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The Tax Lawyer

Real-World Reform of Partnership Allocations

by Walter D. Schwidetzky


Section 704(b) and its Regulations allows partnerships a great deal of flexibility on how items of income and deduction are allocated to partners.  This flexibility has been heavily criticized over the years.  The article reviews section 704(b) and its Regulations, including the partner’s-interest-in-the-partnership test, the substantial-economic-effect safe harbor, and “target allocations.”  (Target allocations are widely used notwithstanding the lack of clear legal underpinnings).  The article discusses the shortcomings of the existing scholarship, argues for a flexible section 704(b) allocation regime, but acknowledges that reform is necessary.  The article proposes a new definition of substantiality, limiting section 704(b) to “bottom-line” items, and adding a safe harbor for target allocations.