Partnership's allocation method satisfies sec. 704(b) and (c).

Typically, the IRS has bee unwilling to rule on whether allocations are "substantial' under Sec. 704(b) because the issue is inherently factual; see Rev. Proc. 87-35. Despite this ruling position the Service recently ruled in Letter Ruling 9540034 that a partnership' method of allocating items o income, gain, loss and deduction has substantial economic effect under Sec. 704(b). Prior to this ruling, the IRS issued only two other rulings relating to "substantiality" under Sec. 704(b) (Letter Rulings 9207027 and (TAM) 9219002).

In Letter Ruling 9540034, two companies formed a partnership to develop oil and gas properties and chose not to elect out of subchapter K. One company transferred an interest in a land lease to the partnership and another conducted the drilling operations. The partnership agreement provided that the Tax Matters Partner would maintain a fair market value (FMV) capital account and a tax basis capital account for each partner. Each partner's FMV capital account would be increased nd decreased in accordance with Regs. Sec. 1.704-1 (b) (2) (iv) (b). The partnership agreement required that liquidating distributions be made in accordance with the partners' positive FMV capital account balance Each partner was unconditional obligated to restore any deficit balance in its capital account following the partnership's liquidation Because the partnership agreement satisfied the three requirements for establishing economic effect contained in Regs. Sec. 1.704-1 (b) (2) the IRS found that the allocation would have economic effect.

In addition to ruling that the all cations would have economic effect, the Service determined that such economic effect would be "substantial. The partnership agreement apparently provided for disproportionate distributions of income to the partner conducting the drilling operations until the allocated amount offset th amount of partnership operating expenses funded by its contributions. Citing Regs. Sec. 1.704-1 (b) (5), Example 19(ii), the IRS determined that there was a reasonable possibility that the allocations under the partnership agreement would substantially affect the dollar amounts to be received by the partners from the partnership (given the speculative nature of the partnership's drilling activities). That is, there was not a strong likelihood that the economic effect of such allocations would be largely offset by allocations of income.

With regard to allocations relating to contributed property, the partnership was required to reduce the contributing partner's capital account for all simulated depletion from the contributed property; the entire adjusted tax basis of the contributed property was allocated to the contributing partner; and any gain recognized by the partnership on the disposition of the contributed property was allocated to the contributing partner (to the extent of built-in gain). The Service ruled that this method of making allocations was reasonable when applied to the partnership's Sec. 704(c) property. Except for rulings on securities partnerships, this is the first letter ruling since final Sec. 704(c) regulation were issued in 1994 that addresses an allocation method for contributed property.

From Barksdale Penick, Esq., and Creighton Castle, Esq., Washington, D.C.