Discussion:Negative capital accounts

It appears that you have allocated the rental loss and sale loss among the partners ... and as a result, some partners now have negative capital balances. (Note: Were your allocations in accordance with the operating agreement? .... I hope so.)

It sounds like you have read tax literature, that you don't seem to understand, regarding negative capital balances.

You have been greatly misinformed if you think that the partnership has to do something to force the negative capital balances to $-0-.

You should leave the negative capital balances alone. Do not pull some magical income $amount out of the air to use as an off-set to bring the deficit capital accounts to a $-0- position. It's not expected of you and it's nonsense to even consider.

The individual partner's will have to deal with the negative capital balances when they prepare their 1040.

A partner who's K-1 shows a negative capital balnce will have to limit his deductible pass-through K-1 loss to his adjusted basis in the partnership. Any loss not deducted, by the partner, due to basis limitation ... will be suspended until the partner has future basis against which to deduct it.

So- you, as the preparer of the partnership return should not worry about what to do. You should do nothing. The responability of dealing with negative partnership balances is a partner respnsability and will be dealth with by each parter seperately when he/she prepares his/her 1040.

The other scenario when a partner can end up with an erroneous negative captial account is when the partnership does not follow Section 752 nonrecouse debt allocation (i.e. not taking the minimum gain rule)and allocates losses to a partner. Both of the above cases (sections 704(b) and 752)are partnership issues, so I respectfully disagree with Derwood opinion.

Sec 752 and nonrecourse debt does not affect capital balances. Sec 752 and nonrecourse only affects partner's outide cost basis.

I disagree that 704(b) only deals with special allocations. The application of 704(b) may cause allocations of partnership losses to the partners that is different from their ownership percentages - but that's the whole point - to make sure the allocation meets the requirement of Substantial Econcomic Effect.

The economic effect requirements of 704(b) only deal with special allocations. Since non-special allocations are based strictly on partners profit & loss sharing ratios, then non-special allocations are automatically respected for tax purposes and therefore do not have to satisfy the economic effect requirements of 704(b) in order to be respected for tax purposes.

Yes, if there is a decrease in partnership minimum gain, each partner must be allocated a share of the minimum gain charge-back. However, the minimum gain charge-back rules would not apply if all of the debt was full-recourse.

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Example: A and B form a general partnership on Jan 1, 2009. A contributes $90,000 and B contributes $10,000. The partnership agreement allocates profits and losses on a 90-10 ratio and all distributions on a 90-10 ratio (regardless of capital balances). The partnership agreement does not have a capital account maintenance requirement or a deficit restoration requirement.

Obviously, none of the allocations in this scenario satisfy the safe-harbor rule because: A) there is no deficit restoration requirement; B) there is no capital account maintenance requirement; and C) there is no requirement that liquidating distributions be made in accordance with positive balances in capital accounts.

If you answer is yes, then I disagree.

According to Reg. Sec. 1.704-1(b)(1) ....an allocation will be respected if it is made in accordance with the partners' interest in the partnership.

Any allocation that is made in accordance with the partners' interest in the partnership is a non-special allocation. Thus all non-special allocations are automatically respected for tax purposes simply because they are not special allocations.

Special allocations are allocatios that are not made in accordance with the partners' interest in the partnership.

Only special allocations have to have substantail economic effect, in order to be respected.

I think you and I are using 2 different definitions of the term “special allocation”, which is defined in the 702 regs as an allocation that differs from the allocation of profit or loss, generally.

Also, the P & L sharing ratio itself is an example of a non-special allocation that is subject to the substantial economic effect rules (or alternatively, the PIP rules).

For example, if the partnership in my example has no debt and the 90% partner funds a $500,000 loss, it would be totally inappropriate to allocate $50,000 of that loss to the 10% partner who contributed only $10,000. (My answer would change if they amended the partnership agreement to conform to SEE).

Back to your original question which was whether the substantial economic effect requirement applies to every allocation. The answer is yes. Look at the statute (below). SEE is applied first, and PIP is applied next.

(b) Determination of distributive share. A partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances), if— (1) the partnership agreement does not provide as to the partner's distributive share of income, gain, loss, deduction, or credit (or item thereof), or (2) the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect.