One of the greatest benefits of a partnership tax structure is the ability to have disproportionate allocations. For example, suppose A and B form an equal partnership -- that is, they each receive 50% of the partnership's profits and losses. However, the partnership uses a disproportionate allocation method. Partner A could really use the actual income while partner B doesn't need it. Under this situation it's possible to allocate 90% of the income to partner A and 10% to partner B. However, these allocations must also be "substantial" -- a term of art used in partnership tax which is fleshed out in the accompanying Treasury Regulations.
A word of caution: substantial partnership allocations are perhaps one of the most complex areas of tax law. What follows is a brief explanation of this concept. In reality, this section of the code requires many pages to explain its nuances (my "learned treatise" collection of this concept extends to literally hundreds of pages). With that being said, here is the central concept of "substantiality."
Except as otherwise provided in this paragraph (b)(2)(iii), 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. Notwithstanding the preceding sentence, the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement.
Let's translate the above statement into English. Conceptually, think of each potential allocation being a see-saw. When a partner receives more of something, the other partners must receive less. So, in our examples above, when partner A receives 90% of the partnership's income, Partner B receives 10%. This allocation substantially effects the two partners' allocations. In addition, the allocation passes the second test as Partner A has receives more benefits while Partner B's situation is substantially diminished (he's receiving less income).
Again, it's important to remember there are many nuances to this concept that are far beyond a blog post. However, the see-saw analogy helps to convey the basic concept. If you have any additional questions, please call us at 832.330.4101.
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