10.1.

10: Substantial Economic Effect

A complicated set of Regulations under 704 of the Code requires that any allocation of profits and losses,
to be recognized for tax purposes, have substantial economic effect. Since investment partnerships are
not tax-driven nor leveraged significantly, the bite of the 704(b) Regulations is not usually dangerous;
they are designed to impact on situations where profits and losses are allocated in one direction as an
economic matter and in another direction for tax purposes. Since there is often confusion on the
substantial economic effect test,
[1]
it is worth repeating that the fact a partner is allocated an interest in
profits and losses that does not correspond with the capital he has contributed is not dispositive for
purposes of measuring substantial economic effect; such allocations are the province of the partners in
the course of their negotiations. What interests the Treasury in this context is an allocation system keyed
to some form of tax minimization scheme, as when a high-income partner is getting 50% of the economic
distributions but 80% of the losses. To repeat, allocating losses and profits specially in order to save taxes
is not typical of investment partnerships, where the emphasis is on achieving high rates of return in an
economic sense.
Minimum Gain Chargeback and Qualified Income Offset
Two specific issues are often highlighted by practitioners and, without purporting to exhaust the subject,
deserve summary mention. Minimum gain chargeback is a concept that becomes relevant if the
partnership incurs nonrecourse debt. The problem is that losses or deductions attributable to nonrecourse
debt do not, by definition, have economic effect because the lender, not the partners, bears the economic
loss. Therefore, allocations of such deductions and losses must comply with I.R.C 704-2, working with an
artificial number styled minimum gain, which is the gain the partnership would have realized if it sold the
property securing the nonrecourse debt. Since non-recourse debt is not usually a feature of investment
partnerships, a reference to the minimum gain rules, including the minimum gain chargeback rules under
I.R.C 704-2(f) should be sufficient. Qualified income offset has to do with the problem that limited
partners, since their liability is limited, may enjoy losses for which they are not economically liable. Since it
is unlikely that the limited partners capital accounts will descend to zero in investment partnerships, the
Treasurys ukase that capital accounts be reduced by reasonably anticipated future distributions is not a
burning issue.
[1]
The substantial economic effect test against which special allocations are measured is in fact a
multipart test. The phrase economic effect is satisfied if: Profits and losses are reflected in the partners
capital accounts; upon liquidation, the proceeds (after allocation of profits or losses in the last year and
payment of bills) are distributed in accordance with capital accounts; and, finally, as indicated in the Text,
deficit capital balances are restored. Treas. Reg. 1.704-1(b)(2)(ii). The qualifier substantial refers to a
murky test that, in essence, has overtones of the famous Pareto Optimality condition in economics. A
distributive share status is not Pareto Optimal if it is possible to transfer $1 in wealth from one player to
another and produce a net gain (or loss) in the results of both the players as a group-transferors loss is
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less than transferees gain. When the loss and gain are in equilibrium, the status is Pareto Optimal. Under
Treas. Reg. 1.704- 1 (b)(2)(ii), the requirement that the allocation be substantial is lost if special
allocations are made which improve the after-tax effect on one partner and do not diminish the after-tax
effect of the other or others.
Sub-Topics
10.1.10.a: U.S. Trade or Business: U.S. Source Rules
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