Bulletproofing special allocations.

Holland, Michael L.

INTRODUCTION

Partnerships and those entities taxed as partnerships have always been popular forms in which to conduct business because the partnership itself is not subject to federal income taxation and the partnership under Internal Revenue Code (IRC) section 704(b) may specially allocate to the partners items of income, gain, loss, deduction, or credit.

The opportunity to specially allocate these items to minimize overall partner tax liabilities is very attractive and could be abused. To prevent abuse, both the code and subsequent Internal Revenue Code Regulations (Regs) limit the use of special allocations. Additionally, over the years a body of case law has developed that sets out limits but also offers some planning opportunities.

Successfully providing for special allocations requires avoiding the numerous pitfalls surrounding this provision. Properly using the guidance in the Code, Regs, and case law will bulletproof partnership special allocations from successful attack by the Internal Revenue Service (IRS).

SPECIAL ALLOCATIONS

Interestingly, the term "special allocation" does not appear in the IRC itself but does appear in the Regs and the legislative history to the Tax Reform Act of 1976 (S. Rep No. 938, 94th Cong., 2nd Sess 98 (1976). The idea for partnership special allocations originated with the American Law Institute in 1954 and made its way into the Code as [section]704(b) in that year. The initial provision only limited these allocations to the extent that the principal purpose for the allocation was the avoidance or evasion of income tax. The report of the Senate Finance Committee that accompanied that 1954 provision for the first time used the term "substantial economic effect" in commenting on whether an allocation would be valid. This term also appeared in the original Regs for new subchapter K of the 1954 Code and contained six tests to evaluate whether or not a special allocation had substantial economic effect. The original language of 704(b) was amended by the Tax Reform Act of 1976 which strengthened the limitation by prohibiting any allocation which does not have "substantial economic effect." The amended section 704(b) provides that partnership bottom line income or loss ([section]702(a) (8)) or any income, gain, loss, deduction, or credit (provided for in [section]702(a)(1)-(7))may be allocated under the partnership agreement if the allocation has substantial economic effect.

Although cases decided prior to the 1976 amendment were nominally adjudicated under the 1954 language which only prohibited allocations that had a principal purpose of tax avoidance or evasion, fundamentally the test applied was "substantial economic effect". Thus even the early case law is useful in evaluating allocations under the current code provision and subsequent regulations.

The regulations for amended IRC [section]704(b) provide three ways that the special allocation will be respected:

1) the allocation can have substantial economic effect (as discussed subsequently);

2) the allocation can be in accordance with the partner's interest in the partnership taking into account all facts and circumstances; or

3) the allocation can be deemed to be in accordance with the partner's interest in the partnership under one of several special rules (discussed subsequently).

Of the three ways to validate a special allocation, the first method requiring the allocation to have substantial economic effect provides the most specific guidance. Under IRC Reg. [section] 1.704 (b)(2)(i) there is a two part test for evaluating the allocation:

1) It must have economic effect and

2) Be substantial.

ECONOMIC EFFECT

Any special allocation which creates a benefit or burden for a partner must in order to be valid assign all ultimate economic responsibility for the allocation to the partner receiving the benefit or burden.. There is a three part safe harbor provision which satisfies the economic effect requirement and will only satisfy that requirement if throughout the full life of the partnership all three criteria are met:

1) partners' capital accounts are maintained using book accounting rules:

2) at liquidation of the partnership or the liquidation of any partner's interest in the partnership, liquidating distributions will be based on the positive amounts in the partner's capital accounts; and

3) if a partner has a deficit balance in his capital account after liquidation, the partner is unconditionally required to make a contribution to the partnership to bring the deficit amount up to zero.

Part three of the three part economic effect safe harbor is open-ended in the amount of deficit restoration required of partners, however some risk can be avoided and the safe harbor provisions still met through an alternative requirement for what is essentially part three of the test. The alternative is satisfied if the partner who receives the special allocation is obligated to restore a limited amount of deficit and the partnership agreement contains a qualified income offset. Any special allocation to the partner cannot create a deficit larger than the amount the partner is required to restore. The ending balance in the partner's capital account should take into consideration adjustments, allocations of loss and deductions, and distributions that are reasonably expected to be made by the end of the tax year. A qualified income offset requires the partnership to allocate income to the partner who unexpectedly receives an allocation, adjustment, or distribution described above in an amount to eliminate the deficit as quickly as possible.

Note that if an allocation creates a deficit beyond the amount required to be restored, only the excess amount of the allocation will be disallowed and will be a proportionate amount of all special items allocated to the partner. Also a year-end change in the amount of deficit the partner must restore will not invalidate prior allocations if the ending deficit does not exceed the amount of deficit the partner must restore after the change.

There is a bit of relief for the partners under the "deemed" equivalence provisions. Even if the safe harbor tests are not met, an allocation will be deemed to have economic effect if at the end of the partnership tax year, a liquidation of the partnership would produce the same economic results to the partners that would have occurred under the safe harbor provisions.

The following examples and court decisions will illustrate the rules and criteria for economic effect discussed above.

Example 1

Assume an equal two person partnership formed by C and D by contributing $50,000 each. The partnership purchased a building for $100,000. The agreement is that C and D will share income (computed without depreciation deductions) equally. The cash flow and all depreciation will be allocated to C. Capital accounts will be maintained in accordance with the safe harbor rules except that upon liquidation of the partnership, distributions to the partners will be equal regardless of capital balance and no deficits will have to be made up. The first year depreciation of $25,000 is allocated to C. C has received the full $25,000 of depreciation for a deduction on his tax return but in liquidation, he would still get one half of the sale proceeds. He bears no economic consequence or risk of loss by deducting the full $25,000 depreciation amount. The allocation lacks economic effect and is disregarded.

A similar result was reached in one of the early court cases concerning special allocations. In Orrisch (Stanley C. Orrisch and Gerta E. Orrisch v. Commissioner 55 TC 395) the taxpayer and his partner owned and operated two apartment houses and under their unwritten partnership agreement they were to share equally the gains and losses from the operation of the apartments as well as the proceeds from any sales. A subsequent amendment to the partnership agreement allocated to Orrisch all depreciation deductions with the understanding that any gain attributable to the specially allocated depreciation was to be allocated to Orrisch. Orrisch put up two-thirds of the initial capital in the partnership. In the first three years of operation the partnership suffered losses attributable to accelerated depreciation deductions which were shared equally by the two partners. Orrisch had significant non-partnership income and partner Crisafi had non-partnership losses.

Early in year four, an amendment allocating all the depreciation to Orrisch was made. There was a gain charge back provision but proceeds from a sale that produced a loss were to be shared equally. The depreciation charges for years four and five along with half the partnership losses in years one through three left Orrisch's capital account with a deficit of $25,187.

In its opinion the court observed that Orrisch had large amounts of income which would be offset by the additional deduction for depreciation and that Crisafi, in contrast, had no taxable income from which to subtract the partnership depreciation deductions but the insulation of Crisafi from at least part of a potential capital gains tax was an obvious tax advantage. Orrisch argued that the allocation had substantial economic effect since the allocation was reflected in the balance of the capital accounts. The court countered by pointing out that an allocation has economic effect if the dollar amount of assets distributed to partners is independent of tax consequences and noted that the proceeds of the sale of the property would be distributed equally. Thus in this situation the only effect of the allocation would be a trade of tax consequences. Obviously if the property were sold at a gain the special allocation would only affect the tax liabilities of the partners and would have no other economic effect.

Now assume a variation (Example 2) on Example 1. The partnership agreement now provides that liquidation proceeds will be distributed according to capital account balances if liquidation occurs in the first five years of the partnership and then equally if liquidation occurs later. Special allocations under such an agreement would not have economic effect. There are two problems in this agreement: The requirement to liquidate on capital balances must be satisfied over the life of the partnership, and the provisions for deficits to be made up or the alternative to this requirement must be met.

Consider a further variation (Example 3) on Example 1 above. Assume the same facts in example 1 except that distributions will be based on partners' capital balances through out the life of the partnership and that the partnership agreement contains a qualified income offset in lieu of any deficit restoration as discussed above.

Under the alternative economic effect test, the allocation in year one has economic effect.

Example 4

Continuing the facts from Examples 1 and 3, suppose that the second year depreciation allocated to Partner C is $30,000.

The alternative economic effect test is satisfied only to the extent of $25,000 of the allocation. The remaining $5,000 of the allocation must be reallocated to Partner D. Under the partnership if the property were sold for $45,000 (its adjusted basis at the end of year 2) all the proceeds would go to Partner D. Therefore it is Partner D, not C, who bears the economic burden of the last $5,000 of year two depreciation.

A variation (Example 5) using the facts in Example 4 except that the partnership agreement requires Partner C to restore a deficit in his capital account up to $5,000. Because of the limited deficit make-up requirement up to $5,000 the full year 2 depreciation of $30,000 has economic effect because the deficit created in Partner C's capital account does not exceed the $5,000 maximum make-up obligation. It is interesting to note that the regulations say that the make-up requirement may be eliminated after the $5,000 is contributed by Partner C to the partnership and that the prior allocations remain valid. There are two other ways to meet the obligation to make up a deficit. A negotiable promissory note with a principal amount (to continue the facts above) of $5,000 can be made out to the partnership due upon the earlier of the end of the fourth year or liquidation of Partner C's interest. The same result could be achieved with a deferred obligation to contribute $5,000 to the partnership at the earlier of the end of the fourth year or liquidation of Partner C's interest. Both of the arrangements are acceptable under the alternative test and the year two allocation of the full $30,000 of depreciation has economic effect.

A last example (Example 6) with respect to economic effect: Assume partners L and M contribute $150,000 and $50,000 respectively to a general partnership which allocates all income, gain, loss and deduction 75 percent to L and 25 percent to M. The partnership maintains no capital accounts for the partners. L and M are liable under state law for 75 percent and 25 percent respectively of any partnership liabilities. The safe harbor provisions of the regulations are not met but the allocations have economic effect under the economic equivalence test. A similar situation was affirmed in Dibble (Phillip A. Dibble and Phyllis K. Dibble, et al. v. Commissioner 49 TCM 32). The Court noted that although the partnership agreement had deficiencies with respect to the safe harbor provisions, it still had economic effect because the provisions of the local state Uniform Limited Partnership Act would apply to require that liquidation distributions be made in accordance with the capital account balance and no partner would bear more than his share of the economic costs of the special allocation because the taxpayers maintained positive capital account balances.

SUBSTANTIAL

Not only must there be economic effect, the effect must be "substantial". Substantiality is the second part of the substantial economic effect requirement and to be substantial, there must be a reasonable likelihood that the allocation will affect in a material way the dollar amounts received by the partners independent of any tax effects. In addition, an allocation is not substantial if as a result of the allocation, the after-tax position of at least one partner is likely to be improved in present value terms compared to the position of that partner if the allocation were not made and there is a strong possibility that no partners' after tax position will be diminished in present value terms as a result of the allocation.

Shifting tax consequences, such as capital gains to one partner and an equal amount of ordinary gains to another partner, but not dollars, within a tax year is also not substantial. In particular, if as a result of a special allocation, the net increases and decreases in each partner's capital account would likely be about the same as would occur without the special allocation and the total tax liabilities of the partners considering their outside non-partnership tax items are less than they would have been without the special allocation then the allocation is not substantial.

Certain transitory allocations between partners from year to year are also not substantial. Thus if the partnership agreement provides an allocation to a partner in one year and there is a strong probability that subsequent allocations to the other partner or partners in subsequent years will offset the effect of the earlier allocation so that all partners' capital accounts are approximately the same amount that would have resulted without the special allocation and the total tax liabilities of the partners is less than it would have been without the special allocations, then the transitory special allocations are not substantial.

There is an exception to the transitory allocations rule called the five year rule. If at the time the original transitory allocation is made there is a strong possibility that the subsequent allocations will not have for the most part offset the initial allocation within five years, then the allocations are substantial.

Several examples which illustrate the application of the "substantial" criterion follow.

Consider Partners A and B (Example 7) who form a partnership to develop a new computer chip. A invests $2,500 and will work full time in the venture while B invests $100,000. The partnership will borrow any additional capital needed. The partnership agreement allocates all deductions for research expenditures and any interest expense on partnership loans to partner B.

Additionally, partnership income or loss will be allocated 90percent to B and 10percent to A computed net of the deductions for research expenditures and interest expense until Partner B has received income allocations equal to the total of the research expenditures and interest expense previously allocated to him and his share of any taxable loss. Thereafter, partners A and B will share all taxable income or loss equally. The partnership agreement provides for cash flow from operations to be distributed equally and the partnership capital accounts and liquidation distributions follow the safe harbor provision for economic effect therefore, these allocations have economic effect. Because there is not a strong probability at the time the allocation became a part of the partnership agreement that the amount of research expenditures and interest expense would be largely offset by allocations of income to B, the economic effect of the allocations is substantial. The partners in this example assume a meaningful amount of risk because the actual outcome could not be reasonably forecast.

In contrast to Partners A and B (Example 7), no significant risk is assumed by Partners C and D (Example 8). Individuals C and D form a two person investment partnership which owns corporate bonds and tax-exempt bonds. For the foreseeable future, C expects to be in the 40 percent marginal tax bracket and D expects to be in the 15 percent marginal tax bracket. Based on the interest portfolio, the partnership expects to earn about $600 of tax exempt interest and about $600 of taxable interest. C and D made equal capital contributions to the partnership and have also agreed to share equally in the gains and losses from the sale of partnership assets and they have agreed to allocate income so that 90 percent of the tax-exempt interest goes to C and 10 percent to D and all of the taxable interest to D. The cash generated by the investments will follow the income allocations. The partnership agreement provides that the capital accounts will be accounted for under the safe harbor provisions, liquidation payments will be based on positive capital balances, and partners are obligated to bring any negative capital balance up to zero. The allocations have economic effect but are not substantial. If income is shared equally then C's after tax share of partnership income is $300 of tax-exempt income and $180 of taxable interest (net of tax) for a total of $480. D's after tax amount will total $555 ($300 tax exempt and $250 after tax, taxable interest). With the special allocation C will have $540 net of tax (90 percent of $600 of tax exempt interest) while D will have after tax income of $570 ($60 tax exempt and $510 from taxable interest). Thus, at the time the allocations became a part of the partnership agreement C expected to enhance his after-tax income and there is also a strong likelihood that neither C nor D will have their after tax income diminished.

Example 9 reaches a similar result. Equal partners E and F and the partnership all have a December 31 year end. The safe harbor provisions for economic effect are included in the partnership agreement. At the beginning of the year when the partnership is expecting [section]1231 losses, the partnership agreement is amended for one year only to allocate all such losses to E who expects to have no gains from [section] 1231 transactions in the tax year, and to allocate an equal amount of partnership loss and deduction of a different character to F who expects to have [section]1231 gains. Any partnership loss and deduction in excess of these allocations will be allocated equally to E and F.

At the time the partnership agreement was amended it was very likely that the partnership would have losses other than [section]1231 losses that would equal or exceed the [section]1231 losses. The allocations have economic effect because of the safe harbor provisions but they are not substantial. The partners have assumed little risk with respect to the amount of losses each will receive. They have really only altered the amount of taxes that would otherwise be paid. To paraphrase the Regulations, because there is a strong likelihood, at the time the allocations became a part of the partnership agreement, that the net increase and decrease to E's and F's capital accounts will be the same at the end of the tax year as they would have been without the allocations, and that the total taxes paid by E and F for the year will be less than they would have been without the allocations, the allocation is not substantial.

Finally, Example 10 illustrates transitory allocations and an exception to the general disallowance of such transitory allocations under the 5-year rule. G and H form a general partnership to buy and lease machinery. Partners and partnership have a December 31 year-end and each partner invests $200,000. The partnership borrows $1,600,000 and with the $400,000 of invested capital purchases $2,000,000 of equipment to lease. The partnership agreement provides that capital accounts are maintained in accordance with the economic effect safe harbor rules. Liquidation proceeds will be based on positive capital account balances and negative capital accounts must be restored. The partnership agreement also stipulates that:

1) partnership net taxable loss be allocated 90 percent to G and 10percent to H until the partnership begins to produce net income and then 90 percent of net income is to be allocated to G and 10 percent to H until income equal to any previous loss allocated to G has been achieved;

2) all further partnership net income or loss is to be shared equally; and

3) cash flow from operations is to be distributed equally.

The partnership leases the equipment to a financially strong corporate lessee for a 12 year term. The partnership expects losses in years one through five of $200,000, $280,000, $160,000, $140,000 and $120,000 respectively. Generally when the income/loss stream is very predictable (little risk) the allocation is treated as insubstantial. The interest expense and principle payment is scheduled, the lease payments are prescribed by contract, the lessee is a strong company unlikely to go bankrupt, and the depreciation amounts are known from the schedule. However, because at the time of the allocation provisions, it was highly likely that the net losses in years one through five would not be largely offset by net income within five years, the allocation is substantial. This is determined on a first-in, first-out basis. The year one loss for example will not be offset until years six, seven, and eight. The year five loss will not be offset until years 11 and 12. The five year rule essentially says that offsets to be received beyond five years in the future really are not very predictable and the risk thus assumed makes the transitory allocation substantial.

The essentials for developing a special allocation that is bulletproof from IRS attack are now laid out. There have been no court cases involving questions of substantiality. The assumption is that taxpayers have not designed special allocations which obviously are not substantial and that the IRS has not been aggressive in challenging special allocations with respect to substantiality. From the previous examples, the substantiality test can be met so long as the ultimate benefits cannot be reasonably predicted. That means avoiding year-end allocations always and one year allocations generally. Based on the number of cases litigated, the great stumbling block in providing for successful special allocations has been complying with the economic effect criterion. The safe harbor provisions offer the easiest path to satisfy the economic effect test. This is certainly true for partnerships in those states which have adopted the Uniform Partnership Act. A particularly attractive solution is the safe harbor with the alternative to part three of the provisions which limits a partner's deficit responsibility in conjunction with a gain charge-back arrangement. Following the guidelines as developed and discussed makes the tax of [section]704(b) special allocations predictable and therefore an attractive tool in partnership tax planning.

Michael L. Holland, Valdosta State University

Example 1
 C D

Beginning Capital Balance $50,000 $50,000
Less year 1 depreciation (25,000) 0
End of year 1 capital balance $25,000 $50,000

Example 4

 C D

End of year 1 capital balance $25,000 $50,000
Less year 2 depreciation -30,000 0
End of year 2 capital balance $(5,000) $50,000