What is economic effect in relation to substantial economic effect? In previous articles I have discussed substantial economic effect in general and the background or history. The regulations under IRC 704(b) test a partnership allocation to determine if it has substantial economic effect, and such is a two-part test. First the allocation must have economic effect, which is more of a mechanical or objective analysis. Second, the economic effect must be substantial. This second part of the test is quite subjective. Whether or not an allocation has substantial economic effect is made at the time the allocations became a part of the partnership agreement, but when analyzing a specific transaction, the analysis occurs at the end of the partnership’s taxable year to which the allocation was made or relates too. It is interesting to note that the IRS will not issue a determination letter in regards to an allocation of a partner’s income, loss, gain or deduction under the partnership agreement having (or not having) substantial economic effect, or that such allocation is in accordance with the partner’s interest. Furthermore, it is important (and interesting to note) that even if an allocation has substantial economic effect under IRC Section 704(b), this determination is not conclusive to the final tax treatment of the item. An item can be re-characterized under a doctrine such as the form over substance doctrine or the assignment of income doctrine.
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.