Chapter 4

Q3. What happens if there are no allocation agreements?

A3. Code section 704(b) provides that distributive shares are determined for tax purposes in accordance with the partner's interest in the partnership, taking into account all facts and circumstances

Q30. How do the regulations test for "economic effect"? Name the different pieces

A30. The regulations test "economic effect" mechanically, (1). By providing a three pronged primary test (the big three), (2). Then a more flexible alternative test and finally (3). A narrowly applicable fallback test of "economic effect equivalence"

Q95. What happens to an allocation that does not have substantial economic effect because it is not substantial?

A95. The item will be reallocated according to the partner's interests in the partnership

Q52. In these circumstances, would the $20K cost recovery deduction allocated to A for year one and two have economic effect under the alternate test? Why?

A52. Yes, because A's capital balance has not yet fallen below zero

Q59. What if the partnership reasonably expected $10K of operating income for year 2?

A59. A's $5K share of the resulting capital account increase could be taken into account and the anticipatory reduction to his capital account at the end of year 2 would only be $15K ($20K distribution less $5K anticipated income).

Q76. What about the after-tac substantiality test?

A76. The after-tax substantiality test is failed at the time the allocation is made because A is expected to enhance his after-tax economic consequences as a result of the allocation, and there is a strong likelihood that neither A nor B will substantially diminish his after-tax consequences

Q80. With the intent of providing an additional level of clarity regarding the substantiality requirement, the regulations further identify what two specific scenarios in which an allocation or set of allocations will lack substantiality?

A80. (1). Instances of shifting allocations and transitory allocations

Q81. What is the Treasury's concern?

A81. Is that initial allocation will be offset by one or more later allocations, resulting in no significant economic consequences to the partners (no net impact on their capital accounts-ostensibly failing the pre-tax standard of the substantiality requirement), but reducing their tax liability.

Q1. Code section 704(a) provides that a partner's distributive share of income, gain, loss, deduction or other tax items shall be determined by?

A1. The partnership agreement

Q17. What is a critical precept of the substantial economic effect test?

A17. Is that an allocation is valid for tax purposes only if it is "consistent with the underlying economic arrangement of the partners".

Q20. When drafting the partnership agreement what is the message of the regulations?

A20. Is that the capital account rules must be incorporated in the partnership agreement if an allocation is to satisfy the economic effect prong of the safe harbor test

Q23. These rules are set to determine what? And not what?

A23. These rules are set to determine throughout the life of the partnership the "book value" of each partner's interests in the firm. Thus, a partner's capital account may differ markedly from his outside basis, especially where the partnership has liabilities

Q54. So in short, under the alternate test and allocation will be sustained to what extent?

A54. To the extent of a partner's positive capital account plus any limited obligation to restore a deficit. (Hoping further examples will explain this better)

Q66. If an allocation fails to meet either the primary or alternative tests for economic effect, the regulations offer relief if the allocation has?

A66. Economic effect equivalence

Q8. Under code section 704(a), how should allocations be done?

A8. Allocations of income, expense, deduction and or credit are done based on the partnership agreement

Q12. What does it mean for an allocation to have an "economic effect"?

A12. Means generally that the allocation must be consistent with the economic business deal of the partners

Q34. Example to read through

A34. A special allocation of $100 of extra income can be respected for tax purposes only if the partners eventually will receive the economic benefit of that income

Q6. Without this section, what are a couple of examples of what people could do to avoid tax?

A6. (1). The partnership could be used to shift income or losses between partners in high and low marginal income tax brackets or (2). To allocate the character of income or losses among partners with different tax profiles.

Q70. Would an allocation that yields the same balances in the partner's capital accounts that would be produced absent the allocation satisfy the substantiality requirement?

A70. No

Q71. What does the standard say and what does it mean in English?

A71. It says the following, the economic effect of an allocation is considered to be substantial if there is a reasonable possibility that he allocation will affect substantially the dollar amounts to be received by the partners from the partnership independent of tax consequences. I think this means that generally, you made the allocation and that you can prove you did it for a reason that was not tax related.

Q74. Why is this important?

A74. Because if no one is getting a substantial detriment, the special allocation is effectively guaranteeing that no partner is exposed to a material risk of realizing a worse after tax result, which in turn suggest that the partners are making tax-driven allocations to the detriment of the country

Q96. For this purpose, how are the partner's interests in the partnership determined?

A96. The regulations make it clear that for this purpose the partners interests are determined by how they economically share the item. In the example of the shifting allocation, A and B would share the reallocated Section 1231 and capital losses 50/50 because that is ow they economically bore those losses

Q90. Is the economic effect of this allocation substantial in year 1?

A90. Viewing year one in isolation, it is substantial because A benefits from economically from the allocation and the other partners suffer (for example, if the partnership were liquidated at the end of year 1, A would come out ahead because the allocation of 100% of the year one income would increase his capital account (and thus his share of liquidation) relative to the capital accounts of B and C.

Q91. What about if you view all three years together?

A91. Not substantial because viewing all three years together, the economic effect of the deal is a "wash" because the partners are well aware from the start that the net increases and decreases in their capital accounts resulting from the allocations will be the same at the end of year three as they would have bene in the absence of the allocations. Moreover, because the allocation enables A to apply his expiring net operating loss deduction against the year 1 partnership income, the total taxes of A, B and C over the three year period are reduced

Q93. Example - In the A and B example were they were equal partners who made special allocations of section 1231 loss and capital loss. How would the comparison in this example be made?

A93. Because A and B generally were 50/50 partners the comparison would be made to those sharing percentages

Q94. What if A and B had different sharing percentages from year to year? Or suppose they had different sharing percentages in various partnership items? Then what would be the partners interests in the partnership for purposes of the comparison?

A94. The regulations do not address these more complicated issues

Q97. Example - Using the initial example where we discussed the general rule for testing substantiality, A was allocated $9K of tax-exempt interest and B was allocated $1K of tax-exempt interest and $10K of table interest. What would happen here in a reallocation?

A97. Thus, A's capital account increased by a total of $9K (45% of total partnership income) and B's capital account is increased by a total of $11K (55%). Since the special allocation failed the substantiality test, the tax-exempt and table interests would be reallocated according to the economic sharing relationship between the partners: 45% to A and 55% to B

Q10. If a partnership agreement provides for an allocation, what are the three ways under the regulations in which the allocation will be respected?

A10. (1). The allocation can satisfy the standards for having substantial economic effect (2). Taking into account all facts and circumstances, the allocation can be in accordance with the partner's interest in the partnership (3). The allocation can be deemed to be in accordance with the partner's interest in the partnership under one of several special rules that apply to specific tax items

Q11. What are the two general pieces of the safe harbor test to determine if a partnership allocation has substantial economic effect?

A11. To be respected for tax purposes an allocation first must have "economic effect" and then there is a "substantiality" test

Q13. What does the substantially test entail generally?

A13. In general, for the economic effect of an allocation to be substantial, there must be a reasonable possibility that he allocation will affect substantially the dollar amounts to be received by the partners from the partnership apart from tax purposes.

Q14. If a partnership agreement is silent as to the partner's distributive shares of income, losses and other tax items, or if a special allocation is found wanting because it lacks substantial economic effect, then how are the allocations determined?

A14. Then the partner's respective shares of income, loss and other items are determined in accordance with the partner's respective " interests in the partnership".

Q15. How is a partner's interest in a partnership determined?

A15. This is determined by taking into account "all the facts and circumstances"

Q16. Under regulation 1.704-1(b)(3), in determining a partner's interest in the partnership, what are the 4 following factors among those that will be considered?

A16. (1). The partner's relative contributions to the partnership (2). The interests of the partners in economic profits and losses (if different than that in taxable income or loss) (3). The interests of the partners in cash flow and other non-liquidating distributions, and (4). The rights of the partners to distributions of capital upon liquidation.

Q18. The reference point employed by the regulations for testing whether allocations are sufficiently linked to the partner's economic deal is?

A18. Is the capital account

Q19. What does the capital account represent?

A19. A capital account essentially represents a partner's equity in the partnership. At any point during the life of the firm, it identifies the amounts the partners would be entitled to receive if and when their interest in the partnerships were liquidated.

Q2. Code section 761(c) defines the partnership agreement as including any modifications up to the time for filing the partnership's tax return. What does this permit?

A2. This permits partners to make what are called "special allocations" which are allocations that differ from the partner's respective interest in partnership capital.

Q21. Capital accounts are considered property determined and maintained only if each partner's capital account is increased by (3 items)

A21. (1). The amount of money contributed to the partnership by the partner (2). The FMV of property contributed by the partner to the partnership (net of liabilities securing the property that the partnership is considered to assume or take subject to under section 752), and (3). Allocations to the partner of partnership income and gain, including tax-exempt income

Q22. And decreased by (4 items)

A22. (1). The amount of money distributed to the partner by the partnership (2). The FMV of property distributed to the partner by the partnership (net of liabilities secured by the property that the partner is considered to assume or take subject to under section 752) (3). Allocations to the partner of partnership expenditure that are neither deductible in computing taxable income nor property chargeable to capital accounts and (4). Allocations of partnership loss and deduction (excluding the items limited in (3) above).

Q24. When you contribute property, would you update the value of the partner's capital account by its FMV or by its tax basis?

A24. Because capital accounts reflect the value of contributed property rather than its tax basis, further adjustments may be required to ensure that capital accounts are adjusted by book income rather than taxable income

Q25. What do the regulations say about the valuations of property being contributed?

A25. The regulations provide that a FMV reasonably agreed to among the partners in arm's length negotiations will control if the partners have sufficiently adverse interests

Q26. What happens if the service was to look back and say that a valuation that was used was inappropriate?

A26. The effect of a valuation error could be potentially devastating because, if capital accounts are improperly maintained, all allocations in the partnership agreement will be set aside and result in a re-allocation in accordance with the partners' interest in the partnership.

Q27. Are book capital accounts constantly being fluctuated to reflect updates to FMV?

A27. Typically no

Q28. The regulations allow partnerships to restate assets at their current FMV only in what defined instances?

A28. (1). The admission of a new partner to the partnership (2). A distribution in complete or partial liquidation of a partner's interest in the firm (3). The grant of a partnership interest as consideration for the provision of services to the partnership, or (4). Where substantially all of the partnership's property (excluding money) consists of marketable securities provided in all cases the adjustments are made for a substantial non-tax business purpose.

Q29. In providing that an allocation will have economic effect only if it is consistent with the underlying economic arrangement of the partners, what do the regulations mean?

A29. The regulations mean that if there is an economic benefit or burden corresponding to the allocation, the partner to whom the allocation is made must receive the benefit or bear the burden

Q31. Under the primary test (Big three), an allocation will have economic effect if, and only if, throughout the life of the partnership, the partnership agreement provided what?

A31. (1). Capital accounts must be determined and maintained in accordance with the rules of Section 1.704-1(b)(2)(iv) of the regulations. (2). Upon a liquidation of the partnership, or of any partner's interest, liquidating distributions must be made in accordance with the positive capital account balances of the partners and (3). If a partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, he must be unconditionally obligated to restore the deficit by the later of (a). the end of the table year of the liquidation of the partner's interest or (b). 90 days after the date of the liquidation

Q32. How do most partnerships make sure that these items are met?

A32. These requirements are easily met simply by including the requisite provisions relating to maintenance of capital accounts, distributions on liquidation and restoration of deficit capital accounts in the partnership agreement and by adhering to them for the duration of the partnership.

Q33. What is the rationale for the big three?

A33. Unless tax allocations of income or loss are accompanied by increases or decreases to the partner's capital accounts, there is no way to assure that he tax consequences ever will reflect the partners' economic business deal

Q35. What does a negative capital account indicate?

A35. Indicates that the partner is in debt to the partnership (i.e. to creditors or the other partners)

Q35. What do the regulations require in regards to this upon a liquidation?

A35. They require that the partner must satisfy that debt (by restoring the deficit) on or before a liquidation

Q36. Example - Assume A and B, each contributing $40K form the AB general partnership to purchase and lease depreciable equipment. The partnership agreement provides that (1). the partners equally will share taxable income and cash flow except that all cost recovery deductions are specially allocated to A (2). Capital accounts will be maintained in accordance with the regulations and (3). On liquidation all distributions will be made equally between A and B. Neither partner, however, has any obligation to restore a deficit in his capital account. Would this agreement pass muster?

A36. No, lets assume that after the first year there is $0 operating income/loss and you only had a ($20K) cost recovery deduction that is allocated to A pursuant to the agreement. A's capital account is thus reduced to $20K while B's stays at $40K. Assume now that the FMV of equipment matches its basis of $60K and it sell and then liquidates. The agreement requires that the proceeds be allocated evenly at $30K each.

Q37. Why is this an issue?

A37. If the special allocation of cost recovery deductions to A is to have economic effect, A must bear the full risk of economic loss corresponding to that allocated deduction. A does not bear that loss if the capital account balances-which are designed to reflect the economic entitlements of the partners are ignored on liquation

Q38. What should have happened to have this allocation have economic effect?

A38. The agreement should have provided for distributions in liquidation to be made in accordance with the positive capital accounts of the partners i.e. $20K to A and $40K to B. Only then would the tax allocation match the economics.

Q39. Because the allocation lacks economic effect, what would happen?

A39. The $20K cost recovery deduction must be reallocated in accordance with the partner's interests in the partnership, 50/50 in this example

Q4. Code section 704(b) which, in addition to governing allocations where the partnership agreement fails to do so, provides that particular items or the entire amount of partnership income or loss will be allocated in accordance with the partner's interests in the partnership if?

A4. If the agreed upon allocation lacks substantial economic effect

Q61. What happens if in year 3, the partnership unexpectedly distributes cash to Partner A, driving his capital account below zero, without any corresponding increase?

A61. This is when the "qualified income offset plays a role.

Q62. What does the "qualified income offset" (QIO) provision do?

A62. The QIO is a provision in the partnership agreement stating that any partner who has a deficit capital account as a result of unexpectedly receiving a distribution (or the other specialized adjustment listed in the regulations) must be allocated items of future income or gain in an amount and manner sufficient to eliminate any remaining deficit balance as quickly as possible

Q63. Why is the QIO necessary? What has occurred with this unexpected distribution?

A63. The unanticipated distribution has created a deficit balance in a partner's capital account beyond that which the partner is obligated to restore, the foundation of the alternate test for economic effect is compromised.

Q64. What does this mean about historical allocations now?

A64. In hindsight, previous allocations of loss to the partner (that had substantial economic effect when made) will no longer have economic effect because the intervening distribution created a deficit balance that the partner does not have to restore.

Q65. So does QIO address this issue retroactively or prospectively? How?

A65. It addresses the issue prospectively. Instead of retroactively requiring the partnership to reallocate losses in prior years so as to prevent the subsequent distribution from creating the problematic capital account deficit, we treat it prospectively by allocating future income items to the partner as rapidly as possible to restore the partner's capital account to zero (or to a negative amount equal to the partner's limited deficient make-up obligation).

Q67. What does this mean?

A67. Under this final fallback, allocations are deemed to have economic effect if they partnership agreement, interpreted by reference to applicable state law, ensures that a liquidation of the partnership as of the end of each partnership taxable year will produce the same economic results as if the Big Three were satisfied

Q68. All of that relates to the first major test, what is the second major test under the regulations in regards to allocations?

A68. The second major test under the regulations looks to whether the economic effect of an allocation is "substantial"

Q69. When does it have to be substantial?

A69. Both in the year of the allocation and over the life of the partnership

Q7. So then you can say that code section 704(b)(2) was made specifically to do what?

A7. The code's all purpose standard for testing the validity of allocations of a partnership's tax items

Q71. Example - Suppose a partnership allocated economic income on a pro-rata basis but coupled this with special allocations of income of a certain tax character (ordinary, LT Cap etc..) among the partners in an amount sufficient to match the division of economic income. Would this always work?

A71. If the allocation does not alter the partner's capital accounts from those that would result if the special allocation of character items were not made, it is difficult to characterize the economic effect of the allocation as substantial. In this case, the allocation would have zero economic effect. The regulations require the allocation to potentially yield a meaningful variance in the partners capital account balances - a variance that could "substantially" alter the partner's rights to pre-tax income

Q72. Even if one assumes that he pre-tax articulation of the substantiality requirement is satisfied, the regulations further provide that the economic effect of the allocation is not substantial if, at the time the allocation become part of the partnership agreement what (2)items?

A72. (1). 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 (2). There is a strong likelihood, that the after-tax economic 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.

Q73. What is the prior question saying in English terms?

A73. The first prong of the after-tax test "that one partner might be advantaged by the special allocation" will almost certainly be satisfied as it is difficult to imagine a special allocation scheme where there exists no reasonable prospect that at least one partner will improve their tax position. So the crux of the after-tax test rests in the second prong which essentially asks whether there exists a reasonable possibility tat any partner might face a substantial detriment as a result of the allocation

Q58. So if the partnership is expected to break even in year 3, how would partner A treat the allocation? What is the result?

A58. The allocation to A must be tested under the alternate test by first reducing A's capital account by the $20K anticipated year three distribution. As a result, his capital account falls to zero, and the $20K year two cost recovery deduction will be reallocated to B

Q60. Now, return to the end of year 2 and assume no distributions are on the horizon. What would happen then?

A60. In that event, the $20K special allocation to A in year 2 will be respected under the alternate test

Q40. Example - Same basis facts except that A and B agreed from the outset to make distributions in accordance with the partner's positive capital account balances, but their agreement still fails to include a deficit restoration requirement. Now assume that for year 2and 3 there was still $0 operating income/loss but that you continued to have ($20K) cost recovery deductions being allocated to partner A every year. If the partnership sells the equipment for $20K and liquidates what would happen based on their agreement? Is this ok?

A40. Agreement still has an issue. In this example the ending capital balance of partner A is ($20K) while Partner B = $40K. The agreement would entitle Partner B to the entire $20K but this allocation does not have economic effect because B, who enjoyed none of the cost recovery deductions associated with the equipment should be entitled to fully recover her $40K investment while A, whose $60K of cost recovery deductions ostensibly were coupled with an equivalent economic burden, has only lost $40K under the arrangement.

Q41. What must happen for A's economic burden to correspond to the allocation?

A41. Partner A must be obligated to restore the $20K deficit balance in his capital account so that B is not short-changed

Q42. After such a restoration, would the economics be respected?

A42. Yes, because A will have lost $60K and B will have recouped her entire $40K investment satisfying the command that" in the event there is an economic benefit or an economic burden that corresponds to an allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden.

Q43. Of the big three items, which is the most troublesome and why?

A43. The deficit restoration requirement is the most troublesome of the Big Three in the case of limited partnerships because limited partners and members of an LLC typically are unwilling to make such an open-ended commitment. There is a reluctance of most investors to consent to an unconditional obligation to restore a deficit capital account balance upon liquidation.

Q44. Is there a solution?

A44. Yes, the regulations provide an alternate test to avoid this problem and preserve special allocations of losses as long as they do not reduce a partner's capital account below zero

Q45. Would this alternative test serve as the standard means by which most partnerships comply with the substantial economic effect safe harbor?

A45. Yes, that is correct

Q46. So just to be clear, if a partnership agreement satisfies the first two requirements of the Big Three but fails to include an unconditional deficit make-up provision, what do the regulations provide?

A46. They provide an alternate test for economic effect

Q48. What is a "qualified income offset"?

A48. Is a provision requiring that partners who unexpectedly receive an adjustment, allocation, or distribution that brings their capital account balance negative, will be allocated all income and gain in an amount sufficient to eliminate the deficit balance as quickly as possible.

Q49. So what happens if an allocation of loss would create or increase a deficit in a partner's capital account (in excess of any limited deficit make-up obligation)?

A49. The loss must be reallocated in accordance with the partner's interest in the partnership

Q5. Explain the general importance of code section 704(b) in regards to substantial economic effect

A5. Very generally, the point of them is to prevent making allocations that do not make any sense but that would help certain people from a tax standpoint based on bottom line allocations (net income) - Think about the Orrisch v. Commissioner case and the allocating of depreciation. Substantial economic effect meaning that the allocation may actually affect the dollar amount of the partner's share of the total partnership income or loss independently of tax consequences.

Q50. Might partners attempt to manipulate the alternate test for economic effect by careful timing of distributions and other events that could be anticipated at the tie of the allocation under scrutiny? What do the regs do about this?

A50. Yes, partners could try to do this and to prevent such gambits, the regulations require that, for purposes of the alternate test, partners must reduce their capital accounts by distributions that are reasonably expected as of the end of the partnership year in which the loss allocation was made.

Q51. Example - Recall that A and B each contributed $40K to the AB partnership which used the funds to acquire $80K of depreciable equipment. Assume now that the first 2 prongs of the Big Three are satisfied, but the agreement does not include a deficit restoration requirement. A & B share all profits and losses equally, except all cost recovery deductions are allocated to A. As before, the partnership breaks even apart from the $20K annual cost recovery deduction. The agreement does contain a "qualified income offset" and neither distributions nor the other items specified in the regulations are expected to cause or increase a deficit balance in A's capital account

A51. Use this for the following questions

Q53. What if the cost recovery deduction allocated to A in year two were $25K?

A53. Only $20K (A's remaining capital account) would have economic effect. The $5K balance would be reallocated to partner B who bears the economic burden in the absence of any deficit restoration agreement by A.

Q55. Example - assume it is near the end of year 2. The partners need cash, and the partnership holding only the equipment (presumed to be worth $40K) raises the funds by borrowing $40K with the equipment as collateral. The plan is to distribute the cash equally to the partners. What happens to A if he received the cash before the end of year 2?

A55. If $20K of cash were distributed to A before the end of year 2, it would reduce his capital account to zero and A would not be entitled to any further cost recovery deductions under the alternate test

Q56. What if instead, the partnership waited until early in year 3?

A56. If the partnership waited until early in year 3 to make the distribution, A's capital account at the end of year 2 still would be $20K, enabling the $20K special allocation to pass muster for that year

Q57. How do the regulations preclude this maneuver?

A57. The regulations require A's capital account to be reduced by distributions that are reasonably expected to be made in future years to the extend they exceed reasonably expected capital account increases during the same period.

Q75. Example - Assume that AB general partnership invests in interest producing securities. Partner A expects to be in the 30% marginal tax bracket and Partner B expects to be in the 15%. Now assume that the partnership satisfies the Big Three and thus all of its allocations will have economic effect. Now assume that the partnership will earn equal amounts of tax-exempt and taxable interest and the partnership agreement allocates the tax-exempt interest 90% to A and 10% to B and the table interest 100% to B. would this work from a pre-tax standpoint?

A75. Yes, the allocations, when compared to an even division of all income items, has a meaningful effect on the partner's capital account balances as the likely division of economic income to A and B will be 45% and 55% respectively, hence the pre-tax variance of the substantiality requirement appears to be satisfied.

Q77. Example - Assume the partnership earns $10K each of tax-exempt interest and taxable interest. Please show the pre and post tax allocation for A and B

A77. Partner A would get $9K of tax-exempt interest and partner B would get $1K and he would also get $10K of taxable interest leaving Partner A with $9K pre-tax income and Partner B with $11K of pre-tax income. Partner B would then have 1,500 of tax and an after-tax balance of $9,500 compared to Partner A's $9K

Q78. What if there had been no special allocation and the equal partners had shared the tax-exempt interest and the taxable interest 50/50, what would be the result?

A78. Pre-tax each partner would have a $10K balance and after tax- Partner A would have a balance of $8,500 and Partner B would have a balance of $9,250

Q79. So would this special allocation pass the after-tax substantiality test?

A79. No, because the after-tax consequences of at least one partner are enhanced relative to the consequences if there had been no such allocation, and there is a strong likelihood that the after-tax consequences of no partner will be substantially diminished.

Q82. When do you have "shifting" and when do you have "transitory"?

A82. The effect of offsetting allocations is "shifting" if they occur within the same taxable year; it is "transitory" if the allocations span two or more taxable years.

Q83. The regulations provide that the economic effect of an allocation (or allocations) within one partnership taxable year is not substantial if?

A83. If at the time the allocation becomes part of the partnership agreement, there is a "strong likelihood" that the capital accounts of the partners will be unaffected by the allocation (because of an equal and offsetting allocation in the same year), and the total tax liability of the partners will be less than if there had been no such allocations, taking into account any tax consequences that result from the interaction of the allocation with tax attributes of the partner that are unrelated to the partnership.

Q84. Example - Assume that AB general partnership leases 1231 real property and invests in marketable securities (they are holding up to the Big 3). At beginning of the year, the partnership anticipates incurring a $100K loss on the sale of 1231 property, and it is in a position to realize a $100K capital loss on the sale of stock. Otherwise it expects to break even. Partner A expects to have $500K of ordinary income and no section 1231 gains for the year. Partner B expects to have $300K of ordinary and a $200K section 1231 gain from a sale unrelated to the partnership.

A84. To maximize tax benefits resulting from the interaction of the partnership's expected losses with the individual tax attributes of the partners, A and B amend their agreement and allocate up to $100K of section 1231 loss to A and an equivalent amount of capital loss to B; all other losses in excess of these allocations will be divided equally between the partner.

Q85. What is the end result? What did the effect of this have on each partner?

A85. Partner A = Special allocation = $500K of ordinary - (100K) of 1231 loss = Taxable income of $400K, if they had done an equal division then $500K of ordinary income - ($50K) of 1231 loss and ($3K) of ordinary = $447K of net taxable income Partner B = Special allocation = $300K of ordinary income + $200K of 1231 gain - ($100K) of capital loss = $400K of net taxable income. If they had done a equal division then = $300K of ordinary income + $200K of 1231 gain - ($50K) of 1231 loss - ($50K) of capital loss = $400K of net taxable income

Q86. What happened here? Is this ok to do?

A86. Because of A's ability to fully utilize the section 1231 loss in the current year to offset ordinary income, A's net income is reduced by $47K as a result of the allocation, while B's net income is unaffected. Consequently, the economic effect of the allocations is unsubstantial, and the losses must be reallocated in accordance with the partner's 505/50 interests in the partnership

Q87. When do transitory allocations lack substantial economic effect?

A87. If the partnership agreement provides for the "possibility" over two ore more taxable years, that an "original allocation" will be largely offset by one or more "offsetting allocations" and, at the time the allocation become part of the agreement, there's a "strong likelihood" that the partner's capital accounts will emerge unaffected by the allocations (relative to what would have occurred had there been no allocations) and the partners enjoy a reduction in their total tax liability for the period involved.

Q88. The regulations presume the requisite" strong likelihood" if what?

A88. If the allocation in fact result in no material change to the partner's capital accounts and taxes were reduced relative to what would have occurred If there had been no special allocation

Q89. Example - Assume the equal 3 person ABC partnership has fixed flow of income (LT rental property). At the beginning of year 1, Partner A knows for certain that he has an expiring net operating loss deduction from activities unrelated to the partnership, while B and C are in the highest marginal tax brackets. To help A but burden neither B nor C, the partners agree to allocate 100% of the partnership income to A in year 1, the trade off is that 100% of the income will be divided equally between B and C in the succeeding 2 years, after which the partners will revert back to an equal 3 way division of profits. At all times, the partnership agreement adheres to the Big 3 so that allocations have economic effect

A89. Questions to be asked

Q9. Under code section 704(b), what does it say about allocations?

A9. It says that allocations will be done based on the partner's interest in the partnership (determined by taking into affect all facts and circumstances) when the following two items occur (1). The partnership agreement does not discuss allocations, or (2). The allocation stated in the partnership agreement does not have substantial economic effect

Q47. What is the alternate test?

Q47. An allocation will have economic effect under the alternate test that it does not create or increase a deficit in the partner's capital account and the agreement includes a provision known as a "qualified income offset).

Q92. How is the determination of whether an allocation is shifting, transitory, or fails the general after-tax rule regarding substantiality to be made?

Q92. It is to be made by comparing it to the result if the allocation were not contained in the partnership agreement. This means the comparison is to be made to the allocation that would be made if it was determined in accordance with the partner's interests in the partnership, disregarding the allocation that is being tested