| ||Tax-Driven Partnership Allocations with Economic Effect: The Overall After-Tax Present Value Test for Substantiality and Other Considerations|
Richard M. Leder*
* Partner, Chadbourne & Parke LLP, New York, New York. New York University, B.S. 1958; Brooklyn Law School, L.L.B 1961. The author acknowledges with appreciation the substantial contribution to the preparation of this article by Eryn Tandler. This article is a slightly revised version of a paper presented at The Tax Forum in New York on May 7, 2001.
This paper is intended to analyze partnership allocations that walk the tightrope of substantiality while attempting to avoid falling off into the black hole of partner's interest in the partnership (PIP). These allocations will all be in partnerships that are engaged in significant business activities or in recognized forms of investment ventures, such as leveraged leasing, but the allocations are purely tax-motivated. This paper will assume that the allocations meet the economic effect test, or alternate economic effect test, and will not run afoul of the shifting or transitory allocation rules. In other words, the allocations this paper examines should meet all of the requirements set forth in the Regulations for substantial economic effect, subject to the special rule in the Regulations that tests the substantiality of allocations based on their after-tax present values ("the PV Test"). If the PV Test is met, the allocations would not have substantial economic effect. Where applicable, other possible Service attacks, including the partnership anti-abuse rule ("the Anti-Abuse Rule"), will be examined. In conclusion, this paper will attempt to determine how parties might fare if they fall into the dark world of PIP.
The PV Test provides:
Notwithstanding the [basic general rule], 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.
There are numerous situations in which U.S. tax benefits among partners may be optimized through special allocations, allocations that would not be made, but for the tax effect ("Tax-Driven Allocations"). The desire for Tax-Driven Allocations arises in many contexts including those in which the involvement of tax-exempt, tax loss or other tax-indifferent partners, foreign partners who wish to minimize their U.S. source income, U.S. taxpayers with excess foreign tax credits or an overall foreign loss who wish to maximize foreign source income and avoid foreign source deductions, CFCs who wish to avoid allocations of subpart F income, taxpayers with expiring tax attributes who covet income acceleration, and individuals who prefer capital gains to ordinary income.
Part II of this paper will examine the PV Test and its numerous conceptual questions. Part III will examine the manner in which the PV Test may apply to specific examples. In each example, the substantial economic effect test is met, subject to examination under the PV Test. Part IV will look at some principles outside of section 704(b) that may apply to these allocations. Finally, Part V suggests some of the principles for allocation under the default provisions-PIP-to Tax-Driven Allocations that lack substantiality solely because of the PV Test.