How to Structure a Partnership Special Allocation

A partnership’s flexibility extends to how profits and losses are divided. A special allocation is a provision in a partnership agreement that distributes a specific item of income, gain, loss, or deduction to partners in proportions that differ from their ownership interests. For example, two partners with 50/50 ownership might agree to allocate 80% of a depreciation deduction to one partner. This allows partners to reflect their unique contributions, such as when one partner provides significant cash while another brings valuable expertise. These arrangements allow the tax consequences of a transaction to follow the actual economic deal struck between the business’s owners.

The Foundation of Special Allocations

The motivation for special allocations is to align tax consequences with the economic realities of the partnership. Partners negotiate these arrangements to reflect who bears the financial risk or who will reap the economic reward of specific activities, provided they have a genuine business purpose.

For instance, consider a real estate partnership where one partner contributes the majority of the cash for a down payment. To compensate for this greater financial risk, the agreement might specially allocate the depreciation deductions from the building to the cash-contributing partner.

Another scenario involves debt. If a partnership takes out a loan and one partner personally guarantees it, that individual bears the entire economic risk of loss if the partnership defaults. The agreement can specially allocate the deductions associated with that debt to the guaranteeing partner, ensuring the tax benefit goes to the person shouldering the potential financial burden.

The Economic Effect Safe Harbor

For a special allocation to be respected by the IRS, it must have “substantial economic effect,” a two-part test detailed in Treasury Regulation § 1.704-1. The first part, “economic effect,” is met if the allocation is consistent with the partners’ underlying economic arrangement. The regulations provide a three-part safe harbor test to prove economic effect.

First, the partnership must maintain proper capital accounts for each partner. A partner’s capital account tracks their equity, starting with the cash and fair market value of contributed property, and is adjusted for subsequent contributions, income, losses, and distributions.

Second, the partnership agreement must state that upon liquidation, all asset distributions will be made according to the partners’ final positive capital account balances. This rule ensures that a partner allocated income will receive more cash, while a partner allocated losses will receive less, cementing the allocation’s reality.

The final requirement is that any partner with a negative capital account at liquidation must be obligated to restore that deficit, known as a Deficit Restoration Obligation (DRO). A DRO proves that a partner truly bore the economic burden of any losses allocated to them.

Because many partners are unwilling to agree to an unlimited DRO, an alternative known as a Qualified Income Offset (QIO) is permitted. If an agreement already requires proper capital account maintenance and liquidation, a QIO provision can be used. A QIO states that if a partner’s capital account unexpectedly becomes negative, such as from a surprise distribution, they will be allocated future income to eliminate that deficit as quickly as possible.

The Substantiality Test

Meeting the economic effect test is only the first half of the analysis; the allocation’s economic effect must also be “substantial.” This second prong of the test prevents partners from using allocations that are designed to reduce taxes without a meaningful impact on their pre-tax financial positions. An allocation is substantial if there is a reasonable possibility that it will affect the dollar amounts the partners receive from the partnership, independent of tax considerations.

The regulations identify two primary situations where an allocation will fail this test: shifting and transitory allocations. A shifting allocation occurs when partners amend their allocation for a single tax year to reduce their total tax liability. For example, if a partnership has $100,000 of tax-exempt interest and $100,000 of taxable rental income, specially allocating the tax-exempt income to a high-bracket partner and the rental income to a tax-exempt partner would likely fail.

A transitory allocation involves multiple years where an initial allocation is likely to be offset by a corresponding allocation in the future. For instance, allocating large depreciation deductions to a partner in year one, only to allocate the gain from the asset’s sale to that same partner later, would be considered transitory. The partner receives a significant tax deferral benefit, which is often the sole purpose of such a structure.

Consequences of a Failed Allocation

When a special allocation fails the substantial economic effect test, the IRS will disregard it. The flawed allocation is disregarded, and the item is then reallocated according to each “Partner’s Interest in the Partnership” (PIP). This reallocation is not arbitrary; it must be done in accordance with the true economic arrangement. The PIP standard is a facts-and-circumstances test that determines this arrangement by examining their genuine interest in the business’s profits and losses.

Key factors considered in determining a partner’s interest in the partnership include:

• The partners’ relative capital contributions to the partnership.
• Their interests in the overall economic profits and losses.
• Their interests in the partnership’s cash flow and other non-liquidating distributions.
• Their rights to receive distributions of capital upon liquidation.

By weighing these factors, the IRS determines the proper allocation that aligns with the partners’ underlying economic deal.

Required Allocations for Property and Debt

While many special allocations are elective, some are mandatory under the tax code to prevent the shifting of tax consequences. One required allocation falls under Internal Revenue Code Section 704. This rule applies when a partner contributes property that has a fair market value different from its adjusted tax basis. This difference is called “built-in gain” or “built-in loss.” The code mandates that when the partnership sells that property, the built-in gain or loss must be allocated to the partner who contributed it, preventing them from shifting a pre-contribution tax liability to others.

Another area with specific rules involves nonrecourse deductions, which are governed by Treasury Regulation § 1.704-2. Nonrecourse debt is a loan for which no partner is personally liable. Deductions attributable to this debt cannot have economic effect because no partner bears the economic risk of loss. The regulations provide a separate safe harbor, and these allocations will be respected if they are made in a manner reasonably consistent with allocations of another partnership item that does have substantial economic effect.