This two-part article first discusses the rules governing safe-harbor allocations.Next, it discusses the rules governing targeted allocations and reasons for the use of targeted allocations.So, what does it take for the allocation to have substantial economic effect (i.e., to satisfy the safe harbor in the regulations)?The test for whether an allocation has substantial economic effect is really a two-part test.Most partnership agreements, however, require that taxable income or loss be allocated in the same manner as Sec. For purposes of this article, unless indicated otherwise, the terms “partnership allocation” or “partnership allocations” mean allocations of partnership Sec.704(b) book income or loss, but with the assumption that the partnership agreement requires that partnership taxable income or loss be allocated in the same manner as partnership Sec. Starting in the early 1990s, however, a new method of wedding the partnership’s tax and economic consequences arose (so-called targeted, or forced, allocations 5).In next month’s issue, part II discusses some issues targeted allocations raise and recommends guidance the IRS should issue.
Along with this flexibility, however, comes complexity.Second, an allocation will have economic effect if it satisfies the alternate test for economic effect.Third, an allocation will have economic effect if, taking into account all the facts and circumstances, the allocation reaches the same result as if the three strict requirements were contained in the partnership agreement.These three tests for economic effect are explained in the next three sections.Basic test for economic effect: satisfies three strict requirements.
Thus, if a partnership is formed on day 1, but no agreement (oral or written) satisfying the requirements set forth in the previous sentence is entered into until day 2, then the allocations will never satisfy the basic test for economic effect. Through oversight, an entity is formed but no agreement (oral or written) is entered into until sometime after the formation.