By definition, partners share the profits and losses from a partnership. In many cases, partnerships will just split the profits and losses equally among the partners. If the partners are not equal, the distribution will be in proportion to their relative ownership shares. In some cases, the distribution may be different from the percentage ownership, especially when one partner has contributed more capital to the business. When the profits and losses are allocated to the partners in a different ratio from their percentage ownership or relative capital contribution, it is referred to as a special allocation.
Tax Shelters and IRC 704
Prior to the enactment of Internal Revenue Code section 704, some partnerships exploited special allocations to provide tax benefits to partners that were completely out of proportion with their investment in the partnership. These tax shelters would allocate huge losses to certain investing partners, who could use these losses to offset their tax liability on other income. To curb this abuse, the Internal Revenue Service now requires that a special allocation have a “substantial economic effect.” This means that it has to be done for a reason other than the avoidance of tax obligations.
The substantial economic effect test is one of three tests that a partnership can use to ensure that the IRS will respect the allocation of profits and losses. The other tests depend on the allocation being in accordance with either the partner’s stated interest in the partnership, i.e. what it says in the partnership agreement, or the partner's actual economic interest in the partnership, i.e. how much the partner contributed. In order to qualify for the substantial economic effect test, the partnership must accurately maintain its capital accounts, which are the records of each partner’s contributions and distributions, and each partner must have an unlimited obligation to restore a negative balance in his capital account.
Managing Special Allocations
Special allocations that do have an economic purpose will be respected by the IRS, and can be very useful for partnerships where one party contributes a majority of the capital and the other is contributing skills and effort. In this case, even if the partners agree to split ownership of the partnership 50/50, they may agree to allow the capital partner to receive 80 percent of the profits until his contribution is paid back, after which the profits would be distributed in accordance with the partner’s relative ownership.
Consequences of Improper Allocations
If the IRS determines that the partnership has not appropriately allocated its profits and losses, it has the authority to redetermine each partner’s share. If the partnership has made a special allocation and the IRS finds that there is no substantial economic effect, the actual allocations are not reversed, but the IRS will not recognize them. This means that the partners' tax burdens could shift dramatically, forcing them to pay tax on income they did not receive or lose deductions they thought they were getting.
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