Professor Abrams – Partnership Tax – Fall 2014
I. General Test for Economic Effect Test
a. Allocations must be consistent with the underlying economic arrangement of the partners
i. Capital Account Requirement – The partnership must maintain its capital account in accordance with § 1.704-1(b)(2)(iv)
ii. Liquidation Requirement – Upon liquidation, liquidating distributions must be made in accordance with the positive balances in the partners’ capital accounts
iii. Deficit Makeup Requirement – If after liquidation any partner has a deficit in her capital account, she must be unconditionally obligated to restore that deficit
II. Alternate Test for Economic Effect
a. The agreement must meet the fist two requirements of the General Test
b. The agreement must contain a qualified income offset (QIO) provision
c. The allocation must not create (or increase) a deficit in a partner’s capital account in excess of the partner’s obligation to restore a deficit
III. Contributed Property
a. Allocations to contributing partner under § 704(c)(1)(A)
i. The contributing partner shall be credited in her capital account the full fair market value of the property
ii. Her outside basis shall be credited with the current basis of the contributed property
iii. The partnerships inside basis in the property (book value) shall be the full fair market value of the contributed value and the basis shall be carryover from the contributing partner (step in the shoes)
iv. Built-in gain or loss must be allocated to the contributing partner (tax without book equals § 704(c) layer allocable to the contributing partner)
v. Regulations imposed a ceiling limitation on allocations under § 704(c)(1)(A) – partners cannot be allocated more tax income or loss than is recognized by the partnership. Treas. Regs. § 1.704-3(b).
vi. Regulations promulgated three alternatives that can be used to respond to the problems caused by the ceiling limitation:
1. Traditional Method
a. Do nothing
b. Book/tax disparity will remain until the partnership is liquidated
2. Traditional Method with Curative Allocations
a. Uses other partnership taxable income or deductions of consistent character to eliminate any book/tax disparity caused by the ceiling limitation
b. Allocating other taxable income or deductions to the partner with the disparity offsets it
c. If there is not enough income or deductions to offset the disparity in one year, the regulations do not permit a subsequent curative allocation in the next year. Treas. Regs. § 1.704-3(c)(3)(i).
d. A partnership may limit its curative allocations to allocations of one or more particular tax items, even if the allocation of those available items does not offset fully the effect of the ceiling rule. Treas. Regs. § 1.704-3(c)(1).
IV. Contributed Property and Reverse Allocations
a. Remedial Allocation Method
i. Divided into two components
1. One unappreciated
2. One with zero basis
ii. Acts as if two properties have been contributed
1. One with carry over adjusted basis and fair market value
2. The other with zero basis and fair market value equaling the built-in loss
a. The second, zero basis property is treated as newly purchased by the partnership, so its depreciation schedule does not carry over from the contributing partner but instead starts fresh. Treas. Regs. § 1-704-3(d)(2).
b. A partnership can use the remedial allocation method with respect to any contributed property even if there is no ceiling limitation issue.
b. Reverse § 704(c) Allocations to the Exiting Partners
i. Upon the admittance of a new partner, regulations provide that assets may be revalued and capital accounts may be restated to reflect their fair market values. Treas. Regs. § 1-704-1(b)(2)(iv)(f).
ii. The restatement of assets is optional
iii. When assets are restated, they are allocated among the existing partners according to the partnership agreement
iv. Though technically regulated by the § 704(b) regulations, allocations are analyzed by the § 704(c) principles…called reverse § 704(c) allocations
V. Failure to Satisfy the Economic Effect Test
a. Regulations provide an economic equivalence test when an allocation fails to meet the general and the alternative economic effect tests. They shall nevertheless be deemed to have economic effect, provided that:
i. As of the end of such year or at the end of each partnership taxable year,
ii. A liquidation of the partnership at the end of such year or at the end of any future year,
in. Treas. Regs. § 1.704-2(c).
iii. Nonrecourse deductions give rise to partnership minimum gain
iv. Minimum gain gives rise to recognition of income upon disposition of the property
v. The tax burden associated with nonrecourse deductions in minimum gain
vi. Whichever partner enjoys the benefit of claiming a nonrecourse deduction must also suffer the burden of the recognition of minimum gain
d. General Principles
i. The Partnership agreement must satisfy the general or alternate economic effect test with respect to allocations of tax items other than nonrecourse deductions
ii. Allocations of nonrecourse deductions must be made in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities
iii. The partnership agreement must contain a minimum chargeback provision
1. If there is a net decrease in partnership minimum gain for a partnership taxable year…each partner must be allocated items of partnership income and gain for that year equal to that partner’s share of the net decrease in partnership minimum gain. Treas. Regs. § 1-704-2(f)(1).
e. Distribution of Refinancing Proceeds
i. When a partnership borrows using a nonrecourse loan against a property in excess of its basis, that excess increases partnership minimum gain
ii. If a partner is distributed the excess, that same partner also taxed on the gain should the property be disposed of
f. Partner Nonrecourse Debt
i. When the debt is nonrecourse against the partnership but one or more partners are liable for repayment by means of guarantee or otherwise