Debt discharge allocation lacks substantial economic effect.

Under IRC section 761(c), partners are allowed to amend their agreements as long as such changes are made by the time the partnership information return is due (not including extensions). Furthermore, under section 704(b), allocations of items such as income, gain, loss, deduction or credit provided for in a partnership agreement will be respected if they have "substantial economic effect." If they do not, the code says, they will be reallocated according to the partners' interests in the partnership. In revenue ruling 99-43, the IRS found a partnership's allocation of debt discharge income lacked substantiality.

Facts. A and B, both individuals, formed a 50/50 partnership contributing $1,000 each of capital. Their agreement provided for all partnership items to be allocated 50/50 and all partnership property to be revalued if either of them contributed additional capital.

The partnership used the $2,000 capital contributions and borrowed an additional $8,000 on a nonrecourse basis to purchase nondepreciable property for $10,000. After one year, the fair market value of the property declined to $6,000. A and B were forced to work out an agreement with the bank in which it forgave $2,000 of the loan principal. The partnership paid the deductible costs, $500, associated with the bank agreement with a cash capital contribution by A. A's capital account was debited and credited with the agreement costs and the capital contribution. At the time of the "workout" agreement, B was insolvent and made no additional contribution. As a result, the partners agreed that A would have a 60% partnership interest and B would have the remaining 40%.

It "Pays" to Be No. 1

In 1998 the top 1% of U.S.
income earners (those making
more than $269,496 annually)
paid 34.8% of all federal
individual income taxes, up
from 27.6% in 1988.

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Top 5 Pay Even More

The upper 5% of U.S. income
earners (those making more than
$114,729 annually) paid 53.8%
of all 1998 federal individual
income taxes, compared to only
45.6% in 1988.

[ILLUSTRATION OMITTED]

The decline in property value and the workout agreement produced two items that had to be allocated between A and B--the $2,000 of cancellation-of-indebtedness (COD) income and the $4,000 loss from the decline in property value. The $2,000 item was taxable income. The $4,000 revaluation loss was not deductible and was treated as an adjustment to the partners' capital accounts.

The original partnership would have allocated these amounts 50% each to A and B. However, they had amended the partnership agreement to allocate these two items after the workout agreement with the bank. The entire $2,000 of income from the cancellation of debt was allocated to B, the insolvent partner. The $4,000 revaluation loss was allocated $1,000 to A and $3,000 to B.

Observation. Do the allocations in the amended partnership agreement have substantial economic effect under section 704(b)? To qualify, there must be a reasonable possibility the allocations will substantially affect the dollar amounts each partner receives regardless of the tax consequences. In this case, after the agreement with the bank, the capital account balances of A and B were zero under the allocations in both the original and amended partnership agreements. Because of this, the special allocation in the amended agreement fails the substantial economic effect test: it does not have an impact on the amounts due to the partners--as represented by the capital accounts--when the partnership is liquidated

Furthermore, the IRS will not consider an allocation tb have substantial effect if it results in shifting tax consequences--that is, the total tax liability of the partners would be less than without the allocations. If the amounts in this case were allocated according to the original partnership agreement, A and B each would have $1,000 of COD income. B would not have to report this amount as taxable because he was insolvent at the time of the cancellation, and A would be taxed on the $1,000 of income. However, the result of the special allocation was to allocate all the COD income to B. Again, B would not have to report this income because of insolvency, and A would escape taxation on $1,000 of income. The result would be that none of the $2,000 of income would be taxed. The special allocations A and B made shift tax consequences by reducing the partners' total tax liability; therefore, the allocation does not have substantial economic effect.

The IRS noted that the allocations also could fail the test if they are found to be transitory allocations--that is, original allocations offset by other allocations in different taxable years that reduce the total tax liability of the partners.

Result. The special allocations in the amended partnership agreement lack substantiality. If they had been made prior to the property's decline in value and the workout agreement, then their effect might have been deemed substantial. However, the ruling points out that if the decline had been foreseeable, then the allocations still would be subject to close scrutiny by the IRS.

--Cheryl Metrejean, CPA, PhD, Assistant Professor of Accountancy, E.H. Patterson School of Accountancy, University of Mississippi, Oxford.