Problem Area 7Partner’s Distributive Shares • Sec 704(a) - distributive share shall be determined by reference to the partnership agreement. • Sec. 704(b) - if agreement fails to provide for a partner’s distributive share or the allocation lacks substantial economic effect, allocations will be pursuant to partners interest and facts and circumstances • Basic thrust - ensure that distributive share of tax consequences conforms to the partner’s share of economic consequences.
Substantial Economic Effect • Designed to prevent the use of special allocations for tax avoidance purposes while allowing use for bona fide business purpose. • Two part test: tax allocation has economic effect and must be substantial - focus is on the partner’s capital account, liquidation rights, deficit payback provisions
Test for Economic Effect • Basic test • capital accounts are created and maintained in accordance with regs 1.704-1(b)(2)(iv) • liquidating distributions are made in accordance with partner’s positive capital account balances • Deficit accounts must be restored. • Alternate test - qualified income offset. • allows allocations as long asa capital deficit is not created or deficit does not exceed restoration obligation. Same tests as above used.
Substantiality • Test is basically subjective • General rule - • substantial - economic effects must affect the partner’ dollar distributions from the partnership and may not benefit the after tax results of some partners unless it also hurts the after tax results of another partner. The government may not be the only loser. • Cannot do tax motivated allocations. • Common: Shifting Allocations and Transitory allocations
Failure of Economic Effect and Substantiality • If either test fails - the allocation will be re-allocated according to partners’ interest in the partnership. • Focus of facts and circumstances is on partners’ shares of contributions, rights to cash flow, liquidation rights, and economic profit and loss allocations.
Sec 704(c) allocations • These cannot have economic effect – Why? What are they? • Allocate pre-contribution gain/loss to the partners. • Sec 704(c) permits a curative allocation or remedial allocation to offset tax system’s denial of the economic set of circumstances • What are the curative/remedial allocations designed to achieve?
Transactions Between Partner & Partnership – Sec. 707 • Sale of Property to Partnership • At a Gain (Sec. 707(b)(2)) • Partner: Actual or by related attribution: if sells property at a gain that will NOT be a capital asset in the partnerships hands – gain will be ordinary income. • Related parties: parties that own directly or indirectly > 50% of the partnership’s profits or capital interests. Indirect ownership factor in Brothers / Sisters / Spouses / Ancestors / Lineal Descendants / Common ownership in entites • See Sec. 707(b)(3) and Sec. 267 (c)
Transactions Between Partner & Partnership – Sec. 707 • Sale of Property to Partnership • At a Loss (Sec. 707(b)(1)) • Partner: Actual or by related attribution: if sells property at a loss, no deduction allowed if between related parties. • Sec. 267 (d) applies to subsequent sales. • Related parties: parties that own directly or indirectly > 50% of the partnership’s profits or capital interests. Indirect ownership factor in Brothers / Sisters / Spouses / Ancestors / Lineal Descendants / Common ownership in entites • See Sec. 707(b)(3) and Sec. 267 (c)
Disguised Sale RulesSec 707 (a) (2) (B). • Designed to prevent usage of non-recognition under Sec 731 to defer gain on transactions • Sec 707 (a) (2) (B) in general • Money/Property are contributed to a partnership by a partner • There is a related direct or indirect transfer of/property by the partnership to such partner or another partner, and • The transfers when viewed together are more appropriately viewed as a sale or exchange - 707 (a) treatment results
Payments to Partners • Sec 707 (a) treated as though with an unrelated party • Sec 707 (C) guaranteed payments • Sec 704 (a) and Sec 731 – Payments out of operations • See chart on pg. 137 • SE Tax Issues?
Sec 704 (c) (1) (B) • Triggering of B-I-G on distribution of property by partnership to a non-contributing partner within 7 years. • Contributing partner recognizes appropriate character of gain/loss in amount equal to the g/l that would have been allocated to that partner if the property had been sold at FMV at time of distribution. • G/L recognition will cause basis adjustments • Special rule for like-kind exchanges – G/L may be deferred if appropriate like-kind exchange rules do apply.
Recognition of Pre-Contribution Gain – Sec. 737 • Involves distribution of property to a partner with B-I-G. Gain recognition: lesser of • excess of FMV of property (other than money) received over adj. basis of partner’s interest before the distribution reduced by any cash received in distribution, or • The net pre-contribution gain • Pre contribution gain defined in Sec. 737 (b). • Partner basis is adjusted for gain recognition as is partnership basis in property – Sec. 737 (c)