In short, the economic impact as a whole is an attempt to get the partner receiving the economic benefits of an allocation to bear the economic risk. In other words, an allocation to a partner for tax purposes should have an equal impact on the amount of property or cash to which the partner would be entitled if the partnership were wound up. As regards economic effect, the general rule is that a distribution has an economic effect only if, during the term of the company, the articles of association provide: first, for the establishment and management of a member`s asset account in accordance with a maintenance obligation; second, liquidation distributions are made in accordance with the partner`s capital account balance (positive capital account balance) also taking into account adjustments for the current year; and third, that a partner whose capital account balance is absolutely obliged (mandated) to restore his capital account by bringing money or property into the partnership. This third requirement is also known as the deficit recovery obligation. Section 704(b) and its provisions confuse even the most experienced tax professionals. Targeted allocations and preferential cascading liquidation distributions are largely becoming the norm. Practitioners should take great care to understand the complexity of corporate taxation and to ensure that the language of the partnership agreement has a significant economic impact or otherwise reflects the interests of the partners in the partnership in accordance with the provisions of § 704 (b). As this discussion unfolds later, the IRS or the courts may reallocate items of income or loss and assess penalties for insufficient payment or accuracy if a partnership`s allowances are not met. This general rule is intended to prevent certain abuses of the distribution rules that generate tax savings but have an « economically neutral » effect (when the tax does not follow the economy). For example, an LLC holds well-rated bonds that generate a steady stream of income.
a member of the LLC has an expiring NOL; The agreement allocates all of the LLC`s revenues to that member for one year; The agreement provides that the income of the LLC will be allocated to the second member for subsequent years until the same amount of income has been allocated to him; The allowances do not have a significant economic impact. While it is true that the tax rules applicable to LLCs are designed to allow taxpayers to conduct joint business and investment activities through a flexible economic arrangement without incurring corporate tax, many taxpayers do not realize that LLC members do not have full discretion in attributing the associated tax consequences. In fact, the IRS has adopted very complicated rules to prevent taxpayers from « abusing » the LLC structure. For an allocation to have an economic impact, it must be consistent with the underlying economic arrangement of the Members. This means that in the event of an economic advantage or burden corresponding to the allowance, the member to whom an allowance is granted must bear that economic advantage or burden. In other words, the tax must follow the economy. The fact that an allowance has an economic effect is not enough. In addition, the economic impact of the allocation must be significant. In particular, there must be a reasonable possibility that the allowance will significantly affect the dollar amounts received from LLC members, regardless of the tax consequences of the allocation. For example, if an LLC agreement attributes the loss to one of the two members for one year and also provides that the liquidation of the distributions will be carried out in equal shares to both members, it can be said that the allocation has no economic effect because it did not result in an economic loss for the member (to whom the loss was attributed). The second part of the two-part test of essential economic performance is materiality. For an allocation to be substantial, « there must be a reasonable possibility that the allowance (or allowances) will have a material impact on the dollar amounts that partners must receive from the partnership, regardless of the tax consequences » (Regulations.
Article 1.704-1(b)(2)(iii)(a)). This section largely prevents a partnership from manipulating temporal differences in deductions or tax rates by allocating categories of income, such as .B total capital gain to a partner with significant unused capital losses. Example (7)(ii) in the Regulations. Second. 1.704-1 deals with how an allocation may have economic effects, but is not substantial. In the Holdner case, one of the taxpayers was a CPA. In Renkemeyer, the firm in question was a law firm specializing in federal tax law. Both cases led the Tax Court to ultimately approve the REDISTRIBUTION of income by the IRS to the detriment of taxpayers. The complex rules of § 704 (b) and associated regulations confuse even the most experienced tax professionals. Partnership agreements should be carefully reviewed by a partnership tax expert to ensure that allowances, especially special grants, are respected by the IRS and the courts.
Any partnership agreement that does not comply with the Safe Harbor rules for significant economic impact, or that ultimately does not allocate revenue based on the partner`s interest in the partnership, must be immediately amended by competent counsel who understands the complex language required to comply with section . . .