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Capital accounts and the alternate test for economic effect.

The most often overlooked and misunderstood limitation on the allocation of partnership losses is a limited partner's fair market value (FMV) (i.e., "book") capital account, and its impact on proper application of the alternate test for economic effect under Regs. Sec. 1.704-l(b)(2)(ii)(d).

Allocations of partnership loss to a limited partner must overcome many obstacles before they may be deducted. For example, Sec. 704(d)provides that a partner's distributive share of partnership loss will be allowed only to the extent of the adjusted basis of such partner's interest in the partnership at the end of the partnership year in which the loss occurred. In addition, Sec. 465 at-risk limitations and Sec. 469 passive loss limitations must be considered.

Before giving careful consideration to all these rules, practitioners should first examine whether the loss allocation is valid under Sec. 704(c) and Regs. Sec. 1.704l(b). According to Regs. Sec. 1.704-1(b)(1), these and other provisions may result in reallocation of partnership losses before the adjusted basis, at-risk basis, passive loss and other limitations would otherwise apply. Although several provisions of the Sec. 704(b)regulations can result in reallocation of partnership losses, the "alternate test for economic effect" in Regs. Sec. 1.704-1(b)(2)(ii)(d)may present the easiest tax planning opportunity to understand. Conversely, it contains many often overlooked pitfalls. General rules for economic effect Allocations are deemed to have economic effect if made in accordance with a partnership agreement that contains all three requirements of Regs. Sec. 1.7041(b)(2)(ii)(b). The first requirement is maintenance of "book" capital accounts in accordance with the rules of Regs. Sec. 1.704-1(b)(2)(iv). The second is that, on liquidation of the partnership or any partner's interest in the partnership, all liquidating distributions must be made in accordance with the partners' "book" capital accounts. The third requirement is that if a partner has a deficit "book" capital account balance on liquidation, such partner must unconditionally and without limit be obligated to restore the deficit to the partnership.

The alternate test for economic effect Limited partners would not be "limited" if they were subject to the third requirement of unlimited deficit restoration. For partners not obligated to restore deficit capital account balances, or obligated to restore only a limited dollar amount of deficit capital account balances, the alternate test for economic effect substitutes two additional requirements for the unlimited deficit restoration requirement. The first is that the partnership agreement contain a "qualified income offset" provision. The qualified income offset provision simply requires that if a partner unexpectedly receives an adjustment, allocation or distribution that creates or increases a prohibited deficit balance, gross income and gain must be allocated to such partner in an amount and manner sufficient to eliminate such deficit as quickly as possible.

The second is that an allocation will be considered to have economic effect only to the extent such allocation does not create or increase a deficit balance in any limited partner's capital account (as specially adjusted for purposes of this requirement)in excess of the sum of such partner's limited deficit restoration obligation, if any, and share of minimum gain, if any (see Regs. Sec. 1.704-2(g)). Minimum gain is essentially the excess of nonrecourse liability over the book basis of the asset that secures the nonrecourse liability.

In summary, if a partner is not required to restore deficit capital account balances, items that would create or increase a deficit balance cannot be allocated to such partner, subject to the adjustments mentioned. If a deficit is created inadvertently, such deficit must be eliminated as quickly as possible through allocations of gross income or gain.

The capital account

The capital account balance for purposes of the alternate test for economic effect must be determined in accordance with the rules of Regs. Sec. 1.704-1 (b)(2)(iv), reduced by adjustments for oil and gas depletion, certain allocations of loss and deduction (e.g., pursuant to Sec. 704(e), Sec. 706(d) or Regs. Sec. 1.75 1-1(b)(2)(ii))and distributions, any and all of which as of the end of the tax year are reasonably expected to be allocated in the future to any partner. This requires that the practitioner be familiar with both the "book" capital accounting rules and the modifications contained in the alternate test for economic effect provisions. As onerous as these modifications may seem, with the exception of the modification for anticipated future distributions, they are applicable to only a few narrow and specific situations. General awareness and use of a checklist approach should be sufficient to avoid making improper allocations based on an erroneous capital account balance.

Pitfalls and misunderstandings

Problems arise when deals are structured to take into account limitations based on adjusted tax basis (including allocated debt basis in accordance with Sec. 752 and the applicable regulations ), without considering projected capital account balances. Not only does a limited partner's projected capital account at liquidation seriously affect the economics of the investment, it is one of the most important factors limiting allocations of loss and deduction over a partnership's life. It is a common error to assume that, because a limited partner has tax basis in a partnership, allocations of loss and deduction are proper. Unfortunately, it is not uncommon for partnerships to allocate losses in excess of both a limited partner's adjusted tax basis and modified "book" capital account balance, despite the absence of a limited deficit restoration obligation or apportioned share of minimum gain to support the allocation.

Tax planning opportunities

The first step in planning to avoid an unexpected reallocation of loss or deduction from limited partners to the general partner is to maintain a model of current and projected "book" capital account balances and partners' shares of partnership minimum gain, The model must be based on the allocation provisions in the partnership agreement and projected economic performance of the partnership's assets. The second step is to consider planning opportunities that affect "book" capital account balances, alter the partners' limited deficit restoration obligations or change current allocations of partnership minimum gain. By affecting one or more of these three items, valid allocations of loss or deduction can be retained for the benefit of the limited partners or purposely reallocated to the general partner.

Contributions made on or before the last day of the partnership's tax year will increase a partner's "book" capital account for purposes of the limitation imposed by the alternate test for economic effect. A partner's account will be increased by the amount of cash or the FMV of property contributed. A partner's assumption of partnership liabilities in accordance with the requirements of Regs. Sec. 1.704-1(b)(2)(iv)(c) has the same effect as a contribution of an equivalent amount of cash. Liabilities are considered to be assumed only to the extent that the assuming party is subjected to personal and ultimate liability for such obligation, the obligee is aware of the assumption, and can directly enforce the obligation against the assuming party. If a limited partner is already liable for a partnership debt (e.g., as a guarantor), the additional economic risk associated with such an assumption may not be significant compared to the tax savings made possible by the resulting allocation of losses from the partnership. A more difficult and fact sensitive method of increasing "book" capital account balances is to engineer a restatement in accordance with the requirements of Regs. Sec. 1,704-1(b)(2)(iv)(f). This strategy will increase capital accounts if partnership property has increased in value, and will decrease accounts if the reverse is true.

A partner's limited deficit restoration obligation can be altered by amending the partnership agreement on or before the original due date for the partnership's tax return. Depending on the partnership's financial strength, increasing a limited deficit restoration obligation may be the least costly method of preserving allocations to a limited partner. Nevertheless, care must be taken when amending a partnership agreement. According to Regs. Sec. 1,704-l(b)(4)(vi), the tax consequences of an amendment and the facts and circumstances surrounding it will be scrutinized to determine whether the amendment (increasing or decreasing a partner's deficit restoration obligation) was part of the original agreement, which could result in reallocation of prior years' losses.

A partner's share of minimum gain can be increased by creating a debt structure that results in an allocation of purported nonrecourse debt basis to such partner as a lender under the applicable Sec. 752 regulations. This will resuit in an allocation of minimum gain away from all other partners to the lending partner. By carefully drafting the related security agreement to minimize the collateral's tax basis (or "book" basis, if applicable), the total amount of minimum gain can also be affected. Needless to say there are economic and other considerations that must be analyzed before adopting this strategy.

From Michael R. Einspahr, CPA, Denver, Colo.
COPYRIGHT 1992 American Institute of CPA's
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Author:Einspahr, Michael R.
Publication:The Tax Adviser
Date:Jul 1, 1992
Words:1505
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