Question

Your clients, Grayson Investments, Inc. (Ana Marks, President), and Blake Caldwell, each contributed $200,000 of cash to form the Realty Management Partnership, a limited partnership. Grayson is the general partner, and Blake is the limited partner. The partnership used the $400,000 cash to make a down payment on a building. The rest of the building’s $4,000,000 purchase price was financed with an interest-only nonrecourse loan of $3,600,000, which was obtained from an independent third-party bank. The partnership allocates all partnership items equally between the partners except for the MACRS deductions and building maintenance, which are allocated 70% to Blake and 30% to Grayson. The partnership wants to satisfy the “economic effect” requirements of Reg. §§ 1.704–1 and 1.704–2 and will reallocate MACRS, if necessary, to satisfy the requirements of the Regulations. Under the partnership agreement, liquidation distributions will be paid in proportion to the partners’ positive capital account balances. Capital accounts are maintained as required in the Regulations. Grayson Investments has an unlimited obligation to restore its capital account, while Blake is subject to a qualified income offset provision. Assume that all partnership items, except for MACRS, will net to zero throughout the first three years of the partnership operations. Also assume that each year’s MACRS deduction will be $200,000 (to simplify the calculations).

1. Prepare Tax Memorandum to the file evaluating the allocation of MACRS in each of the three years under Reg. §§ 1.704–1 and −2.

Answer 1

Answer :

Maloney, Raabe, Young, Nellen, & Hoffman, CPAs
5191 Natorp Boulevard
Mason, OH 45040

October 4, 2019

Grayson Investments, Inc., General Partner in care of Ms. Ana Marks
Blake Caldwell, Limited Partner
The Realty Management Partnership
53 East Marsh Avenue
Smyrna, GA 30082

Dear Ana and Blake:

You have asked us to outline the consequences to you of the proposed MACRS cost recovery allowance allocation for the building owned by your partnership. The following analysis demonstrates the effects of your proposed 70% allocation to Blake and 30% allocation to Grayson Investments, Inc., where the partnership has $200,000 of annual cost recovery deductions, and where we assume that no other items of income or loss are required to be reported for any year.

Substantial Economic Effect Test

An allocation that meets the “substantial economic effect” (SEE) requirements of Code § 704(b) and the underlying Regulations will be accepted by the IRS. The economic effect test is designed to ensure that a partner who receives any allocation of loss, deduction, etc., actually bears the burden of that allocation. To be deemed to have economic effect, three tests must be met. First, the partnership must determine and maintain partners’ capital account balances as required under the Regulations. This requirement is satisfied, since we assist you in maintaining records. Second, upon liquidation of the partnership, distributions must be made to partners with positive capital account balances at the end of the year. This is required under your partnership agreement.

The third test is met if all partners are required to restore deficits in capital account balances upon liquidation of the partnership. An alternative test allows an allocation to meet this third requirement to the extent the partner is subject to a qualified income offset requirement (QIO). As a general partner, Grayson, Inc., has an unlimited obligation to restore any negative capital contribution, so the company meets the third requirement under the general test. The partnership agreement provides that Blake is subject to a qualified income offset provision, so the alternative test for the third requirement is met as long as an allocation does not result in Blake having a negative capital account balance following the allocation.

Year 1

The first year’s depreciation will be allocated $140,000 to Blake and $60,000 to Grayson, resulting in ending positive capital account balances of $60,000 and $140,000, respectively. The allocation of MACRS will satisfy the above economic effect requirements of the Regulations, because, at the end of the first year, neither partner will have a negative capital account balance. Upon a hypothetical sale of the property for its $3,800,000 adjusted basis, there would be sufficient cash to pay the liability and provide additional cash of $200,000. Under the partnership agreement, this would be distributed $140,000 to Grayson and $60,000 to Blake (i.e., in accordance with ending capital account balances). Because each of you originally contributed $200,000 to the partnership, Grayson will have borne $60,000 and Blake will have borne $140,000 of the economic burden associated with the MACRS allocation.

Year 2

The proposed allocation of the MACRS deductions will not satisfy the requirements of the Regulations. At the end of the year, Blake will have an ($80,000) (negative) capital account balance, and Grayson’s balance will be $80,000 (positive). Because Blake is a limited partner and has no deficit capital payback requirement, he cannot bear any economic risk of loss relative to the last $80,000 of MACRS allocated to him. The depreciation allocated to Blake is limited to the $60,000 positive capital account balance. Grayson will be allocated the remaining $140,000. Upon a hypothetical sale of the property for its $3,600,000 adjusted basis, there would be only enough cash to pay the debt. Neither of you would receive any money upon liquidation. Since you each contributed $200,000 to the partnership and receive no cash on liquidation, you would each have borne a $200,000 economic burden relative to the MACRS—which corresponds to the cumulative MACRS allocated to each of you.

Year 3

The allocation will be respected in year 3. The $3,600,000 remaining debt on the property is nonrecourse and exceeds the adjusted basis of the property ($3,400,000 after year 3 MACRS) by $200,000. This amount is termed a “minimum gain” (i.e., the amount of gain the partnership would recognize on foreclosure or sale of the property for the amount of the debt). If the partnership agreement includes a “minimum gain chargeback” provision, MACRS related to this $200,000 increase in minimum gain can be allocated $140,000 to Blake and $60,000 to Grayson. A “minimum gain chargeback” provision requires that when the minimum gain is eventually realized (e.g., through sale of the property), the gain will be allocated to the party receiving the deductions related to the nonrecourse debt.

For example, if the property was sold at the end of the third year for the amount of the debt ($3,600,000), a gain of $200,000 would arise, although there would be no cash available to distribute to the partners (the cash is all used to pay the debt). If the partnership agreement requires that this gain is allocated $140,000 to Blake and $60,000 to Grayson, then the depreciation can be allocated as outlined under the partnership agreement. In this case, Blake would have borne $340,000 of economic burden ($200,000 initial contribution plus $140,000 gain on sale of the property); over the life of the partnership, he should be able to claim $340,000 of MACRS ($140,000 year 1, $60,000 year 2, and $140,000 year 3). Similarly, Grayson bears $260,000 of economic burden ($200,000 initial contribution plus $60,000 gain on sale), so over the life of the partnership, that company should be able to claim $260,000 of MACRS ($60,000 year 1, $140,000 year 2, and $60,000 year 3).

This memo does not contain legal citations because it is written to a client.

The following cites are provided for your benefit:

Reg. § 1.704–1(b)(2)(ii)(b) outlines the three requirements for economic effect.
Reg. § 1.704–1(d) provides the alternative QIO test.
Reg. § 1.704–2 outlines minimum gain requirements [see especially Reg. § 1.704–2(f)].