Academic journal article Entrepreneurial Executive

Bulletproofing Special Allocations

Academic journal article Entrepreneurial Executive

Bulletproofing Special Allocations

Article excerpt


Partnerships and those entities taxed as partnerships have always been popular forms in which to conduct business because the partnership itself is not subject to federal income taxation and the partnership under Internal Revenue Code (IRC) section 704(b) may specially allocate to the partners items of income, gain, loss, deduction, or credit.

The opportunity to specially allocate these items to minimize overall partner tax liabilities is very attractive and could be abused. To prevent abuse, both the code and subsequent Internal Revenue Code Regulations (Regs) limit the use of special allocations. Additionally, over the years a body of case law has developed that sets out limits but also offers some planning opportunities.

Successfully providing for special allocations requires avoiding the numerous pitfalls surrounding this provision. Properly using the guidance in the Code, Regs, and case law will bulletproof partnership special allocations from successful attack by the Internal Revenue Service (IRS).


Interestingly, the term "special allocation" does not appear in the IRC itself but does appear in the Regs and the legislative history to the Tax Reform Act of 1976 (S. Rep No. 938, 94th Cong., 2nd Sess 98 (1976). The idea for partnership special allocations originated with the American Law Institute in 1954 and made its way into the Code as [section]704(b) in that year. The initial provision only limited these allocations to the extent that the principal purpose for the allocation was the avoidance or evasion of income tax. The report of the Senate Finance Committee that accompanied that 1954 provision for the first time used the term "substantial economic effect" in commenting on whether an allocation would be valid. This term also appeared in the original Regs for new subchapter K of the 1954 Code and contained six tests to evaluate whether or not a special allocation had substantial economic effect. The original language of 704(b) was amended by the Tax Reform Act of 1976 which strengthened the limitation by prohibiting any allocation which does not have "substantial economic effect." The amended section 704(b) provides that partnership bottom line income or loss ([section]702(a) (8)) or any income, gain, loss, deduction, or credit (provided for in [section]702(a)(1)-(7))may be allocated under the partnership agreement if the allocation has substantial economic effect.

Although cases decided prior to the 1976 amendment were nominally adjudicated under the 1954 language which only prohibited allocations that had a principal purpose of tax avoidance or evasion, fundamentally the test applied was "substantial economic effect". Thus even the early case law is useful in evaluating allocations under the current code provision and subsequent regulations.

The regulations for amended IRC [section]704(b) provide three ways that the special allocation will be respected:

1) the allocation can have substantial economic effect (as discussed subsequently);

2) the allocation can be in accordance with the partner's interest in the partnership taking into account all facts and circumstances; or

3) the allocation can be deemed to be in accordance with the partner's interest in the partnership under one of several special rules (discussed subsequently).

Of the three ways to validate a special allocation, the first method requiring the allocation to have substantial economic effect provides the most specific guidance. Under IRC Reg. [section] 1.704 (b)(2)(i) there is a two part test for evaluating the allocation:

1) It must have economic effect and

2) Be substantial.


Any special allocation which creates a benefit or burden for a partner must in order to be valid assign all ultimate economic responsibility for the allocation to the partner receiving the benefit or burden. …

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