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What allocations methods create “Substantial Economic Affect” in a partnership.

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Brett Thompson, JD, CPA
The partnership agreement should be reviewed for the requirement of contribution if the capital accounts become negative. One method is that the partners must contribute to the partnership to the extent of their negative capital accounts. This is the first method the IRS suggests and should not be entered into if the partners want limited liability. Nonetheless, some agreements have this provision anyway.

There are three methods that should be inspected before the partnership agreement is signed. These are safe harbor rules but they might yield unintended results to the partners, who might have entered into a different deal but have to live with the allocation method that is in the partnership agreement.

These problems arise when a partner contributes appreciated property that is depreciable herein after the “contributing partner”. In such a case, the depreciation deduction can distort the economics among the partners. That is a shifting of benefits that is not warranted by the economics of the deal, especially shifting pre-contribution of appreciated property. There are 3 methods the IRS descripts in its regulations.

Under the “Traditional Method” §1.704-3(b). Here the non-contributing partners get the depreciation deduction up to what the partnership agreement says as if the property were valued at fair market value. Any remaining depreciation goes to the contributing partner. There is a “ceiling rule” that trys to prevent shifting pre-contribution appreciation.

Under the “Traditional Method with Curative Allocations,” §1.704-3(c) which sanctions the use of other income and deductions of other items, not just depreciation to avoid distortions.

Finally, there is the “Remedial Method” which allows partners to create out of a taxable income and deduction, which the non-contributing party can claim all of their book depreciation as a deduction despite the fact that property is not generating this much tax depreciation deductions, despite the ceiling rule.

Then there is the “Targeted Allocations” which is not a safe harbor. This is where the partners decide what the outcome should be and work backwards to show they are following one of the safe harbor methods. If it doesn’t fit into one of the safe harbors, they can still use it, although they must test for substantial economic effect.
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