1. Partnership Allocation

2. Partnership Agreement Flexibility Allocating profits/losses Amount & timing of distributions Compensation paid to partners Receipts upon liquidation

3. 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

4. Section 704(b) – In General General Rule: A partner’s 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 partner’s interest in the partnership taking into account all facts & circumstances

5. 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

6. 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

7. 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

8. 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 partner’s 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 partner’s interest, or (b) 90 days after the date of the liquidation

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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)

15. 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.

16. 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 partner’s capital account

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. Depreciation Recapture Depreciation recapture merely changes the tax character of an item – thus it cannot have substantial economic effect Partner’s share is equal to the lesser of: Partner’s share of total gain from disposition of property Total depreciation previously allocated to partner with respect to property

24. 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

25. 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.

26. 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 A’s recapture was limited to $600

27. Tax Credits Cannot have economic effect because not included in partners’ capital accounts Allocated in accordance with partners’ interests in the partnership

28. 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

29. Contributed Property Built-in gain = FMV > Partner’s adjusted basis at the time of contribution Built-in loss = FMV < Partner’s adjusted basis at the time of contribution

30. 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.

31. 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 – A’s basis: $12,000 + $4,000 = $16,000 B’s basis: $20,000 + $4,000 = $24,000

32. 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

33. 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”

34. 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

35. Sales & Exchanges – Traditional Method with Curative Allocations Curative allocation – an allocation made solely for tax purposes that differs from the partnership’s allocation of the corresponding book item To correct ceiling rule distortions No economic effect Not reflected in partners’ capital accounts

36. 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

37. 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

38. Traditional Method with Curative Allocations – Example A B Tax BookTax 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

39. Sales & Exchanges – Remedial Method Solely tax allocations with no effect on the partnership’s book capital accounts If the ceiling rule results in a book allocation to a noncontributing partner that differs from the partner’s 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

40. 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

41. 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

42. 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 A’s book depreciation) & B receives the remaining $400

43. Traditional Method Example After five years: The tax & capital accounts for A & B are brought back into balance A B Tax BookTax 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

44. 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

45. 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)

46. 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

47. 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

48. 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)

49. 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)

50. 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)

51. 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

52. Nonrecourse Liabilities General rule: Allocated among partners in accordance with their respective shares of partnership profits Complex reality – partner’s share of nonrecourse liabilities is the sum of The partner’s 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 partner’s share of any remaining nonrecourse liabilities determined in accordance with his share of partnership profits

53. 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)

54. 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.

55. 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

56. Partner’s 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

57. 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

58. Allocations of Nonrecourse Deductions Allowed Because… Even though the allocations of nonrecourse deductions that reduce a partner’s 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 partner’s capital account will be increased accordingly.

59. Nonrecourse Debt – Minimum Gain Chargeback Minimum gain chargeback – income and gain in an amount equal to the net decrease in the partner’s share of minimum gain for the taxable year Ex: property is foreclosed without the receipt of any cash – no longer a partnership minimum gain

60. 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

61. 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

62. 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 partner’s share is based on the number of days during which he was a partner during that year

63. 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