Partnership Taxation: Substantial Economic Effect

Partnership taxation is a complex area of tax law. We’ll be walking through some of the issues you should be aware of.

The first is to ensure you are getting the deal you thought you were.  Partners (or LLC members where the LLC has multiple members and does not “check the box“) can agree on how to allocate the profit and losses of the business as they see fit in the agreement.  The allocations can be done in any manner the partners/members choose, provided that the allocations have “substantial economic effect.” See IRC 704(b); Treas. Reg. 1.704-1(b).

The agreement partnership (or LLC operating agreement) will have “substantial economic effect” where it meets a two part analysis:

First Part: Economic Effect: It must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or economic burden that corresponds to an allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden.  For it to have effect the three following items must be present throughout the full term of the partnership in the agreement:

(a) That capital accounts are kept in accordance with the applicable regulations;

(b) Upon liquidation of the partnership (or any partners interest), liquidating distributions are made in accordance with the positive balances of the capital accounts, taking into account all adjustments for the year of liquidation; and

(c) If a partner has a deficit in his capital account following liquidation, he is unconditionally obligated to restore the amount.

Second Part: Substantiality of Economic Effect. The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.