Substantially%20Requirment

1
Substantially Requirment
Two ways to fail 1. Shifting allocations
- Total tax liability of the partners
is reduced by the allocation, and -
Strong likelihood that the capital accounts of
the partners will be unaffected by the
allocation. 2. Transitory allocation
- Possibility that over two or more years
original allocation will be largely offset by
offsetting allocations and - Strong
likelihood partners capital accounts will emerge
unaffected and partners will have enjoyed reduced
tax liabilities. Note Presumption that FMV
of property equals adjusted basis.
2
Problem 153 -1
Basic Facts A B each contribute 100k cash
to LP. A is GP B is LP. LP buys office bldg for
200k 10 yr life straight line. All
depreciation allocated to B all other items
equally shared. Complete deficit restoration.
(a) Breakeven except for depreciation.
Capital accounts end of year A equal 100k B
equal 80k (100k less 20k depreciation). (b)
Sale building Jan 1, year 2 for 180k? How
allocate proceeds? 100k A 80k B. If sell for
200k? 20k gain allocated equally. A capital
account goes to 110k and Bs goes to 90k.
Proceeds distributed accordingly. (c) What
if agreement says gain first allocated to extent
of cost recovery deductions? Then, all 20k to B.
Both capital accounts at 100k, and 200k proceeds
distributed equally. Note No substantial
issue because of Reg. presumption that FMV of
property equals basis.
3
Problem 153 -1
Basic Facts A B each contribute 100k cash
to LP. A is GP B is LP. Lp buys office bldg for
200k 10 yr life straight line. All
depreciation allocated to B all other items
equally shared. Complete deficit restoration/
(d) No deficit restoration, but B has
qualified income offset. - What
effect year 1? Nothing capital account
positive. - What effect year 6?
Depreciation first 5 years will zero out Bs
capital account. Year 6 allocation would produce
negative balance that would have no have economic
effect. Thus, for year 6, must look to which
partner bears loss by comparing liquidation at
beginning of year with liquidation at end. Net
impact is that amount equal to depreciation in
year 6 is born by A (reduce positive balance), so
would be allocated to A, whose account would drop
to 80k.
4
Problem 153 -1
Basic Facts A B each contribute 100k cash
to LP. A is GP B is LP. Lp buys office bldg for
200k 10 yr life straight line. All
depreciation allocated to B all other items
equally shared. Complete deficit restoration/
(e) What result in (d) if B contributed
promissory note for 100k? - Note
not satisfy unconditional deficit restoration
obligation (primary test). Thus no impact under
primary economic effect test until paid.
- But note does constitute limited
obligation to restore under alternative test if
due by later of end of tax year of liquidation or
90 days after liquidation. Thus, under
alternative test, year 6 depreciation allocated
to A. - Note Note not increase As
outside basis. So, 704(d) basis limitation would
kick in and require carryover until A gets some
outside basis by paying note or some other means
in later years.
5
Problem 153 -1
Basic Facts A B each contribute 100k cash
to LP. A is GP B is LP. Lp buys office bldg for
200k 10 yr life straight line. All
depreciation allocated to B all other items
equally shared. Complete deficit restoration/
(f) Same as (e), but yr 6 value is 400k,
partners borrow 200k recourse and distribute
equally to themselves early yr 7. -
Year 1 to 5 allocation to B still good because no
negative capital account. - Refi
proceeds distribution in yr. 7 reasonably
expected, so under alternative test wipe out
effect of Bs 100k note. So 20k deduction in
year 6 cant be allocated to B under alternative
because would take negative. - Thus,
both primary and alternative tests fail. Must
look to partnership interests. Although 20k
allocation to A would take A negative after refi
proceeds, A is GP so has duty to restore to pay
off recourse creditors. Thus, A gets 20k
depreciation allocation in year 6.
6
Problem 153 -1
Basic Facts A B each contribute 100k cash
to LP. A is GP B is LP. Lp buys office bldg for
200k 10 yr life straight line. All
depreciation allocated to B all other items
equally shared. Complete deficit restoration/
(g) Same as (f), but yr 6 value is 300k,
partners and partners agree that when hit 400k,
then will refi on recourse basis and distribute
200k. Here, the reasonable expectation test of
future distribution not satisfied because
property FMV assumed to equal basis at all times
will never get to 400k. Thus, B gets 20k year
6 depreciation under alternative test by virtue
of 100k note to partnership. (h) Assume no
deficit restoration or qualified income offset?
Year 1 depreciation to B if agreement says
liquidate per positive capital account balances
(all positive in year 1). Year 6 All to A
because B account would go negative and thus no
economic effect. Note same result as under
alternative test.
7
Problem 153 -1
Basic Facts A B each contribute 100k cash
to LP. A is GP B is LP. Lp buys office bldg for
200k 10 yr life straight line. All
depreciation allocated to B all other items
equally shared. Complete deficit restoration/
(i) Same as (h) no deficit restoration or
qualified income offset but B gave 100k
promissory note. Issue Is note relevant for
determination the partners interests? If so,
year 6 depreciation would go to B. Regs say
nothing. Many think is it and that note should
be considered even though not increase outside
basis.
8
Problem 153 - 2

• Basic Facts C and D equal partners of GP. D
  is non-resident alien. All foreign source income
  allocated to D, who exempt from US tax. US and
  foreign source income uncertain. Economic effect
  assumed.
• All US income to A and foreign source income to
  B? Allocation OK because income sources
  uncertain. No substantial issue if allocation
  may diminish after-tax yield to partners, which
  is possible here.
• What if all income shared equally, but D given
  priority of foreign source for Ds one-half ?
  Fail substantial requirement. This
  impermissible shifting. Ds taxable income goes
  down with not corresponding diminishing effect on
  any of the partners.
• What result in (a) if it is relatively certain US
  and foreign income will be roughly equal? Fail
  substantial test. Strong likelihood D will
  save taxes and capital accounts of the partners
  will not change. Impermissible Shifting.

9
Problem 153 - 3
Basic Facts E contributes 990k as LP F
contributes 10k as GP. Purchase 1 mill
equipment. All 168 cost recovery deductions to
E 99 income to E until recovered cost recovery
deductions and all losses. Then, 50 -50. Assume
primary economic effect test satisfied. Any
substantial issue? Maybe. - Note
This not gain charge back provision, which would
be OK. This is shifting allocation provision and
may be transitory and thus fail substantial
test. - If it appears cost recovery
deductions will not be recovered for at least
five years, using FIFO assumption, then probably
not transitory. If recovered within 5 year
period based on projections, then run big
transitory risk.
10
Four Part Test For Nonrecourse Deduction
Allocation
1. First two Primary requirements
met. 2. Nonrecourse deductions are
allocated during life of partnership on basis
that is reasonable consistent with the manner
some other significant item is allocated.
3. Partnership agreement contains minimum gain
chargeback provision. 4. All other
allocations and capital account adjustments are
in accordance with 704 Regs.
11
Problem 162
Basic Facts L contributes 320k as LP G
contributes 80k as GP. Borrow 1.6 mill
non-recourse and buy 2 mill property. Loan
requires interest only for 5 years. - Income,
gains, losses allocated 80-20 until income and
gains for first time exceed losses then 50-50.
- First two primary tests met only G has
deficit restoration. L has qualified income
offset and minimum gain chargeback. -
Non-liquidating distributions 80-20 until return
of 400k then 50-50. - STL 10 year
depreciation of building. - Clear over
long-term that income and gains will exceed
losses.
12
Problem 162

Year 1 Year 2
Year s Depreciation and loss 200k
200k 200k
G Capital account 40k (80-40)
0 (40-40) -40 (0-40) L
Capital acount 160k
(320-160) 0 (160-160) -160 (0-160)
Note Years 1 and 2 No nonrecource
deductions because no increase in minimum gain
(NR liability in excess of basis). So
allocations permitted under normal rules
primary test satisfied for G and Alternative test
for L. Year 3 Nonrecourse deduction of 200k
excess of NR liability over basis. This 200k
allocation OK because 4 part test met.