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Partnership - Audit Technique Guide - Chapter 6 - Partnership Allocations (Revised 12-2007)

LSBM:04-1107-076
Revised 12/2007

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 5 | Table of Contents | Chapter 7

Chapter 6 - Table of Contents

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INTRODUCTION

For partnership allocations to be respected they must either be made in accordance with the partners’ interests in the partnership or they must meet the requirements for the substantial economic effect safe harbor.   If allocations do not have substantial economic effect, they will be reallocated according to the partners’ interests in the partnership.

This chapter will describe:

  • Factors considered in determining the partners’ interests in the partnership
  • Economic effect
  • Substantiality
  • Allocation of items attributable to non-recourse debt
  • Allocation of tax credits

This chapter will summarize a complex system of rules which have been designed to curb abuse.   IRC section 704(b) was intended to prevent partners from allocating partnership items based on purely tax rather than economic consequences.   The rules governing partnership allocations (IRC section 704(b) and its accompanying regulations) have been criticized as being some of the most difficult and complex.  Simple business enterprises, which allocate income and loss in a straightforward and consistent manner, should not be unduly concerned with the complexity of IRC section 704(b).

Unlike S corporations, which must report all income and expenses in proportion to stock ownership, partnerships provide the flexibility of making special allocations of income, gain, loss, or deductions among the various partners.   For example, a partnership agreement may allocate all of the depreciation deductions to one partner subject to the limitations described below.   Additionally, a partnership agreement may specify that the partners may share capital, profits, and losses in different ratios.  Stated differently, the sharing of profits does not have to coincide with the sharing of losses. 

Because of the flexibility inherent in Subchapter K, partnership agreements can be written to reflect whatever economic sharing arrangement and risk sharing arrangement the parties wish to execute.   For example, Partner A, who has skills, goes into business with Partner B, who has capital.   Partner B contributes $100,000 in cash.   A and B agree to split the business profits 20/80 until B recovers his entire investment; thereafter profits are split 50/50.   Special allocations permit partners to assume different levels of risk and to set the timing of income in accordance with their preferences.

Such flexibility comes with strings attached.   Partners are not able to allocate tax benefits among themselves in a manner that is divorced from their allocation of economic profit or loss.   A partner who is economically enriched by an item of partnership income or gain is required to shoulder the associated tax burden.  Similarly, a partner who is economically hurt by an item of partnership loss will be allocated the tax benefit of the loss.   The tax allocations must ultimately conform to the economics of the partnership’s transactions.

Even if the tax allocations of income, gain, loss, or deductions clearly reflect the economic sharing arrangement of the partners, other statutory provisions may come into play:

  1. IRC section 704(c) prescribes rules for sharing allocations pertaining to contributed property.
  2. IRC section 704(d) prevents a partner from deducting loss if it exceeds the basis of his/her partnership interest.
  3. IRC section 465 limits deduction of distributive share of partnership loss to amounts at-risk.
  4. IRC section 469 limits deduction of distributive share of partnership loss from passive activities.

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ISSUE:  TESTING PARTNERSHIP ALLOCATIONS

An allocation of partnership income, gain, loss, deduction, or credit will be respected if it meets any one of the following tests:

  1. is made in accordance with the partners’ interests in the partnership, or
  2. has substantial economic effect, or
  3. is considered to be made in accordance with the partners’ interest in the partnership under the special rules of Treas. Reg. section 1.704-1(b)(4).

The last category covers allocations of tax credits, percentage depletion in excess of cost, and deductions or losses attributable to partnership non-recourse liabilities.

The following sections will cover these three tests by which partnership allocations will be respected.

Partner’s Interest in the Partnership Test

Partnership Agreement

A partner’s distributive share of income, gain, loss, deduction, or credit is generally determined by the partnership agreement.   The term “partnership agreement” is very broad and refers to any agreement which has an impact on the economic sharing arrangement among the partners or between one or more partners and the partnership.  Treas. Reg. section 1.704-1(b)(2)(ii)(h).   The partnership agreement may be oral or written.   Any document or oral agreement which bears on the underlying economic arrangement of the partners, is considered to be part of the partnership agreement.   Examples of such documents may be:

  • Loan and credit agreements;
  • Assumption agreements;
  • Indemnification agreements;
  • Subordination agreements;
  • Correspondence with a lender concerning terms of a loan;
  • Guarantees.

Emphasis:   The partnership agreement encompasses more than just the partnership agreement document.

Determining the Partner’s Interest in the Partnership

The partner’s interest in the partnership test is a subjective facts and circumstances test.  It seeks to determine the true economic sharing arrangement of the partners based on all of the facts and circumstances (Treas. Reg. section 1.704-1(b)(3)). The regulations consider the following factors to be relevant but not exclusive:

a) the partners’ relative contributions to the partnership
b) the interests of the partners in economic profits and losses
c) the interests of the partners in cash flow and other non-liquidating distributions
d) the rights of the partners to distributions of capital upon liquidation

There is an important interconnection between the partners’ interest in the partnership test and the substantial economic effect test.  The two tests can be viewed as two different roads leading to the same destination.  Both seek to ensure that tax allocations parallel the partners’ economic sharing arrangement.  Allocations will be respected under either set of rules.  The economic effect test is a mechanical test governed by lengthy and detailed regulations.  In contrast, the regulations covering the partners’ interests in the partnership test are short, simple, and subjective.

The essence of both tests is to tie the tax allocations to the partners’ economic sharing arrangement.

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Substantial Economic Effect Test

The substantial economic effect test is actually a two-part test.   An allocation is respected only if the allocation has “economic effect” and that economic effect is “substantial” Treas. Reg. section 1.704-1(b)(2)(ii).

Emphasis:   “Economic effect” and “substantiality” are two separate and different inquiries.   An allocation could have economic effect and still not be respected due to insubstantiality.

The substantial economic effect test (SEE test) provides a “safe harbor.”   Its advantage is that it is mechanical and well defined.   It removes the taxpayer from the subjectivity surrounding the partner’s interest in the partnership test.

It is important to bear in mind that the SEE test does not apply to the allocation of nonrecourse deductions or tax credits because they do not have a corresponding economic allocation.   Additionally, even though allocations of foreign tax expenditures decrease the partners’ capital accounts, such allocations are not analyzed under substantial economic effect.  The partner to whom such expenditure is allocated can take a dollar for dollar offsetting foreign tax credit which arises at the partner, not the partnership level.  See Treas. Reg. section 1.704-1(b)(4)(viii).  

The term “non-recourse deduction” refers to any loss, deduction, or IRC section 705(a)(2)(B) expenditure attributable to partnership non-recourse liabilities.   A non-recourse liability is one in which the lender’s only recourse is to the property securing the debt.   Since the partners have no economic risk of loss with respect to the debt, deductions based on non-recourse deductions do not fall within the realm of substantial economic effect.

It is important to distinguish between recourse and non-recourse debt because the substantial economic effect test is only applicable in the context of recourse as opposed to non-recourse debt.   The regulations contain a separate “safe harbor” for non-recourse deductions.   This will be discussed in the section “Allocations Attributable to Non-recourse Deductions.”

Emphasis:   If the partnership is funding its losses or deduction through non-recourse debt, do not evaluate allocations based on substantial economic effect.

Economic Effect

The way the economic effect regulations tie tax allocations to economic benefits and burdens is through the capital accounts.   For an allocation to satisfy the primary economic effect test the partnership agreement must, throughout the full term of the partnership, provide as follows:

  1. Capital Accounts: the partners must maintain their capital accounts in accordance with the rules contained in Treas. Reg. section 1.704-1(b)(2)(iv).
  1. Liquidation: upon liquidation of the partnership, or any partner’s interest in the partnership, liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners.
  1. Unlimited Deficit Restoration: upon liquidation, a partner with a deficit in his/her capital account has an unconditional obligation to restore the amount of the deficit.

It should be emphasized that the first requirement focuses on the maintenance of book or economic capital accounts.   The purpose of the capital account maintenance rules is to ensure that the underlying economic arrangement of the partners is clearly reflected.   Analysis of the book capital accounts is intended to reveal the contribution obligations and the liquidation rights of the partners.   If a partnership satisfies the primary economic effect test, then upon liquidation, a partner is entitled to any positive amount in his/her capital account balance or is obligated to restore a deficit capital account.

A partner is treated as obligated to restore the deficit balance in his/her capital account to the extent of any unconditional obligation of the partner to make subsequent contributions to the partnership by the partnership agreement or by state or local law.

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Example 6-1

Hal, a high bracket taxpayer, and Larry, a low bracket taxpayer form a general partnership in which they agree to allocate all of the depreciation deductions to Hal.   Everything else is allocated equally.   The partnership agreement contains the three requirements for the primary economic effect test.   They each contribute $50,000 and obtain a recourse debt of $900,000.  They purchase a building for $1,000,000. Their opening balance sheet is as follows:

Building 

1,000,000

Recourse Debt 

900,000

        Capital – Hal 

50,000

          Capital – Larry

50,000

Assets 

1,000,000

Liabilities & Capital

1,000,000

 

 

 

The partnership’s income and expenses except for depreciation are equal.  Only interest is paid on the debt.   A $50,000 loss due to depreciation expense is allocated to Hal per the agreement.   Thus, at the end of Year 1, Hal’s capital account is reduced to zero.   At the end of Year 2, Hal’s capital account is a negative $50,000.

 Scenario A:

The partnership sells the building for $1,100,000 and liquidates at the beginning of Year 3. Since the building’s adjusted basis is $900,000, the gain is $200,000 ($1,100,000 less $900,000). Hal and Larry split the gain equally, each receiving $100,000:

     

Capital 
Hal 

Capital
 Larry

Beginning 

     (50,000)

  50,000

Allocated Gain  

100,000

    100,000

Totals 

50,000

150,000

 

 

 

  

Upon liquidation of the partnership, Hal and Larry would receive the amounts in their capital account balances, $50,000 to Hal and $150,000 to Larry.   Hal has borne the economic burden of the depreciation deductions since his proceeds upon liquidation are reduced by that amount.   Thus, the special allocation of all depreciation to Hal has economic effect.

 Scenario B:

The partnership sells the building for $800,000 and liquidates at the beginning of Year 3.   The sale produces a loss of $100,000 ($800,000 less adjusted basis of $900,000).   The loss is split equally.

   

Capital 
 Hal

Capital
 Larry

Beginning 

(50,000)

50,000

Allocated Loss   

(50,000)

    (50,000)

Totals 

    (100,000)

0

 

 

 

 

Because Hal is a general partner, under state law Hal is required to restore the negative amount in his capital account in order to pay the lender ($800,000 sales proceeds plus $100,000 from Hal).   The allocation of depreciation to Hal has economic effect.   Larry’s liquidating distribution was based on his positive account balance and Hal was obligated to restore his capital account deficit.

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Example 6-2

The facts are the same as in Example 6-1, but Hal is a limited partner, who is not obligated to restore any deficit in his capital account.   Therefore, the partnership agreement fails to satisfy the third requirement of the primary economic effect test.   Accordingly, the special allocation of depreciation to Hal would not have economic effect.

For purposes of IRC section 704(b), the partnership agreement includes all agreements among the partners or between the partners and the partnership.  Thus, although the responsibility of the partnership’s debt may appear to be shared equally among the partners, it is important to be alert to the impact of side agreements or guarantees.

Alternate Test for Economic Effect

The primary test for economic effect requires all of the partners to have an unconditional deficit restoration obligation.   They must make contributions to restore negative capital accounts, if any, upon the partnership’s liquidation.   This requirement obviously presents a problem for limited partners who wish to limit their obligations to make additional capital contributions.

The alternate economic effect test addresses this situation.   Under the alternate test, the first two requirements of the primary test for economic effect must be met (capital accounts must be maintained in accordance with the regulations and positive capital account balances must be respected upon the partnership’s liquidation).  However, an unlimited deficit restoration obligation is not required. Instead, the regulations require that the partnership agreement contain a “qualified income offset”, sometimes called a “QIO provision.”

The regulations state that the partnership agreement contains a qualified income offset if it provides that a partner who unexpectedly receives certain adjustments, allocations, or distributions will be allocated items of income and gain in order to eliminate a prohibited deficit balance as quickly as possible.   If necessary, the partner will be allocated gross income or gain.

In summary, partners who are not required to restore negative capital account balances cannot be allocated items that would create a negative capital account beyond their obligation to restore.   The QIO provision is intended to eliminate any unexpected deficit balance in a partner's capital accounts.   The QIO provision is especially important in the context of partnership non-recourse debt, which will be discussed later in the chapter.

Economic Effect Equivalence

The economic effect equivalence test is also known as the “dumb-but-lucky” rule.  Treas. Reg. section 1.704-1(b)(2)(ii).   This provision can protect allocations based on unsophisticated but unabusive partnership agreements from falling outside the parameters of the economic effect safe harbor.   If a partnership agreement fails to include the three requirements needed to satisfy the economic effect test, its allocations can, in many instances, still be respected.   For this to happen, it has to be shown that a liquidation of a partnership at the end of the year in which the allocation in question takes place, would produce the same results that would occur if the three requirements of the primary economic effect test had been met.

 Example 6-3

Joe, a real estate developer and Sara, a physician, form a partnership to operate an apartment building.   Sara is a limited partner who contributes $100,000 to be used as working capital and guarantees $100,000 of the partnership’s $500,000 debt.   Joe is a general partner.  Joe and Sara want to cut expenses, so they write their own partnership agreement without consulting an accountant or attorney.   They agree that all of the losses will go to Sara, with future profits being split 50/50.   They are unaware of the complex provisions of IRC section 704(b) so none of the requirements for meeting the primary economic effect test or the alternate economic effect test are included in their partnership agreement.

At the end of 5 years, the partnership has cumulative losses of $50,000 which have been allocated to Sara.   The partnership liquidates, repays the lender, and distributes $50,000 to Sara.   The allocations to Sara are valid because they produced the same results as if the partnership agreement satisfied the economic effect safe harbor.

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Examination Techniques

  • Obtain not only the partnership agreement, but also any other documents which describe the business deal – letters, loans, guarantees, indemnification, that is, any collateral arrangement which could affect a partner’s rights and obligations.
  • Compare the allocations in the partnership agreement with those actually made on the tax return.   If there are differences, ask for an explanation and supporting documents.
  • Determine the nature of the partnership’s debt.   Pursue a substantial economic effect analysis only in the context of recourse debt.
  • Review the partnership agreement for the three requirements of economic effect contained in Treas. Reg. section 1.704-1(b)(2)(ii).
  • Before proposing adjustments, be sure to consider the economic effect equivalence test, the “dumb but lucky” rule.   Some unsophisticated or very old partnership agreements might not contain the three requirements of economic effect, but the allocations might still have economic effect equivalence.

Supporting Law

IRC section 704(b)
Supporting Regulations:

Economic Effect                                                              section 1.704-1(b)(2)(ii)
Alternate Test for Economic Effect                               section 1.704-1(b)(2)(ii)(d)
Economic Effect Equivalence                                       section 1.704-1(b)(2)(ii)(i)
Partnership Agreement Defined                                   section 1.704-1(b)(2)(ii)(h)

Orrisch v. Commissioner, 55 T.C. 395 (1970)

In this case, the partnership agreement was amended to allocate all of the depreciation on two buildings to Orrisch.   The agreement provided that gain on the sale of partnership property would be charged to Orrisch’s capital account to the extent of the depreciation allocations, and the remainder shared according to partnership interests.

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.

Goldfine v. Commissioner, 80 T.C. 843 (1983)

In this case, Goldfine, an affluent attorney, and Blackard, a real estate developer formed a partnership to own and operate an apartment complex.  The partnership agreement called for an equal split of the proceeds of any sales of partnership property, cash distributions on refinancing, or liquidation.   All of the depreciation was allocated to Goldfine, a high bracket taxpayer, and all of the income computed without depreciation was allocated to Blackard (who had net operating losses from other activities).   Because the partnership agreement called for an equal division of net proceeds upon liquidation instead of distributions based on the balances in the partners’ capital accounts, the allocations lacked economic effect.

Miller v. Commissioner, T.C. Memo 1984-336

Allocations of all the partnership’s depreciation to Miller were found not to have substantial economic effect.   The partnership agreement made no provisions for the special allocations to be reflected in Miller’s capital account and provided that upon liquidation, proceeds would be divided based on ownership percentages and not based on capital account balances.   The court concluded that Miller did not bear the economic burden of the depreciation deduction allocations.

Martin Magaziner v. Commissioner, T.C. Memo 1978-205

In this case, the partnership agreement called for a substantial portion of the interest and depreciation deductions in the early years of the partnership to be allocated to Magaziner, a dentist.   The property was sold at a gain in Year 6 and Magaziner received more than half of the proceeds while the taxable gain was divided equally.

The court concluded that the special allocations did not have economic effect because the partners’ distributions were not made in accordance with their capital account balances.

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Substantiality Test

Even if an allocation passes the economic effect test, it must still be considered to be substantial.   The substantiality test is designed to prevent abusive allocations which are motivated by the partners’ individual tax profiles.   Unlike the economic effect test, the substantiality test is not strictly mechanical.

An allocation is considered to be substantial if there is a reasonable possibility that it will affect the amount of money partners will receive independent of tax consequences.  If a tax savings occurs for one or more partners in the partnership and the economic sharing arrangement is unaltered, then the allocation probably lacks substantiality.   It is impossible to evaluate substantiality without knowing the tax profiles of the partners receiving the allocations.   Thus, analyzing allocations for substantiality involves looking beyond the partnership return.

Emphasis:   It is impossible to evaluate substantiality without knowing the individual tax profiles of the partners involved.

Tests for Substantiality

Overview

The regulations contain one affirmative test and three negative tests for determining substantiality.   The affirmative test, which is the general rule, states that an allocation is substantial if it has a pre-tax dollar effect.   In other words, the allocation is substantial if it affects the amount of money to be received by the partners independent of tax consequences.  If the capital accounts are left unchanged, either within a given year, or over a period of years, then the allocation(s) may be insubstantial.  Therefore, a threshold question is “Are Capital Accounts Affected?”

However, even if the capital accounts are impacted, the allocation can still be found to be insubstantial under the “Some Help, No Hurt” test found in Treas. Reg. section 1.704-1(b)(2)(iii)(a). 

The three types of insubstantial allocations described in the regulations are as follows:

  1. Shifting Allocations:
  2. Transitory Allocations:
  3. “Some Help, No Hurt” allocations

Shifting Allocations

A shifting allocation reduces the partners’ overall tax liabilities in a given year without altering their capital account balances.   In other words, while the partners may be allocated the same amount of income or loss, the partners attempt to select the character that will interact in the most favorable manner with their own individual tax profiles.   A straightforward example would be one in which a partner with a large net operating loss carryforward is allocated all of the partnership’s taxable dividends while a high tax bracket partner is allocated an equal amount of the partnership’s tax exempt interest income.   Since capital account balances reflect amounts and not character, a pure capital account analysis of this situation would not indicate that the allocation lacked substantiality.

Example 6-4

D and M are partners in partnership DM.   D also owns another business that has created a large carryforward net operating loss.   M is a high tax bracket taxpayer.   DM expects income both from its business operations and from interest in municipal bonds.   The partnership agreement allocates all income from interest in the municipal bonds to M and an equal amount of income form DM’s business operations to D.   The remaining income from business operations is shared equally.   D will use his carryforward net operating loss to offset the income allocation he receives from DM. M is also in a good tax position because he is a high tax bracket taxpayer and is being allocated tax free income.   This transaction lacks substantiality.  The capital accounts are increased by the same amounts, yet the partners gain an after-tax advantage.

Transitory Allocations

Transitory allocations occur over 2 or more years.  An allocation is considered transitory when an original allocation is offset by a reversing allocation in the future and there has been a tax savings for one or more partners.  In other words, if the allocations taken as a whole produce a wash in the capital accounts, and there has been a tax savings for one or more partners, then the allocations may be considered to be transitory.

In analyzing whether or not allocations are transitory, the regulations begin the analysis when the suspect allocations become a part of the partnership agreement.  If, from the beginning, there is a strong likelihood that the allocations taken as a whole will leave the capital accounts unaffected, and one or more partners has a tax savings, then the allocations will not be respected. 

Example 6-5

Rod and Chris are partners in a partnership which owns a single tenant commercial building.   The tenant, a financially sound business, has given them a ten-year lease. Because Rod and Chris wanted to entice the tenant to their building, they structured the lease to have a below market rent in the first two years.   Rod is a high bracket taxpayer who plans to dispose of other real estate at a gain over the next 2 years.   Chris has a net operating loss carryforward and would not immediately benefit from an allocation of loss.

The partners agree that Rod will be allocated the partnership’s rental losses in the first 2 years of the lease.   Rod will receive an income chargeback in years three and four, and thereafter the partners will split the income 50/50.  The allocation of loss to Rod during the first 2 years would probably be considered to be an insubstantial transitory allocation.   When the allocation became part of the partnership agreement, there was a strong likelihood that the allocations would produce a tax savings for Rod and that the allocations would produce a wash in his capital account.

Transitory Allocation Safe Harbors

The regulations discuss three instances in which allocation which would otherwise be deemed to be insubstantial transitory allocations will be respected:

  1. Riskiness;
  2. Five Year Rule;
  3. Value Equals Basis Rule.  

Riskiness

Transitory allocations hinge on blending predictable future events with taking advantage of the partners’ individual tax profiles.   The level of risk involved in the partnership’s contemplated business transactions have a bearing on whether or not at the outset there is a strong likelihood that there will be a tax savings with capital accounts remaining neutral.

As stated in this chapter’s overview, one of the reasons the Code permits special allocations is to provide entrepreneurs with the ability to apportion risk.   If the allocations produce a bona fide shifting of entrepreneurial risk from one partner to the other, rather than a mere tax savings, the allocations will be respected.

Example 6-6

Jim and Marc form a partnership to set up a new Internet-related business.  Since Jim has started other successful technology related businesses, he is a high bracket taxpayer and would like to be allocated all losses during the initial years of the new partnership’s business.   The partners agree that Jim will receive all losses until the partnership becomes profitable.   All profits will be allocated to Jim until he has recovered his losses and then the partners will share equally in profits and losses.

This example differs from Example 6-1 in that it is unknown if the business will be successful.   At the time the allocations are made a part of the partnership agreement, it cannot be said that there is a “strong likelihood” that the capital accounts will be left neutral or that Jim will have a tax savings.   If the business takes off in the first year, Jim will have more taxable income.   If the business fails, the losses in Jim’s capital account will never be recovered.

Five Year Rule

If there is a strong likelihood that the offsetting allocations will not be made within 5 years of the original allocation, the transitory allocation may be respected.   Treas. Reg. section 1.704-1(b)(2)(iii)(c).   The 5-year rule presumes that a sufficient level of risk exists for the allocations to be considered substantial.

Value Equals Basis

Offsetting allocations can come from income chargebacks or gain chargebacks.   A gain chargeback occurs when gain on the disposition of partnership property is allocated to the partner who received earlier losses from the property, generally the partner who received depreciation deductions.   The gain chargeback will restore the decrease in the partner’s capital account caused by the original allocations of depreciation.

Such a fact pattern could be viewed as transitory because it involves original allocations of loss which are reversed by later offsetting allocations from gain on the disposition of property, potentially leaving the capital accounts neutral.   This situation, however, is protected by the value equals basis rule.

The value equals basis concept presumes that the property’s basis is the maximum amount of value that the partnership could ever realize upon the property’s disposition.  Thus, although offsetting income allocations could come from the disposition of the property that gave rise to the original loss allocations, the regulations ignore this possibility and assume, however unrealistically, that the value of the property will never exceed its basis.

Therefore, depreciation deductions are presumed to reflect true economic loss, regardless of what is happening in the real world.   This presumption protects allocations of loss caused by depreciation and later offset by an allocation of gain on the sale of property from being attacked as transitory allocations.  Note that the value equals basis rule does not protect fact patterns involving income chargebacks.

“Some Help, No Hurt” Allocations

This rule is also known as the overall tax-effect rule.   This rule looks at the partners as a group and takes into consideration the individual tax profiles of the partners in determining the overall tax effect of an allocation.   The rule states that if the after-tax economic consequences of at least one partner will be enhanced as a result of the allocation, and no partner’s after-tax economic consequences will be hurt, then the allocation lacks substantiality.   This is true even if the allocation may affect the actual dollar amounts to be received by the partners.

 Example 6-7

  X and Y are unrelated corporations who are equal partners in a partnership that generates $100 of net taxable income every year.  X has a net operating loss that will expire after two years.  Y is in the 40% bracket.  After expiration of the NOL, X expects to be in the 40% bracket.

Before filing their partnership return, X and Y amend their partnership agreement to allocate all of the income for the next two years to X.  For the following three years, Y will be allocated all of the income.  Thereafter, they will return to their original sharing arrangement.

Analysis:

With the special allocation, X will pay no tax on the $100 of income received in years one and two, and Y will receive $60 after tax in years three, four, and five.  Applying a discount rate of 5%, the present values of these income streams would be:

                                                        X Corp                                  Y Corp

Year One                            100 x .952 =    $95.20              0 x .952 =          $0
Year Two                            100 x .907 =      90.70              0 x .907 =           0
Year Three                             0 x .864 =              0            60 x .864 =     51.84
Year Four                               0 x .823 =              0           60 x .823 =     49.38
Year Five                               0 x .784 =               0            60 x .784 =     47.04
Present Value After Tax:                          $185.90                               $148.26

Without the special allocation, the present value of the income streams would be as follows:

X Corp                                            Y Corp

Year One                              50 x .952 =    $47.60            30 x .952 =   $28.56
Year Two                              50 x .907 =      45.35            30 x .907 =     27.21
Year Three                           30 x .864 =      25.92            30 x .864 =     25.92
Year Four                             30 x .823 =      24.69            30 x .823 =     24.69
Year Five                              30 x .784 =      23.52            30 x .784 =     23.52
Present Value After Tax:                            $167.08                               $129.90

As one can see, with the special allocation X Corp has income on a present value after tax basis of $185.90 as opposed to $167.08 over the five year period.  With the special allocation, Y Corp has $148.26 as opposed to $129.90.  Both partners' after tax economic positions are improved due to the special allocation, and the Treasury is the only injured party.  The allocation would therefore be insubstantial.

Note that this example used an allocation of income.  In evaluating an allocation of loss funded by one partner's loan to the partnership (recourse debt), the outlay of cash would have to be taken into consideration in calculating the present value of the income stream.  Unless tax rates were higher than 100%, a partner would not be able to improve its situation on a present value after tax basis when taking into consideration the cash outlay that funded the loss.  

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Examination Techniques

  • Obtain and review the tax returns or RTVUEs of the partners to ascertain the individual tax profiles of the partners.
  • Review all amendments to the partnership agreement – was the partnership agreement amended after the end of the taxable year and before the filing of the return?
  • Take into account the character of the special allocation item.

Supporting Law

IRC section 704(b)
IRC section 761(c)
Supporting Regulations:
  General Rule                                                                    section 1.704-1(b)(2)(iii)
  Some Help, No Hurt                                                        section 1.704-1(b)(2)(iii)
  Shifting Allocations                                                        section 1.704-1(b)(2)(iii)(b)
  Transitory Allocations                                                    section 1.704-1(b)(2)(iii)(c)
  Amendments to partnership agreements                              section 1.761-1(b)(4)(vi)

Revenue Ruling 99-43 – The Service ruled that partnership special allocations lacked substantiality under Treas. Reg. section 1.704-1(b)(2)(iii).   The partnership allocated all of its cancellation of indebtedness income to the insolvent partner who would be able to exclude it from his gross income.  Book loss from the revaluation of partnership property lowered the partners’ capital accounts. These allocations did not produce any net effect on the partner’s capital account but produced an overall tax savings.

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Allocations Attributable to Non-recourse Deductions Test

The special rules in Treas. Reg. section 1.704-1(b)(4) refer the reader to Treas. Reg. section 1.704-2 that covers the rules pertaining to non-recourse deductions.

As stated previously, a non-recourse debt is one in which the lender can only look to the property securing the debt, and not to the partners, for repayment.  In a pure non-recourse situation, the lender can foreclose on the property but cannot take collection action against the partners.  The non-recourse deduction rules are particularly important in connection with real estate partnerships where borrowing on a non-recourse basis is a common business practice.

The proceeds from non-recourse borrowing can be included in the basis of depreciable property.  Depreciating property secured by non-recourse debt is one way of creating non-recourse deductions.

An allocation of deduction or loss which is attributed to a non-recourse liability cannot have economic effect because no partner bears the economic risk of loss.

The special rules in Treas. Reg. section 1.704-1(b)(4) refer the reader to Treas. Reg. section 1.704-2 that covers the rules pertaining to non-recourse deductions.

As stated previously, a non-recourse debt is one in which the lender can only look to the property securing the debt, and not to the partners, for repayment. In a pure nonrecourse situation, the lender can foreclose on the property but cannot take collection action against the partners.   The non-recourse deduction rules are particularly important in connection with real estate partnerships where borrowing on a nonrecourse basis is a common business practice.

The proceeds from non-recourse borrowing can be included in the basis of depreciable property.   Depreciating property secured by non-recourse debt is one way of creating non-recourse deductions.

An allocation of deduction or loss which is attributed to a non-recourse liability cannot have economic effect because no partner bears the economic risk of loss.

The regulations in section 1.704-2 provide a safe harbor for allocating deductions and loss attributable to non-recourse debt.   The regulations have two main goals.  One is to tie the partnership’s allocation of non-recourse deductions to other items in the partnership which do have substantial economic effect.   By doing this, the regulations attempt to establish a rational relationship between the partner’s economic interest in the partnership and his or her share of the non-recourse deductions.   The second goal is to ensure that partners who have received nonrecourse deductions will also receive an appropriate share of minimum gain.

Partnership Minimum Gain

It is impossible to understand how non-recourse deductions are properly allocated without understanding the concept of minimum gain.   In evaluating non-recourse deductions minimum gain, as opposed to economic effect, is the focus.   Minimum gain is created as the partnership claims deductions, typically depreciation, that decrease the partnership’s book basis in the property below the balance of the nonrecourse debt securing the property.

Emphasis:   A partnership with non-recourse debts and negative capital accounts has minimum gain.

 Example 6-8

Assume a partnership purchases depreciable property for one million dollars which is completely financed with non-recourse debt.   If the partnership takes a $200,000 depreciation deduction, the basis of the property is now only $800,000.   The amount by which the debt exceeds the basis, in this case $200,000, is the amount of the minimum gain.

It is important to note that minimum gain is calculated using the property’s book basis, not its tax basis.  In many instances, the book basis and the tax basis may be the same amount.  In Example 6-8, the partnership purchases the property, so the property’s book basis equals its tax basis.  There may be a disparity between book basis and tax basis if the asset is contributed to the partnership.  Additionally, a revaluation upon the admittance of a new partner will create such a disparity.

Emphasis: Book basis, not tax basis, is used in the calculation of minimum gain.  Depending on the circumstances, the book basis and the tax basis may be the same.

The concept of minimum gain came out of a 1983 court case, Commissioner v. Tufts. In that case, a non-recourse lender foreclosed on an apartment building whose fair market value had fallen below the amount of the outstanding debt. When a borrower surrenders property to a lender in exchange for debt relief, the transaction is treated as a sale or exchange.   The petitioner in Tufts argued that the amount realized was the fair market value of the property.   The court determined that the amount realized by the borrower included the full amount of the non-recourse debt. 

If the book basis of the property is less than the outstanding amount of the non-recourse debt, there is a potential taxable gain on the disposition of the property regardless of its fair market value.   This potential gain is referred to as the minimum gain.

Emphasis:   Simply put, minimum gain is present when the amount of non-recourse debt encumbering the property exceeds the property’s book basis.

Minimum gain is created in the following ways:

  • Deductions (generally depreciation)
  • Refinancing of non-recourse debt
  • Conversion of a recourse debt to a non-recourse debt

Minimum Gain Chargeback

Another key to understanding non-recourse allocations is the concept of minimum gain chargeback.   The general idea behind the minimum gain chargeback is that a partner who receives the tax advantage of a deduction for which he or she bears no economic risk of loss (such as depreciation deductions generated by basis created by non-recourse borrowing) may bear a tax liability in the future due to an allocation of income. This allocation of income is called a “minimum gain chargeback.”   At the appropriate time, income must be allocated to the partner who received the corresponding non-recourse deductions.

The allocation of income to partners who received non-recourse deductions – minimum gain chargeback – is triggered when there is a decrease in minimum gain.  A net decrease in partnership minimum gain occurs when:

  • Debt is repaid
  • Taxable disposition of the property encumbered by the debt 
  • A non-recourse liability is converted to a recourse liability

Emphasis:   Minimum gain chargeback refers to the allocation of income to partners who previously received non-recourse deductions.   This occurs when there is a decrease in minimum gain.

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Safe Harbor Allocation of Non-recourse Deductions

Allocations of non-recourse deductions will be deemed to be made in accordance with the partners’ interests in the partnership if the following requirements are met:

  1. Book capital accounts are maintained in accordance with the economic effect safe harbor rules, liquidating distributions are made in accordance with positive capital account balances, and the partnership agreement either contains an unlimited deficit restoration obligation or a qualified income offset.
  2. The manner in which the partnership allocates non-recourse deductions among the partners must meet a consistency requirement.   This means that the allocation of non-recourse deductions must be made in a manner similar to the allocation of items which do have substantial economic effect.   Thus, a partnership would not be able to allocate all depreciation deductions to one partner while allocating all other items on a 50/50 basis.
  3. The partnership agreement must have a minimum gain chargeback provision.
  4. All other material allocations and capital account adjustments under the partnership agreement are recognized under the regulations (safe harbor or partners’ interests in the partnership).

The second requirement attempts to tie the allocation of non-recourse deductions to other items in the partnership which have substantial economic effect.   For example, if the partnership agreement splits all of a partnership’s items of income, gain, and loss 50/50, it would be inconsistent to allocate one partner 90 percent of the partnership’s non-recourse deductions.   Partners with straightforward allocations of economic profit and loss will most likely allocate their non-recourse deductions along the same lines.

If the partnership agreement has a more complex economic sharing arrangement, non-recourse deductions may be allocated within a certain range and still meet the consistency requirement.   The example given in Treas. Reg. section 1.704-2(m)(ii)-(iii) articulates this point.   If a partnership has an initial sharing arrangement between a limited and a general partner of 90:10 which changes at the partnership’s break even point to a 50:50 split, then allocating non-recourse deductions on any ratio between 90:10 and 50:50 will meet the consistency requirement.   An allocation of 99:1, however, would not be considered to be consistent, with other items which do have substantial economic effect.

Example 6-9

Tim and Beverly form a partnership to which Tim contributes $10 and Beverly contributes $90.  The partnership borrows $900 on a nonrecourse basis and purchases a building for $1,000.  Note that the book and tax basis are the same, $1,000.  The property is depreciated over ten years on a straight line basis, $100 per year for both book and tax.   The minimum gain for the first five years is as follows:

(A)Year

(B) Beginning Book Basis

(C)Depreciation

(D)Nonrecourse Debt

(E)Ending Book Basis

(F) Minimum Gain (Column D over Column E)

1

1000

100

900

900

0

2

900

100

900

800

100

3

800

100

900

700

200

4

700

100

900

600

300

5

600

100

900

500

400

The partnership allocates 90% of the depreciation to Beverly and 10% to Tim.    Their partnership agreement contains a qualified income offset and a minimum gain chargeback provision.  Additionally, in order to meet the requirements for the safe harbor under Reg. 1.704-2(e), other items of income, gain, loss and deduction will also be made on a 90/10 basis.

At the end of Year One, the property’s book basis is $900.  Since this amount is not less than the property’s nonrecourse debt, there is no minimum gain.  Note that the analysis of how to allocate Year One depreciation would come under substantial economic effect, since the partners are bearing the economic burden of Year One depreciation and not the nonrecourse lender.  It is only at the end of Year Two, when the property’s book basis is $800, that $100 of minimum gain is produced ($900 of nonrecourse debt less book basis of $800).   At that point, the analysis of how to allocate Year Six depreciation would fall under the nonrecourse rules of Treas. Reg. section 1.704-2. 

The partnership’s rental income and operating expenses break even every year except for a loss created by the depreciation.  Thus, every year Tim is allocated a loss of $10 and Beverly is allocated a loss of $90.

In Year Six, the partnership becomes profitable.  Tim and Beverly prudently decide to start paying down the debt.  The partnership makes a $200 payment on the debt.  The new amount of the nonrecourse debt is therefore $600 (see Column D below).  This creates a minimum gain chargeback in the amount of $200, the difference between Year 5’s ending amount of minimum gain of $400 and Year Six’s ending amount of minimum gain of $200 (see Column F below).

(A) Year

(B) Beginning Book Basis

(C)Depreciation

(D) Nonrecourse Debt

(E) Ending Book Basis

(F) Minimum Gain

5

600

100

900

500

400

6

500

100

600

400

200

The minimum gain chargeback is allocated 10% to Tim and 90% to Beverly, in the same manner in which they shared the nonrecourse deductions.

Exceptions to the Minimum Gain Chargeback Requirement

The general rule is that a net decrease in partnership minimum gain creates a minimum gain chargeback to the partners who previously received the nonrecourse deductions.   There are, however, instances in which a decrease in minimum gain will not necessitate a chargeback. The most common ones are:

  • If the amount of non-recourse debt decreases because it was converted to recourse debt for which partners will bear the economic risk of loss, then the partners will not be subject to a minimum gain chargeback.   If the debt is converted to recourse with respect to some partners, but not others, then the partners who do not assume any economic risk of loss, as defined in the 752 regulations will be allocated minimum gain.   Future allocations will be evaluated using the substantial economic effect rules.
  • If a partner contributes his or her own money to pay down the non-recourse debt or increase the basis of the property, minimum gain will decrease but no chargeback is necessary.   In this case, the partner has “restored” her prior non-recourse deductions with her own money; therefore an allocation of minimum gain is not necessary.

IRC Section 704(c) Minimum Gain

The concept of IRC section 704(c) minimum gain will apply in cases in which there was a contribution of property.  IRC section 704(c)(1)(A) requires that “income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution.”  In other words, the partner who contributes property with a built-in gain or loss cannot sidestep the assignment of income principle by contributing the property to a partnership.

Confusion can arise in understanding the terms minimum gain, IRC section 704(c) minimum gain, built-in gain, and Tufts gain.

As described earlier in this chapter, minimum gain is the difference between the amount of nonrecourse debt encumbering the property and its book basis.  Again, the book basis and the tax basis may be the same amount.  Minimum gain is also sometimes referred to as “704(b) minimum gain”.  The concept pertains to the amount of nonrecourse allocations generated as the partnership operates.

IRC section 704(c) minimum gain is the difference between the amount of nonrecourse debt encumbering the property and the property’s tax basis.  In contrast, IRC section 704(c) gain is the difference between the property’s fair market value at the date of contribution and its tax basis.  IRC section 704(c) gain is also referred to as “built-in gain.”

In the context of subchapter K, “Tufts gain” is a colloquialism that can signify either IRC section 704(b) minimum gain, or IRC section 704(c) minimum gain, or both.

Example 6-10

Beverly contributes property to a partnership with a $150 FMV and a $50 tax basis.  Note that the book basis of the property, $150, differs from its tax basis.  The property is encumbered by a $100 nonrecourse debt.  Tim contributes $150 cash.

Upon formation, Beverlyhas IRC section 704(c) built in gain of $100, and IRC section 704(c) minimum gain of $50.  Recall that the concept of IRC section 704(c) minimum gain is different from the general concept of IRC section 704(c) gain, which compares the value of the property to its basis at the time of contribution.

This means that if the partnership sold the property the next day for $150, Beverly would be allocated the built-in gain of $100.  On the other hand, if hazardous chemical waste was found on the property the next day and the partnership let the bank foreclose on the property for no consideration other than the debt relief, Beverly would still be allocated IRC section 704(c) minimum gain of $50 (the difference between the amount of the nonrecourse debt and the tax basis).  Note that upon formation, there is no IRC section 704(b) minimum gain because the book basis of $150 exceeds the nonrecourse debt of $100.

Assume the tax depreciation period and method is fifteen years straight line with five years remaining and that the book depreciation method also will use straight line over the remaining five year ($30 book depreciation per year and $10 tax depreciation per year). At the end of Year One, the book basis is $120 and there is no minimum gain.  Assuming the partnership agreement meets the substantial economic effect rules under Treas. Reg. section 1.704-1, the $30 of book depreciation could be allocated to either party.  In this case we’ll assume it’s all allocated to Tim (whether Tim can only receive $10 of tax depreciation, or perhaps something more, will depend on the §704(c) method the partnership decides to use). 

At the end of Year Two, the book basis is $90 and the tax basis is $30.  This means that there is now minimum gain is $10, which is the $100 nonrecourse debt less the book basis of $90 (and not the tax basis of $30).  This increase in minimum gain means that $10 of the book depreciation will be treated as nonrecourse deductions.  Accordingly, $20 of the book depreciation can be allocated to Tim under the substantial economic effect rules, but the final $10 of book depreciation can only be allocated to Tim if the partnership agreement meets the requirements of section Treas. Reg. section 1.704-2(e), which we’ll assume it does.

Assume the property is sold on January 1st of the third year for $90.  This results in a tax gain of $70 (100 -30) and a book gain of $10 (100 – 90).  Since Tim was allocated the $10 of nonrecourse deductions, he will be allocated the first $10 of book gain, which will be matched by $10 of tax gain.  This required allocation is known as a “minimum gain chargeback.”  In this case, the chargeback of book gain to Tim represents all of the book gain on the transaction; the remaining amount of tax gain, $60, will be allocated to Beverly, because it is the remaining amount of her IRC section 704(c) minimum gain.

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Supporting Law

IRC section 704(b)
Treas. Reg.section 1.704-2:
    Definition of Non-recourse Liability section 1.704-2(b)(3)
    Partnership Minimum Gain  section 1.704-2(d)
    Safe Harbor Requirements  section 1.704-2(e)

Resources

Federal Taxation of Partnerships and Partners, William S. McKee, William F. Nelson, Robert L. Whitmire (Publisher: Warren, Gorham & Lamont) (3rd Ed. 2001)

Federal Income Taxation of Partners and Partnerships, Karen C. Burke (Publisher: West Nutshell Series) BNA Tax Management 712-1st TM

“Treatment of COD Income Under Sections 704 and 752,” The Tax Advisor (May 1993)

“IRS Provides Guidance on Special Partnership Allocations of COD Income,” The Tax Advisor (December 1999)

“Allocations of Non-recourse Debt Deductions,” The Tax Advisor (October 1987)

“Non-recourse Debt Regulations Resolve Most Special Allocation Issues,” The Journal of Partnership Taxation (Spring 1987)

Allocation of Tax Credits(Not Foreign Tax Expenditures)

It is impossible to evaluate whether or not a tax credit was properly allocated without first understanding the nature of the credit, the nature of the debt being used to finance the property (recourse or non-recourse), and the complex rules of IRC section 704(b) concerning economic effect, substantiality, and the allocation of nonrecourse deductions.   A basic understanding of the principles presented in this chapter is necessary in order to determine if the allocation of credits should be respected.

The Tax Code has numerous provisions for tax credits.   The credits most commonly seen in the partnership context are the low-income housing credit under IRC section 42 and the rehabilitation tax credit under IRC section 47.   The rehabilitation credit is part of the investment tax credit. Both the investment tax credit and the low-income housing credit fall under the IRC section 38, General Business Credit.

The regulations treat the allocation of the investment tax credit (which includes the rehabilitation credit) differently from other credits.   For this reason, the allocation of the rehabilitation credit will be discussed separately.

Tax Credits In General

In general, tax credits do not impact the partners’ capital account.   They, therefore, have no effect on the dollar entitlements of the partners in terms of cash distributions or cash upon liquidation.   Thus, an allocation of a credit cannot have substantial economic effect and must be allocated according to the partners’ interests in the partnership.

There is no specific, mechanical, safe harbor for allocating tax credits.   The regulations state that if a partnership expenditure that gives rise to a tax credit and also gives rise to valid allocations of loss or deduction, then the credit will be allocated in the same manner as the loss or deduction which decreases the partners’ capital accounts.   The regulations also state that identical principles apply with credits that arise from gross receipts of the partnership.   Treas. Reg. section 1.704-1(b)(4)(ii).

Example 6-11

Bucknell Corp., a real estate developer, is a partner in a low-income housing partnership.   The other partner is an investment partnership. Profits and losses are split 50/50, with the depreciation and low income housing credit specially allocated 99 percent to the investment partnership and 1 percent to Bucknell Corp.   The debt is recourse debt from an unrelated lender and both partners are general partners.   Assume that the partnership’s allocation of depreciation, 99 percent to the investment partnership, has substantial economic effect under IRC section 704-1.

Since a partnership expenditure gives rise to the tax credit (the building’s qualified basis) and also gives rise to a valid allocation of partnership deduction (depreciation) which reduces the capital accounts, the allocation of tax credit 99 percent to the investment partnership partner will be respected.

In the above example, the allocation of credit is respected because its associated allocation of depreciation deduction is respected.   The allocation of credit parallels the allocation of depreciation.

In analyzing whether or not credits are properly allocated, it is critical to determine if the “other valid allocation” to which the credit is tied is to be analyzed using the economic effect rules of Treas. Reg. section 1.704-1(b)(2) or the rules in Treas. Reg. section 1.704-2 concerning the allocation of non-recourse deductions.

In the above example, if the debt were non-recourse, the depreciation deductions would lack economic effect to the extent that they were attributable to the debt because no partner bears the economic risk of loss for them.   Non-recourse deductions must be allocated either in accordance with the partners’ interests in the partnership under Treas. Reg. section 1.704-1(b)(3) or under the safe harbor nonrecourse deduction provisions under Treas. Reg. section 1.704-2(e).

The second requirement of the non-recourse deduction safe harbor presents an area of concern in evaluating the allocation of a tax credit in a non-recourse context.   This consistency requirement stipulates that allocations of non-recourse deductions are allocated in a manner that is reasonably consistent with some other “significant” partnership item (other than a minimum gain chargeback) having substantial economic effect.   This item must be attributable to the property securing the nonrecourse debt.

Example 6-12

The facts are the same as in Example 6-9, but the debt is non-recourse debt.  The partnership agreement meets the non-recourse debt safe harbor under Treas. Reg. section 1.704-2(e).   The partnership agreement calls for allocating depreciation in accordance with the allocation of a significant partnership item that has both substantial economic effect and related to the property secured by the non-recourse debt.   The allocation of the credit in accordance with the allocation of depreciation will be respected.

Banks often become investors in low income housing partnerships.  If a bank acts as a non-recourse lender in addition to being a partner, the bank is considered to bear the economic risk of loss to the extent that the liability is not borne by another partner.   Treas. Reg. section 1.752-2(c)(1).

Example 6-13

A real estate development corporation and a bank form a partnership to develop low-income housing.   The bank acts as the lender and provides nonrecourse financing.   The partnership agreement calls for profits and losses to be split equally with all of the depreciation and credit being allocated to the bank.   In this case, the special allocation of depreciation and tax credit to the bank would be evaluated under the economic effect rules since the bank bears the economic risk of loss.   As long as the allocation of depreciation to the bank has substantial economic effect, the allocation of the credit will be respected.

Rehabilitation Credit

Unlike the low-income housing tax credit, the rehabilitation tax credit does have an impact on the partners’ capital accounts.   The partnership must reduce the depreciable basis of the building by the amount of the rehabilitation tax credit.  Similarly, a partner must reduce his capital account by his ratable share of the rehabilitation tax credit.

The rule for allocating the rehabilitation tax credit is found in Treas. Reg. section 1.46-3(f)(2).   The general rule is that each partner’s share of the rehabilitation costs is based on the general profit ratio of the partnership.   This ratio should reflect the partners’ real economic sharing arrangement.

The exception to the general rule is that a special allocation is possible if:

  1. All related items of income, gain, loss, and deduction with respect to the property are specially allocated in the same manner, and
  2. Such allocation is made either in accordance with the partner’s interest in the partnership or has substantial economic effect.

Example 3 in Treas. Reg. section 1.46-3(f)(3) discusses a partnership engaged in the business of renting equipment whose cost qualified for the investment tax credit.  Under the partnership agreement, the income, gain or loss on disposition, depreciation and other deductions attributable to the equipment are specially allocated 70 percent to one partner and 30 percent to the other partner.   The conclusion is that if this allocation is made in accordance with the partners’ interests in the partnership or has substantial economic effect, the cost of the equipment (and therefore the tax credit) will be taken into account 70 percent by one partner and 30 percent by the other partner.

These regulations do not permit the flexibility of separately allocating items being generated by the same property.  It would not be possible to sever the depreciation and credits from other items of deduction or income being generated by the same property.   All related items of income gain, loss, and deduction from a particular property must be allocated together.   Additionally, such allocation must meet the other requirements of IRC section 704(b).

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 Example 6-14

A real estate professional and a bank form a partnership to rehabilitate and rent a historic building making equal contributions.   The bank is also acting as the partnership’s lender.   The bank is to receive 99 percent of the depreciation deductions and 99 percent of the rehabilitation credit.   All other profits and losses are to be split 50/50.   The partnership will maintain capital accounts in accordance with the regulations, positive capital account balances will be respected upon liquidation, and the partnership agreement contains an unlimited deficit restoration agreement. The debt is recourse debt.

In this example, the allocation of the tax credit 99 percent to the bank will not be respected because a) it is not in accordance with the general profit sharing ratio of the partnership and b) the income, loss, and deductions are not allocated in the same manner.   The credit will be reallocated in accordance with the partners’ interests in the partnership (50 percent each).

Examination Techniques

Credits in General

  • Determine the nature of the credit.
  • Determine what expenditure or receipt is most closely associated with the creation of the credit.
  • Review the partnership agreement to discern the business deal (partners’ interests in the partnership) or to verify that the requirements for substantial economic effect are present.
  • Verify that the item most closely associated with the credit is allocated properly and that the credit is allocated in the same manner.

Investment Tax Credits (Including Rehabilitation Credit)

  • Check to see if all items being generated by the property (income, gain, loss, deduction) are allocated in the same manner.
  • Review the partnership agreement to discern the business deal (partners’ interests in the partnership) or to verify that the requirements for substantial economic effect are present.

Supporting Law

Allocation of Credits   Treas. Reg. section 1.704-1(b)(4)(ii)
Allocation of section 38 Credits Treas. Reg. section 1.46-3

Resources

Corporate Investment in the Low-Income Housing Tax Credit, The Journal of Taxation, December 1993, Peter M. Lampert

ALLOCATION OF FOREIGN TAX EXPENDITURES

Final regulations that apply to partnership taxable years beginning on or after October 19, 2006, provide guidance under IRC section 704(b) regarding allocation of creditable foreign tax expenditures (CFTEs) by partnerships. The final regulations remove allocations of CFTEs from the substantial economic effect safe harbor of Treas. Reg. section 1.704-1(b)(2) and establish a safe harbor under which allocations of CFTEs will be deemed to be in accordance with the partners’ interests in the partnership.  In general, the safe harbor of the final regulations requires allocations of CFTEs to be in proportion to the partners’ distributive shares of income (for U.S. tax purposes) to which the creditable foreign tax relates.

The foreign tax expenditure regulations clarified the application of the regulations under IRC section 704 to foreign taxes paid or accrued by a partnership and eligible for credit under IRC section 901(a) (creditable foreign tax expenditures or CFTEs).   While allocations of CFTEs that are disproportionate to the related income may have economic effect in that they reduce the recipient partner’s capital account and affect the amount the recipient partner is entitled to receive on liquidation, this effect will almost certainly not be substantial after taking U.S. tax consequences into account.  The after-tax economic consequences to a foreign or other tax-indifferent partner whose share of the tax expense is borne by the U.S. taxable partner will be enhanced by reason of the allocation, and there is a strong likelihood that the after-tax economic consequences to a U.S. partner will not be substantially diminished since the allocation of the CFTE increases the allowable foreign tax credit and results in a dollar-for-dollar reduction in the U.S. tax the partner would otherwise owe. 

The regulations were based on the assumption that partnerships specially allocate foreign taxes where the recipient partner would elect to take the CFTE as a credit, rather than as a deduction.  As a matter of administrative convenience, the regulations apply to all allocations of CFTEs even though, in rare instances, a partner may instead elect to deduct rather than credit the CFTEs.  Thus, the regulations provide that partnership allocations of CFTEs cannot have substantial economic effect and, therefore, must be allocated in accordance with the partners’ interests in the partnership. 

The regulations provide a safe harbor under which partnership allocations of CFTEs will be deemed to be in accordance with the partners’ interests in the partnership.  Under this safe harbor, if the partnership agreement satisfies the requirements of Treas. Reg. section 1.704-1(b)(2)(ii)(b) or (d) (i.e., capital account maintenance, liquidation according to capital accounts, and either deficit restoration obligations or qualified income offsets), then an allocation of the CFTEs that is proportionate to a partner’s distributive share of the partnership income to which such taxes relate (including income allocated pursuant to IRC section 704(c)) will be deemed to be in accordance with the partners’ interests in the partnership.  If the allocation of the CFTEs does not satisfy this safe harbor, then the allocation of the CFTEs will be tested under the partners’ interests in the partnership standard set forth in Treas. Reg. section 1.704‑1(b)(3).  The final regulations provide that the allocation of the foreign tax credits must be ignored for purpose of determining the partners’ interest in the partnership.

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