7746 / Can a limited partner who enters a partnership late in the year receive a “retroactive” allocation of partnership losses that occurred before entering the partnership?

Partnership income or loss may not be retroactively allocated to a partner acquiring an interest during the year. The partner’s allocable share may be determined according to the portion of the year the partnership was held or by an interim closing of the books.¹ Proposed regulations on these issues were published in April 2009.²

Thus, a partner admitted during the year cannot deduct a full year’s depreciation. Losses not shown to have occurred after an individual became a partner are prorated and a deduction allowed only for the part of the partnership year that the individual was a partner.³ However, where an interim closing of the books had been made, and it accurately reflected the losses incurred by the partnership after the new partner entered the partnership, the result was that a year-end total loss could not be prorated according to the portion of the year the new partner was a partner.⁴ Losses accrued by an accrual basis partnership prior to cash basis partners’ becoming partners were not deductible by the cash basis partners.⁵ However, new partners have been permitted to deduct losses incurred by a cash basis partnership prior to their entry where an interim closing of the books established the losses were paid by the partnership after their entry and the interim closing of the books method reflected economic reality because the contributions of the new partners were needed to pay the expenses.⁶

The IRC provides for special allocation rules with respect to certain amounts attributable to periods after March 31, 1984, in cash basis partnerships, and with respect to amounts paid or accrued by a lower tiered partnership after March 31, 1984, to prevent avoidance of the retroactive allocation prohibition.⁷

In the case of a cash method partnership, interest, taxes, payments for services or for the use of property, and other items prescribed by regulations (none have yet been issued)—“allocable cash basis items”—are to be assigned to each day in the period to which it is economically attributable (i.e., to the day or days in such period to which the item would accrue if the partnership were on the accrual method) and allocated among the partners in proportion to their interests in the partnership at the close of each day.⁸ If, using this method, any portion of such an item is economically attributable to periods before the beginning of the taxable year, that portion will be assigned to the first day of the year and allocated to the persons who were partners on that day, in proportion to their varying interests in the partnership. (Similarly, any portion economically attributable to periods after the end of the taxable year will be assigned to the last day of the year.) This determination will require allocation of such items in the manner in which the partners would have borne the corresponding economic cost even though the cost is actually borne by another partner (typically, a later-admitted partner) in connection with a change in the partners’ interests in the partnership. If persons to whom all or part of such items are allocable are not partners in the partnership on the first day of the partnership taxable year in which the item is taken into account, then their portions must be capitalized by the partnership and allocated to the basis of partnership assets.⁹

In the case of tiered partnerships, if a partnership is a partner (an upper-tier partnership), its share of any item of income, gain, loss, deduction, or credit of the lower-tier partnership will, except as otherwise provided in regulations, be allocated among the partners of the upper-tier partnership (1) by assigning the appropriate portion of each item to the appropriate day in the upper-tier partnership’s taxable year on which the upper-tier partnership is a partner in the lower-tier partnership, and (2) by allocating the portion assigned to a day among the partners in proportion to their interests in the upper-tier partnership as of the close of the day (determined in a manner consistent with IRC Section 704). For this purpose, items allocable to periods before or after the upper-tier partnership’s taxable year will be assigned to the first or last day of that year, respectively. If the persons to whom items are properly allocated are no longer partners in the upper-tier partnership on the first day of the upper-tier partnership taxable year in which the item is taken into account, then such persons’ portions of such items are capitalized and allocated to the basis of partnership assets.¹⁰