8933 / How is partnership income and loss allocated among partners? What is the “substantial economic effect test”?

The partnership agreement often provides for the allocation of separately stated items of partnership income, gain, loss, deductions and credits among the partners (known as a partner’s distributive share), and sometimes provides for an allocation system that is disproportionate to the capital contributions of the partners (a so-called “special allocation”). Despite this, if the method of allocation lacks “substantial economic effect” (or if no allocation is specified), the distributive shares will be determined in accordance with the partner’s interest in the partnership, based on all the facts and circumstances.¹

The substantial economic effect test exists in order to “prevent use of special allocations for tax avoidance purposes, while allowing their use for bona fide business purposes.”² Under the regulations, generally, an allocation will not have economic effect unless the partners’ capital accounts are maintained properly, liquidation proceeds are required to be distributed based on the partners’ capital account balances and, following distribution of such proceeds, partners are required to restore any deficits in their capital accounts to the partnership. Further, the economic effect will generally not be considered substantial unless the allocation has a reasonable possibility of substantially impacting the dollar amounts received by partners, independent of tax consequences. Allocations are also insubstantial if they merely shift tax consequences within a partnership tax year or are likely to be offset by other allocations in subsequent tax years.³

If a partner contributes property to a partnership, allocations must generally be made to that partner to reflect any variation between the basis of the property to the partnership and its fair market value at the time of contribution.⁴ When contributed property is distributed to a partner who did not contribute that property, the contributing partner must recognize gain or loss upon distributions occurring within seven years of the contribution.⁵ A contributing partner, however, is treated as receiving property which the partner contributed (and no gain or loss will therefore be recognized on the distribution) if the property contributed is distributed to another partner and like-kind property is distributed to the contributing partner within the earlier of (1) 180 days after the distribution to the other partner, or (2) the partner’s tax return due date (including extensions) for the year in which the distribution to the other partner occurs.⁶

For contributions of property made after October 22, 2004, if the property has a built-in loss, the loss is considered only in determining the items allocated to the contributing partner. Also, when determining items allocated to other partners, the basis of the property is its fair market value at the time it was contributed to the partnership.⁷

The 2017 tax reform legislation changed the rules governing the treatment of basis following a substantial built-in loss. Generally, a partnership must adjust the basis of partnership property following a transfer of a partnership interest if the partnership has suffered a substantial built-in loss immediately following the transfer. Under prior law, a substantial built-in loss existed if the adjusted basis in the partnership’s property exceeded the fair market value of the property by more than $250,000.

The 2017 tax reform legislation expanded the definition of substantial built-in loss to include situations where, immediately after the transfer, the transferee would be allocated a net loss of more than $250,000 upon a hypothetical disposition by the partnership of all the partnership’s assets in a taxable transaction for cash equal to the fair market value of the assets.⁸

The IRS is entitled to reallocate income and deductions attributable to distributions of property from a partnership to an individual and the individual’s controlled corporation to prevent distortions of income.⁹ See Q 8934 for special rules that apply to allocations attributable to nonrecourse allocations.