Substantial Economic Effect

By Matthew Cavitch, J.D.

Tax allocations in a partnership agreement will not be honored if they lack "substantial economic effect." [IRC § 704(b)(2); Treas. Reg. § 1.704-1(b)(1)(I)] Treasury has defined "substantial economic effect" in some of the most intricate regulations ever adopted. Much of the unintelligible legalese in partnership and operating agreements is designed to comply with these Section 704 regulations.

Substantial economic effect requires that two tests be satisfied: (1) the allocation must have economic effect, and (2) the economic effect must be substantial. [
Treas. Reg. § 1.704-1(b)(2)(I)]

The first test means that if there is an "economic burden that corresponds to an allocation, the partner to whom an allocation is made must . . . bear such economic burden." [Treas. Reg. § 1.704-1(b)(2)(ii)(a)] For example, suppose that AB Partnership grants a conservation easement that creates a tax deduction. The conservation easement deduction does reflect a real economic burden. It means that the grant of the easement reduced the fair market value of AB's property. If A's share of the deduction is to be allocated to B, then the economic loss must be borne by B, not A. That is accomplished by reducing B's capital account by the entire , not just half. A's capital account would not be reduced. Assuming that the operating agreement is drafted so that liquidation proceeds are distributed based upon positive capital accounts, then B will get less than he would otherwise have received in liquidation. That qualifies as economic effect.

The second test is tougher to be certain about. The general rule regarding substantiality is that "the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences." [
Treas. Reg. § 1.704-1(b)(2)(iii)(a)] In the above example, upon liquidation, A will get more real dollars and B will get fewer real dollars. Maybe the IRS could argue that AB Partnership will never be liquidated, so that the economic effect of the easement is moot. This may be logically possible, but liquidation ought to be treated as at least a "reasonable possibility." Maybe the IRS could argue that B is likely to never sell and that A will eventually withdraw and get bought out at a price that does not reflect any impact of the easement. If B is the only remaining owner, then its capital account becomes irrelevant to its share of any liquidating distribution. Again, this may be logically possible, but liquidation at a time with multiple owners as at least a "reasonable possibility."

Thus, the above example ought to satisfy the general rule for substantiality. However, the general rule is subject to three separate and intricate exceptions...

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