LLC and Partnership Taxation: Beyond the Basics

• Chapter 1 - Allocation of Partnership and LLC Income under Section 704(b)
  • Learning Objectives
  • Introduction
  • Economic Effect: The General Test
    • General Requirements
    • Maintenance of Capital Accounts
    • Section 704(b) vs. GAAP
    • Treatment of Liabilities
    • Liquidating Distributions
    • Restoration of Deficit Capital Balances
  • Deemed Economic Effect
  • Alternate Test for Economic Effect
    • Rationale
    • Requirements
    • Qualified Income Offset - Correcting Inadvertent Errors
    • Partial Economic Effect
    • Adjusted Capital Accounts
  • Substantiality
    • Overview
    • Shifting Tax Consequences
    • Transitory Allocations
    • Transitory Allocations vs. Shifting Tax Consequences
    • Overall Tax Effects Test
  • Denied Allocations: Determining the Partners' or LLC Members' Interests in the Entity
    • In General
    • No Deficit Restoration Requirement
  • Other Issues
    • Distributions of Partnership Property
    • Section 734(b) Adjustments
    • Transfers of Partnership Interests
    • Optional Revaluation of Partnership Property
    • Determining Fair Market Value
  • Allocation of Deductions Attributable to Nonrecourse Debt
    • Overview
    • Nonrecourse Deduction Defined
    • General Requirements for Economic Effect
    • Consistency with Other "Significant" Items
    • Minimum Gain Chargeback
  • Summary
  • Questions
• Chapter 2 - Allocations with Respect to Contributed Property: Section 704(c)(1)(A)
  • Learning Objectives
  • Introduction
  • The Traditional Method
    • Allocations of Tax Gain or Loss
    • Cost Recovery Deductions
    • Depreciation Methods
    • Anti-Abuse Provision
    • The Ceiling Rule
    • Nontaxable Dispositions
  • The Traditional Method with Curative Allocations
  • The Remedial Allocations Method
    • Mechanics
    • Computation of Book Items
  • Special Rules
    • Section 704(b) Revaluations
    • Small Disparities
    • Aggregation of Properties
    • Tiered Partnerships
  • Summary
  • Questions
• Chapter 3 - Allocation of Partnership Recourse Liabilities under Section 752
  • Learning Objectives
  • How Liabilities Affect Partner Tax Consequences
    • Basic Concepts
    • Transactions that Change Partners' Shares of Partnership Liabilities
    • Effect of Liabilities on Partners' and LLC Members' Amounts at Risk
  • Allocation of Liabilities among the Partners - In General
    • Recourse vs. Nonrecourse Liabilities
  • Allocation of Recourse Liabilities
    • General Rules - "Constructive Liquidation"
    • Limited Partners
    • Book vs. Tax Capital Accounts
    • Effect of Partner Guarantees
    • Special Allocations of Partnership Income and Loss
  • Questions
• Chapter 4 - Allocation of Partnership Nonrecourse Liabilities and Related Deductions under §§752 and 704(b)
  • Learning Objectives
  • Distinguishing between Recourse and Nonrecourse Liabilities
    • Obligation to Make Payment
    • Partner Guarantee of Interest on Nonrecourse Loan
    • Partner Providing Collateral for a Partnership Nonrecourse Loan
    • Nonrecourse Loans by Partners
    • "Wrapped" Debt
    • De Minimis Exceptions
  • Allocation of Nonrecourse Debts
    • Conceptual Difficulties in Allocating Nonrecourse Liabilities
    • Nonrecourse Liabilities Allocated by Reference to Partners' Profits Interests
    • Minimum Gain
    • Tax vs. Book Minimum Gain
    • Other Partnership Profits
  • Allocation of Deductions Attributable to Nonrecourse Debt
    • Overview
    • Nonrecourse Deduction Defined
    • General Requirements for Economic Effect
    • Consistency with Other "Significant" Items
    • Minimum Gain Chargeback
  • Treatment of Contingent Liabilities
    • General
    • Mechanics
    • Sale or Transfer of Interest in Partnership or LLC
    • Liquidating Distribution to §1.752-7 Partner or Distribution of Property Secured by §1.752-7 Liability to Another Partner
    • Exceptions
  • Questions
• Chapter 5 - Advanced Distribution Rules
  • Learning Objectives
  • Non-Liquidating Distributions Generally
    • Non-Cash Distributions
    • Cash Distributions
    • Receipt of Cash and Property
  • Distribution of Multiple Properties
    • Decrease in Basis of Unrealized Receivables and/or Inventory
    • Decrease in Basis of Other Assets
    • Liquidating Distributions
    • Allocating an Increase in Basis among Multiple Properties - Ordinary vs. "Other" Assets
    • Allocating an Increase in Basis among Multiple "Other" Assets
  • Summary
  • Questions
• Chapter 6 - Adjustments to the Basis of Partnership/LLC Assets
  • Learning Objectives
  • Introduction
  • Section 743 - Adjustments Following the Transfer of a Partnership Interest
  • Distributions of Partnership Property
    • Situation 1 - Gain Recognized by Distributee Partner
    • Situation 2 - Loss Recognized by Distributee Partner upon Distribution of Partnership Property
    • Situation 3 - Increase or Decrease in Basis of Assets Distributed in Complete Liquidation of a Partner's Interest
    • Situation 4 - Decrease in Basis of Partnership Assets Distributed in Partial Liquidation of a Partner's Interest
  • Allocating the Adjustment Amount among Partnership Properties
    • Transfers of Partnership Interests
    • Income in Respect of a Decedent
    • Partnership Goodwill
    • Distributions of Partnership Property
    • Section 751(b) Distributions
    • Making the Section 754 Election
    • Relief When Election Not Made
  • Questions
• Chapter 7 - Sale of an Interest in a Partnership or LLC
  • Learning Objectives
  • General Tax Consequences Associated with Sale
    • Effect of Liabilities
    • Receipt of Property other than Cash
    • Holding Period of Partnership Interest
  • Hot Assets and Section 751(a)
    • Hot Assets under Section 751(a)
    • Rules of Application
    • Statement Must Be Attached to Return
  • Collectibles and Unrecaptured Section 1250 Gain
    • Collectibles Gain
    • Unrecaptured Section 1250 Gain
  • Installment Sales
  • Potential for Termination of the Partnership
    • Technical Terminations under §708
    • Consequences
    • What Constitutes a Sale under §708?
  • Consequences to the Purchaser
  • Questions
• Chapter 8 - Latest Developments
• Appendix A - Partnership Return of Income Checklist
• Appendix B - Limited Liability Entity (LLC, LLP, et. al.) Addendum to the Partnership Return of Income Checklist
• Appendix C - Partnership/LLC Tax Organizer

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Chapter 1 - Allocation of Partnership and LLC Income under Section 704(b)

Learning Objectives

After completing this chapter, you should be able to

• Analyze a partnership or LLC agreement to determine whether special allocations called for in that agreement will be allowable under the §704(b) regulations, and when they will not be recognized by the IRS;

• Understand the potential economic consequences to a partner or LLC member of a special allocation;

• Recognize the sections of a partnership agreement that must exist in order for a special allocation to be valid;

• Understand the potential tax consequences when a partner or LLC member has a negative balance in his/her capital account;

• Recognize the relationship between partnership and LLC allocations of profit and loss and the allocation of the risks and rewards of entity operations; and

• Distinguish between the requirements for “substantiality” and those for “economic effect” under the regulations and understand the importance of future expectations when determining whether a proposed allocation will be both appropriate to achieve the economic objectives of the partner/members and legitimate under the §704(b) regulations.

Introduction

Section 704 affords investors a wide degree of latitude in dividing partnership and LLC profits and losses. Section 704(a) allows the partner/members to divide items of entity income or loss in any manner they choose,¹ subject only to the constraints of Sections 704(b) and 704(c).² Section 704(c) requires special allocations with respect to contributed property and is the subject of the next chapter. Section 704(b) requires that the partnership’s tax allocations have “substantial economic effect.”

The criteria which must be satisfied before an allocation is considered to have substantial economic effect have been meticulously set forth in two sets of final regulations issued in September, 1986 and December, 1991. The basic premise of the regulations is very straightforward. The tax consequences of partnership/LLC allocations must follow the economic consequences of those allocations. A partner or LLC member who receives the economic benefit of a partnership or LLC gain must be allocated the associated tax burden (the tax on the additional income). Conversely, an investor cannot be allocated the tax benefits of an entity loss unless he/she bears the economic burden of that loss. If an allocation has no significant economic consequence, it will be disregarded for tax purposes.

Allocations that are determined not to have substantial economic effect are disregarded and the investors’ distributive shares of affected item(s) are determined according to their respective “interests in the partnership.” The regulations establish a two-part test to determine whether an allocation has substantial economic effect. First, the allocation must have economic effect. Second, the economic effect of the allocation on the partner or member must be substantial.

Economic Effect: The General Test

General Requirements

For an allocation to have economic effect, it must affect the amount the partner or LLC member will receive upon liquidation of the entity. Thus, if an LLC member is allocated all of the LLC’s depreciation expense, he/she must be entitled to a lesser share of the proceeds from an eventual liquidation of the LLC. That is, he/she must bear the economic burden of any depreciation in the value of LLC property.

This means that the entity must accurately record income or loss allocations in the investors’ capital accounts and must tie the investors’ rights at liquidation to the balances in those capital accounts. Accordingly, the regulations set forth three requirements for an allocation to have economic effect:³

1. The partnership/LLC agreement must provide for the proper determination and maintenance of partner/member capital accounts throughout the life of the entity;

2. The agreement must provide that upon liquidation of either the entity, or of an individual investor’s interest, liquidating distributions must be made in accordance with the positive capital balances of the investors; and

3. The agreement must require investors with negative balances in their capital accounts at liquidation to restore the deficits in those accounts.

The third requirement above assures that sufficient funds will be available to the partnership/LLC to repay its creditors and to liquidate the interests of those partner/members with remaining positive capital balances.

Tax Planning Point. Note that under the “substantial economic effect” rules, tax losses allocated to partners and LLC members will generally be associated with real economic losses. Thus, practitioners whose clients receive so-called “special allocations” of losses from an LLC or partnership should take care to ensure that those clients understand the potential economic costs that may accompany those tax allocations. Indeed, investors in an LLC or partnership who receive disproportionate loss allocations will often be required to make additional contributions to capital if the entity is unsuccessful. The purpose of the regulations under §704(b) is to ensure that tax loss allocations are accompanied by real dollar costs to recipients.

Maintenance of Capital Accounts

Since tax basis capital accounts seldom reflect fair market values, the regulations require the creation and maintenance of a separate set of investor capital accounts. These capital accounts are similar to the partnership’s tax capital accounts with a few minor differences. They are intended to reflect as accurately as possible the economic relationship between the partner/members.

The regulations require that capital accounts be increased by

• Cash contributions (including increases in the partner/members’ shares of partnership/LLC liabilities);⁴

• The fair market value of property contributed to the partnership or LLC by the partner/members (net of liabilities assumed by the partnership/LLC); and

• Allocated items of book income and gain as determined under §704(b) and the regulations thereunder, including non-taxable income and gain.

Capital accounts must be decreased by

• Distributions of cash from the partnership/LLC to a partner/member (including partner/member liabilities assumed by the entity, but not including guaranteed payments made to the partner/member by the partnership/LLC);

• The fair market value of any property distributed to a partner/member (net of liabilities assumed by the distributee in connection with the distribution);

• Allocated expenditures that are not deductible in computing partnership/LLC income under Sections 702 or 703 and are not properly chargeable to capital (e.g., syndication costs, expenses incurred in generating tax-exempt income, etc.); and

• Allocated items of book loss and deduction as determined under §704(b) and the regulations thereunder, including “simulated” oil and gas depletion.⁵

1 Special allocations should be clearly spelled out in the partnership or LLC agreement.
2 Further restraints have been laid out by the courts with respect to family partnerships. Allocations in family partnerships are governed by section 704(e).
3 Reg. §1.704-1(b)(2)(ii)(b).
4 Reg. § 1.704-1(b)(2)(iv)(c).
5 Reg. §1.704-1(b)(2)(iv)(b).

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