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In resolving the question whether the principal purpose of a provision in a partnership agreement is the avoidance or evasion of Federal income tax, all the facts and circumstances in relation to the provision must be taken into account. Section 1.704-1(b)(2), Income Tax Regs., lists the following as relevant circumstances to be considered:
Whether the partnership or a partner individually has a business purpose for the allocation; whether the allocation has "substantial economic effect", that is, whether the allocation may actually affect the dollar amount of the partners' shares of the total partnership income or loss independently of tax consequences; whether related items of income, gain, loss, deduction, or credit from the same source are subject to the same allocation; whether the allocation was made without recognition of normal business factors and only after the amount of the specially allocated item could reasonably be estimated; the duration of the allocation; and the overall tax consequences of the allocation.
Under their 1963 partnership agreement, partners A and B were to share equally the gains and losses from the operation of two apartment houses as well as the proceeds of the sale thereof. In a 1966 amendment to the partnership agreement, the partners allocated to A all of the deductions for depreciation allowable on the houses on the understanding that, in the event of a sale thereof, A would pay the tax on the gain attributable to the specially allocated depreciation.
Was the amendment to the partnership agreement allocating to petitioners the entire amount of the depreciation deduction allowable on two buildings owned by the partnership made for the principal purpose of avoidance of tax within the meaning of section 704(b)?
The court held that the special allocation of depreciation was made for the principal purpose of the avoidance of tax within the meaning of sec. 704(b), I.R.C. 1954, and consequently, the computation of A's share of the partnership losses during 1966 and 1967 may include only 50 percent of the allowable depreciation on the houses. The evidence is persuasive that the special allocation of depreciation was adopted for a tax-avoidance rather than a business purpose. Depreciation was the only item which was adjusted by the parties; both the income from the buildings and the expenses incurred in their operation, maintenance, and repair were allocated to the partners equally. Since the deduction for depreciation does not vary from year to year with the fortunes of the business, the parties obviously knew what the tax effect of the special allocation would be at the time they adopted it. Furthermore, as shown by our Findings, petitioners had large amounts of income which would be offset by the additional deduction for depreciation; the Crisafis, in contrast, had no taxable income from which to subtract the partnership depreciation deductions, and, due to depreciation deductions which they were obtaining with respect to other housing projects, could expect to have no taxable income in the near future. On the other hand, the insulation of the Crisafis from at least part of a potential capital gains tax was an obvious tax advantage. The inference is unmistakably clear that the agreement did not reflect normal business considerations but was designed primarily to minimize the overall tax liabilities of the partners.