Rev. Rul. suggests strategic partnership failure to book-up.

In Rev. Rul. 99-43, the Service ruled that a pair of allocations having economic effect was nevertheless invalid because it was not substantial. Even though the substantiality requirement is much less well-defined in the regulations than is the economic effect requirement, substantiality will come to play an increasing role in partnership allocations; because recently promulgated regulations under Secs. 743 and 755 now implicitly incorporate the detailed Sec. 704(b) "substantial economic effect" rules promulgated in Regs. Sec. 1.704-1(b). In particular, ordinary income recognized by an exiting partner under Sec. 751(a) can be reduced or eliminated if the partnership can ensure that his share of the unrealized appreciation in the partnership's ordinary income assets is small or even zero. This can be accomplished by carefully crafted special allocations, allocations that will have "economic effect" as defined in Regs. Sec. 1.704-1(b)(2)(ii) but may lack "substantiality" as defined in Regs. Sec. 1.704-1(b)(2)(iii).

Rev. Rul. 99-43 is important because it offers guidance beyond that contained in the "substantial economic effect" regulations. Further, while it held the allocations presented in the ruling invalid, it offered a roadmap for drafting equivalent tax allocations that should survive challenge. Finally, Rev. Rul. 99-43 suggests that eschewing capital account restatements may provide strategic tax advantages.

In Rev. Rul. 99-43, individuals A and B each contributed $1,000 to the general partnership PRS. Each partner was allocated 50% of profits and losses, and the partnership agreement provided that, if either partner contributed additional capital in the future, PRS would revalue its assets and restate capital accounts. Such revaluation and restatement is permitted (but not required) by Regs. Sec. 1.704-1(b)(2)(iv)(f) and (g).

The partnership purchased nondepreciable property for $10,000, using its capital of $2,000 as well as $8,000 borrowed from a bank. After one year, the value of the property fell to $6,000. As part of a workout with the bank, the loan was reduced to $6,000. A contributed additional capital of $500, which was used to pay currently deductible expenses. The partnership agreement was amended to provide that future items of profits and loss would be allocated 60% to A and 40% to B.

As a result of the workout, the partnership recognized $2,000 of cancellation of debt (COD) income for both book and tax purposes. The partners agreed to allocate this entire amount to B (who was insolvent at the time). The partnership also had $4,000 of book loss resulting from the revaluation of the partnership's property, and the partners agreed to allocate it $1,000 to A and $3,000 to B. Finally, the partnership allocated the entire $500 of book and tax deductions arising from the payment of workout expenses entirely to A. In tabular form, the books became:

                           A        B

Capital contributions   $1,000    $1,000
Additional capital
  contributed by A         500         0
Allocation of
  workout expenses        (500)        0
Allocation of
  COD income                 0     2,000
Allocation of
  revaluation loss      (1,000)   (3,000)
Final capital
  account balances           0         0

As a result of these allocations, each partner's capital account was reduced to zero. Had the partners simply allocated both the COD income and the revaluation loss equally between the partners, the capital accounts also would have been reduced to zero. However, by allocating both the income and loss disproportionately, the partners attempted to allocate all the taxable income to the insolvent partner, thereby minimizing the partners' joint tax liability without affecting the amount either partner would receive on liquidation.

The ruling concludes that the disproportionate allocation of COD income and revaluation loss constitute a "shifting" pair of allocations, because there is a strong likelihood that they will have offsetting effects. The disproportionate allocation of COD income entirely to B has an immediate effect of increasing B's capital account, thereby increasing the number of dollars B will receive on liquidation of A's partnership interest. The disproportionate allocation of the revaluation loss to B then reduces the amount B will receive on liquidation, thereby restoring the partners' relative shares to equality.

Of course, the revaluation loss will only affect the amount the partners will receive on liquidation if the property in fact declines in value. However, under Regs. Sec. 1.704-1(b)(2)(iii)(c)(2) (the "value equals basis" rule), partnership property is conclusively presumed to have fair market value (FMV) equal to current partnership book value. Thus, when property is revalued for adjusting capital accounts, the value of the property is conclusively presumed to have declined to the restated value. As a result, the diminution in value reflected in the book-down is conclusively presumed to have occurred, so that the loss resulting from that book-down is conclusively assumed to offset the disproportionate allocation of COD. These two disproportionate allocations thus have offsetting effects and, for that reason, fail the substantiality test of Regs. Sec. 1.704-1(b)(2)(iii)(b).

While the ruling's conclusion that the allocations are invalid seems inescapable, suppose the partnership agreement had provided that partnership assets would not be revalued when new capital is contributed by either partner. Thus, when the workout occurs, the only tax items to be allocated are the COD income and the $500 of current expenditures (this latter item plays no role in the analysis of the ruling or in the analysis that follows). Allocation of the current deduction to A and the COD income to B has economic effect that is substantial and So should be valid.

To maintain the economics of the transaction, the partners must also agree that when the partnership's property is sold, the first $2,000 of loss will be allocated entirely to B. This is not a current allocation, because no book or tax loss has yet been realized from disposition of the property. But a current allocation and a future allocation can together be invalid if there is a strong likelihood that they will have offsetting effects. Such a pair of allocations is called "transitory" under the regulations. Is the current disproportionate allocation of current COD income and the anticipated future disproportionate allocation of loss invalid as transitory?

No. While the two allocations will have offsetting effects, there is no "strong likelihood" of future loss, because under the "value equals basis" rule of Regs. Sec. 1.704-1(b)(2)(iii)(c)(2), the future loss is conclusively presumed not to occur: the property is conclusively presumed to equal its current book value of $10,000. By electing not to revalue the partnership's property as part of the workout, the partners can cause the "value equals basis" rule to transmute from an unstoppable sword in the government's hands into an impassable shield in the taxpayer's hands.

If the partnership's property turns around in value after the workout, failure to have restated capital accounts may cause problems, unless properly anticipated and addressed. For example, suppose one year later the property is sold for its then FMV of $10,000. This sale produces no book gain or loss (because the asset's value was not restated as part of the workout) and no tax gain or loss (because the property was purchased by the partnership for $10,000 and no depreciation was allowed or allowable). Thus, the partnership books will read:

                           A         B

Capital contributions   $1,000    $1,000
Additional capital
  contributed by A         500         0
Allocation of
  workout expenses        (500)        0
Allocation of
  COD income                 0     2,000
Final capital
  account balances      $1,000    $3,000

Because there has in fact been no offsetting disproportionate allocation of loss to B, B's capital account remains disproportionately high. This is not what the partners intended. To prevent its occurrence, the partnership agreement should provide that if, on disposition of the property by the partnership, there is less than $2,000 of loss, additional items of partnership income or loss will be allocated to restore the partners' capital accounts to parity.

Is this "additional items" allocation transitory when coupled with the disproportionate allocation of COD income to B as part of the workout? Determination of whether a current allocation and a future allocation together constitute an invalid pair of transitory allocations is determined when the allocations are placed into the partnership agreement (Regs. Sec. 1.704-1(b)(2)(iii)(c)). Unless it is "strong[ly] likely" that additional items will occur, these allocations should be valid. To reduce a possible challenge to the "additional items" allocations, the partners might wish to limit the additional items to gain or loss from dispositions of partnership property; under the "value equals basis" rule, partnership assets are conclusively presumed not to increase or decrease in value.

Most partnership tax specialists advise clients to revalue partnership assets and restate capital accounts whenever permitted by the regulations to ensure that the economic arrangements among the partners is maintained, Rev. Rul. 99-43 suggests that this strategy needs rethinking: because of the "value equals basis" rule, revaluations and restatements have significant impact on the substantiality of partnership allocations. If the economics of the partnership can be maintained some other way, eschewing revaluations and restatements may offer significant tax benefits.

FROM HOWARD ABRAMS, J.D., WASHINGTON, DC