704 B IRS Partnership Allocations

IRC Sect.
704(b): Partnership Allocations

Navigating Complex Rules to Determine Valid Allocation of Income, Gain, Loss, Deductions or Credits
WEDNESDAY, OCTOBER 8, 2014, 1:00-2:50 pm Eastern
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IRC Sect. 704(b):
Partnership Allocations
Oct. 8, 2014
David Forst Amanda Wilson

Fenwick & West Lowndes Drosdick Doster Kantor & Reed
dforst@fenwick.com amanda.wilson@lowndes-law.com
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
5
Today’s Program
Review of Partnership Allocation Rules Slide 7 – Slide 50

[Amanda Wilson]
Partnership Non-Recourse Debt Allocations Slide 51 – Slide 66

[David L. Forst]
Two Approaches to Capital Account Maintenance Slide 67 – Slide 72

[David L. Forst]
Amanda Wilson, Lowndes Drosdick Doster Kantor & Reed
REVIEW OF PARTNERSHIP
ALLOCATION RULES
Orlando, Florida | www.lowndes-law.com
Circular 230
To comply with Treasury Department regulations, we inform you that,

unless otherwise expressly indicated, any tax advice contained in this
communication (including any attachments) is not intended or written to
be used, and cannot be used, for the purpose of (i) avoiding penalties
that may be imposed under the Internal Revenue Code or any other
applicable tax law, or (ii) promoting, marketing or recommending to
another party any transaction, arrangement, or other matter.
8
Allocations – Section 704(a)
One of the key benefits of a partnership is the flexibility in allocating

partnership items among the partners.
Section 704(a) provides that a partner’s distributive share of

partnership income, gain, loss, deductions or credit shall, except
as otherwise required by the IRC, be determined by the
partnership agreement.
9
Allocations – Section 704(b)
Section 704(b) requires a partner’s distributive share of partnership

income, gain, loss, deductions or credit to be determined in
accordance with the partner’s interest in the partnership if
(1) Partnership agreement does not provide for distributive share

or
(1) Partnership agreement allocations do not have substantial

economic effect.
10
Allocations
Thus, allocations of a partner’s distributive share of partnership income,

gain, loss, deductions or credit will be respected if they
(1) are either in accordance with the partners’ interests in the

partnership or
(2) if they have substantial economic effect.
11
Partners’ Interest in the Partnership
Factors to consider:
• The partners' relative contributions to the partnership,
• The interests of the partners in economic profits and losses (if

different than that in taxable income or loss),
• The interests of the partners in cash flow and other non-liquidating

distributions, and
• The rights of the partners to distributions of capital upon liquidation.
12
Partners’ Interest in the Partnership
Allocations are generally in accordance with the partners’ interests in

the partnership if all allocations are being made in accordance with the
respective contributions of the partners.
For example, if A and B each contributed $100, allocations would be in

accordance with the partners’ interests in the partnership if all
partnership items are shared 50-50.
Liquidating distributions can be made in accordance with the partners’

respective interests in the partnership.
13
Substantial Economic Effect

AB is a partnership that owns 3 properties. All income allocated 50% to
A, except 60% of income from property 1 is allocated to A. This is a
special allocation.
Special allocations will be respected if they have substantial economic

effect. Substantial economic effect is a safe harbor.
Two part analysis. Allocations must
(1) Have economic effect; and
(2) The economic effect must be substantial.
14
Economic Effect
General principle: If there is an economic benefit or burden that

corresponds to an allocation, the partner to whom the allocation is
made must receive the economic benefit or burden.
More simply, if a partner gets the benefit of an allocation of $100 of tax

loss, the partner must suffer the $100 economic loss. If a partner
suffers the burden of $100 of tax gain, the partner must get the $100
of cash.
This is accomplished by maintaining capital accounts and liquidating

in accordance with those accounts.
15
Basic Test for Economic Effect
There are three requirements to satisfy the basic economic effect test:
(1) Capital account requirement
(2) Liquidation requirement
(3) Deficit make up requirement
16
Capital Account Requirement
To have economic effect, the partnership must maintain its capital

accounts in accordance with the rules of Reg. §1.704-1(b)(2)(iv).
Generally, this is accomplished with a provision in the partnership

agreement stating that “a capital account will be established and
maintained for each partner in accordance with Treasury Regulation
§1.704-1(b)(2)(iv).”
What does this do? A partner’s capital account tracks and reflects the
partner’s equity investment in the partnership.
17
Capital Account Maintenance Rules
A partner’s capital account equals
• FMV of contributions
• Plus allocable share of partnership income
• Less FMV of distributions
• Less allocable share of partnership loss
Partnership liabilities generally are not taken into account in calculating

capital account balances.
18
Liquidation Requirement
For economic effect, liquidating distributions to the partners must be

made based on positive capital accounts. In other words, no waterfall
distributions.
If allocations have gone awry, positive capital account balances will not
be the same amount as what would be received under the waterfall
distributions. Consider including a savings clause in the partnership
agreement to avoid/minimize this risk.
19
Deficit Make Up Requirement
If a partner has a deficit in his capital account upon liquidation of the

partnership, the partner must have an unconditional obligation to
restore the deficit. This deficit restoration obligation (“DRO”) may be
provided for in the partnership agreement or by state law.
A DRO may come from a partner contributing a promissory note to the

partnership or having an obligation (whether imposed by the
partnership agreement or state law) to make subsequent contributions
to the partnership.
A partner can have a limited DRO.
20
Example
A and B contribute $100 each to AB partnership. The partnership
agreement provides that 60% of partnership items are allocated to A
and 40% are allocated to B. AB has a $200 loss.
A’s CA B’s CA
Contribution 100 100
Income (120) (80)
(20) 20
For the entire allocation to have economic effect, A must have a DRO.
Otherwise, B is bearing the economic risk for $20 of the losses.
21
Planning Opportunity
Treas. Reg. §1.761-1(c) provides a “partnership agreement” can be

modified or amended with respect to a taxable year after the close of
the taxable year, provided the amendment occurs on or before the due
date for the partnership return (without extension).
This gives partners a planning opportunity to amend how they allocate

income and losses after the close of the year. In particular, to provide
for a limited DRO to the extent necessary to support a loss allocation.
22
Alternate Test for Economic Effect
(1) Capital account requirement.

(2) Liquidation requirement.
(3) Partnership agreement has a qualified income offset (“QIO”)
provision. The QIO must require that any partner with an
unexpected negative capital account be allocated all of the next
items of partnership income so as to eliminate the negative
balances as quickly as possible.
(4) The allocation does not create or increase a deficit in a partner’s
capital account in excess of the partner’s obligation to restore a
deficit.
23
Substantiality
The economic effect of an allocation is substantial if there is a

reasonable possibility that the allocation will affect substantially the
dollar amounts to be received by the partners from the partnership,
independent of tax consequences.
In short, an allocation lacks substantiality if the allocation has

favorable tax consequences to one partner without corresponding
detrimental tax consequences to the other partners and no overall
change on the partners’ capital accounts.
24
Substantiality
If the only effect of an allocation is to reduce taxes without

substantially affecting the partners’ pre-tax distributive shares, the
economic effect is not substantial.
25
Substantiality
Even if the general rule is satisfied, the economic effect is not

substantial in the following cases:
(1) Shifting Tax Consequences
(2) Transitory Allocations
(3) After-Tax Effect
26
Shifting Tax Allocations

Occurs if there is a strong likelihood that:
(1) the net increases and decreases that will be recorded in the
partners’ respective capital accounts for such taxable year will
not differ substantially from the net increases and decreases
that would be recorded in the partners’ capital accounts if the
allocations were not contained and
(2) the total tax liability of the partners will be less than if the
allocations were not contained in the partnership agreement
(taking into account the tax consequences that result from the
interaction of the allocation with the partner’s tax attributes
even if unrelated to the partnership).
27
Example
A and B are equal partners, but A is a tax exempt entity. AB has $100
of ordinary income and $100 of tax exempt income.
The partnership agreement allocates A the $100 of ordinary income

and B the $100 of tax exempt income. The economic effect to both
partners is the same, but the total tax liability for the partners is $0.
Without the special allocation, the total tax liability would be $17.5
($50 x 35%).
This allocation lacks substantiality under the shifting tax

consequences rule.
28
Shifting Allocations
Exception: Value equals basis rule.
A partnership’s assets are irrebuttably presumed to have a value

equal to their basis (or book value if different from basis).
So, even if there is appreciated or depreciated property in the

partnership that could be used to make future allocations, the
appreciation or depreciation is ignored.
29
Transitory Allocations
If a partnership agreement provides for a possibility that one or more

allocation (“original allocation”) will be largely offset by one or more
allocation (“offsetting allocation”) and there is a strong likelihood that:
(1) the net increases and decreases that will be recorded in the
partners’ respective capital accounts for such taxable year will
not differ substantially from the net increases and decreases
that would be recorded in the partners’ capital accounts if the
allocations were not contained and
30
(2) the total tax liability of the partners will be less than if the
allocations were not contained in the partnership agreement
(taking into account the tax consequences that result from the
interaction of the allocation with the partner’s tax attributes
even if unrelated to the partnership.)
31
Example
A and B are equal partners, but A has $100 of NOLs that are expiring
in the next 2 years. AB has $50 of income each year. AB allocates
all $100 of income to A in years 1 and 2, and then $100 of income to
B in years 3 and 4. Thereafter, income is shared equally.
The economic result is unchanged by this special allocation, but the

allocation allows A to take advantage of expiring NOLs. The total tax
liability is $17.5 ($50 x 35%), instead of $52.5 ($150 x 35%).
This is a transitory allocation and lacks substantiality.
32
Exceptions:
• Value equals basis rule.
• 5 year rule: If at the time of allocation, there is a strong likelihood

that the original allocation will not be largely offset within 5 years,
presumption that economic effect of allocation is not transitory.
• Risky ventures. Because a risky venture is speculative in nature,

there is not a strong likelihood that the offsetting profits/income
will ever materialize.
33
After-Tax Rule
An allocation does not have substantial economic effect if, at the time
the allocation is added to the partnership agreement,
(1) the after-tax economic consequences of at least one partner

may be enhanced compared to such consequences if the
allocation were not contained in the partnership agreement,
and
(2) there is a strong likelihood that the after-tax consequences of

no partner will be substantially diminished compared to the
consequences if the allocation were not in the partnership
agreement.
34
Slide Intentionally Left Blank
Example
Same as prior example, but AB allocates $90 of income to A in years
1 and 2, and $110 to B in years 2 through 4.
This allocation passes the other two tests, because there is a

material effect on capital accounts (A gets $10 less). But, on an
after-tax basis, A’s economic position is improved, and B’s economic
position is not substantially diminished (it is actually better).
A B
Tax After-Tax Tax After-Tax
With $0 $90 $38.5 $71.5
W/O $17.5 $82.5 $35 $65
This allocation violates the after-tax rule and lacks substantiality.

36
After-Tax Rule
The focus of this rule is on after-tax consequences, not pre-tax capital

accounts. Thus, you cannot avoid lack of substantiality by using an
unequal number of years.
Exceptions:
• Value equals basis rule.
• Risky venture.
37
No Substantial Economic Effect
If no substantial economic effect, a reallocation will occur in accordance

with the partners’ interest in the partnership. Presumption that partners
share per capita (i.e., 50-50 if 2).
Factors to consider in rebutting this presumption:

• the partners’ relative contributions to the partnership;
• the interests of the partners’ in economic profits and losses (if
different from taxable income and loss);
• interests in cash flow or other nonliquidating distributions; and
• rights to distribution on liquidation.
38
Tax Credits
Allocations of tax credits are not generally reflected by adjustments to

the partners’ capital accounts and thus they lack economic effect.
Tax credits are allocated in accordance with the partners’ interests in
the partnership.
39
General Rule
At issue is the partners’ interests in the year the credit arises.
If the expenditure that results in a tax credit also results in allocations of

partnership loss or deductions, partners’ interest in the partnership with
respect to the credit is in the same proportion as the partners’
distributive shares of the loss or deduction.
More simply, the credits must be allocated in accordance with the

general allocation of partnership losses or deductions, or where there
are special allocations of partnership items, with the allocation of
partnership items to which the credits are attributable.
40
Example
A and B form a partnership AB. The partnership agreement provides

that all profits and losses will be allocated 75% to A and 25% to B. The
partnership agreement has provisions such that the allocations have
substantial economic effect. The agreement also provides that any
credits will be allocated equally between A and B.
AB incurs expenses that give rise to a $1000 tax credit. Because the
expense will be allocated 75% to A and 25% to B, the credit must
likewise be allocated 75% to A and 25% to B. The allocation of the
credit 50-50 to A and B will not be respected.
41
Special Rules
Special allocation rules for certain tax credits. For example:
• For Section 38 general business credit, allocations of cost or

qualified investments made pursuant to Treas. Reg. 1.46-3(f) or
1.48-8(a)(4)(iv) are in accordance with partners’ interests in the
partnership.
• For Section 45 wind energy production tax credits, see safe

harbor set forth in Notice 2007-65.
42
Special Rules
Special allocation rules for certain tax credits. For example:

• For creditable foreign tax expenditures (CFTE), Treas. Reg.
1.704-1(b)(viii)(a)(2) provides that an allocation deemed in
accordance with partners’ interest in partnership if:
1.CFTE allocated in proportion to distributive share of income

to which CFTE relates; and
2.Allocation of all other partnership items that, in the

aggregate, have a material effect on the amount of CFTEs
allocated to the partners in (1) are valid (i.e., have substantial
economic effect).
43
Recent Tax Credit Guidance
Historic Boardwalk Hall, LLC v. Commissioner (Third Circuit 2012)

• LLC created by NJ government entity to renovate convention
hall. LLC generated significant rehabilitation tax credits.
• Pitney Bowes acquired a 99.9% ownership interest in the LLC.
• Received 99.9% of tax credits plus 3% preferred return on its
$20 million capital investment.
• Tax Court held that the LLC was a valid partnership and Pitney
Bowes a bona fide partner.
• Third Circuit determined that Pitney Bowes was not a bona fide
partner as it did not have a meaningful share of risks/benefits.
44
Historic Boardwalk
• No meaningful downside as Pitney Bowes was clearly going to

recoup its economic investment through the tax credits and
preferred return. The Project was fully-funded and almost
complete before Pitney Bowes came in and Pitney Bowes had
no audit risk because of a tax benefits guaranty.
• No meaningful upside as share of 99.9% of cash flow was

illusory. There was debt financing that would strip out all of the
net cash flow and the project was anticipated to generate large
operating deficits.
45
Chief Counsel Advice 20124002F
• Fund invested in a partnership that was generating historic tax

credits. Fund put in $0.90 for each $1 of credits generated.
Fund entitled to credits and a preferred return (guaranteed by
other partner). Fund had no obligation other than its capital
contribution.
• Fund could put its interest to other partner for amount of unpaid
preferred return.
• Call option to acquire Fund’s interest at FMV.
46
Recent Guidance
Chief Counsel Advice 20124002F
• Fund was not a bona fide partner as it did not have any
meaningful downside of risk or meaningful upside of benefit.
• Fund had guaranty of receiving preferred return and tax credits.
• Fund was entitled to cash flow and FMV on the call right, but
these were found to be illusory as there was no cash flow or
value after credits, management and development fees were
netted out.
47
Section 704(c)
Section 704(c) applies where the Section 704(b) book value of

partnership property differs from the tax basis in the property.
• For example, A contributes property with basis of $60 and FMV

of $100.
Section 704(c) overrides the general allocation rules of Section 704(b)

and provides a separate allocation mechanism for the tax items related
to Section 704(c) property.
48
Section 704(d)
Section 704(d) provides that a partner’s distributive share of

partnership loss shall only be allowed to the extend of the partner’s
basis in the partnership as of the end of partnership year. Any excess
loss is suspended.
Thus, if a partner is allocated losses in excess of his or her basis, the

partner can only deduct the allocated losses to the extent of basis. Any
excess is a suspended loss and carried forward until the partner has
sufficient basis.
• For example, A is allocated $100 in losses, but has basis of $60.

A can only deduct $60 currently. Remaining $40 of loss
suspended.
49
David L. Forst, Fenwick and West
PARTNERSHIP NON-RECOURSE
DEBT ALLOCATIONS
General principles
 Allocation of tax items attributable to partnership

nonrecourse liabilities (nonrecourse deductions)
cannot have economic effect because the creditor
alone bears the economic burden attributable to the
debt.
 Therefore, nonrecourse deductions must be allocated

in accordance with the partner’s interest in the
partnership.
 But Treas. Reg. §1.704-2(e) provide a safe harbor.
52
Safe Harbor:
Reg. §1.704-2(e)
 Throughout term of the partnership:
• Capital accounts are properly maintained.
• Partnership liquidates with positive capital accounts.
• Either full capital account deficit restoration obligation or
qualified income offset
 Through term of partnership after year of NR borrowing:
• Partnership has minimum gain chargeback provision.
• Partnership agreement allocates NR deductions “in a
manner that is reasonably consistent with allocations
that have substantial economic effect of some other
significant partnership item attributable to the property
securing the nonrecourse liabilities.”
 All other material allocations and capital account
adjustments are proper.
53
Partner NR Liabilities:
Reg. §1.704-2(i)
 Partnership losses, deductions or Sect. 705(a)(2)(B)

expenditures that are attributable to a particular partner non-
recourse liability (“partner nonrecourse deductions”) must be
allocated to the partner that bears the economic risk of loss
for the liability.
 The amount of partner non-recourse deductions with respect
to a partner non-recourse debt equals the net increase during
the year in minimum gain attributable to the partner non-
recourse debt (“partner nonrecourse debt minimum gain”),
reduced (but not below zero) by proceeds of the liability
distributed during the year to the partner bearing the
economic risk of loss for the liability that are both attributable
to the liability and allocable to an increase in the partner non-
recourse debt minimum gain.
54
Definitions
 “Nonrecourse liability” is a non-recourse liability as

defined in §1.752-1(a)(2) (or a §1.752-7 liability
assumed by the partnership from a partner on or
after June 24, 2003). Reg. §1.704-2(b)(3)
 “Partner nonrecourse liability” means any partnership

liability, to the extent the liability is non-recourse for
purposes of §1.1001-2, and a partner or related
person (within the meaning of §1.752-4(b)) bears
the economic risk of loss under §1.752-2 because,
for example, the partner or related person is the
creditor or a guarantor. Reg. § 1.704-2(b) (4)
55
Distinction between Recourse and Non
Recourse Debt
 Recourse debt is a partnership liability is a recourse

liability to the extent that any partner or related
person bears the economic risk of loss (EROL) for
that liability under Treas. Reg. §1.752-2. Treas. Reg.
§1.752-1(a)(1)
 Non-recourse debt is a partnership liability that is a

non-recourse liability to the extent that no partner or
related person bears the EROL for that liability under
Treas. Reg. §1.752-2. Treas. Reg. §1.752-1(a)(2)
56
Partnership Minimum Gain– Reg. §1.704-
2(d)(1)
 The amount of partnership minimum gain is

determined by first computing for each partnership
non-recourse liability any gain the partnership would
realize if it disposed of the property subject to that
liability for no consideration other than full
satisfaction of the liability, and then aggregating the
separately computed gains.
 For any partnership taxable year, the net increase or
decrease in partnership minimum gain is determined
by comparing the partnership minimum gain on the
last day of the immediately preceding taxable year
with the partnership minimum gain on the last day of
the current taxable year.
57
A Partner’s Share Of Minimum Gain:
Reg. §1.704-2(g)
 The sum of—

• Non-recourse deductions allocated to that partner (and to that
partner’s predecessors in interest) up to that time; and
• The distributions made to that partner (and to that partner’s
predecessors in interest) up to that time of proceeds of a non-
recourse liability allocable to an increase in partnership
minimum gain.
 Minus the sum of—
• that partner’s (and that partner's predecessors in interest)
aggregate share of the net decreases in partnership minimum
gain; and
• Their aggregate share of decreases resulting from revaluations
of partnership property subject to one or more partnership non-
recourse liabilities.
58
A Partner’ Share of Decrease In Minimum
Gain: Reg. §1.704-2(g)(2)
 The amount of the total net decrease multiplied by

the partner’s percentage share of the partnership’s
minimum gain at the end of the immediately
preceding taxable year.
 A partner’s share of any decrease in partnership

minimum gain resulting from a revaluation of
partnership property equals the increase in the
partner’s capital account attributable to the
revaluation, to the extent the reduction in minimum
gain is caused by the revaluation.
59
Distributions Of NR Debt Proceeds:
Reg. §1.704-2(h)
 If, during its taxable year, a partnership makes a

distribution to the partners allocable to the proceeds
of a non-recourse liability, then the distribution is
allocable to an increase in partnership minimum gain
to the extent the increase results from encumbering
partnership property with aggregate non-recourse
liabilities that exceed the property’s adjusted tax
basis.
60
Partner NR Minimum Gain ChargeBack:
Reg. §1.704-2(i)(4)
 If, during a partnership taxable year, there is a net

decrease in partner non-recourse debt minimum
gain, then any partner with a share of that partner
non-recourse debt minimum gain as of the beginning
of the year must be allocated items of income and
gain for the year (and, if necessary, for succeeding
years) equal to that partner’s share of the net
decrease in the partner non-recourse debt minimum
gain.
61
General Rule on Partnership Minimum
Gain Charge-Back: Reg. §1.704-2(f)(1)
 If there is a net decrease in partnership minimum

gain for a partnership taxable year, then the
minimum gain chargeback requirement applies, and
each partner must be allocated items of partnership
income and gain for that year equal to that partner’s
share of the net decrease in partnership minimum
gain.
62
Recourse Conversion Exception to General Minimum
Gain Chargeback Rule – Reg. §1.704-2(f)(2)
 A partner is not subject to the minimum gain charge-

back requirement to the extent the partner’s share
of the net decrease in partnership minimum gain is
caused by a recharacterization of non-recourse
partnership debt as partially or wholly recourse debt
or partner non-recourse debt, and the partner bears
the economic risk of loss (within the meaning of Reg.
§1.752-2) for the liability.
63
Capital Contribution Exception to Minimum Gain
Chargeback General Rule – Reg. §1.704-2(f)(3)
 A partner is not subject to the minimum gain

chargeback requirement, to the extent the partner
contributes capital to the partnership that is used to
repay the non-recourse liability or is used to increase
the basis of the property subject to the nonrecourse
liability; and the partner’s share of the net decrease
in partnership minimum gain results from the
repayment or the increase to the property’s basis.
64
Items To Use For Chargeback:
Reg. § 1.704-2(f)(6)
 Any minimum gain charge-back required for a

partnership taxable year consists first of certain gains
recognized from the disposition of partnership
property subject to one or more partnership non-
recourse liabilities; and then, if necessary, consists of
a pro rata portion of the partnership’s other items of
income and gain for that year. If the amount of the
minimum gain charge-back requirement exceeds the
partnership's income and gains for the taxable year,
then the excess carries over.
65
David L. Forst, Fenwick and West
TWO APPROACHES TO CAPITAL

ACCOUNT MAINTENANCE
Two Approaches
 The partnership agreement contains detailed

allocations of book profits and losses, and these
allocations determine distributions
 The “wizard” decides:

• Generally partnership agreement contains a provision
stating that at the end of the taxable year allocations
are made so that , each partner’s capital account is
equal to:
– The amount that would be distributed to that
partner in liquidation if all partnership assets were
sold at their §704(b) book value, less
– The partner’s share of minimum gain.
68
Typical detail of allocations
 Profit allocations
• Reverse prior losses
• Preferred return
• Residual sharing ratio (with threshold amounts for
profits interests)
 Loss allocations
• Reverse prior profits (in reverse order)
• Residual sharing ratio
69
Effect of this Approach
 Allocations drive distributions
 Judgment exercised upfront
 Role of return preparer is to read carefully.
70
Steps the Wizard must take
 Determine amounts each partner would get on

hypothetical year-end liquidation
 Take into account interim distributions
 Make appropriate annual allocations and adjustments

to capital accounts.
71
Effect of Wizard Approach
 Economic deal reflected in distributions.
 Generally preferred by non-tax principals
 The wizard must make annual hypothetical

distribution determinations
 Substantial economic effect safe harbor compliance

depends on wizard.
72

704 B IRS Partnership Allocations

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704 B IRS Partnership Allocations

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What are the two approaches to capital account maintenance discussed in the document?

What are the two approaches to capital account maintenance discussed in the document?

What are the typical details included in allocations of profits and losses under the first approach?

What are the typical details included in allocations of profits and losses under the first approach?

IRC Sect.

704(b): Partnership Allocations

WEDNESDAY, OCTOBER 8, 2014, 1:00-2:50 pm Eastern

For Assistance During the Program:

David Forst Amanda Wilson

Review of Partnership Allocation Rules Slide 7 – Slide 50

Partnership Non-Recourse Debt Allocations Slide 51 – Slide 66

Two Approaches to Capital Account Maintenance Slide 67 – Slide 72

To comply with Treasury Department regulations, we inform you that,

Allocations – Section 704(a)

One of the key benefits of a partnership is the flexibility in allocating

Section 704(a) provides that a partner’s distributive share of

Allocations – Section 704(b)

Section 704(b) requires a partner’s distributive share of partnership

(1) Partnership agreement does not provide for distributive share

(1) Partnership agreement allocations do not have substantial

Thus, allocations of a partner’s distributive share of partnership income,

(1) are either in accordance with the partners’ interests in the

(2) if they have substantial economic effect.

Partners’ Interest in the Partnership

• The partners' relative contributions to the partnership,

• The interests of the partners in economic profits and losses (if

• The interests of the partners in cash flow and other non-liquidating

• The rights of the partners to distributions of capital upon liquidation.

Partners’ Interest in the Partnership

Allocations are generally in accordance with the partners’ interests in

For example, if A and B each contributed $100, allocations would be in

Liquidating distributions can be made in accordance with the partners’

Substantial Economic Effect

Special allocations will be respected if they have substantial economic

Two part analysis. Allocations must

(1) Have economic effect; and

(2) The economic effect must be substantial.

General principle: If there is an economic benefit or burden that

More simply, if a partner gets the benefit of an allocation of $100 of tax

This is accomplished by maintaining capital accounts and liquidating

Basic Test for Economic Effect

(1) Capital account requirement

(2) Liquidation requirement

(3) Deficit make up requirement

Capital Account Requirement

To have economic effect, the partnership must maintain its capital

Generally, this is accomplished with a provision in the partnership

Capital Account Maintenance Rules

A partner’s capital account equals

• Plus allocable share of partnership income

• Less FMV of distributions

• Less allocable share of partnership loss

Partnership liabilities generally are not taken into account in calculating

For economic effect, liquidating distributions to the partners must be

Deficit Make Up Requirement

If a partner has a deficit in his capital account upon liquidation of the

A DRO may come from a partner contributing a promissory note to the

A partner can have a limited DRO.