In episode 59 of How Tax Works, Matt Foreman discusses allocations and distributions, and the requirement that the allocations have Substantial Economic Effect, which is broken into two parts, (i) that the allocations have economic effect and (ii) that the economic effect is substantial on a pre-tax and post-tax basis.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:08]:
Hello and welcome to the 59th episode of How Tax Works. I’m Matt Foreman. In this episode, I will discuss partnership allocations and the need for substantial economic effect, often abbreviated SEE. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listen— listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. New episodes every 2 weeks.

Matthew Foreman [00:00:47]:
Next episodes, I think I’ll do— I’m, I’m not totally sure. It’s about a month out at this point, so I’m, I’m not totally— haven’t gotten that point yet mentally, um, and figured it out. Get to kind of go through some logistics of what I want to do and plan out some of my fall stuff. But I think I’m gonna do a standalone episode on Section 83 elections based on questions that I have. Candidly, I think it would be helpful to have an episode where I just explain when to make 83 elections and when not, when it’s not necessary. Necessary in what they do. Because I think there are people who generally understand them, but for reasons that I can’t entirely comprehend, seem to struggle with certain, I’ll say, mechanical-ish aspects of them and whether they need to do things. And I just, I’m just gonna go through the questions.

Matthew Foreman [00:01:36]:
If you have any questions, concerns, constructive criticism, you can email me. I have some upcoming webinars. you know, free, free continuing legal ed, continuing professional ed for CPAs, continuing education for enrolled agents, and continuing, I think they’re continuing professional education. I think it’s CPAs as well for CFPs, certified financial planners. There’s 6 of them in the fall. November 3rd, passive activity loss limitations. November 10th, selling a business, tax and non-tax considerations. November 17th, payroll taxes, SOAR about series and S corps.

Matthew Foreman [00:02:10]:
December 1st, Opportunity Zone 2.0, hopefully with regulations. December 8th, QSBS, Qualified Small Business Stock, under Section 1202 of the Internal Revenue Code, uh, hopefully with some regulations, some more stuff going on, some more guidance, because, uh, they said they’d get it, but I’ve been lied to before. Still, still waiting for Infrastructure Week. And then December 15th, granting equity to employees, which is going to be both, you know, an internal, like, an income tax thing, but also a lot of exec comp. I’m co-presenting with my exec comm partner. So it’s going to be talking about ERISA, not just, not just the name of a child anymore, right? It’s also, also a thing. So the agenda, right? So first off, for those who don’t know, unfortunately it’s, it’s a bit out of date now and will continue to get so, but I’m, I’m a big fan of The Logic of Subchapter K by Professors Cunningham, Laura, and Noel. I, I had the, the fortune to have Noel Cunningham as my partnership tax professor at my LM.

Matthew Foreman [00:03:07]:
And I think it’s really important to, you know, it’s got a really good overview of this kind of stuff. And a lot of how I think about it comes from how it was presented. I took it in JD and I took it in my LM. So I think that’s important. So first off, what is a partnership, right? So, you know, what’s in a name? That which we call a rose by any other name would smell as sweet. Romeo and Juliet, Act 2, Scene 1. These are tax partnerships. I gotta call ’em partnerships, but they’re tax partnerships be like, oh, I don’t, I don’t have a partnership.

Matthew Foreman [00:03:36]:
I have an LLC. And I’m like, cool. LLCs generally taxed as partnerships. LPs, general partnerships, limited partnerships, limited liability limited partnerships, which is what Sirius is. And professional limited liability companies, PLLCs. Watch out for single-member entities and watch out for foreign partners and members. But those are kind of not really relevant to here. But I always throw that out there ’cause sometimes every so often you’ll see a foreign partner and there’s interesting rules that kind of deal with that.

Matthew Foreman [00:04:00]:
You’ll see foreign owners owning LLCs, which if you listen to my podcast, you’ll know I think is the bad idea generally. So what, what is an allocation? Okay, I think that’s a really important question. And people laugh when they say, what is an allocation? It kind of sounds like Jerry Seinfeld, right? Like, what is an allocation anyway? And allocations are essentially what happens when you have income. People are like, oh, I didn’t get any money, how can I pay taxes? And the answer is very simple. Okay. That an allocation is how income loss, income gain loss deduction credits are divided between the partners. Sometimes it’s pro rata. There’s a what’s called a waterfall, which is how things go out from it.

Matthew Foreman [00:04:44]:
Everything needs to be allocated. It can be what’s called pro rata or non-pro rata. You can have special allocations of specific things. And there’s 2 kinds of allocations that are really popular. Okay. There is, and you can kind of hybrid between these. You don’t actually have to pick Pick one. And people are like, well, is it capital account or— the two are— one is capital account or layer cake, capital account driven or layer cake, and the other one is targeted allocations.

Matthew Foreman [00:05:10]:
And the— it doesn’t actually— A, it doesn’t say what it is, and B, the theoretical nature of them is that if you do this right, if you do your allocation properly and you have substantial economic effect, you should actually end up at the same spot. So I think it’s really important to do it, right? It’s really important to say, you know, what’s going on. A little different in liquidating distributions. This is, you know, year over year, but it’s important to do. So capital account or capital account-driven layer cake is basically like a third, a third, a third, right? You have 3 partners and it says, you know, partner A gets a third and partner B gets a third and partner C gets a third, or it’s like 20-20-40 or If I got the math right, 20, 20, 60, right? Targeted, okay, is different. It says, instead of saying a third, let’s just hold whatever they may, it says each partner’s allocable share of the profit or loss during the period in question is equal to the positive or negative difference between the beginning or ending targeted capital accounts, target capital accounts of the partners during such period. It’s really important. And I think that’s really an option.

Matthew Foreman [00:06:17]:
To understand that they’re exactly the same. You know, in the end, if done properly. Every so often they’re different, and every so often they do different things. But I think it’s really important to note they’re almost always the same. So what is substantial economic effect, or SEE? There’s really 2 parts for it. Economic effect— so the allocation must have— each allocation must have economic effect, one. And 2, the economic effect must be substantial. Okay.

Matthew Foreman [00:06:43]:
And they talk about these in— and I’m going to give you a whole long site in Treasury Regulation 1.704-1 and . Okay, that’s, that’s where they sit. To have substantial effect, first off, it must follow the capital account— capital accounting rules, which is in Treasury Regulation 1.704-1. They must liquidate consistently with the capital account balances. Okay. And 3, they either must have a deficit makeup obligation or qualified income offset. Those— that only matters if the capital accounts drop below zero. So a deficit makeup obligation, or also, which is a DMO, or a deficit restoration obligation, DMO, what those are is if your capital account is below zero at the time the partnership winds up, you have to actually put money back into the partnership to bring it back to zero, and then your other partners will get that money because the assumption is that they have positive Uh, capital accounts, they’ll need it.

Matthew Foreman [00:07:42]:
A qualified income offset is extremely specific, extremely similar, except instead of actually going above zero, you’re just allocated income to bring it up to zero. So instead of putting in $100, you’re allocated $100 of income. Obviously tax rates are not 100%, despite what some people seem to believe. And so as a result, you have a situation where you’re just going to have income tax on it. It is extremely common to have this at the end of a partnership that has a lot of debt, such as a real estate investment partnership that does not go well. And people always say, well, I didn’t get any cash out of this. How do I have income? And the answer is, well, no, but you got deductions and you’re basically reversing those direct— those deductions because you got a benefit that in the end you should not have received. So that’s really important.

Matthew Foreman [00:08:31]:
I could talk about that in more detail, but I think that’s fine for now. And 2, you know, once that’s— do you have economic effect? And 2, the economic effect must be substantial. Okay. And there’s 2 tests for it. Need both. Pre-tax, there’s a reasonable possibility that the allocation will affect substantially the dollar amounts received by the partners independent of tax consequences. Number 2 is the post-tax. The allocation cannot enhance the after-tax position of one partner without affecting the after-tax position of any other partner.

Matthew Foreman [00:09:01]:
So basically what they’re saying is the allocation actually has to change how much money you get, and the allocation can’t— you can’t have like a, you know, tax-indifferent partner and just be like, yeah, yeah, that person gets all the ordinary income because they’re not going to pay tax on it, but then the capital gains go the other way because they’ll pay tax on it. It is commonly something I run into when one partner is a C corporation. Right, because C corporations pay one tax rate no matter what, no matter how much income they have. And so they don’t care if they get ordinary income or capital gains, whereas individuals such as, you know, you and me, we care. It matters. There are 2 other things that, you know, create a situation where you don’t have a substantial economic effect. One is you have what’s called a shifting allocation, which happens in a single year. It’s under Treasury Regulation 1.704-1.

Matthew Foreman [00:09:54]:
And in a single year, you shift different tax characteristics, generally capital versus ordinary, to want to different partners. Again, this is the situation where you have a corporation and as one partner, an individual as another, or, you know, you have one partner, they’re both individuals. One partner has NOLs that they can use to offset the income, so they don’t really care. Whereas the other partner does not have NOLs, so they’d rather have capital gains. And that partner’s like, well, look, my NOLs are, are are going away in a year. So it’s worth it to me. I want to use them. I want to burn them up.

Matthew Foreman [00:10:28]:
So that’s, that’s a shifting allocation where you shift specific characteristics. The other one is called a transitory allocation, 1.704-1, and it spans at least 2 years, but there’s a presumption if it spans more than 5 years. So if it spans more than 5 years, not problematic. And the idea is that an allocation that will later be offset by another allocation. The example that I always give is in year 1, one partner gets all the depreciation. Then in year 2 and after that, the other partner or partners get additional deductions to even off that year 1 of income. That is a textbook transitory allocation because it’s a benefit in one year for one partner and then other years. it evens itself out.

Matthew Foreman [00:11:21]:
That’s the problem. That is going to change the tax, the after-tax benefits, purely because of timing. So what happens if there’s no substantial economic effect? Okay, the item or items must be reallocated based on the partner’s interest in the partnership. Okay, Treasury Regulation, this is under Treasury Reg 1.704-1. What is a partner’s interest in the partnership? The answer is, generally speaking, it’s how much of the partnership you own. Not helpful, right? The— you look at the factors. Factors are in the same section: relative contributions, interest in economic profits and losses, interest in cash flow and other non-liquidating distributions, and right to liquidating distributions. You’ll notice that this has nothing to do with voting.

Matthew Foreman [00:12:10]:
Voting, theoretically, it’s probably a very, very, very, very, very minor factor, but it’s really not a significant factor at all. Um, I think that’s really important to note. They’re looking at what, you know, how much will you get from this partnership when it winds up and now, and we’re gonna, you know, whether this is a, a current allocation or a liquidating allocation. Mm-hmm. And then we’re gonna match that. So if you have a transitory allocation, it’s just going to back out the allocation and give you another, you know, the right that that’s really correct. And it can be done over multiple years, and they often do. Under 1311, 1312, 1313, 1314, they can go back to closed years and bring it all out.

Matthew Foreman [00:12:58]:
Because if you have something, an item of income that sort of is affected by another year, wrong timing, things like that, you can actually go back and really open up a lot of years. So it’s kind of an interesting one. All right. I think we’ve hit enough brain damage at this point. We’re gonna take some music and then come home for distributions, guaranteed payments, and a few other ancillary things, and then we’ll, we’ll close it on up. So give us a minute. We’ll get some music. You know what’s funny about the music is, I may have said this before, I was on hold with New York State and, and state, you know, every state has their own on-hold music and New York State’s a lot more like jazzy, funky pop rather than this.

Matthew Foreman [00:13:37]:
You know, as many of you know, this is the IRS is on hold music. It’s really like Muzak trying to be jazz. It’s kind of interesting. And I was sort of chuckling at the idea that I keep making you all listen to this. We re-upped it for another year. So, so you’re stuck in this for at least another year. Maybe at some point I’ll change the music, but not anytime soon. I kind of get a kick out of it.

Matthew Foreman [00:13:59]:
And I found that people find it funny too. If you really hate it, you know, let me know. I’ll probably ignore it anyway, but, you know, just curious. All right, take a minute for some music. We’ll be right back. We’re back. We’re talking about substantial— we’re talking about allocations and the need for substantial economic effect. However, distributions are actually an underrated but very important part part of substantial economic effect.

Matthew Foreman [00:14:59]:
The problem is actually rarely the allocations. The problem often, at least so far as I reach it, is matching allocations and distribution. Let’s look back at the substantial requirement. Substantial pre-tax, there’s 2, pre-tax and post-tax. The pre-tax is the reasonable possibility that allocations will affect substantially the dollar amounts received by the partners independent of the tax consequences. And post-tax, the allocation cannot enhance the after-tax of one partner without adversely affecting any other partner. How can an allocation not be substantial, right? That’s an important question. So say partnership has $100 of complete capital gains and $100 of ordinary income.

Matthew Foreman [00:15:38]:
Partner A gets all the capital gains, Partner B gets all the ordinary income, and they distribute $100 to each. So, you know, but look, but Partner B has a $500 NOL, or Partner B is a corporation, so they don’t really care that they’re kind of getting the bad one. Again, the problem is rarely the allocations themselves. And I think that’s really important to sort of think through and talk about it, right? Everyone assumes, and I think this is more important, everyone assumes the allocation amounts and the distribution amounts will match or at least close. But look at it, you know, if you were to do this differently, right? If the partner who gets $100 of ordinary income gets a $150 allocation. or distribution, and the partner who gets $100 of capital gain allocation gets a $50 distribution, that just feels different, right? It feels like it shouldn’t be as problematic. And I think that’s an important point. Okay.

Matthew Foreman [00:16:32]:
So if you look at shifting allocations, right, it’s often an issue with character, capital versus ordinary, or it can be one partner, again, corporation or nonprofit. So they’re more tax different, so the distinction is irrelevant. I talk about transitory allocations a lot because I run into them a lot, unfortunately, and you have to talk through, is this an issue, and things like that. It’s more a timing issue than anything else, right? Partner A receives extra depreciation in year 1, partner B receives extra amount of depreciation or other deductions, business deductions, year 2, 3, 4, 5, whatever. You can’t use allocations to defer or accelerate income for other purposes, right? You just can’t, even if it’s beneficial. And they say, well, why, why do they care? And the answer is because it’s sort of the idea of a partnership is in a lot of ways, how do you, you know, put people together? And the idea is that, look, this is just an amalgam of a lot of people. And because it’s an amalgam of a number of people, It’s really, you should get a pro rata amount of the whole thing. You should not be able to pick and choose which ones you get and when.

Matthew Foreman [00:17:46]:
And that’s the idea, right? That you should just do it. The IRS and states, you know, very much view the idea of pure pro rata. Look, if you’re just pure pro rata, distributions have to be pro rata. You have no issues. Sometimes I’ll run into this, and I’m sure I’m not the only professional who does this. Well, say, look, like, I can kind of come up with situations where these may not be substantial economic effect. However, they may also have it depending on how the facts go, what’s going on, things like that. So sometimes you can set these up and you look back at it and you’re like, well, that might not have substantial economic effect.

Matthew Foreman [00:18:19]:
So sometimes you have to amend returns to prevent that as an issue. Some people just take the audit risk, right? That’s important. I also want to talk about guaranteed payments. I think, you know, look, like they don’t really go in here and without an active audience to ask questions, this is not the longest podcast episode I’ve had. So we’re going to do some more stuff. First issue is what are called guaranteed payments. It is a fixed payment to the partner. The payment does not depend on partnership income.

Matthew Foreman [00:18:46]:
It is functionally a replacement for a W-2 for a partner. That’s how it works. What happens when something is considered a guaranteed payment, right? People always ask that. If the partner’s distributive share exceeds the guaranteed payment versus if the guaranteed payment exceeds the distributive share. And the guaranteed payment, you know, some people have one, oh, I have a guaranteed payment, but if there’s income, then we don’t do it. No, no, no, no, it’s a guaranteed payment or it’s not. This used to not really matter as much. Then in 2018, there was 199 Cap A.

Matthew Foreman [00:19:17]:
There are pass-through entity taxes today. Guaranteed payments, not subject to PTETs. So you’re going to have a tax drag there. And guaranteed payments are not considered eligible for 199 Cap A, which is a deduction. And so it became much more important to not have guaranteed payments. A lot of partnerships really reevaluated how they’re doing guaranteed payments. And I think that’s really important. Guaranteed payments, the way they effectively work from an accounting perspective is they’re basically a payment before you even get to the allocation of income.

Matthew Foreman [00:19:51]:
So for example, if you have a partnership that makes $200 and one of the partners receives a $100 guaranteed payment, the total income that can be allocated is only $100. $100’s already gone. So it really in that way functions a lot like a W-2, which is generally deductible as an ordinary necessary business expense, assuming, you know, all the requirements are met. And that’s it. Same way for a guaranteed payment, right? But it’s not deducted. It’s just sort of shifted directly over to— that one partner. Members, partners of a partnership, which includes LLC members, assuming it’s taxed as a partnership, not like an S corp or C corp or whatever, cannot receive W-2s. Everyone always says, but I’ve seen it, Matt, how can they not? I’ve seen it before.

Matthew Foreman [00:20:36]:
And I’m like, well, they’re not allowed. I’ve seen people do it. There’s generally no tax benefit to it. You know, you can put money in a 401 by just being a partner. Things like that. So I think the IRS sort of shrugs at it and says, well, you know, whatever, we don’t really care. What I said to someone, and we were talking about it, is that, you know, because there’s no benefit, I suspect the IRS is very aware of it. And since they don’t care, that they’re just kind of going to let it go.

Matthew Foreman [00:21:04]:
And I think this is reasonable to do it because I think that, you know, again, as long as you’re not getting a tax benefit from it, there’s no real harm to anyone in doing it. And it simplifies, it creates withholding. I’m of the opinion that partners should be allowed to be given what I’m going to sort of say is like a W-2, but it should be paid out with normal withholding. And then it should just be added back into as part of the distributive share or guaranteed payment as you see fit. And I think that’s really important to note. People kind of, you know, ask what I’m talking about for this. But I think this should just be kicked back into your K-1, which is how income for partners is determined, is allocated, is just distributed, you know, shown similar to W-2. And I’ve always been of the opinion, and maybe this is me, that we should just kind of allow partners to do this because it’s easier.

Matthew Foreman [00:22:00]:
They’ll get a W-2, you check a box. This is also in a K-1. It’ll flow up to a K-1 and we’re done here. That’s it. I think it’ll simplify things. It’ll also eliminate the need for guaranteed payment in a lot of situations. And I think it’ll simplify reporting. And I think there are a lot of people who just say, look, like, I want W-2 withholding because W-2 withholding will automatically get me really close and I don’t have to do the work.

Matthew Foreman [00:22:23]:
It is not hard to do W-2 withholding, but it’s something that you have to— or to do withholding for a partner. But it’s something you have to do, something you have to spend time doing. And so we were just like, look, W-2s exist, we can outsource that. I already have employees and that’s it. So I think that’s really kind of important one to do. All right. On that note, that was the 59th episode of How Tax Works. I hope you learned something.

Matthew Foreman [00:22:48]:
Back in 2 weeks with the 60th episode, likely a standalone episode on 83 elections based on the questions that I get, but we’ll see. It’s at about 5, it hasn’t come out for about 5 weeks. That’s a lie. Um, it doesn’t come out for 7 weeks after I record this, so we’ll see how that goes. I have a, I have a while to record it. Uh, thank you all for listening. Have a nice day.