Question

13. How will the IRS treat special allocations of income or loss among partners if the allocations do not have substantial economic effect? Attach Internal Revenue Code Section

Answer 1

Special Allocations - The partnership agreement may provide different allocation ratios for sharing items of income, gain, deduction, losses and credits among the individual partners. When an allocation ratio differs from the partner's profit and loss sharing ratio, or it differs from a partners relative capital contribution, it is referred to as a special allocation.

Generally, the partnership agreement determines a partner's distributive share of any item or class of items of income, gain, loss, deduction, or credit. The allocations provided for in the partnership agreement or any modification will be disregarded if they do not have substantial economic effect. If an allocation does not have substantial economic effect or the partnership agreement does not provide for the allocation, the partner's distributive share of the partnership items is determined by the partner's interest in the partnership.

Substantial economic effect. An allocation has substantial economic effect if both of the following tests are met.

1. There is a reasonable possibility that the allocation will substantially affect the dollar amount of the partners' shares of partnership income or loss independently of tax consequences.
2. The partner to whom the allocation is made actually receives the economic benefit or bears the economic burden corresponding to that allocation.

If a partnership agreement is silent and does not provide for a special allocation, or if a special allocation is made and the allocation lacks substantial economic effect, then a partner's distributive share of profit or loss can be re-determined by the IRS in accordance with the partner's interest in the partnership.

It all Cover in IRC Sec. 704(b)