Partnership Allocation

Partnership Agreement Flexibility

Allocating profits/losses Amount & timing of distributions Compensation paid to partners Receipts upon liquidation

Partnership Agreement Determines distributive share of

income, gain, loss, deduction (§704(a))

§704(b) governs allocations where partnership agreement is silent as well as special allocations Special allocation = differ from partners’

respective interests in partnership capital

Section 704(b) – In General General Rule: A partner’s income, loss,

deductions, credits & other items are determined in accordance with the partnership agreement or other special allocation

If partnership agreement is silent or special allocation fails: Allocate in accordance with the partner’s

interest in the partnership taking into account all facts & circumstances

Section 704(b) – In General Interests are equal unless they can

be proven otherwise considering: Relative contributions of partners Interests in economic profits & losses if

they differ from interests in taxable income

Interests in cash flow & other nonliquidating distributions

Rights to distribution of capital upon liquidation

Section 704(b) – Special

Allocation Substantial economic effect: 2-part test

Economic effect = allocation must be consistent with the economic business deal of the partners

Substantiality = reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences

Applied on an annual basis

Economic Effect The partner to whom the allocation

is made must receive the benefit or bear the burden Primary test – The Big Three Alternate economic effect Economic effect equivalence

Economic Effect The Big Three

Capital accounts must be determined & maintained in accordance with the rules of Section 1.704-1(b)(2)(iv) of the regulations

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

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 taxable year of the liquidation of the partner’s interest, or (b) 90 days after the date of the liquidation

Economic Effect The Big Three

Ensures that special allocations for tax purposes are allowed only if the partners will eventually receive the economic benefit of that income

Thus, allocations must be reflected in capital accounts & distributions must be made based on positive capital accounts

The Big Three – Maintenance of Partners’ Capital Accounts

Capital Account Identifies amounts the partners would

be entitled to receive if & when their interests were liquidated

“Book value” – may differ from basis Contributions & distributions valued

at FMV when contributed or distributed instead of adjusted tax basis

The Big Three – Maintenance of Partners’ Capital Accounts

Increased by Money contributed by partner FMV of property contributed by

partner (net of liabilities) Allocations to partner of partnership

income & gain, including tax-exempt income

The Big Three – Maintenance of Partners’ Capital Accounts Decreased by

Money distributed to partner FMV of property distributed to partner

(net of liabilities) Allocation of partnership expenditures

neither deductible in computing taxable income nor properly chargeable to capital account

Allocations of partnership loss & deduction

The Big Three – Example

A and B each contribute $30,000 to form the AB general partnership. The partnership uses this $60,000 to purchase a piece of machinery. The partnership agreement states that all depreciation deductions will be specially allocated to A

The Big Three – Example #1 After depreciation of $15,000, AB

liquidates and distributes the $45,000 proceeds from the sale of its machinery to A and B

Partners’ capital accounts A: $30,000 - $15,000 = $15,000 B: $30,000 - $0 = $30,000

***The $45,000 must be allocated in accordance with the partners’ capital accounts ($15,000 to A and $30,000 to B)

The Big Three – Example #2 After depreciation of $45,000, AB

liquidates and distributes the $15,000 proceeds from the sale of its machinery to A and B

Partners’ capital accounts A: $30,000 - $45,000 = ($15,000) B: $30,000 - $0 = $30,000

***A must contribute an additional $15,000 upon liquidation so that B can receive his full $30,000 distribution.

Alternate Economic Effect If the agreement fails to include an

unconditional deficit make-up provision

Deemed to have economic effect if: Does not create or increase a deficit

in the partner’s capital account

Economic Effect Equivalence If the agreement fails both the

primary & alternate tests Deemed to have economic effect

if: Partnership agreement ensures that a

liquidation of the partnership will produce the same economic results as if The Big Three were satisfied

Substantiality Pass this test unless:

An allocation benefits one or more partners after taxes without adversely affecting any partner

Comparing the results from the allocation with the results if no allocation was made

Tax consequences must be considered

Substantiality – Example Partner A: 30% tax bracket;

allocated 90% tax-exempt interest Partner B: 15% tax bracket;

allocated 10% tax-exempt interest & 100% dividends

$10,000 of tax-exempt interest & $10,000 of dividends distributed

Substantiality – Example Partner A: $9,000 TE interest Partner B: $10,000 dividends - $1,500 tax

= $8,500 + $1,000 TE interest = $9,500 Without this allocation

Partner A: $5,000 dividends - $1,500 tax = $8,500

Partner B: $5,000 dividends - $750 tax = $9,250

Because both A and B benefit from the allocation, it fails the substantiality test and is disallowed

Shifting Allocations Shifting various types of losses

from one partner to another in a single year in order to minimize total taxable income

Capital accounts unaffected “Strong likelihood” that this result

will occur when allocation made Lack economic effect

Transitory Allocations Possibility within five taxable years that

an original allocation will be largely offset by one or more offsetting allocations

“Strong likelihood” that partners’ capital accounts will emerge unaffected

Partners enjoy reduction in total tax liability for period involved

Lack economic effect

Depreciation Recapture Depreciation recapture merely changes

the tax character of an item – thus it cannot have substantial economic effect

Partner’s share is equal to the lesser of: Partner’s share of total gain from

disposition of property Total depreciation previously allocated to

partner with respect to property

Depreciation Recapture This prevents a partner from being

allocated depreciation recapture gain without ever having been allocated depreciation deductions on that property

The partner that suffers the loss should also enjoy the benefit

Depreciation Recapture – Example

The AB Partnership purchases a piece of equipment for $5,000. A and B agree that depreciation deductions will be allocated 90% to A and 10% to B. Gain on sale of property will be shared equally between A and B. After one year, AB sells the equipment for $5,200.

Depreciation Recapture – Example A and B will split the $1,200 gain Of that amount, how much will be classified as

depreciation recapture? A: Gain recognized = $600 Depreciation allocated = $900 Depreciation recapture = $600 B: Gain recognized = $600

Depreciation allocated = $100 Depreciation recapture = entire remaining $400

because A’s recapture was limited to $600

Tax Credits Cannot have economic effect

because not included in partners’ capital accounts

Allocated in accordance with partners’ interests in the partnership

Contributed Property In exchange for partnership interest Recognize neither gain nor loss Basis in contributed property

carries over to partnership for tax purposes

Record at FMV on partnership books

Contributed Property Built-in gain = FMV > Partner’s

adjusted basis at the time of contribution

Built-in loss = FMV < Partner’s adjusted basis at the time of contribution

Contributed Property Example

The AB Partnership is formed with A contributing Gainacre, a capital asset, with an adjusted basis of $12,000 and a FMV of $20,000, and B contributing $20,000 in cash. A and B agree to allocate profits according to their equal 50% interests in the partnership. AB subsequently sells Gainacre for $20,000.

Contributed Property Example – Continued

1 – No book gain is realized. 2 – Because the $8,000 tax gain is allocated equally to A and B in accordance with the partnership agreement, A effectively shifts $4,000 of his built-in gain to B3 – A’s basis: $12,000 + $4,000 = $16,000

B’s basis: $20,000 + $4,000 = $24,000

Contributed Property – Example Continued

***704(a) thus enables partners to shift income or loss for tax purposes without any corresponding economic benefit or burden

***704(c) governs allocation of gain or loss in these situations

Sales & Exchanges – The Traditional Method Allocate any built-in gain or loss to the

contributing partner for tax purposes Gainacre sold for $20,000 = $8,000 built-in

gain allocated to A Gainacre sold for $35,000 = $8,000 built-in

gain allocated to A; remaining $15,000 accrued gain allocated to A and B based on their partnership interests

Required to keep two sets of accounts – one for “book” and one for “tax”

The Ceiling Rule Total gain or loss allocated to the partners

may not exceed the tax gain or loss realized by the partnership Gainacre sold for $15,000

$5,000 book loss (Both A and B receive $2,500) B receives no corresponding tax loss to this book loss

because the partnership realized a tax gain A receives entire tax gain of $3,000 = $15,000 -

$12,000 (instead of actual economic gain of $5,500 = $8,000 precontribution gain - $2,500 book loss)

This shifts income and loss among partners

Sales & Exchanges – Traditional Method with Curative Allocations

Curative allocation – an allocation made solely for tax purposes that differs from the partnership’s allocation of the corresponding book item To correct ceiling rule distortions No economic effect Not reflected in partners’ capital

accounts

Sales & Exchanges – Traditional Method with Curative Allocations

Reasonable if: Does not exceed amount necessary

to offset the effect of the ceiling rule The income or loss allocated has the

same character & the same tax consequences as the tax item affected by the ceiling rule

Traditional Method with Curative Allocations – Example In addition to selling Gainacre for

$15,000, the partnership also sells stock for $30,000 resulting in a $10,000 long-term capital gain Each partner receives $5,000 book gain For tax purposes, A is allocated $7,500 capital

gain and B allocated $2,500 capital gain, thus curing the ceiling rule distortion

The curative allocation must be of the same tax character as the income or loss distorted by the ceiling rule

Traditional Method with Curative Allocations – Example

A B

Tax Book Tax BookOn Formation $12,000 $20,000 $20,000

$20,000Gainacre – Tax Gain 3,000 Gainacre – Book Loss (2,500)

(2,500)Stock – Tax Gain 7,500 2,500Stock – Book Gain 5,000

5,000Balance $22,500 $22,500 $22,500

$22,500

Sales & Exchanges – Remedial Method Solely tax allocations with no effect on the

partnership’s book capital accounts If the ceiling rule results in a book

allocation to a noncontributing partner that differs from the partner’s corresponding tax allocation, the partnership may make a remedial allocation to the noncontributing partner equal to the full amount of the disparity and a simultaneous offsetting remedial allocation to the contributing partner

Characterization of Gain/Loss Prevents the conversion of gain or loss from

capital to ordinary or vice versa through contribution of property to a partnership Unrealized receivables – any gain or loss

recognized by partnership will be ordinary Inventory items – remain ordinary income for

five years after contribution at which time their character is determined at the partnership level

Capital loss property – built-in loss must retain its character as a capital loss for five years after contribution; any additional loss is characterized at the partnership level

Depreciation – Traditional Method

Tax depreciation on contributed property is allocated first to the noncontributing partner in an amount equal to his share of book depreciation

The balance of tax depreciation is allocated to the contributing partner

Could be affected by ceiling rule

Traditional Method Example An asset with FMV of $20,000 and

carryover basis of $12,000 is contributed to a partnership by A. A and B each have a 50% interest. Book depreciation = $4,000/yr, five yrs

A & B each receive $2,000 per year Tax depreciation = $2,400/yr, five yrs

A receives $2,000 (the same as A’s book depreciation) & B receives the remaining $400

Traditional Method Example After five years:

The tax & capital accounts for A & B are brought back into balance

A B

Tax Book Tax BookOn Formation $12,000 $20,000 $20,000

$20,000Depreciation (2,000) (10,000) (10,000)

(10,000)Balance $10,000 $10,000 $10,000

$10,000

Other Depreciation Methods Traditional method with curative

allocations – curative allocation from another partnership asset or additional ordinary income

Remedial method – tax allocation of additional depreciation to noncontributing partner & simultaneous offsetting allocation of ordinary income to contributing partner

Allocation of Liabilities Recourse liabilities – allocated in

proportion to the partners’ respective shares of partnership losses ( best indication of which partners would be responsible for paying)

Nonrecourse liabilities – allocated by reference to the partners’ respective shares of partnership profits (those debts would be paid from partnership profits or assets)

Allocation of Liabilities Limited partners

Not liable for partnership losses beyond capital contribution

Share in nonrecourse liabilities Not allocated partnership recourse

liabilities beyond amounts obligated to contribute to partnership or pay to creditor in the future

Recourse Liabilities A partnership liability is a recourse

liability only to the extent that a partner or any person related to a partner bears the economic risk of loss with respect to that debt To the extent that the partner would

ultimately be obligated to pay the debt if the partnership could not pay its own debts

Based on partnership agreement and other legal obligations between partners and creditors

Recourse Liabilities – Example AB Partnership purchases a building

with $70,000 cash ($25,000 contributed each by A and B) and a $20,000 recourse liability. If the building becomes worthless, who bears the economic risk of the $70,000 loss? A: $25,000 - $35,000 = ($10,000) B: $25,000 - $35,000 = ($10,000)

Recourse Liabilities – Example #2 AB Partnership purchases a building

with $70,000 cash ($25,000 contributed each by A and B) and a $20,000 recourse liability. Losses are allocated 60% to A and 40% to B. If the building becomes worthless, who bears the economic risk of the $70,000 loss? A: $25,000 - $42,000 = ($17,000) B: $25,000 - $28,000 = ($3,000)

Recourse Liabilities – Example #3 AB Partnership purchases a building

with $70,000 cash ($40,000 contributed by A and $10,000 contributed by B) and a $20,000 recourse liability. Losses are shared equally. If the building becomes worthless, who bears the economic risk of the $70,000 loss? A: $40,000 - $35,000 = $5,000 B: $10,000 - $35,000 = ($25,000)

Nonrecourse Liabilities A partnership liability is a

nonrecourse liability to the extent that no partner bears the economic risk of loss with respect to that debt

Nonrecourse Liabilities General rule: Allocated among partners in

accordance with their respective shares of partnership profits

Complex reality – partner’s share of nonrecourse liabilities is the sum of

The partner’s share of partnership minimum gain The amount of gain that the partner would

recognize if the partnership disposed of contributed property in full satisfaction of liabilities and no other consideration

The partner’s share of any remaining nonrecourse liabilities determined in accordance with his share of partnership profits

Nonrecourse Debt – Partnership Minimum Gain Partnership minimum gain – the amount of

gain that the partnership would realize if it disposed of partnership property subject to a nonrecourse liability in full satisfaction of the debt and for no other consideration As the adjusted basis of the encumbered

property is reduced below the amount of the nonrecourse liability (depreciation)

As the amount of the nonrecourse liability is increased in excess of the adjusted basis of the property (refinancing)

Partnership Minimum Gain – Example To finance the purchase of a $50,000

building with a 10 year life, A provides $9,000, B provides $1,000, and the partnership takes out a $40,000 loan. Over the first two years, depreciation deductions total $10,000. When allocated to A and B, their capital accounts are reduced to $0. In year 3, an additional $5,000 of depreciation is taken – reducing the carrying value of the asset below the value of the nonrecourse debt and creating negative capital accounts for both A and B.

Partnership Minimum Gain – Example If the asset is sold at this time in full

satisfaction of the debt, what gains would A and B realize? $40,000 debt relief - $35,000 adjusted basis

= $5,000 partnership minimum gain If an additional loan of $10,000 secured

by the property is taken out, what gains would A and B realize? $40,000 debt relief + $10,000 additional

loan - $35,000 adjusted basis = $15,000 partnership minimum gain

Partner’s Share of Partnership Minimum Gain Keep track of respective shares in order

to: Determine extent to which they may have a

capital account deficit Ensure that they are allocated their

appropriate share of partnership minimum gain when it is recognized by the partnership

Properly determine their share of partnership nonrecourse liabilities

Nonrecourse Debt – Nonrecourse Deductions Nonrecourse deductions – deductions that

create or increase partnership minimum gain (by reducing adjusted basis of an asset that secures nonrecourse debt below the amount of the debt, often cost recovery deductions) Previous example = $5,000 nonrecourse

deductions in year 3 because of the $5,000 net increase in partnership minimum gain for that year

With additional $10,000 loan, nonrecourse deductions increase to $15,000

Allocations of Nonrecourse Deductions Allowed Because… Even though the allocations of

nonrecourse deductions that reduce a partner’s capital account below zero do not have economic effect, they are allowed because at some time in the future, the partner will be taxed on his share of minimum gain, and the partner’s capital account will be increased accordingly.

Nonrecourse Debt – Minimum Gain Chargeback Minimum gain chargeback –

income and gain in an amount equal to the net decrease in the partner’s share of minimum gain for the taxable year Ex: property is foreclosed without the

receipt of any cash – no longer a partnership minimum gain

Nonrecourse Debt – Safe Harbor Test Allocations of nonrecourse deductions will

be respected if the following four requirements are satisfied:

Throughout the life of the partnership, the partnership agreement must satisfy the requirements of either The Big Three test or the alternative test for economic effect

For the life of the partnership, nonrecourse deductions must be allocated in a manner that is reasonably consistent with allocations of some other significant partnership item (having substantial economic effect) attributable to the property securing the nonrecourse liabilities of the partnership

Nonrecourse Debt – Safe Harbor Test (continued)

Beginning in the first year in which the partnership has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain, the partnership agreement must contain a minimum gain chargeback

All other material allocations and capital account adjustments under the partnership agreement must have substantial economic effect

Partnership Interests Change Two methods to determine distributive

shares of partners Interim closing of the books method – traces

income & deduction items to the particular segment of the taxable year during which they are paid or incurred

Proration method – partnership items are prorated throughout the year and a partner’s share is based on the number of days during which he was a partner during that year

Changing Interests – Example A one-third partner is admitted to the

partnership on July 1 Interim Closing: The partner would be

allocated his one-third share of all items paid or incurred during the last six months of the year

Proration: The partner would be allocated one-half (July through December) of his one-third share of partnership items for the entire taxable year regardless of when those expenses were paid or incurred