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Jeremy Wells: Last year. Three individuals, let's just call them Jessica. Seth and Grady got together and formed lighthouse LLC, which they operate as a business. So this is a true, bonafide business. They haven't made any entity election. So this is just a multi-member LLC. [00:00:30] Jessica initially provided $500,000 to In Cash to Lighthouse to cover the start up and initial operating expenses. Seth contributed some real estate with a fair market value of $500,000, and his adjusted basis in that property was $200,000. Grady didn't contribute any cash or property, but he will provide services and run the business. So you've got a situation where you've got three individuals, [00:01:00] they come together, they register this entity together. It's a multi member LLC, so by default it will be treated as a partnership for federal tax purposes. Jessica has contributed cash. Seth has contributed some real estate. Grady will contribute services. They want to structure the profit allocations out of this business, such that lighthouse repays Jessica and Seth for their contributions as [00:01:30] quickly as possible. Jessica and Seth, they want to get their money back, essentially. And there's nothing wrong with that. A lot of investors do. They want to make sure that they get their return on investment first, at least their return of capital before anybody else starts getting a cut of any profits. But they're concerned. They want to make sure that they structure the partnership in such a way that they can accomplish this without being unfair or without running afoul of federal [00:02:00] partnership tax law.
Jeremy Wells: This is a fairly common situation for a lot of partnerships. At least one partner intends to provide services while another partner provides capital to get up and running. A lot of times we will call this the silent partner, right? The partner who just contributes cash or property in the background isn't really involved in the business. There's someone else who is actually running the business. That person doesn't bring anything to the table [00:02:30] initially, but is the one doing all of the work for the business. The one who contributes the cash or property is going to want to make sure that they get paid back first for that contribution. The capital contributing partner usually wants to get repaid as soon as possible. And one advantage of the partnership entity type, especially under federal tax law, is that there's a lot of leeway. There's there [00:03:00] are ways that partnership operators have come up with over the decades to structure the partnership and the partnership agreement, and the way the partnership allocates different items of income or deduction or credit, or we'll talk about that in a minute to make sure that certain partners get allocated, not just cash return on their, uh, [00:03:30] on the capital that they contributed, but profits or losses. More generally, partnerships have a lot of flexibility to allocate profits and losses so that they reflect the economics of the partner's underlying arrangement. So in particular to lighthouse LLC and Jessica, Seth, and Grady.
Jeremy Wells: In this example, we're going to look at how they can structure their partnership agreement [00:04:00] to accomplish what they're trying to do. But we're going to look at the guardrails that are set up in federal partnership tax law to make sure that the financial accounting matches up with the economic reality of that partnership agreement, and then that turns into proper tax reporting of the partnership [00:04:30] and its income. So in this course, you're going to be able to explain how partnership income is determined and pass through to partners. We're going to distinguish separately stated partnership items from ordinary business income or loss. We're going to look at some examples of what those separately stated partnership items are going to explain the tax consequences of contributing property to a partnership, [00:05:00] especially when that is appreciated property. So it has a fair market value that is higher than the adjusted basis of that property. And specifically, look at a particular part of subchapter K, section 704 C that deals with this situation. And then finally we're going to look at whether a partnership allocation is going to be respected [00:05:30] under IRC section 704. And that's going to have to do with substantial economic effect. We're going to break that concept down too. So let's get into it. The first and most basic rule that we have to understand about partnership income and partnership tax law is that partnerships are pass through entities, meaning they do not pay federal income tax on the income that they generate.
Jeremy Wells: Rather, [00:06:00] partners include their distributive shares of the partnership's income gains, losses, deductions and credits in their own income. And here's the kicker they do this regardless of whether the partnership distributes any cash or property. This is IRC section 701. This is the very first section in all of subchapter K. So this sets the groundwork for how we think about partnerships [00:06:30] under federal tax law. Partnerships generally do not pay tax. They don't pay federal income tax. Now if the partnership has employees it will pay employment taxes. It will pay other kinds of taxes, especially at the state and local level. But as far as federal income tax goes. Partnerships don't pay tax. Generally partners do. This goes back to in. Is really a critical part of what [00:07:00] I discussed back in episode 31 on partnership formation about how federal tax law is a mix of both the aggregate and the entity approaches to partnerships. In some ways, partnerships act like an entity A and a unique individual taxpayer, but then in other ways, they act like an aggregate of the individual partners [00:07:30] that are involved in it. So IRC section 701 states that partners, not the partnership pay tax on their distributive shares. That goes along with the aggregate conception of looking at partnerships. And that is true whether the partnership distributes cash or property or not.
Jeremy Wells: So think about if you are a partner in a partnership and that partnership is profitable, it is going to pass through on paper a portion [00:08:00] of that profit to you. You are going to include that portion of your profit, that distributive share of the partnership's income in your total income. And then when you calculate your individual income tax, you're going to include that distributive share of partnership income. And that's going to be true whether you actually got a distribution of cash or other property out of that partnership. In the next episode, I'm [00:08:30] going to talk about distributions more and how partnerships can use those distributions and the way we think about distributions. But for now, this is the key point to keep in mind that partners pay tax on their distributive share of the income that comes out of that partnership. Now there is a Supreme Court case. Bazi USB bazi 410 US 441 from 1973. That's a good example of thinking [00:09:00] about how partners are subject to taxation for their distributive share of partnership income, regardless of whether there's been an actual distribution or not. And sometimes that can happen in ways that partners aren't even prepared for. So in the bazi case, a group of physicians formed a limited partnership, or they were in this limited partnership known as Permanente. They entered into an agreement with Kaiser Foundation Health Plan to provide medical care [00:09:30] and hospital services. Now, if you are out in the western half of the US, you probably heard of Kaiser Permanente.
Jeremy Wells: This is a today. This is a pretty large healthcare provider throughout a lot of the US. But back in the 70s, this was a relatively new situation. And the economics, the economic arrangement between Kaiser and Permanente was set up so that the doctors would join this partnership [00:10:00] called Permanente, and then they would the partnership would contract with Kaiser to provide these health services. So in exchange, Kaiser paid Permanente, the doctors, a base compensation consisting of two different amounts. First, an amount paid directly depending on the total number of members that were enrolled in the health plan. And then second, a retirement [00:10:30] plan paid into a trust and funded solely by Kaiser for Permanente's partners and Non-partner physicians. So there's two different kinds of compensation going on here. One is the funds directly paid to permanente. And then that would be or could be distributed and paid out to the doctors. The second was a retirement plan that was funded by Kaiser, but paid into a trust that would hold essentially those pension funds for [00:11:00] those doctors when they retired. And qualifying retirees from Permanente could then receive a retirement income contract from that trust once they retired. Now, Permanente never reported any of Kaiser's contributions into that retirement trust as income. They only reported what they were paid based on the number of members that were included in this arrangement. They did not report [00:11:30] the payments into the retirement fund.
Jeremy Wells: The IRS argued that those payments into the trust were Compensation paid to the partners. In fact, they pointed to the partnership agreement in the courts and said the partnership agreement calls this compensation. There are two forms of compensation the direct payments and the payments into the retirement fund. The physicians responded they never received that money. They never had access to it. It was paid directly into a [00:12:00] trust. They never had control of the funds. So as cash basis taxpayers, they shouldn't have to report the income. Both the district court and the appellate court agreed with the physicians and said, you're right, you never had control of the funds. You never had access to it. It's not income to you. But the U.S. Supreme Court flipped that decision around and decided for the IRS. Now, the court based that decision on two principles. First, that income is taxable to the party that earned it. This is the assignment of [00:12:30] income doctrine. And that has also, uh, come out of a couple of other precedential cases. The first is Commissioner V Culbertson, and that's the same Culbertson that we've been talking about the last couple episodes. And then also Lucas v Earl 281 US 111 1930. So the payments into the trust were part of the base compensation for the doctors in Permanente. [00:13:00] Second, each partner has to include their distributive share of the partnership's income in their taxable income.
Jeremy Wells: And that meant that the share of the payments, regardless of whether and how much of the retirement benefit any partner expected to actually receive, was taxable income for each partner. In fact, there were even cases where some of the doctors were disqualified because they left Permanente early. They broke their contract, something like that. And for those years [00:13:30] that they were receiving shares of the deposits into that trust from Kaiser. They had to report that as income to them, even though later on they weren't eligible to draw on the benefits from that fund. So that is a really interesting kind of situation, and it can seem a bit harsh to the partner, to the taxpayer. But ultimately, combining these two principles, the Supreme Court held that those payments were actually [00:14:00] income to the partners, that those amounts, the distributive share of those amounts paid into that retirement trust was actually income for the partnership and therefore needed to be included in the partner's distributive share of partnership income. Now, there are some aspects of partnership income that need to be considered separately from the ordinary business income [00:14:30] of the partnership. In other words, some items, some of the that income deduction, gain loss or credit has specific tax treatment at the partner level. So partnerships have to separately state the distributive shares of those items. And again this goes back to the aggregate approach to thinking about partnerships that the partnership from a federal tax perspective sometimes [00:15:00] has to be thought of as a collection of individuals.
Jeremy Wells: And because individuals are taxed differently on different kinds of income and deductions, the partnership needs to take that into account when it's reporting its own income and each partner's distributive share. So some examples of these separately stated items are qualified dividends because those receive capital gains treatment they're not included in [00:15:30] ordinary income, capital gains and losses write capital gains have preferential tax rates for individuals, and so it wouldn't make sense to conflate capital gains with ordinary business income. For example. Charitable contributions are another separately stated item because there are limitations based on AGI for the individual of how much of that is deductible. It's also an itemized contribution. Excuse [00:16:00] me, it's an itemized deduction. And so those charitable contributions from made by the partnership for each partner, his or her distributive share needs to be added to any other charitable contributions that individual made. And those would be reported as an itemized deduction on schedule A, if the taxpayer itemizes. So those can't be treated as an ordinary business deduction by the partnership, they need to be separately [00:16:30] stated foreign taxes paid or accrued because individuals may qualify for the foreign tax credit, and then gains and losses from sales or exchanges of section 1231 property, because, again, those are going to have differential implications for different taxpayers. Now, the character of any item of income gain, loss deduction or credit included in a partner's distributive share is the same as [00:17:00] if the partner had realized it directly from the source.
Jeremy Wells: Ordinary business income or loss is generally not separately stated. So if the partnership is in business, then that business income and all of the section 162 ordinary necessary business expenses are generally reduced down into a single measure of net income that would be passed through as ordinary business income. [00:17:30] But anything that is a separately stated item needs to be pulled out of that calculation and treated separately. That all comes from IRC section 702. Now a partnership has to compute its taxable income as a distinct entity, but it also has to determine the character of the separately stated kinds of income due to those special tax treatments at the partner level. So this is an instance. Irc section 702 is a great [00:18:00] instance of where we see the entity and the aggregate conceptions almost happening at the exact same time, because the partnership has to calculate its income as a distinct entity. The individual partners don't just figure out their own individual shares of the partnership's income. The partnership does that, and it reports that on its own tax return. But in so doing, the partnership has to keep in mind that individual partners are going to be taxed differently [00:18:30] on different parts of that income. And so it needs to state separately the various different parts of that income. Now, on form 1065, if you look at schedule K, you will see a list of separately stated items.
Jeremy Wells: A lot of the ones that I just mentioned are listed there qualified dividends, capital gains, section 1231 gains or losses and so on. One common item that's not [00:19:00] included in that list from section 702, but that is listed there in schedule K, is interest income. Now I often see interest income on returns that were prepared by other tax pros or firms. I often see interest income reported as other income on line seven on page one of the 1065. That is incorrect. Interest income is not simply [00:19:30] other income. It is a separately stated item and it should be reported on schedule K line five. In fact, if you look at the schedule K you will see an entry there for interest income. This ensures that it properly flows to form 1040 schedule B. Now why would it be important to separately state interest income as opposed to just including it as some sort of other income in ordinary business income? Well, interest [00:20:00] income might have implications for other calculations on the individual's tax return. One example would be net investment income tax on form 8960. Right. So that interest income, even though it's sourced from a partnership, even if the partner is actively involved in that partnership, that interest income is still interest income, just as if the partner had earned it directly. And so therefore it needs to be reported by the individual as interest [00:20:30] income.
Jeremy Wells: The partner can't do that if it's not reported as interest income, as a separately stated item on their K-1, and then therefore on the 1065. Now, some determinations such as passive loss limitations under IRC section 469 are made at the partner level, while others, such as the existence of a profit motive, for example, are made at the partnership level. So in Simon V Commissioner 834.99 [00:21:00] this is in the Third Circuit. 1987. The court maintained precedent that the determination of the partnership's profit motive is rightly tested at the partnership, not the partner level. So if the partnership does not obviously have a profit motive, then that has implications [00:21:30] for whether the partnership can deduct those ordinary and necessary expenses under IRC section 162. Moreover, a determination of a profit objective can only be made with reference to the actions of those individuals who manage the partnership affairs and not the investment intent of any particular partner. This came up as an issue in Simon that 1 or 2 [00:22:00] of the partners claimed to have an investment intent, and therefore that, from their perspective, meant that the partnership was a had a profit motive or had an investment intent. But the court disagreed. The court said what actually matters is the partnership. But the partnership is really just the people that are running the partnership. And so if we look at the people running the partnership, the general partners, the member managers, if we're talking about [00:22:30] an LLC, the officers, if the LLC has, uh, has appointed officers more like a corporation.
Jeremy Wells: Uh, that sort of setup, if we look at the individuals actually running the business part of that LLC, do they have a profit motive? Are they treating this entity like a business? If so, then the partnership may have a profit motive, but if even they're not, then the partnership itself doesn't. This was [00:23:00] an interesting situation here in, in this, uh, Simon case, because if you can't show that the partnership, meaning those actively running the partnership don't have that profit motive, that has serious implications for the partnership, including the deductibility of those business expenses under section 162. Now, in general, a partner can't deduct partnership expenses on her individual tax return. [00:23:30] Right. The partnership reports the partnership income. And then from that reports to each partner via the K-1 their distributive shares of that income. So individuals generally speaking, aren't able to take any deductions in excess of what their distributive shares are reported from the partnership. However, there's an exception when the partnership agreement [00:24:00] or established practice within the partnership requires the partner to bear those expenses without reimbursement, then a partner can deduct the amount of the expense from her individual gross income. The partner has to show that she was required to pay the expenses without reimbursement. Otherwise, the expense is considered an expense of the partnership and is not deductible by the partner.
Jeremy Wells: There are a series [00:24:30] of tax court cases, including Klein, Farnsworth, uh, Wallander, Wallander and Lewis all that have this same consistent theme that the partnership agreement or established practice within that partnership. And that's going to be a relatively high bar to prove in court that the partnership will not reimburse the partner [00:25:00] for those expenses. And then, and only then, can the partner deduct those expenses on her individual return as unreimbursed partnership expenses. Now, what you will see on the individual partner's return is an entry on schedule E, page two below where you see the K one from the partnership reported with its income or loss. You will see on the next [00:25:30] line, usually up e unreimbursed partnership expenses. And that will usually be some negative amount. That is that the expenses that that individual partner paid that the partnership would not reimburse. Now, if a partnership has a reimbursement policy in place, but a partner just chooses not to request reimbursement for qualifying expenses under that policy, then she still can't deduct those expenses on her individual return. [00:26:00] So the partnership will allow reimbursement. The only recourse that partner has is to get reimbursement from the partnership. I do see a lot of practitioners, a lot of preparers, and even quite a few individual returns that have up. And there is not really enough due diligence done to make sure that those up are, uh, are appropriate, that that partner is eligible to deduct [00:26:30] those unreimbursed partnership expenses.
Jeremy Wells: Because in order to determine that, you really have to look at the partnership agreement, or you need to do some investigative work and ask around and make sure that the partnership one will not reimburse those expenses. And that two, it's established practice within the partnership for the partners to pay those expenses out of pocket. But in general, when I'm working with partnerships, I advise the partners to just avoid [00:27:00] that as much as possible and pay most, if not all, of the partnership's expenses from the partnerships, funds and bank accounts, because why take the chance that those Unreimbursed partnership expenses might get thrown out if the. It's not clear from the partnership agreement or from the testimony of the partners that that is established practice. One more place where [00:27:30] partners have to do some accounting on their own in regard to the partnership is the contribution of assets to the partnership. Now, generally, partners don't recognize gain or loss on contributions of property to a partnership in exchange for an interest in the partnership that is, in other words, built in gains and losses are preserved. So [00:28:00] let's look at another example here. Jessica and Seth form lighthouse, LLC. Let's say this is a different lighthouse LLC from the first one. Jessica contributes $100,000 in cash. Seth contributes a piece of real property with a basis of $20,000 in adjusted basis of $20,000 that has a fair market value of $80,000, along with equipment with a basis of $60,000 and fair market value [00:28:30] of $20,000.
Jeremy Wells: So this makes sense. Real estate usually appreciates equipment usually depreciates in value. Seth does not recognize upon that contribution. He does not recognize the $60,000 of built in gain on the real property, or the $40,000 loss on the equipment. Right. But notice what happened. Jessica contributed $100,000 in cash. So we would expect that the book value of [00:29:00] whatever Seth is contributing, right? The market value of whatever Seth is contributing would also be $100,000 if they're going to be 50, 50 partners. So what he does is he contributes the real property with a fair market value of $80,000, and the equipment with fair market value of $20,000. So together, that is $100,000. But it's the adjusted basis that we need to take into [00:29:30] account and track, because the $100,000 of total contribution by Seth is what matters in terms of their contribution into the partnership and what their interests in the partnership are considered worth. But it is the adjusted basis of those assets that's going to matter for the partnership when it starts taking depreciation on those assets. So we do have to keep both sets of figures in [00:30:00] mind. We have to keep both what's called the inside basis of those assets or the adjusted basis, along with the fair market value at the time of contribution. And that's going to determine the value of Seth's interest in the partnership.
Jeremy Wells: That is his outside basis. We're going to talk more about inside and outside basis later on. But this is a bit of an introduction to those two related but different concepts in partnerships. This comes from IRC section [00:30:30] 721. This non-recognition rule for whenever an individual contributes property, especially a depreciable property into uh, or, uh, appreciable property, right? Because it could be land, part of that real estate contribution could be land, which is non depreciable, but it does appreciate in value. So anytime you have a potential difference in fair market value and [00:31:00] adjusted basis of an asset, you're going to need to take this non-recognition into account. When the partnership takes, uh, accepts that contribution, then it adopts the partner's adjusted basis of that contributed property. And that is what's known as inside basis or the tax basis of that property. The partnership's inside [00:31:30] basis is the contributors adjusted basis, while the property's book value is generally recorded at fair market value and the book value, the fair market value is what's going to determine the value of the contributors basis in their interest in the partnership. But the adjusted basis of that asset is what's going to determine its inside basis or tax basis for the partnership of the asset [00:32:00] itself. So when a partner contributes property with a built in gain or loss. The partnership has to allocate the pre contribution built in gain or loss to the contributing partner to prevent shifting of tax consequences.
Jeremy Wells: Now the rule about the partnership adopting the partner's adjusted basis that comes from IRC section 723. The rule about attributing [00:32:30] or allocating the built in gain or loss to the contributing partner that comes from IRC section 704. See, there's more discussion of that in regulation section 1.7043. And that's a somewhat complicated part of partnership tax law is taking into account the difference between the book value and the inside basis of [00:33:00] contributed assets. In fact, we typically refer to this situation as 704 C property. So in that prior example, Seth contributed a piece of real property with a basis of $20,000 that has a fair market value of $80,000. And Jessica is entitled to 50% of the depreciation deduction because they each contributed cash or property of $100,000 each. So they are 5050 partners. [00:33:30] Now assume the depreciation in the first year of the partnership. Owning that asset would have been $8,000 based on the fair market value. Right. So Jessica would have benefited from $4,000 in depreciation deduction. Why are we using fair market value here? Because this is what Seth's interest in his assessed basis in his partnership interest is based on. That was based on the fair market value of the asset, but the actual depreciation deduction [00:34:00] that the partnership can take is based on his adjusted basis, when he contributed it to the partnership and that amount of depreciation based on the adjusted basis, or now the partnership's inside basis in that asset is just $2,000.
Jeremy Wells: So under book accounting, each partner would expect $4,000 of depreciation. But under tax accounting there's only $2,000 of depreciation expense available. So [00:34:30] how do we account for this. Well the partnership takes SaaS carryover basis. Jessica is going to get as much of the benefit as is allowed, which is the $2,000 of depreciation expense allocated to her. The remaining $2,000 difference for her is known as the ceiling rule or the distortion from the ceiling rule, which limits the total tax items allocated [00:35:00] with respect to contributed property. 704. See property to the amount of tax items the property actually generates. Now that reg section 1.7043 provides three methods for allocating the tax consequences of contributed property, and each of them handles this ceiling rule a little bit differently. So what I just described, where there is $2,000 of allowable depreciation [00:35:30] expense. And so Jessica takes that $2,000. That is roughly the traditional method where you allocate only the actual tax items from the contributed property. There's also the traditional method with curative allocations, where you reallocate other actual tax items to reduce the ceiling rule distortions. There might be other tax items that we have a preference toward. Seth. And so you might use those [00:36:00] in order to balance out, or at least attempt to balance out where you have the ceiling rule distortions. And then there's the remedial method where you create offsetting remedial tax allocations to eliminate the ceiling rule distortions.
Jeremy Wells: It gets very complicated, it gets very complex. And so we're not going to go deep onto any of these now. But there are methods built into the regulations to take into account [00:36:30] the distortion caused by this rule. The ceiling rule under 704 C. Now we move into the concept of thinking about how we account for these book value valuations of partnership interests. So in the previous example, Jessica contributed $100,000 in cash. Seth contributed assets with a fair market [00:37:00] value of $100,000. And so in this case, if we were talking about another kind of tax entity type, like a corporation, we would say they both have $100,000 worth of equity in the business. For partnerships, we reframe equity as capital. So we talk about capital accounts. And the basic accounting equation is the same for partnerships as it is for other any other tax entity type. The [00:37:30] only difference is we use capital instead of equity. So here for partnerships assets total assets equals liabilities plus capital. That basic accounting equation has to hold for a partnership just like it does for any other kind of economic or tax entity type. Now, the capital account represents the book value of the partner's equity in the partnership, or the amount each partner [00:38:00] would be entitled to if the partnership liquidated at book value. In other words, if it paid off all of its liabilities, if it sold all of its assets at book value, and then whatever was left got distributed out to the partners based on their capital allocations, that would be what the capital account represents.
Jeremy Wells: We'll talk more about distributions and especially liquidations in the next episode, but it's important to keep in mind that this capital account means a couple different things [00:38:30] depending on the context in which you're looking at it. It can either be thought of as a book value measure of the partner's equity, or really a a more technically accurate definition would be to think of it as the amount that each partner is entitled to upon liquidation of the partnership. Now, contributions and income items generally increase capital accounts. Deductions, losses and distributions generally [00:39:00] decrease capital accounts. So in that way it operates very much like equity partnership liabilities do not affect capital accounts. Of course they don't because that's a whole separate part of the accounting equation. Assets equal liabilities plus capital liabilities and equity or liabilities and capital are two completely separate concepts. So the partnership can do whatever it wants with its liabilities that will not directly [00:39:30] affect the partner's capital accounts. That's important to keep in mind because in the next episode we're going to talk about outside basis. And the rules for outside basis are different because outside basis and partner capital accounts are two completely different concepts. Now again, the rules for capital accounts are different from basis in that capital accounts, like any other equity measure, can go negative.
Jeremy Wells: I have seen [00:40:00] practitioners get very nervous when they see a partnership or a partner with a negative capital account, because they think that doesn't seem right. I know that bases can't be negative, bases can't go below zero and that's true. Bases can't go below zero. But capital accounts can. In fact, capital accounts going negative is an interesting situation because what does that effectively mean. Think about the definition of capital account [00:40:30] right? Yes. It's the book value of the partner's equity. But it's also the amount that's due to a partner upon the liquidation of the partnership. But what if that's negative. That essentially means if you think about the definition of capital account from that perspective. That essentially means the partner would owe money to the partnership upon liquidation. But that doesn't seem right. So we need to create some rules for partnerships that make sure [00:41:00] that partners don't take advantage of the economic structure of a partnership, such that they get tax benefits that are not with not aligned with the economic reality of the partnership. And the best place to keep track of the economic structure, the economic reality of the partnership is with capital accounts. [00:41:30] And so the probably the most complicated regime within maybe all of the Internal Revenue Code, but especially within subchapter K, is the rules about capital account and making sure that capital accounts reflect the true economic arrangement among the partners.
Jeremy Wells: And the reason we can get into trouble here [00:42:00] is because of that flexibility with partnerships that I talked about earlier. Generally, a partner's distributive share of any partnership item or class of items of income gain, loss deduction or credit is determined by the partnership agreement. This is back to the aggregate conception of partnerships. The partners come together and they have a relatively wide degree of flexibility in how they want this partnership to allocate all of these different items among [00:42:30] themselves. However, there are some guardrails here that prevent partners from taking advantage of this flexibility to create tax consequences that are that are truly just for the purpose of tax avoidance and don't truly reflect the economic arrangement among the partners. So if a partnership agreement either doesn't provide for those allocations, [00:43:00] or if the partnership agreement provides for the allocation of those items to a partner, but the allocation does not have substantial economic effect, then the partner's distributive share of those items is determined in accordance with the partner's interest in the partnership. This is IRC section 704, A and 704 B and 704 B, and the regulations there under [00:43:30] deal with this concept of substantial economic effect. So 704 A gives significant flexibility to partnerships that the partnership can design its allocations however it wants, within reason. Right. According to that partnership agreement. But there are some allocation schemes that would assign partnership items based on purely tax rather than economic [00:44:00] consequences.
Jeremy Wells: Right. So what would this look like? So maybe one partner provides services and manages operations while the other fronts the operating capital and the funding partner expects a return of her investment before or at least a return of her capital before the working partner withdraws any distributions from profits. This sounds like the like the question that opened the episode up. One partner contributes a depreciable asset, while another [00:44:30] secures financing with a personal guarantee. The first partner wants the benefit of Depreciation, while the other partner wants the benefit of interest expense. So. Imagine a situation where the two partners agree that the partner that contributed the property is allocated all the depreciation expense. The other partner who has the personal guarantee for the funding is allocated all of the interest expense, or maybe a situation where an investor contributes capital while a manager contributes expertise. [00:45:00] The agreement provides that the investor first receives a return of contributed capital and a preferred return. On top of that, after which remaining profits are allocated to the investor into the developer. And although the developer contributed almost no capital, the special allocation reflects the partner's economic agreement. Now, this is a particular example that's actually fairly common, which is known as a carried interest. And there are a lot of rules about carried interest and whether they are [00:45:30] legitimate structures for partnerships. So now consider situations where the allocations reflect tax considerations rather than economic reality.
Jeremy Wells: So think about this. One partner has significant income from sources other than the partnership and is in the top income tax bracket. So the second partner depends on the partnership for income. The higher earning partner allocates more profit to the lower earning partner, [00:46:00] who then provides unofficial loans back to the higher earning partner. Right. This is clearly a setup that is just gaming the difference in tax liabilities and tax rates between the two tax payers between the two partners, or consider a situation where partnership includes a partner with significant suspended tax attributes such as net operating loss carryovers. The partners agree to allocate nearly all the partnership's income to [00:46:30] that partner in order to take advantage of those knolls and then minimize their combined tax liability. So here, the economic arrangement among the partners doesn't have anything to do with the actual partnership itself. Rather, they're just trying to take advantage of being able to soak up all of that partner's Nol carryovers. So this is where section 704 B comes in and compels us to ask whether those allocations truly reflect the economics [00:47:00] of the arrangement, or if they are just an attempt to avoid or minimize tax. And this is why Congress included the concept of substantial economic effect in two section 704. In general, allocations has to reflect the partner's underlying economic arrangement. Allocations devised merely to reduce aggregate tax among the partners don't have substantial economic effect, and therefore [00:47:30] they won't be respected.
Jeremy Wells: And the IRS can essentially look at those allocations, say that they don't have substantial economic effect, or even just one particular allocation doesn't have substantial economic effect. And then instead of respecting the way the partners agreed to allocate that item, rather allocate it according to their capital interests or capital percentages. And then that might create a very different result for the partners. Now, the regulations [00:48:00] include three tests to determine if an allocation has economic effect. And here economic effect asks whether the allocation reflects the partner's economic deal as evidenced in its capital accounts. So again, we're going back to capital accounts to see what the economic arrangement of the partners is. There's the basic test, the alternate test and the economic effect equivalent test. In general, the basic [00:48:30] test requires that the partnership maintain capital accounts in accordance with the regulations that it make, liquidating distributions in accordance with positive balances in the partners capital accounts, and that it requires partners to unconditionally restore any capital account deficit upon liquidation. This is known as a deficit restoration obligation. This all has to do with capital accounts. So back to the discussion from a couple of minutes ago. [00:49:00] If a partner's capital account goes negative, that's a situation which might trigger this deficit restoration obligation. Or under the alternate test, it might trigger what is known as a qualified income offset provision. Now, the difference between a Dro and a qualified income offset provision or Qio is that under a DRO? The partner actually owes cash back [00:49:30] to the partnership.
Jeremy Wells: For whatever reason, that partner has a negative capital account, which means that partner has either been allocated too much loss or deduction, or has taken too many distributions or some combination of the two, and essentially owes money back to the partnership in the form of a contribution, a cash contribution that would then bring the capital account back to zero or to some positive amount. A qualified income offset will essentially [00:50:00] temporarily reallocate income to that partner in order to bring their capital account back up to zero or positive. Now, in the alternate test, there needs to be this QIO, along with all of the requirements of the basic test. And then the allocation can't create or increase a deficit in a partner's capital account in excess of the partner's obligation to restore [00:50:30] the deficit. So, in other words, get the capital count back to zero or positive, and don't do anything that would bring it back down into the negative. So these are a couple of different ways that the partnership can ensure that its partners are operating in such a way that their transactions, that their allocations, that their distributions, which we'll talk about in the next episode, [00:51:00] actually match with the economic structure or arrangement among the partners. And that's what economic effect is short for. Now, the substantial part means that an allocation meaningfully changes the dollar amounts received by partners independent of the tax consequences.
Jeremy Wells: And this is a different question, right? So economic effect asks whether the allocation reflects [00:51:30] the partner's economic arrangement. Substantiality asks whether the allocation has a reasonable possibility of meaningfully affecting the dollar amounts received by partners, apart from its tax consequences. Now, together, they provide the principal regulatory safe harbor for respecting partnership allocations. But it's important to keep in mind that failure to meet the safe harbor doesn't necessarily mean that an allocation has to be adjusted, [00:52:00] just rather that it might be subject to further scrutiny under these tests. So let's go back to the case study. We started off with Jessica contributed cash, and she wants to get her return of capital. Seth contributed property. He wants to get his return of capital. And then Grady is just contributing services at some point in the future. So we've seen all of the individual rules. Let's try to bring this together and think about what a partnership agreement among them might look like that satisfies [00:52:30] especially Jessica and Seth, but all three partners, but then also fits within those guardrails set up by subchapter K, especially section 704. So you might see phrasing like until Jessica has received cumulative distributions equal to her initial capital contribution, cash available for distribution will first be distributed to Jessica. Right. So if there are any profits and there's any cash left in the bank, Jessica [00:53:00] is going to get 100% of those distributions until she's received her return of capital invested.
Jeremy Wells: Seth might have language that says once Jessica has been paid off, essentially once she's gotten her return of capital and we're not, you know, paid off is the wrong way to think about this because it's not debt, it's not credit, it's actual equity. But investors want to get their capital back out of the business so that they can go invest in other businesses, right? So [00:53:30] in this case, Seth is going to insist on language that says once Jessica has received her capital contribution back, then any available cash to be distributed will come to him until his contributed properties agreed book value has been returned back to him. And then Grady would want to insist on language that says, okay, once Jessica and Seth have gotten their money back, I need to start getting a [00:54:00] share of the profits because I'm doing all the work here in this partnership. So thereafter, remaining profits and cash distributions would be shared equally, for example, or they might agree to some other percentage breakdown. Now notice that cash distributions aren't the same thing as tax allocations. And again we'll talk about distributions more in the next episode. But because Jessica is receiving the early cash, the agreement has to also allocate sufficient book income to Jessica to maintain [00:54:30] the economic relationship. It can't just be that she starts taking cash distributions.
Jeremy Wells: There has to be an allocation of the income to her so that that income backs up the distributions that are coming out. This is starting to drift more into the territory of basis, although it is going to affect her capital account, because if the income is divided evenly, but then she starts taking distributions, that's going to distort their capital accounts. So we have to be worried about both capital accounts and bases. [00:55:00] They are separate concepts, but they both behave similarly with respect to allocations and distributions. Now Seth contributed appreciated real estate. Don't forget that part. So we need to consider the built in gain of his contribution under IRC section 704. See. So who should ultimately bear that built in gain, which was about $300,000 in the setup? Seth should. Right. And as 704 C prevents that built in gain [00:55:30] from being shifted to Jessica or Grady simply because the property was contributed to a partnership. So there's going to be an allocation of the allowed depreciation that is not going to match the depreciation. That would be calculated for the books for that contributed property. And 704 C is going to tell us how to do that. So some key takeaways for this episode. First of all, partnerships generally allocate items according to [00:56:00] the partnership agreement, not necessarily ownership percentages. This is why it's really important to get a copy of the partnership agreement, or in the case of a multi member LLC, the operating agreement from the owners.
Jeremy Wells: I do not recommend trying to prepare a partnership tax return without the governing documents of the partnership or the LLC. You need to have something written and agreed to by [00:56:30] all of the partners or members to rely on before you start making these calculations on the tax return. Separately, stated items retain their character when pass through to partners. That is a critical planning point for a lot of partnerships. I have seen taxpayers get very surprised because they didn't know that certain items would have certain effects at the partner level. They assumed it would all get mixed [00:57:00] together at the partnership level, and they wouldn't have to worry about the effects at the partner level. That's not necessarily the case. Contributed property carries over its tax basis. And so there might be some section 704 C allocations when tax and book values differ. So be especially careful when you are adding contributed depreciable or appreciated assets to a partnership's depreciation [00:57:30] schedule. And then finally special allocations are respected only if they have substantial economic effect, meaning they reflect the partner's economic arrangement and they're not designed to solely avoid tax. If you found value in this episode, please let me know by liking and leaving a comment in your podcast application of choice or on YouTube. And for the next episode, like I said, we're going to look at outside basis distributions and how to end a partnership and what liquidation looks like. [00:58:00]