How Revenue Ruling 99-43 Affects Partnership Allocations

Partnerships offer a flexible business structure where financial outcomes are passed through to the individual partners. This means the partners, not the partnership itself, report and pay taxes on profits and claim losses or deductions on their personal tax returns. The partnership agreement dictates how these items are divided among the partners, allowing for arrangements that differ from their ownership percentages.

This ability to allocate tax items is not without limits. The Internal Revenue Service (IRS) has rules to ensure that allocations reflect the actual economic arrangement between partners, not just a method for tax avoidance. If an allocation is inconsistent with the partnership’s underlying economics, the IRS can disregard the agreement and reallocate the items to align with the actual deal.

The Substantial Economic Effect Standard

The primary test for a partnership’s allocation of tax items is the “substantial economic effect” standard, outlined in Internal Revenue Code Section 704(b). For an allocation to be respected by the IRS, it must have “economic effect,” and that effect must be “substantial.” If an allocation fails this test, the tax items will be reallocated according to each partner’s actual interest in the partnership.

For an allocation to have economic effect, it must be consistent with the partners’ underlying economic arrangement. The regulations provide three requirements that must be documented in the partnership agreement. The first is that the partnership must maintain capital accounts for each partner, which track each partner’s economic investment, including contributions, distributions, and their share of profits and losses.

The second requirement is that upon liquidation, all distributions must be made according to the partners’ positive capital account balances. This links the allocations recorded in the capital accounts to the final cash distributions when the business dissolves. A partner allocated more income, resulting in a higher capital account, will receive more money upon liquidation.

The final requirement for economic effect is that any partner with a deficit capital account at liquidation must be unconditionally obligated to restore it. This is known as a Deficit Restoration Obligation (DRO), which ensures that partners allocated losses exceeding their investment must make the partnership whole.

The second part of the test is “substantiality.” An economic effect is substantial if there is a reasonable possibility the allocation will affect the dollar amounts the partners receive, independent of tax consequences. The effect is not substantial if it improves the after-tax economic position of one partner while there is a strong likelihood that no partner’s after-tax position will be worse off. This rule prevents allocations that reduce the partners’ combined tax liability without altering their economic positions.

Charitable Contribution Allocations Under Scrutiny

Revenue Ruling 99-43 provides a clear example of this standard in practice. The ruling involves two partners, A and B, who initially agreed to share all partnership items equally. After the partnership donated property to charity, generating a deduction, they amended their agreement to allocate the entire deduction to Partner A. They also allocated an equal amount of taxable gain to Partner A and an equal amount of tax-exempt income to Partner B.

This arrangement was designed to give the tax deduction to Partner A while allocating tax-exempt income to Partner B, minimizing their overall tax burden.

The IRS concluded this special allocation lacked substantiality. The net adjustments to their capital accounts were identical to what they would have been under their original 50/50 agreement. Because the partners’ economic positions did not change, the allocation was considered a “shifting allocation.”

The allocation failed the substantiality test because the partners’ economic positions did not change, but their total tax liability decreased. The special allocation of the deduction to Partner A did not impact the dollar amount A would ultimately receive from the partnership. Since the capital account adjustments were the same as they would have been without the special allocation, the only impact was a tax reduction.

Reallocation Based on Partner Interests

When a partnership allocation is found to lack substantial economic effect, the IRS reallocates the income, gain, loss, or deduction according to the “Partner’s Interest in the Partnership” (PIP). This standard is the default rule for allocations that are not provided for in the partnership agreement or that fail the validation test. The PIP standard aims to reflect the true economic arrangement between the partners.

Determining a partner’s interest in the partnership is a facts-and-circumstances analysis with no single formula. The regulations provide factors to gain a view of the partners’ economic relationship and their agreed-upon sharing of benefits and burdens. The analysis compares how the partners agreed to share the economic consequences of the tax item in question.

The factors the IRS examines include the partners’ relative capital contributions and their interests in economic profits and losses, which may differ from their shares of taxable income. Another factor is the partners’ interests in cash flow and other non-liquidating distributions. The analysis also considers the partners’ rights to capital distributions upon the partnership’s liquidation.

In the scenario from Revenue Ruling 99-43, the charitable contribution deduction would be reallocated. The IRS would analyze the partners’ contributions, rights to distributions, and overall share in the partnership’s economics. Based on the original 50/50 arrangement, the deduction would be reallocated equally between the two partners, aligning the tax consequence with their actual partnership interests.