Partnership Allocations and Substantial Economic Effect: What the IRS Looks For

The Basic Rule of §704(b)

A partner’s distributive share of partnership items is generally determined by the partnership agreement. Under §704(b), however, a partner’s share is instead determined in accordance with the partner’s interest in the partnership, taking into account all facts and circumstances, if the agreement does not provide for the allocation or the allocation does not have substantial economic effect.

Disproportionate, or “special,” allocations are not prohibited. A partnership agreement may, for example, allocate 90 percent of losses to one partner even though both partners contributed equal capital, if the allocation has substantial economic effect. In practical terms, the partner who receives the tax benefit of the loss must also bear the corresponding economic burden.

Treasury Regulation §1.704-1(b)(2) applies a two-part analysis: the allocation must have economic effect, and that economic effect must be substantial.

Economic Effect: The Three Requirements

Under Treas. Reg. §1.704-1(b)(2)(ii)(b), an allocation generally has economic effect only if, throughout the life of the partnership, the partnership agreement provides that:

(1) capital accounts are determined and maintained in accordance with the regulations;

(2) on liquidation of the partnership or of any partner’s interest, liquidating distributions are made in accordance with positive capital account balances; and

(3) a partner with a deficit capital account balance after liquidation of the partner’s interest is unconditionally obligated to restore the deficit to the partnership.

Many agreements, particularly LLC operating agreements, do not include an unlimited deficit restoration obligation. The regulations provide an alternate test. If the first two requirements are met and the agreement contains a “qualified income offset,” an allocation may have economic effect to the extent it does not cause or increase a deficit capital account balance beyond any limited amount the partner is obligated to restore (Treas. Reg. §1.704-1(b)(2)(ii)(d)).

How Capital Accounts Work

Capital accounts track each partner’s economic stake. Under the regulations, a partner’s capital account is increased by money contributed, the fair market value of property contributed (net of liabilities the partnership assumes or takes subject to), and allocations of income and gain. It is decreased by money distributed, the fair market value of property distributed (net of liabilities), and allocations of loss and deduction. Because contributed property is recorded at fair market value, these “book” capital accounts can differ from the partners’ tax basis.

For example, assume two partners each contribute $100,000 in cash and the agreement satisfies the economic effect requirements. If the partnership allocates a $60,000 loss entirely to Partner A, Partner A’s capital account falls to $40,000 while Partner B’s remains $100,000. If the partnership then liquidates, distributions follow those balances, so Partner A receives $60,000 less than Partner B. The tax deduction and the economic loss line up, which is the point of the economic effect test.

Substantiality

Economic effect must also be substantial. Under Treas. Reg. §1.704-1(b)(2)(iii), the economic effect of an allocation is substantial if there is a reasonable possibility that it will affect substantially the dollar amounts the partners receive from the partnership, independent of tax consequences.

The regulations also describe situations in which economic effect is not substantial. In general terms, an allocation is not substantial if, when it becomes part of the agreement, at least one partner’s after-tax position may be enhanced and there is a strong likelihood that no partner’s after-tax position will be substantially diminished. Two specific patterns are addressed: “shifting” allocations, which change the partners’ tax liabilities in a year without substantially changing their capital accounts, and “transitory” allocations, which are likely to be largely offset by later allocations within five years while reducing the partners’ total tax liability.

Nonrecourse Deductions and Minimum Gain Chargeback

Deductions attributable to partnership nonrecourse liabilities cannot have economic effect, because the lender, not any partner, bears the economic burden. Treasury Regulation §1.704-2 provides a framework under which these deductions are deemed allocated in accordance with the partners’ interests in the partnership if certain conditions are met, including a “minimum gain chargeback” provision in the partnership agreement.

Partnership minimum gain is, in general, the gain the partnership would realize if it disposed of property subject to a nonrecourse liability in full satisfaction of the liability and for no other consideration. When partnership minimum gain decreases, for example when the debt is paid down or the property is sold, the minimum gain chargeback generally requires each partner to be allocated income and gain equal to that partner’s share of the net decrease.

Contributed Property and §704(c)

Allocations relating to property contributed with built-in gain or loss are governed by §704(c), not left to the partners’ choice. Section 704(c) requires income, gain, loss, and deduction with respect to contributed property to be shared so as to take account of the difference between the property’s tax basis and its fair market value at contribution. Treasury Regulation §1.704-3 describes three generally reasonable methods (the traditional method, the traditional method with curative allocations, and the remedial method), and other reasonable methods may be used in appropriate circumstances.

When an Allocation Fails

If an allocation lacks substantial economic effect and is not otherwise deemed to be in accordance with the partners’ interests, it is redetermined according to each partner’s interest in the partnership, based on all facts and circumstances. Under Treas. Reg. §1.704-1(b)(3), relevant factors include the partners’ relative contributions, their interests in economic profits and losses, their interests in cash flow and other non-liquidating distributions, and their rights to distributions of capital on liquidation.

Practical Considerations

Allocation provisions should be read together with the agreement’s distribution and liquidation provisions. Points commonly reviewed include whether capital accounts are actually maintained under the regulations, whether liquidating distributions follow capital account balances, whether the agreement relies on a deficit restoration obligation or a qualified income offset, how nonrecourse deductions and minimum gain chargebacks are handled, and which §704(c) method applies to contributed property.

The Bottom Line

Partnerships have real flexibility to allocate items differently from ownership percentages, but each allocation must have substantial economic effect or match the partners’ interests in the partnership. That turns on how capital accounts are kept, how liquidating distributions are made, how deficits are handled, and whether the allocation has economic consequences apart from taxes.