Understanding Substantial Economic Effect in Partnership Agreements

Partnerships provide a valuable framework for collaboration in business, but navigating the tax implications of partnership agreements can be complex. One critical, yet often overlooked concept, is the determination of a partner’s distributive share of allocable partnership items, which is covered under Internal Revenue Code (IRC) Section 704. Under IRC Section 704(b), if a partnership allocation of an item of income, gain, loss, deduction, or credit is not addressed in the partnership agreement, or if the allocation established by a partnership agreement does not have “substantial economic effect,” a partner’s distributive share of such taxable item is determined in accordance with the partner’s “interest in the partnership.”

Two elements that are imperative to understanding partnership allocations under Section 704 are the concepts of Substantial Economic Effect and Deficit Restoration Obligation. In this blog post, we will unpack Substantial Economic Effect and explore its tax implications. We will cover Deficit Restoration Obligations in our next blog post.

The principle of Substantial Economic Effect is a litmus test the Internal Revenue Service (IRS) applies to ensure that the allocation of income, losses, deductions, and credits among partners is not merely an artificial arrangement for tax purposes, but instead reflects the genuine economic arrangement between the partners.

The impact on tax liability can be significant if the allocations fail this test. The IRS has the authority to reallocate tax items according to what it perceives to be in line with the partners’ actual interests in the partnership, which could potentially lead to an unexpected change in the partners’ tax liabilities. The regulations outline a two-part test to determine if partnership allocations have Substantial Economic Effect:

Economic Effect Test. Allocations must change a partner’s capital account and have the potential to affect distributions upon liquidation. They must also be consistent with the underlying economics of the partnership agreement. Thus, the economic effect analysis attempts to ensure that the partner who receives an economic benefit or bears an economic burden relating to the partnership is allocated for tax purposes the item corresponding to such benefit or burden. In other words, an item allocated to a partner for tax purposes should have an equivalent impact on the amount of cash that such partner would be entitled to receive upon liquidation of the partnership.

Substantiality Test. The regulations phrase this inquiry as whether “there is a reasonable possibility that the allocations will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.” Therefore, the substantiality test weighs the tax benefits and detriments to the partners from the allocations. There should not be a strong likelihood that the net economic effect of the allocations and their tax consequences will be substantially the same, regardless of the formal allocations. Essentially, allocations cannot be contrived to achieve tax benefits without a corresponding economic risk.

Source: Bloomberg Tax, RIA Checkpoint