Calculating limited deficit restoration obligation when a partner is liable to partnership creditors.

An allocation of income, gain, loss, deduction or credit by a partnership to its partners is respected as having substantial economic effect if either the general or alternative test of Regs. Sec. 1.704-1(b)(2) is met. The general test requires that (1) capital accounts be maintained in accordance with Regs. Sec. 1.704-1(b)(2)(iv); (2) liquidating distributions be made in accordance with the partners' positive capital account balances; and (3) partners be unconditionally obligated to restore negative capital account balances on liquidation. The alternative test keeps the first two requirements of the general test, but allows a qualified income offset to satisfy the third requirement for partners who do not have an unconditional obligation to restore negative capital account balances. A qualified income offset is a provision that requires loss allocations to be reallocated to other partners, to the extent that they cause or increase a deficit balance in a partner's capital account in excess of any portion of the deficit the partner is required to restore.

In the case of the alternative test, whether the allocation is respected depends on a determination of any negative capital account balance a partner is required to restore. Under Regs. Sec. 1.704-1(b)(2)(ii)(c), a partner's unconditional obligation to make a contribution to the partnership, whether imposed by the partnership agreement or by state or local law, will be treated as an obligation to restore the deficit capital account balance.

Rev. Rul. 97-38

Rev. Rul. 97-38 addresses the situation in which a general partner is required to make contributions to the partnership in the amount necessary to pay partnership creditors. Prior to this ruling, it was unclear what amount (if any) would be treated as an obligation to restore the partner's negative capital account. Therefore, it was not clear if certain allocations to partners had substantial economic effect.

To illustrate the confusion that previously existed, consider this situation. AB is a partnership in which A is a general partner with the obligation to contribute money to the partnership in an amount needed to pay creditors and B is a limited partner with no obligation to make additional contributions. A and B agree that no allocation will be made that causes or increases a deficit balance in any partner's capital account in excess of that partner's obligation to restore the deficit. A and B each contribute $500 to AB, which borrows' $9,000 (recourse debt) and purchases depreciable property for $10,000. The partnership agreement requires profits and losses to be shared equally, except for the depreciation deduction (which will be allocated 100% to A). At the end of the first year, the value of the property has increased to $15,000 and depreciation for the year is $2,000. Assuming income is equal to all other deductions, A is allocated a $2,000 deduction (bringing her capital account to a deficit balance of $1,500).

To determine if this allocation causes a deficit balance in excess of the partner's obligation to restore the deficit, the extent of A's unconditional obligation to make a contribution to the partnership must be determined. If all assets become worthless (similar to the regulations for allocation of liabilities under Sec. 752), A would be obligated to contribute $9,000; the deficit balance would not exceed this obligation and the allocation would hive economic effect. However, if the asset could be sold at its book value of $8,000, A would only be obligated to contribute $1,000 (the balance of the $9,000 loan less the book value of the asset). This would mean that only $1,500 of the depreciation allocation would have substantial economic effect and the remaining $500 would be reallocated to B under the provisions of the qualified income offset.

The Service eliminated this confusion by concluding that, when a partner has a limited restoration obligation by reason of his liability to the partnership's creditors, the amount of the obligation is the amount that the partner would be required to contribute to the partnership to satisfy partnership liabilities if all property were sold for the amount of the partnership's book basis in the property. This position appears to be consistent with value assumptions under Sec. 704(b), as well as a reasonable alternative to valuing partnership assets each year.