Editor: Anthony S. Bakale, CPA
Sec. 704(b) and the regulations thereunder continue to confuse even the most seasoned tax practitioners. Targeted allocations and preferred "waterfall" liquidating distributions are largely becoming the norm. Practitioners must take great care to understand the complexities of partnership taxation and to ensure the partnership agreement language has substantial economic effect or otherwise reflects the partners' interests in the partnership under the Sec. 704(b) regulations. As this discussion touches on later, if a partnership's allocations are not respected, the IRS or the courts can reallocate items of income or loss and assess underpayment or accuracy-related penalties.
Safe-harbor allocations and substantial economic effect
The requirement that a partnership allocation have substantial economic effect under Regs. Sec. 1.704-1(b)(2) has been written about extensively, so only a brief overview is necessary. For an allocation to have substantial economic effect, the allocation must have economic effect as described in Regs. Sec. 1.704-1(b)(2)(ii), and it must be substantial as described in Regs. Sec. 1.704-1(b)(2)(iii).
Economic effect is satisfied based on a three-part test: (1) the partnership must maintain capital accounts in accordance with Regs. Sec. 1.704(b)(2)(iv); (2) liquidating distributions must be from positive Sec. 704(b) capital accounts; and (3) the partnership must contain a deficit restoration obligation (DRO). As a DRO requires a partner with a negative Sec. 704(b) capital account to contribute more cash to the partnership upon liquidation, a newly formed partnership with a DRO is exceedingly uncommon. Fortunately, Regs. Sec. 1.704-1(b)(2)(ii)(d) allows an allocation to have economic effect without a DRO, provided the partnership agreement contains a qualified income offset (QIO). A QIO allows partners to receive certain allocations that cause their Sec. 704(b) capital account to "unexpectedly" go negative, so long as they are obligated to be allocated income in the future to restore their Sec. 704(b) capital account at least to zero "as quickly as possible."
The second part of the two-part test for substantial economic performance is substantiality. For an allocation to be substantial, there must be "a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences" (Regs. Sec. 1.704-1(b)(2)(iii)(a)). This section largely prevents a partnership from manipulating timing differences with respect to deductions or manipulating tax rates by allocations of class of income, such as all capital gain to a partner with large unused capital losses, among others. Example (7)(ii) in Regs. Sec. 1.704-1 discusses how an allocation can have economic effect but lack substantiality.
Allocations lacking substantial economic effect
Sec. 704(b) provides that if the partnership agreement does not provide the partner's share of income, or if the allocations provided lack substantial economic effect, then "[a] partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with the partner's interest in the partnership." A partner's interest in the partnership is defined in Regs. Sec. 1.704-1(b)(3)(i) as "the manner in which the partners have agreed to share the economic benefit or burden." This determination is based on the facts and circumstances.
In ascertaining a partner's interest in the partnership, Regs. Sec. 1.704-1(b)(3)(ii) lists four factors that are considered: (1) contributions made to the partnership; (2) the interest in economic profits and losses; (3) the interest in cash flow and nonliquidating distributions; and (4) the interest in liquidating distributions. The regulation mentions that the four factors are "among those that will be considered," implying that other factors will be weighed if relevant. This is where the IRS or the courts can recast allocations and provide new allocations based on the partner's interest in the partnership.
In Holdner, T.C. Memo. 2010-175, the Tax Court found that deduction allocations between a father and son farming partnership were not in line with the partners' interests in the partnership. The court proceeded to analyze each of the four factors above and largely concluded that there was "no credible evidence" for the special allocations. "[I]n the absence of substantial proof rebutting the presumption of equality, [taxpayers] had equal interests in partnership income, expenses, and other partnership items." The court presumed that the father and son each owned 50% of the farming partnership, and the taxpayers did not provide sufficient evidence to refute that presumption. As it was determined that the father and son each had a 50% interest in the partnership, the IRS's assessment of substantial-underpayment and accuracy-related penalties was upheld.
In a similar case, a partnership specially allocated 88% of its income to an entity that was ultimately owned by an employee stock ownership plan and trust (ESOP). The other partners were beneficiaries of the ESOP (see Renkemeyer, Campbell & Weaver, LLP,136 T.C. 137 (2011)). The court in Renkemeyer discussed how "[a] partner's distributive share of income, gain, loss, deductions, or credits generally is determined by the governing partnership agreement." The partnership agreement was analyzed, and the agreement stated that the allocations were to be based upon the partners' ownership interests. This special allocation did not conform with the partnership agreement; therefore, the "partnership agreement does not support [the taxpayer's] claim that the special allocation of the net business income of the [partnership] . . . is proper."
Since the special allocation was not in accordance with the partnership agreement, the court applied the four-factor test to determine each partner's interest in the partnership to then determine the correct allocation of income. An interesting piece of evidence the court used to determine each partner's interest in cash flow and nonliquidating distributions was provided by the partnership on the tax return: The Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., listed the profit and loss share for the ESOP entity as 10%, but it received 88% of the income allocation. A large disparity between the profit percentage listed and the income allocated is not damning in and of itself, but it should be able to be explained with evidence to support the difference. Additionally, despite receiving 88% of the income allocation, the ESOP entity received no distributions, whereas the remaining partners did. For these and other reasons, the court agreed with the IRS's reallocation of income, which shifted significant taxable income away from the ESOP partner and to the other partners.
It is worth discussing that just because an allocation is not supported by the partnership agreement, or lacks substantial economic effect, does not mean the allocation is automatically discarded. The economic effect equivalence of Regs. Sec. 1.704-1(b)(2)(ii)(i) mentions that if an allocation does not have economic effect, it "shall nevertheless be deemed to have economic effect, provided that as of the end of each partnership taxable year a liquidation of the partnership . . . would produce the same economic results to the partners" as it would if the economic performance three-part test was met.
Similarly, if a partnership allocation is challenged by the IRS for lacking substantial economic effect, but upon further inquiry the allocations otherwise followed the economic interest of the partners, presumably the IRS or the courts would arrive at the same allocations, and the allocation would be respected. Neither of these scenarios is what occurred in the two cases discussed, and the courts agreed with the IRS's reallocation of income, based upon the four-factor test to determine the partner's interest in the partnership.
The comparative liquidation test
The comparative liquidation test in Regs. Sec. 1.704-1(b)(3)(iii) provides another way to determine the partners' interests in the partnership. If an allocation satisfies the first two parts of the economic performance test but otherwise lacks economic performance, each partner's interest in the partnership will be determined based on the distributions received "if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the taxable year to which the allocation relates" and comparing that amount to the same calculation made at the end of the prior tax year. In PNRC Limited Partnership,T.C. Memo. 1993-335, the comparative liquidation test is described in footnote 18 as "mandatory in the limited case where the sole reason a partnership fails the basic test for economic effect is because it lacks a [DRO]."
By comparing what each partner would receive in a hypothetical liquidation at the beginning and end of the tax year, it can be determined which partner bore the economic burden or benefit of the partnership items that lack economic effect, and these items will be allocated accordingly. The comparative liquidation test is easiest to understand when one partner has a Sec. 704(b) capital account that is at zero or negative (see Example (15)(ii) in Regs. Sec. 1.704-1). These allocations, even though they lack economic effect, must still be substantial under Regs. Sec. 1.704-1(b)(2)(iii).
Be prepared to back up special allocations
In Holdner, one of the taxpayers was a CPA. In Renkemeyer, the partnership in question was a law firm that specialized in federal tax law. Both of these cases resulted in the Tax Court's ultimately agreeing with the IRS's reallocations of income to the taxpayers' detriment. The complex rules of Sec. 704(b) and the related regulations continue to befuddle even the most seasoned tax professionals. Partnership agreements should be thoroughly vetted by an expert in partnership taxation to ensure allocations, particularly special allocations, will be respected by the IRS and the courts. Any partnership agreement that does not follow the safe-harbor substantial economic effect rules, or that ultimately does not allocate income based on the partner's interest in the partnership, should be immediately amended by a competent attorney who understands the complex language needed to comply with Sec. 704(b) and the related regulations. As special or targeted allocations can change drastically over time, a prudent tax preparer must make sure to frequently analyze the allocations for compliance or risk having their client's partnership allocations recast by the IRS.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Contributors are members of or associated with Cohen & Company Ltd.