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Partnership Allocation

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Partnership Allocation

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  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 Book Tax 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 Book Tax 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)