Taxation & Estate Planning

APPLYING SUBSTANTIAL ECONOMIC EFFECT RULES WITH PASS-THROUGH PARTNERS

By Charles Rubin

Under Code §704(b), allocations of partnership items of income, gain, loss, deduction and credits must have "substantial economic effect" to be respected for federal income tax purposes. The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Further, the allocations cannot be "transitory" or "shifting."

In testing for substantial economic effect, issues arise how to apply the tests if a partner is a pass-through entity for income tax purposes. Proposed regulations issued in 2005 relating to examining the tax effects on the ultimate owners of pass-through partners were recently finalized.

Generally, the regulations require that the tax consequences are examined at the owner level of the pass-through entity (or the beneficiary level, for trusts and estates). Pass-through entities for these purposes include partnerships, S corporations, estates, trusts, and qualified Subchapter S subsidiaries. Treas.Regs. §1.704-1(d).

Look through treatment will also apply for controlled foreign corporations (CFCs) also, but only if U.S. shareholders of the CFC own in the aggregate (directly or indirectly) at least 10% of the capital or profits of the partnership. If the look-through rules apply, the U.S. shareholders are the ones examined, as to income that passes through or would pass through under Code §951(a). Treas.Regs. §1.704-1(d)(3).

T.D. 9398, 05/16/2008; Reg. § 1.704-1

Full post as published by Rubin on Tax on May 31, 2008 (boomark / email).