Taxation of Business Entities
§703 – Partnership Computation
a) No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.
b) Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated.
c) The Secretary may provide by regulations that subsection (a) shall not apply to gain realized on the transfer of property to a partnership if such gain, when recognized, will be includible in the gross income of a person other than a United States person.
§731(b) – No gain or loss shall be recognized to a partnership on a distribution to a partner of property, including money.
a) A partner's distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this chapter, be determined by the partnership agreement.
b) A partner's distributive share of income, gain, loss, deduction, or credit shall be determined in accordance with the partner's interest in the partnership if—
1) the partnership agreement does not provide as to the partner's distributive share of income, gain, loss, deduction, or credit, or
2) the allocation to a partner under the agreement of income, gain, loss, deduction, or credit does not have substantial economic effect.
(From Ex. On 153): The point is that something has substantial economic effect if the money allocated to each of them is what they actually get (meaning that the money they're theoretically owed by the distributions is actually applied to their account or whatever).
Book v. Tax
· Items of income or expense are allocated to capital accounts regardless of whether or not they are taxable or deductible.
· Appreciated property is “booked” at fair market value, while your basis in your partnership interest is based upon your basis in the property.
· You can have a negative capital account; you cannot have a negative basis.
Substantial economic effect occurs if an allocation is reflected in a partner's capital account (generally).
General test for economic effect: Treas. Reg. 1.704-1(b)(2)(ii)(b)
· For an allocation of partnership income or deduction to have economic effect, the regulations under 704(b) generally require that three conditions be satisfied. Specifically, the partnership agreement must provide,
o for the maintenance of a capital account for each partner pursuant to the rules set forth in the regulations,
o that liquidating distributions will be made in accordance with the positive capital account balances of the partners, and
o that any partner with a deficit capital account is unconditionally obligated to restore the deficit upon the liquidation of the partnership (or when the partner leaves the partnership).
Alternate test for Economic Effect: Treas. Reg. 1.704-1(b)(2)(ii)(d)
· If the requirements above are satisfied and 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 the partnership contains a “qualified income offset” such allocation will be considered to have economic effect to the extent such allocation does not cause or increase a deficit ba
reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. The economic effect of an allocation is not substantial if, at the time the allocation becomes part of the partnership agreement, (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.
If an agreed upon allocation does not have substantial economic effect (or if the partnership agreement does not provide for tax allocations), partnership gross income and deductions are allocated in accordance with the interests of the partners in the partnership. 704(b).
· Although the capital accounts were to reflect a chargeback in the event of a gain, the allocation lacked substantial economic effect because the adjusted capital accounts were not to provide the basis for liquidating distributions. Additionally, Orrisch was not required to make up his capital account in the event that the property was sold at a gain less than the allocated depreciation.