Background on Substantial Economic Effect and IRC Section 704(b)

Under Internal Revenue Code Section 704, a partnership agreement is to determine a partner’s distributive share of the allocated tax items, such as income, loss, gain and credits.  This flexibility is, in part, what can make a partnership an attractive choice of entity for many small businesses or business owners.  However, it is also this flexibility that has been used, and can create unjustified tax consequences by shifting a tax benefit or burden associated with a partnership item or asset to a partner other than the partner who receives an economic benefit or holds the economic burden that would be associated with the asset or activity.  For example, the tax attributes relating to an asset or activity could be allocated to one partner and the non-tax attributes, or an economic attribute could be allocated to another partner.


In 1976 the Internal Revenue Code was amended and out came Substantial Economic Effect, or at least, Substantial Economic Effect became more well defined and applicable.  Prior to the 1976 amendments, the IRS had relatively ambiguous statutory provisions to “attack” certain partnership allocations that may have appeared abusive, or that were actually abusive and probably not the intent of Congress.  Through the 1976 amendments, Congress amended the Internal Revenue Code to provide a more clear (and maybe more of an objective standard if you will) for what would be considered acceptable partnership allocation.  Internal Revenue Code Section 704(b), as amended holds that if a partnership allocation of an item of income, gain, loss, deduction or credit is not addressed in the partnership agreement, or if the allocation established within the agreement does not have “substantial economic effect” then the allocation to the partner or partners will be determined by partnership interest.


The pre-1976 code held that in the absence of an agreement to the contrary, an item of income, gain, loss, deduction or credit would be allocated between partners in accordance with the partner’s distributive share of taxable income or loss of the partnership as stated in IRC Section 702(a)(9).  IRC Section 702(a)(9) defined partnership income or loss exclusive of the items reported on a separate basis (separately stated items) under paragraphs 1 through 8 of IRC Section 702(a).  The 1976 act renumbered separately stated items as paragraphs 1 through 7 under IRC Section 702(a), and IRC 702(a)(9) became IRC 702(a)(8).  Subparagraphs, 1 through 7 are considered separately stated items and (a)(8) is referred to as circumstances requiring bottom line taxable income, bottom line taxable loss or bottom line tax income or loss.  The pre 1976 code, under section 704(b)(2) also provided that an item would be allocated in the same manner as bottom line taxable income if the principal purpose of the provision within the partnership agreement was to avoid or evade federal income tax, even if the partnership agreement required the specific allocation.  One issue or problem with this language is that it does not appear to allow or give the IRS the ability to reallocate the disallowed allocation.  Section 704(b)(2) pre 1976 actually required the reallocation of any separately stated item be in accordance with distributive shares of bottom line taxable income or loss.  The prior Section 704 Treasury Regulations held for a six factor test to determine if a specific allocation was for tax avoidance.  Under these regulations, the presence, or maybe more importantly, the absence of substantial economic effect was the single most important factor of the six, which also became apparent under numerous court case.  These former Section 704 regulations would find substantial economic effect where the allocation could “actually affect the dollar amount of the partners’ shares of the total partnership income or loss independently of tax consequences.”


In 1976, Congress would amend IRC Section 704 and clarify that an allocation of bottom line taxable income or loss is subject to disallowance in the same manner as any separately stated item.  Section 704(b) as amended reads:


“A partner’s distributive share of income, gain, loss deduction, or credit (or item thereof) shall be determined in accordance with the partners’ interest in the partnership (determined by taking into account all facts and circumstances), if: (1) the partnership agreement does not provide as to the partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof), or (2) the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does  not have substantial economic effect.”


Thus, under the amended 704, the first point of reference is to the partnership agreement and absent an allocation provision with the partnership agreement, or if the allocation does not past the muster of substantial economic effect, a reallocation is made by referencing the partner’s interest in the partnership.  Click for an outline of 704.

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