefore receive, if possible his full share of the tax depreciation based on that amount; that is, tax depreciation equal to his share of book depreciation. This approach will have the effect of eliminating the disparities between the tax and book accounts over time. See pp. 177. A: tax / book Formation: 6k / 10k Depreciation Y1-10: (1k) / (5k) Balance: 5k / 5k B: Formation: 10k / 10k Depreciation Y1-10: (5k) / (5k) Balance: 5k / 5k
Example of Remedial Method: A contributed land #1 to the AB partnership. A and B are equal partners. The land has a tax basis of 7k and a FMV of 10k. The partnership takes a tax basis in the property of 7k, A's tax basis in her partnership interest is increased by that amount and no gain or loss under 721a. What if the property is sold for 8k? Land #1 is a long-term capital asset to the partnership.
Book accounts are unaffected. For tax purposes, the partnership creates $1k of long term cap loss that it allocates to B and creates 1k of offsetting long-term capital gain that it allocates to A. This gives B a tax loss equal to his book loss. It places A in the same position as if she had recognized her entire intial gain (3k) and then received a 1k tax loss equal to her book loss. The tax and book accounts are: A: Formation: 7k tax ----------- 10k book Sale Lane #1: 1k tax-----------(1)k book Remedial: 1k tax------------------------ Balance: 9k tax---------------9k book B: Formation: 10k tax------------10k book Sale Lane #1: -----------------(1k) book Remedial: (1k) tax----------------------- Balance: 9k tax----------------9k book
Abusive use of traditional method example. 1.704-3b2: C and D form CD and agree to 50% allocations of partnership items and that CD will make allocations under 704c traditional method. C contributes equipment with an adjusted tax basis of 1k and a book value of 10k , with a view to taking advantage of the fact that the equipment has only one year remaining on its cost recovery schedule although its remaining economic life is significantly longer. D contributes 10k cash, which CD uses to buy securities. D has substantial net operating loss carryforwards that D anticipates will otherwise expire unused. Under 1.704-1b2ivg3, the partnership must allocate the 10k of book depreciation to the partners in the first year of the partnership. Thus, there is 10k of book depreciation and 1k of tax depreciation in the partnership's first year. Under the traditional method, the book depreciation is allocated equally and the tax depreciation is allocated to D. CD sells the equipment during the second year for 10k and recognizes 10k gain (10k AR - 0 tax basis). What happens at the beginning of the 2nd year?
Both the book value and the adjusted tax basis of the equipment are 0. Therefore, there is no remaining built-in gain. The 10k gain on the sale of the equipment in the second year is allocated 5k each to C and D. The interaction of the partnership's one-year write off of the entire book value of the equipment and the use of the traditional method results in a shift of 4k of the precontribution gain the equipment from c TO d (D's 5k share of CD's 10k gain, less the 1k tax depreciation deduction previously allocated to D) The traditional method is not reasonable under these circumstances because the contribution of property is made and the traditional method is used, with a view of shifting a significant amount of taxable income to a partner with a low marginal tax rate and away from a partner with a high marginal tax rate. The Regs provide that if the partnership agreement in effect for the year of contribution had provided that tax gain from the sale of the property would always be allocated first to C to offset the effect of the ceiling rule limitation, the allocation method would not be abusive
Interim closing of the books? Proration method?
Has the same effect that an actual closing of the tax year for a partner would have had The proration method is based on the period of time a partner held a particular percentage interest in the partnership, without regard to when a partnership item was actually incurred. pp. 200-204
State law liquidation approach regs apply a book-value liquidation approach in specified circumstances, the courts have taken other approaches to establish PIP based upon a liquidation model.
In Estate of Tobias v commissioner, the court considered all four factors listed in the regs, but appeared to put emphasis on the rights in liquidation. Because the value of the assets of the partnership was less than the TP's capital contributions, the state court had ordered all of the proceeds in liquidation to be distributed to the TP. The Tax Court found that the TP's PIP in regard to partnership income was 100% for the years in question
A and B are equal partners. A contributes depreciable equipment with a tax basis of 4k and a book value of 10k and B contributes 10k cash. Tax depreciation is now $400 per year, book depreciation remains 1k per year. The book depreciation is again allocated equally to the p2 partners, or $500 each. What's the issue?
In this case, there is not sufficient tax depreciation to give B tax depreciation equal to his book depreciation. The ceiling rule pops up here. If the traditional method is being used, all of the tax depreciation is allocated to B, and a disparity will exist on the books of the partnership: A: Formation: tax 4k----------10k book Depreciation Y1-10: --------(5k) book Balance: 4k tax-------------5k book B: Formation: 10k tax----------10k book Depreciation Y1-10: (4k) tax---(5k) book Balance: 6k tax-------------5k book Book and tax accounts are unequal here--that's the take away
Shifting allocations example. AB owns 1231 property and capital assets and expects to sell each type of property in current year and incur 50k in 1231 loss and a 50k capital loss. The partnership agreement complies with the economic effect rules. A has ordinary income of $300k and no 1231 gains. B has 200k ordinary income and 100k of 1231 gains. The partnership amends the partnership agreement and provides that for the current tax year only, all1231 losses will be allocated to A and all capital losses will be allocated to B. Will the allocation pass the substantial economic effect test?
No, not substantial. A and B will have the same capital account balances they would have had if the allocation were not contained in the partnership agreement--still a $50k loss each, consisting of equal parts of each type of loss. Also, the total taxes of A and B are reduced as a result of the allocation--A's taxes go down, B's taxes are unaffected. See 1.704-1b5
Can allocation of tax credits have economic effect?
No--if an allocation does not comply with the substantial economic effect safe harbor, then it must be allocated in accordance with the partners' interests in the partnership. The regs provide that if an allocation of a tax credit gives rise to a valid allocation of partnership loss or deduction, then the credit must be allocated in the same proportion as the partners' respective shares of the loss or deduction
What is PIP
PIP is "partner's interest in the partnership For 704b, allocation of partnership income and deductions that do not meet the substantial economic effect safe harbor must be allocated in accordance to PIP For 704c, if property is reflected on the books of a partnership at a value that differs from the adjusted tax basis of such property, the tax items attributable to such differences must be allocated in accordance with PIP
A contributed land #1 to the AB partnership. A and B are equal partners. The land has a tax basis of 7k and a FMV of 10k. The partnership takes a tax basis in the property of 7k, A's tax basis in her partnership interest is increased by that amount and no gain or loss under 721a. What if the property is sold for 8k? Partnership distributed its 18k to the partners after the sale, each partner would be given the balance. What happens next? What if B dies before the partnership is liquidated?
Partnership incurs a 2k economic loss, but because the tax basis of the property is 7k, there is actually a tax gain of 1k. Under the "ceiling rule, if the traditional method is used, no partner can be allocated a tax gain or loss other than that which actually incurred. The partnership's tax basis in the land is 7k. If it sells for 8k, the partnership recognized a 1k tax gain. That is its "ceiling". Under the traditional method, the partnership cannot create a greater tax gain or create any tax losses. The tax a book account for A: Formation: tax 7k ------ book 10k Gain: tax 1k ------------- book (1k) Balance: tax 8k ---------book 9k For B: Formation: tax 10k-----book 10k Gain: 0 tax-------------book (1k) Balance: 10k tax-------book 9k The tax and book accounts are now out of balance, but under the traditional method, there is no way to bring them into balance until liquidation. Part 2: For tax purposes, A would recognize 1k of gain 9k-8k and B would recognize 1k of loss 9k-10k and the distortions between the tax and book accounts would be eliminated. Part 3: B's heirs' basis in the partnership interest would be the FMV at the date of death, and any tax gain/loss inherent in the partnership interest would be extinguished
Difference between shifting and transitory allocations?
Shifting allocations occur within a single tax year and transitory allocations occur over a period of up to 5 years Either way, the economic effect of an allocation will not be substantial if there is a strong likelihood that the capital accounts of the partners would be about the same as they would have been had the allocation not been made, and the allocation results in a net reduction of the partners' tax liability
Substantial economic effect rules provide a safe harbor. An allocation has substantial economic effect under 704b if it passes the 2 part test. 1.) The allocation has an economic effect. 2.) The economic effect must be substantial. What are the 3 economic effect tests and the regular economic effect test rules?
There are 3 ways to satisfy the economic effects test: under the regular economic effect test, the alternative economic effect test, and the economic effect equivalence test. The regular economic effect test: i. the partnership must keep capital accounts in accordance with the rules ii. when an interest of a partner is liquidated, the partner must be paid any positive balance in his capital account iii. if a partner has a deficit balance in his capital account, he must pay the deficit ot the partnership by the end of the tax year in which his partnership interest is liquidated. This last rule is called a deficit restoration obligation
Remedial method
This method permits the partnership to create the offsetting tax item--book accounts are unaffected, only tax items may be adjusted First, the partnership determines the partners' shares of book items under 704b. The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method. If the ceiling rule causes the tax item to differ from the book items, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner. The partnership creates an offsetting remedial item in an identical amount and allocates it to the contributing partner under 1.704-3d1. The remedial allocations have the same tax attributes as the tax item limited by the ceiling rule. Thus, if the ceiling rule limited item is an item of long-term capital loss from the sale of a capital asset that was contributed to the partnership, the offset will be long-term capital gain.
Economic effect equivalence test is met if
a liquidation of the partnership at the end of a given year or at the end of any future year would produce the same economic results to the partners as would occur if the formal economic effect test were met, regardless of the economic performance of the partnership. 1.704-1b2(ii)(i)
Book value liquidation as PIP If capital accounts are maintained in accordance with the regs and the partnership liquidates in accordance with capital accounts, the partners' interests in the partnership with respect to an allocation that lacks economic effect will be determined by...
by comparing the manner in which distributions and contributions would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the taxable year to which the allocation related, adjusted for certain items specified in the regs. T Reg 1.704-1b3iii
706d1 provides that if there is any change in a partner's partnership interest during the year, each partner's distributive share of the items of income, gain, loss, deduction, or credit of the partnership for that taxable year is determined by....
by taking into account the varying interest of the partners during the year
Based on capital contributions In PNRC limited partnership v commissioner, the Tax Court found that the PIP was best represented by
by the partners' relative capital contributions to the partnership. In this case, the general partner has initially contributed 71.4% of the capital to the partnership and the limited partner 28.6%. 2 years later, the limited partner made an additional capital contribution to the partnership, reducing the GP's % of total capital contributions to 38.6%. Partnership agreement allocated profits 60% to the GP and 40% to the LP. The partnership only incurred losses. Distributions in liquidation were to be made in accordance with the partners' profit percentages as opposed to capital account balances. The allocations thus lacked substantial economic effect. The court concluded that the unadjusted capital contributions were most indicative of the partners' interests in the partnership, and required losses to be allocated in accordance with those varying contributions
Under 721, no gain or loss recognized when a partner contributes property to the partnership. The partnership takes a _______ basis the property under 723 and the contributing partner takes a
carryover substituted basis in the partnership interest under 722.
In Miller v. Commissioner, the partnership failed to adjust the capital accounts for special allocations to a partner and did not agree to liquidate in accordance with capital account balances. Instead, income and liquidating distributions were...
divided equally among the partners based on the partners' percentages of ownership. An effort to allocate all of the depreciation and all the tax items relating to one investment of the partnership to one partner for five years thus failed. The court reallocated the items in accordance with the partners' percentages of ownership interest Somewhat similarly, in Mammoth Lakes Project v. Commissioner, the court allocated losses in a partnership consistently with the partners' percentage rights to the profits of the partnership. Similarly again, in Shumaker v. Commissioner, there was no partnership agreement and the TPs denied being partners. The court looked to the partners' ownership interests in the assets of the business and the manner in which the had agreed to share the liabilities of the business.
704c1a also governs the manner in which depreciation, amortization and depletion are allocated among the partners. Generally, a noncontributing partner should receive tax depreciation equal to...
equal to that partner's share of book depreciation with the balance of the depreciation being allocated to the contributing partner.
If a partner dies before liquidation, his heirs take...basis
his heirs take the FMV value basis as of the date of death in the inherited partnership interest under 1014, eliminating any tax gain or loss inherent in the partnership interest that existed before then
If the partnership's tax year closes with respect to a partner, that partner is allocated....
his share of items income, gain, loss, deduction, or credit and any guaranteed pmts under 707c for the partnership taxable year up to the date it closes for him.
The regulatory rule allowing the allocations where a partner does not have an unlimited deficit restoration obligation:
i. requirement to keep capital accounts in accordance with the regs and pay to a partner on liquidation of his interest any positive capital account balance is satisfied, and ii. the partner to whom an allocation is made is not obligated to restore the deficit balance in his capital account to the partnership, or is obligated to restore only a limited dollar amount of such deficit balance, and iii. the partnership agreement contains a "qualified income offset" such allocation will be considered to have economic effect to the extent such allocation does not cause/increase a deficit balance in such partner's capital account in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore as of the end of the partnership taxable year to which such allocation relates. In determining the extent to which the previous sentence is satisfied, such partner's capital account will be reduced for: i. adjustments that reasonably are expected to be made to such partner's capital account under 1.704-1b2ivk for depletion allowances with respect to oil/gas properties of the partnership, and ii. allocations of loss and deductions that reasonably are expected to be made to such partner pursuant to 704e2, 706d and 11.751-1b2ii, and iii. distributions that reasonably are expected to be made to such partner to the extent they exceed offsetting increases to such partner's capital account that reasonable are expected to occur during the partnership taxable years in which such distributions reasonably are expected to be made. 1.704-1b2iid
What increases a partner's capital accounts?
i. the amount of money contributed to the partnership ii. the FMV of property contributed to the partnership (net of liabilities secured by the property that the partnership is considered to assume or take subject to under 752) ii. allocations of partnership income and gain, including tax exempt income
When the only difference in the allocations is the tax effect, an allocation of a tax attribute fails the substantiality test. Regardless, the Regs permit allocations of depreciation recapture. The regs provide that a partner's share of recapture gain is the lesser of:
i. the partner's share of total gain from the disposition of the property, or ii. the partner's share of depreciation with respect to the property 1.1245-1e2
Any and all facts relating to the partners' underlying economic agreement will affect the determination of PIP. 1.704-1b3ii provides that the following facts and circumstances are ordinarily take into account for purposes of determining PIP or a partner's interest in any particular item of income, gain, or loss:
i. the partners' relative contributions to the partnership ii. the partners' interests in the economic profits and losses--if different than that in taxable income and loss iii. the interest of the partners in cash flow and other non-liquidating distributions, and iv. the rights of the partners to distributions of capital upon liquidation
When does a partnership agreement contain a qualified income offset?
if and only if, it provides that a partner who unexpectedly receives an adjustment, allocation or distribution described below, will be allocated items of income and gain in an amount and manner sufficient to eliminate such deficit balance as quickly as possible. 1.704-1b2iid "i. adjustments that reasonably are expected to be made to such partner's capital account under 1.704-1b2ivk for depletion allowances with respect to oil/gas properties of the partnership, and ii. allocations of loss and deductions that reasonably are expected to be made to such partner pursuant to 704e2, 706d and 11.751-1b2ii, and iii. distributions that reasonably are expected to be made to such partner to the extent they exceed offsetting increases to such partner's capital account that reasonable are expected to occur during the partnership taxable years in which such distributions reasonably are expected to be made. 1.704-1b2iid"
The regs provide that the book-value liquidation approach does not apply if..
if the resulting allocations would not satisfy the test for substantiality. 1.704-1b3iii ---there are issues with this rule, see 152-53
For transitory allocations, the economic effect of the allocations will not be substantial if:
if there is a strong likelihood that: i. an original allocation and a later offsetting allocation will leave the capital accounts approximately where they would have been had the allocations not occurred, and ii. the tax liability of the partners will be reduced as a result of the allocations However, if there is a strong likelihood that the offsetting allocation will not be made in large part within 5 years of the original allocation, then the economic effect of the allocation will be substantial
In general, the traditional method requires that when the partnership has income, gain, loss or deduction attribute to 704c property, it must...
make appropriate allocations to the partners to avoid shifting the tax consequences attributable to tax gain or loss inherent in contributed property (built-in gain or loss) Under this rule, if the partnership sells 704c property and recognized gain or loss, built-in gain or loss on the property is allocated to the contributing partner to the extent possible.
