IRS Revenue Ruling
1997-38

Code Secs. 704, 752

<<FULL TEXT>>

26 CFR 1.704-1: Determination of partner's distributive share.
(Also section 752; 1.752-2.)

Calculation of a partner's limited deficit restoration obligation. This
ruling holds that the amount of a partner's limited deficit restoration
obligation is the amount of money that the partner would be required to
contribute to the partnership to satisfy partnership liabilities if all
partnership property were sold for the amount of the partnership's book
basis in the property.


REV. RUL. 97-38

ISSUE

If a partner is treated as having a limited deficit restoration
obligation under section 1.704-1(b)(2)(ii)(c) of the Income Tax
Regulations by reason of the partner's liability to the partnership's
creditors, how is the amount of that obligation calculated?


FACTS

In year 1, GP and LP, general partner and limited partner, each
contribute $100x to form limited partnership LPRS. In general, GP and LP
share LPRs's income and loss 50 percent each. However, LPRS allocates to
GP all depreciation deductions and gain from the sale of depreciable
assets up to the amount of those deductions. LPRS maintains capital
accounts according to the rules set forth in section 1.704-1(b)(2)(iv),
and the partners agree to liquidate according to positive capital account
balances under the rules of section 1.704-1(b)(2)(ii)(b)(2).

Under applicable state law, GP is liable to creditors for all
partnership recourse liabilities, but LP has no personal liability. GP and
LP do not agree to unconditional deficit restoration obligations as
described in section 1.704-1(b)(2)(ii)(b)(3) (in general, a deficit
restoration obligation requires a partner to restore any deficit capital
account balance following the liquidation of the partner's interest in the
partnership); GP is obligated to restore a deficit capital account only to
the extent necessary to pay creditors. Thus, if LPRS were to liquidate
after paying all creditors and LP had a positive capital account balance,
GP would not be required to restore GP's deficit capital account to permit
a liquidating distribution to LP. In addition, GP and LP agree to a
qualified income offset, thus satisfying the requirements of the alternate
test for economic effect of section 1.704-1(b)(2)(ii)(d). GP and LP also
agree that no allocation will be made that causes or increases a deficit
balance in any partner's capital account in excess of the partner's
obligation to restore the deficit.

LPRS purchases depreciable property for $1,000x from an unrelated
seller, paying $200x in cash and borrowing the $800x balance from an
unrelated bank that is not the seller of the property. The note is
recourse to LPRS. The principal of the loan is due in 6 years; interest is
payable semi-annually at the applicable federal rate. GP bears the entire
economic risk of loss for LPRs's recourse liability, and GP's basis in
LPRS (outside basis) is increased by $800x. See section 1.752-2.

In each of years 1 through 5, the property generates $200x of
depreciation. All other partnership deductions and losses exactly equal
income, so that in each of years 1 through 5 LPRS has a net loss of $200x.


LAW AND ANALYSIS

Under section 704(b) of the Internal Revenue Code and the regulations
thereunder, a partnership's allocations of income, gain, loss, deduction,
or credit set forth in the partnership agreement are respected if they
have substantial economic effect. If allocations under the partnership
agreement would not have substantial economic effect, the partnership's
allocations are determined according to the partners' interests in the
partnership. The fundamental principles for establishing economic effect
require an allocation to be consistent with the partners' underlying
economic arrangement. A partner allocated a share of income should enjoy
any corresponding economic benefit, and a partner allocated a share of
losses or deductions should bear any corresponding economic burden. See
section 1.704-1(b)(2)(ii)(a).

To come within the safe harbor for establishing economic effect in
section 1.704-1(b)(2)(ii), partners must agree to maintain capital
accounts under the rules of section 1.704-1(b)(2)(iv), liquidate according
to positive capital account balances, and agree to an unconditional
deficit restoration obligation for any partner with a deficit in that
partner's capital account, as described in section
1.704-1(b)(2)(ii)(b)(3). Alternatively, the partnership may satisfy the
requirements of the alternate test for economic effect provided in section
1.704-1(b)(2)(ii)(d). LPRs's partnership agreement complies with the
alternate test for economic effect.

The alternate test for economic effect requires the partners to agree
to a qualified income offset in lieu of an unconditional deficit
restoration obligation. If the partners so agree, allocations will have
economic effect to the extent that they do not create a deficit capital
account for any partner (in excess of any limited deficit restoration
obligation of that partner) as of the end of the partnership taxable year
to which the allocation relates. Section 1.704-1(b)(2)(ii)(d)(3) (flush
language).

A partner is treated as having a limited deficit restoration obligation
to the extent of: (1) the outstanding principal balance of any promissory
note contributed to the partnership by the partner, and (2) the amount of
any unconditional obligation of the partner (whether imposed by the
partnership agreement or by state or local law) to make subsequent
contributions to the partnership. Section 1.704-1(b)(2)(ii)(c).

LP has no obligation under the partnership agreement or state or local
law to make additional contributions to the partnership and, therefore,
has no deficit restoration obligation. Under applicable state law, GP may
have to make additional contributions to the partnership to pay creditors.
However, GP's obligation only arises to the extent that the amount of
LPRs's liabilities exceeds the value of LPRs's assets available to satisfy
the liabilities. Thus, the amount of GP's limited deficit restoration
obligation each year is equal to the difference between the amount of the
partnership's recourse liabilities at the end of the year and the value of
the partnership's assets available to satisfy the liabilities at the end
of the year.

To ensure consistency with the other requirements of the regulations
under section 704(b), where a partner's obligation to make additional
contributions to the partnership is dependent on the value of the
partnership's assets, the partner's deficit restoration obligation must be
computed by reference to the rules for determining the value of
partnership property contained in the regulations under section 704(b).
Consequently, in computing GP's limited deficit restoration obligation,
the value of the partnership's assets is conclusively presumed to equal
the book basis of those assets under the capital account maintenance rules
of section 1.704-1(b)(2)(iv). See section 1.704-1(b)(2)(ii)(d) (value
equals basis presumption applies for purposes of determining expected
allocations and distributions under the alternate test for economic
effect); section 1.704-1(b)(2)(iii) (value equals basis presumption
applies for purposes of the substantiality test); section
1.704-1(b)(3)(iii) (value equals basis presumption applies for purposes of
the partner's interest in the partnership test); section 1.704-2(d) (value
equals basis presumption applies in computing partnership minimum gain).

The LPRS agreement allocates all depreciation deductions and gain on
the sale of depreciable property to the extent of those deductions to GP.
Because LPRs's partnership agreement satisfies the alternate test for
economic effect, the allocations of depreciation deductions to GP will
have economic effect to the extent that they do not create a deficit
capital account for GP in excess of GP's obligation to restore the deficit
balance. At the end of year 1, the basis of the depreciable property has
been reduced to $800x. If LPRS liquidated at the beginning of year 2,
selling its depreciable property for its basis of $800x, the proceeds
would be used to repay the $800x principal on LPRs's recourse liability.
All of LPRs's creditors would be satisfied and GP would have no obligation
to contribute to pay them. Thus, at the end of year 1, GP has no
obligation to restore a deficit in its capital account.

Because GP has no obligation to restore a deficit balance in its
capital account at the end of year 1, an allocation that reduces GP's
capital account below $0 is not permitted under the partnership agreement
and would not satisfy the alternate test for economic effect. An
allocation of $200x of depreciation deductions to GP would reduce GP's
capital account to negative $100x. Because the allocation would result in
a deficit capital account balance in excess of GP's obligation to restore,
the allocation is not permitted under the partnership agreement, and would
not satisfy the safe harbor under the alternate test for economic effect.
Therefore, the deductions for year 1 must be allocated $100x each to GP
and LP (which is in accordance with their interests in the partnership).

The allocation of depreciation of $200x to GP in year 2 has economic
effect. Although the allocation reduces GP's capital account to negative
$200x, while LP's capital account remains $0, the allocation to GP does
not create a deficit capital account in excess of GP's limited deficit
restoration obligation. If LPRS liquidated at the beginning of year 3,
selling the depreciable property for its basis of $600x, the proceeds
would be applied toward the $800x LPRS liability. Because GP is obligated
to restore a deficit capital account to the extent necessary to pay
creditors, GP would be required to contribute $200x to LPRS to satisfy the
outstanding liability. Thus, at the end of year 2, GP has a deficit
restoration obligation of $200x, and the allocation of depreciation to GP
does not reduce GP's capital account below its obligation to restore a
deficit capital account.

This analysis also applies to the allocation of $200x of depreciation
to GP in years 3 through 5. At the beginning of year 6, when the property
is fully depreciated, the $800x principal amount of the partnership
liability is due. The partners' capital accounts at the beginning of year
6 will equal negative $800x and $0, respectively, for GP and LP. Because
value is conclusively presumed to equal basis, the depreciable property
would be worthless and could not be used to satisfy LPRs's $800x
liability. As a result, GP is deemed to be required to contribute $800x to
LPRS. A contribution by GP to satisfy this limited deficit restoration
obligation would increase GP's capital account balance to $0.


HOLDING

When a partner is treated as having a limited deficit restoration
obligation by reason of the partner's liability to the partnership's
creditors, the amount of that obligation is the amount of money that the
partner would be required to contribute to the partnership to satisfy
partnership liabilities if all partnership property were sold for the
amount of the partnership's book basis in the property.


DRAFTING INFORMATION

The principal author of this revenue ruling is Robert Honigman of the
Office of Assistant Chief Counsel (Passthroughs and Special Industries).
For further information regarding this revenue ruling, contact Robert
Honigman on (202) 622-3050 (not a toll-free call).

<<END RULING>>

 

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