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 partners 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 partners 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 partners
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 partners 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
partners 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
Partners share is equal to the lesser of:
Partners 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 As 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 > Partners adjusted
basis at the time of contribution
Built-in loss = FMV < Partners 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 B
3 As basis: $12,000 + $4,000 = $16,000
Bs 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 partnerships 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 Book
On Formation $12,000 $20,000 $20,000 $20,000
Gainacre Tax Gain 3,000
Gainacre Book Loss (2,500) (2,500)
Stock Tax Gain 7,500 2,500
Stock Book Gain 5,000 5,000
Balance $22,500 $22,500 $22,500 $22,500
Sales & Exchanges
Remedial Method
Solely tax allocations with no effect on the
partnerships book capital accounts
If the ceiling rule results in a book allocation
to a noncontributing partner that differs from
the partners 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 As 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 Book
On Formation $12,000 $20,000 $20,000 $20,000
Depreciation (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 partners share of nonrecourse
liabilities is the sum of
The partners 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 partners 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
Partners 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
partners 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
partners 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 partners 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 partners 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