IRS Revenue Ruling
1999-43

  Code Sec. 704

<<FULL TEXT>>

26 CFR 1.704-1: Determination of partners distributive share.

26 CFR 1.704-2: Allocations attributable to nonrecourse liabilities.
(Also Part I, section 108; 1.108-1(a)(1).)

Partnership allocations; cancellation of nonrecourse indebtedness. This
ruling provides guidance on the substantiality of special allocations made
by amendments to a partnership agreement after the events giving rise to
the specially allocated items have occurred.


REV. RUL. 99-43

ISSUE

Do partnership allocations lack substantiality under section
1.704-1(b)(2)(iii) of the Income Tax Regulations when the partners amend
the partnership agreement to create offsetting special allocations of
particular items after the events giving rise to the items have occurred?


FACTS

A and B, both individuals, formed a general partnership, PRS. A and B
each contributed $1,000 and also agreed that each would be allocated a
50-percent share of all partnership items. The partnership agreement
provides that, upon the contribution of additional capital by either
partner, PRS must revalue the partnership's property and adjust the
partners' capital accounts under section 1.704-1(b)(2)(iv)(1).

PRS borrowed $8,000 from a bank and used the borrowed and contributed
funds to purchase nondepreciable property for $10,000. The loan was
nonrecourse to A and B and was secured only by the property. No principal
payments were due for 6 years, and interest was payable semi-annually at a
market rate.

After one year, the fair market value of the property fell from $10,000
to $6,000, but the principal amount of the loan remained $8,000. As part
of a workout arrangement among the bank, PRS, A, and B, the bank reduced
the principal amount of the loan by $2,000, and A contributed an
additional $500 to PRS. A's capital account was credited with the $500,
which PRS used to pay currently deductible expenses incurred in connection
with the workout. All $500 of the currently deductible workout expenses
were allocated to A. B made no additional contribution of capital. At the
time of the workout, B was insolvent within the meaning of section 108(a)
of the Internal Revenue Code. A and B agreed that, after the workout, A
would have a 60-percent interest and B would have a 40-percent interest in
the profits and losses of PRS.

As a result of the property's decline in value and the workout, PRS had
two items to allocate between A and B. First, the agreement to cancel
$2,000 of the loan resulted in $2,000 of cancellation of indebtedness
income (COD income). Second, A's contribution of $500 to PRS was an event
that required PRS, under the partnership agreement, to revalue partnership
property and adjust A's and B's capital accounts. Because of the decline
in value of the property, the revaluation resulted in a $4,000 economic
loss that must be allocated between A's and B's capital accounts.

Under the terms of the original partnership agreement, PRS would have
allocated these items equally between A and B. A and B, however, amend the
partnership agreement (in a timely manner) to make two special
allocations. First, PRS specially allocates the entire $2,000 of COD
income to B, an insolvent partner. Second, PRS specially allocates the
book loss from the revaluation $1,000 to A and $3,000 to B.

While A receives a $1,000 allocation of book loss and B receives a
$3,000 allocation of book loss, neither of these allocations results in a
tax loss to either partner. Rather, the allocations result only in
adjustments to A's and B's capital accounts. Thus, the cumulative effect
of the special allocations is to reduce each partner's capital account to
zero immediately following the allocations despite the fact that B is
allocated $2,000 of income for tax purposes.


LAW

Section 61(a)(12) provides that gross income includes income from the
discharge of indebtedness.

Rev. Rul. 91-31, 1991-1 C.B. 19, holds that a taxpayer realizes COD
income when a creditor (who was not the seller of the underlying property)
reduces the principal amount of an under-secured nonrecourse debt.

Under section 704(b) and the regulations thereunder, allocations of a
partnership's items of income, gain, loss, deduction, or credit provided
for in the partnership agreement will be respected if the allocations have
substantial economic effect. Allocations that fail to have substantial
economic effect will be reallocated according to the partners' interests
in the partnership (as defined in section 1.704-1(b)(3)).

Section 1.704-1(b)(2)(iv)(1) provides that a partnership may, upon the
occurrence of certain events (including the contribution of money to the
partnership by a new or existing partner), increase or decrease the
partners' capital accounts to reflect a revaluation of the partnership
property.

Section 1.704-1(b)(2)(iv)(g) provides that, to the extent a
partnership's property is reflected on the books of the partnership at a
book value that differs from the adjusted tax basis, the substantial
economic effect requirements apply to the allocations of book items.
Section 704(c) and section 1.704-1(b)(4)(i) govern the partners'
distributive shares of tax items.

Section 1.704-1(b)(2)(i) provides that the determination of whether an
allocation of income, gain, loss, or deduction (or item thereof) to a
partner has substantial economic effect involves a two-part analysis that
is made at the end of the partnership year to which the allocation
relates. In order for an allocation to have substantial economic effect,
the allocation must have both economic effect (within the meaning of
section 1.704-1(b)(2)(ii)) and be substantial (within the meaning of
section 1.704-1(b)(2)(iii)).

Section 1.704-1(b)(2)(iii)(a) provides that the economic effect of an
allocation (or allocations) is substantial if there is a reasonable
possibility that the allocation (or allocations) will substantially affect
the dollar amounts to be received by the partners from the partnership
independent of the tax consequences. However, the economic effect of an
allocation is not substantial if, at the time the allocation becomes part
of the partnership agreement, (1) the after-tax economic consequences of
at least one partner may, in present value terms, be enhanced compared to
the consequences if the allocation (or allocations) were not contained in
the partnership agreement, and (2) there is a strong likelihood that the
after-tax economic consequences of no partner will, in present value
terms, be substantially diminished compared to the consequences if the
allocation (or allocations) were not contained in the partnership
agreement. In determining the after-tax economic benefit or detriment to a
partner, tax consequences that result from the interaction of the
allocation with the partner's tax attributes that are unrelated to the
partnership will be taken into account.

Section 1.704-1(b)(2)(iii)(b) provides that the economic effect of an
allocation (or allocations) in a partnership taxable year is not
substantial if the allocations result in shifting tax consequences.
Shifting tax consequences result when, at the time the allocation (or
allocations) becomes part of the partnership agreement, there is a strong
likelihood that (1) the net increases and decreases that will be recorded
in the partners' respective capital accounts for the taxable year will not
differ substantially from the net increases and decreases that would be
recorded in the partners' respective capital accounts for the year if the
allocations were not contained in the partnership agreement, and (2) the
total tax liability of the partners (for their respective tax years in
which the allocations will be taken into account) will be less than if the
allocations were not contained in the partnership agreement.

Section 1.704-1(b)(2)(iii)(c) provides that the economic effect of an
allocation (or allocations) in a partnership taxable year is not
substantial if the allocations are transitory. Allocations are considered
transitory if a partnership agreement provides for the possibility that
one or more allocations (the "original allocation(s)") will be largely
offset by other allocations (the "offsetting allocation(s)"), and, at the
time the allocations become part of the partnership agreement, there is a
strong likelihood that (1) the net increases and decreases that will be
recorded in the partners' capital accounts for the taxable years to which
the allocations relate will not differ substantially from the net
increases and decreases that would be recorded in such partners'
respective capital accounts for such years if the original and offsetting
allocation(s) were not contained in the partnership agreement, and (2) the
total tax liability of the partners (for their respective tax years in
which the allocations will be taken into account) will be less than if the
allocations were not contained in the partnership agreement.

Section 761(c) provides that a partnership agreement includes any
modifications made prior to, or at, the time prescribed for filing a
partnership return (not including extensions) which are agreed to by all
partners, or which are adopted in such other manner as may be provided by
the partnership agreement.


ANALYSIS

PRS is free to allocate partnership items between A and B in accordance
with the provisions of the partnership agreement if the allocations have
substantial economic effect under section 1.704-1(b)(2). To the extent
that the minimum gain chargeback rules do not apply <<ENDNOTE 1>> COD
income may be allocated in accordance with the rules under section
1.704-1(b)(2). This is true notwithstanding that the COD income arises in
connection with the cancellation of a nonrecourse debt.

The economic effect of an allocation is not substantial if, at the time
that the allocation becomes part of the partnership agreement, the
allocation fails each of two tests. The allocation fails the first test if
the after-tax consequences of at least one partner may, in present value
terms, be enhanced compared to the consequences if the allocation (or
allocations) were not contained in the partnership agreement. The
allocation fails the second test if there is a strong likelihood that the
after-tax economic consequences of no partner will, in present value
terms, be substantially diminished compared to such consequences if the
allocation (or allocations) were not contained in the partnership
agreement.

A and B amended the PRS partnership agreement to provide for an
allocation of the entire $2,000 of the COD income to B. B, an insolvent
taxpayer, is eligible to exclude the income under section 108, so it is
unlikely that the $2,000 of COD income would increase B's immediate tax
liability. Without the special allocation, A, who is not insolvent or
otherwise entitled to exclude the COD income under section 108, would pay
tax immediately on the $1,000 of COD income allocated under the general
ratio for sharing income. A and B also amended the PRS partnership
agreement to provide for the special allocation of the book loss resulting
from the revaluation. Because the two special allocations offset each
other, B will not realize any economic benefit from the $2,000 income
allocation, even if the property subsequently appreciates in value.

The economics of PRS are unaffected by the paired special allocations.
After the capital accounts of A and B are adjusted to reflect the special
allocations, A and B each have a capital account of zero. Economically,
the situation of both partners is identical to what it would have been had
the special allocations not occurred. In addition, a strong likelihood
exists that the total tax liability of A and B will be less than if PRS
had allocated 50 percent of the $2,000 of COD income and 50 percent of the
$4,000 book loss to each partner. Therefore, the special allocations of
COD income and book loss are shifting allocations under section
1.704-1(b)(2)(iii)(b) and lack substantiality. (Alternatively, the
allocations could be transitory allocations under section
1.704-1(b)(2)(iii)(c) if the allocations occur during different
partnership taxable years).

This conclusion is not altered by the "value equals basis" rule that
applies in determining the substantiality of an allocation. See section
1.704-1(b)(2)(iii)(c)(2). Under that rule, the adjusted tax basis (or, if
different, the book value) of partnership property will be presumed to be
the fair market value of the property. This presumption is appropriate in
most cases because, under section 1.704-1(b)(2)(iv), property generally
will be reflected on the books of the partnership at its fair market value
when acquired. Thus, an allocation of gain or loss from the disposition of
the property will reflect subsequent changes in the value of the property
that generally cannot be predicted.

The substantiality of an allocation, however, is analyzed "at the time
the allocation becomes part of the partnership agreement," not the time at
which the allocation is first effective. See section
1.704-1(b)(2)(iii)(a). In the situation described above, the provisions of
the PRS partnership agreement governing the allocation of gain or loss
from the disposition of property are changed at a time that is after the
property has been revalued on the books of the partnership, but are
effective for a period that begins prior to the revaluation. See section
1.704-1(b)(2)(iv)(f).

Under these facts, the presumption that value equals basis does not
apply to validate the allocations. Instead, PRs's allocations of gain or
loss must be closely scrutinized in determining the appropriate tax
consequences. Cf. section 1.704-1(b)(4)(vi). In this situation, the
special allocations of the $2,000 of COD income and $4,000 of book loss
will not be respected and, instead, must be allocated in accordance with
the A's and B's interests in the partnership under section 1.704-1(b)(3).

Close scrutiny also would be required if the changes were made at a
time when the events giving rise to the allocations had not yet occurred
but were likely to occur or if, under the original allocation provisions
of a partnership agreement, there was a strong likelihood that a
disproportionate amount of COD income earned in the future would be
allocated to any partner who is insolvent at the time of the allocation
and would be offset by an increased allocation of loss or a reduced
allocation of income to such partner or partners.


HOLDING

Partnership special allocations lack substantiality when the partners
amend the partnership agreement to specially allocate COD income and book
items from a related revaluation after the events creating such items have
occurred if the overall economic effect of the special allocations on the
partners' capital accounts does not differ substantially from the economic
effect of the original allocations in the partnership agreement.


DRAFTING INFORMATION

The principal author of this revenue ruling is David J. Sotos of the
Office of Assistant Chief Counsel (Passthroughs and Special Industries).
For further information regarding this revenue ruling contact Mr. Sotos at
(202) 622-3050 (not a toll-free call).


<<ENDNOTES>>

1/ Under certain circumstances, the COD income would be allocated
between the partners in accordance with their shares of partnership
minimum gain because the cancellation of the nonrecourse debt would result
in a decrease in partnership minimum gain. See section 1.704-2(d).
However, in this situation, there is no minimum gain because the principal
amount of the debt never exceeded the property's book value. Therefore,
the minimum gain chargeback requirement does not govern the manner in
which the COD income is allocated between A and B, and PRs's special
allocation of COD income must satisfy the substantial economic effect
standard. See Rev. Rul. 92-97, 1992-2 C.B. 124.

<<END RULING>>

 

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