In short, economic effect as a whole is an attempt to make the partner receiving the economic benefit of an allocation, bear the economic risk.  Stated otherwise, an allocation to a partner for tax purposes, should have an equal impact on the amount of property or cash the partner would (or should) be entitled to if the partnership liquidated.  The general rule in regards to economic effect, is that an allocation has economic effect only if during the life of the partnership, the partnership agreement provides for: one, the determination and maintenance of a partner’s capital account in accordance with a maintenance requirement; two, liquidating distributions are made in accordance with partner’s capital account balance (positive capital account balance) even when taking into account adjustments for the current year; and, three, that a partner with a negative capital account balance is absolutely required (mandated) to restore their capital account by contributing cash or property to the partnership.  This third requirement is also known as a deficit restoration obligation.

The above are the general requirements for a partnership allocation to have economic effect in the eyes of the Internal Revenue Service.  If you have questions regarding your partnership agreement or the allocation of partnership items, you can speak with a Denver tax attorney and business attorney at The McGuire Law Firm.

If your partnership agreement requires the special allocation of partnership items, it is recommended that you have a tax attorney review the agreement in regards to these allocations having substantial economic effect and that you are aware of the consequences if the IRS were to re-characterize the allocations.

 Call 720-833-7705 or John@jmtaxlaw.com

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.

Section 7701(o) of the Internal Revenue Code provides that transactions after March 30, 2010, a transaction will be treated as having economic substance only if: 1) the transaction changes in a meaningful way, aside from federal income tax effects, the taxpayer’s economic position; and, 2) the taxpayer has a substantial purpose, other than federal income tax savings to enter into the specific transaction.  The first part of the test is reviewed objectively and the second part of the test is reviewed subjectively.

The Internal Revenue Service has released a LB&I Directive, 4-0711-015 to be used by IRS examiners in determining whether the economic substance doctrine should apply to a transaction.

The directive provides the following factors and elements of which could cause the doctrine to likely apply:

1)            Transaction is promoted/developed/administered by tax department or outside advisors

2)            Transaction is highly structured

3)            Transaction includes unnecessary steps

4)            Transaction is not at arm’s length with unrelated third parties

5)            Transaction creates no meaningful economic change on a present value basis (pre-tax)

6)            Taxpayer’s potential for gain or loss is artificially limited

7)            Transaction accelerates a loss or duplicates a deduction

8)            Transaction generates a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset)

9)            Taxpayer holds offsetting positions that largely reduce or eliminate the economic risk of the transaction

10)        Transaction involves a tax-indifferent counterparty that recognizes substantial income

11)        Transaction results in separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years

12)        Transaction has no credible business purpose apart from federal tax benefits

13)        Transaction has no meaningful potential for profit apart from tax benefits

14)        Transaction has no significant risk of loss

15)        Tax benefit is artificially generated by the transaction

16)        Transaction is pre-packaged

17)        Transaction is outside the taxpayer’s ordinary business operations.

If the Economic Substance Doctrine applies to a transaction, certain tax allocations and/or benefits received by the taxpayer could be changed and/or reallocated by the Internal Revenue Service.  In short, the Internal Revenue Service can change the tax implications of  certain transactions because the transaction lacked economic substance.

As a Denver tax lawyer and business lawyer John McGuire is experienced in this relatively new doctrine that can have a large affect and impact on certain transactions you or your business may be considering into.  You can contact The McGuire Law Firm at anytime to schedule a free consultation and we would happy to meet with you.

Schedule your free consultation with a Denver tax attorney and business attorney- Contact The McGuire Law Firm!