Allocation of income without substantial economic effect - what's going on here?

Regulations over the last five or six years have seriously eroded the ability of partners and partnership to allocate income and loss as they see fit.

In recent years, the substantial economic effect test of Sec. 704(b) has emerged, requiring that loss allocations actually affect the dollars that a partner will ultimately be entitled to.

The corollary to Sec. 704(b) is Sec. 752, which assures that a partner will be considered to share in liabilities, based on his ultimate liability to pay them, in an amount sufficient to give him basis to support the losses allocated to him under Sec. 704(b).

The entire Sec. 704/Sec. 752 area is based on the premise of risk (take the tax loss allocation, suffer the cash loss) and reward (suffer the income allocation, take the cash).

One of the mechanisms to assure compliance with the risk side of the equation is a deficit restoration provision. This requires partners with deficit capital accounts when the partnership is liquidated to make contributions to these deficit amounts for payment to creditors and to other partners with positive capital account balances.

An alternative test for substantial economic effect, called a qualified income offset, provides for a limited deficit restoration obligation but generally does not require contributions to satisfy other partners' positive capital accounts.

Many, if not most, partnerships do not contain unconditional deficit restoration provisions. What happens when a partner's limited deficit restorations provision is reduced? For example, what happens when the partnership's liabilities in which he shares, and for which he would be liable, are reduced?

Rev. Rul. 92-97 involved a situation in which A and B contributed $10 and $90, respectively, to a general partnership. Losses were to be allocated 10% to A and 90% to B. Income was to be allocated 50% to each.

The partnership agreement contained no unconditional deficit restoration provision; therefore, the general partners were obligated to restore capital accounts only to the extent necessary to pay creditors.

The partnership borrowed $900 and bought property for $1,000. The partnership, after six years, has break-even operations and fully depreciates the property.

Losses from the depreciation were allocated $100 to A and $900 to B. The equipment became worthless and the lender forgave the debt. Immediately prior to the cancellation of the debt, A's capital account was $(90) and B's was $(810).

The allocation of loss (risk) was based on the partner's limited deficit restoration obligation, i.e., each was liable to contribute proportionally to the partnership to satisfy the debt.

However, if the allocation of income in the partnership agreement were followed, and A and B were allocated $450 each in income when the debt was canceled, A's capital account would then be increased by $450 to $360. But because B would not be required to restore his $(360) negative capital account, A could not reap the reward, i.e., take the cash.

Accordingly, the 50/50 allocation of income lacked substantial economic effect and the cancellation of indebtedness income had to be allocated $90 to A and $810 to B, which brought each capital account to zero.

Observation: If the partnership agreement had contained a full deficit restoration provision, the 50/50 income allocation would have had substantial economic effect because B would have been required to contribute $360 to the partnership for payment to A.

Observation: While the ruling concerns itself only with a "disappearing deficit restoration obligation" occurring as a result of cancellation of recourse debt, the same theory can be applied to a reduction in minimum gain brought about by cancellation nonrecourse debt.

Caveat: The theory could also be applied to repayment of debt out of normal operations.