Subchapter K is intended to permit taxpayers to conduct joint business activities through a flexible economic arrangement without incurring an entity-level tax. To achieve this goal of a flexible economic arrangement, partners are generally permitted to decide among themselves how a partnership’s items will be allocated. Section 704(a) of the Internal Revenue Code (Code) provides that a partner’s distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided, be determined by the partnership agreement.

Section 704(b) places a significant limitation on the general flexibility of section 704(a). Specifically, section 704(b) provides that 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 the allocation to a partner under the partnership agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect. Thus, the statute provides that partnership allocations either must have substantial economic effect or must be in accordance with the partner’s interest in the partnership.

Section 1.704-1(b)(2)(i) provides that the determination of whether an allocation of income, gain, loss, or deduction to a partner has substantial economic effect involves a two-part analysis. First, the allocation must have economic effect within the meaning of §1.704-1(b)(2)(ii). Second, the economic effect of the allocation must be substantial within the meaning of §1.704-1(b)(2)(iii).

For an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that, in the event that there is an economic benefit or burden that corresponds to the allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. §1.704-1(b)(2)(ii)(a). Under §1.704-1(b)(2)(ii)(b), an allocation of income, gain, loss, or deduction (or item thereof) to a partner generally has economic effect if, and only if, throughout the full term of the partnership, the partnership agreement provides: (1) for the determination and maintenance of the partners’ capital accounts in accordance with §1.704-1(b)(2)(iv); (2) for liquidating distributions to the partners to be made in accordance with the positive capital account balances of the partners; and (3) for each partner to be unconditionally obligated to restore the deficit balance in the partner’s capital account following the liquidation of the partner’s partnership interest. In lieu of satisfying the third requirement, the partnership may satisfy the qualified income offset rules set forth in §1.704-1(b)(2)(ii)(d). An allocation also may be deemed to have economic effect if it satisfies the economic effect equivalence rules of §1.704-1(b)(2)(ii)(i).

Section 1.704-1(b)(2)(iii)(a) provides as a general rule that the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Notwithstanding the previous sentence, the economic effect of the allocation (or allocations) is not substantial if, at the time the allocation (or allocations) 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. In determining the after-tax economic benefit or detriment to a partner, tax consequences that result from the interaction of the allocation with such partner’s tax attributes that are unrelated to the partnership will be taken into account.

If the partnership agreement provides for an allocation of income, gain, loss, deduction or credit to a partner that does not have substantial economic effect, then the partner’s distributive share of that item is determined in accordance with the partner’s interest in the partnership. References in section 704(b) or §1.704-1 to a partner’s interest in the partnership, or to the partners’ interests in the partnership, signify the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated, taking into account all facts and circumstances relating to the economic arrangement of the partners.

Section 1.704-1(b)(3)(i) provides that all partners’ interests are presumed to be equal (determined on a per capita basis). However, this presumption may be rebutted by the taxpayer or the IRS by establishing facts and circumstances that show that the partners’ interests in the partnership are otherwise.

Section 1.704-1(b)(1)(iii) provides that an allocation that is respected under section 704(b) nevertheless may be reallocated under other provisions, such as section 482, section 704(e)(2), section 706(d) (and related assignment of income principles), and §1.751-1(b)(2)(ii).

On April 21, 2004, temporary regulations (T.D. 9121, 2004-1 C.B. 903) relating to the proper allocation of partnership expenditures for foreign taxes were published in the Federal Register (69 FR 21405). In the preamble to those regulations, the IRS and the Treasury Department indicated a concern that some partnerships are taking the position that, in determining if the economic effect of a partnership allocation is substantial, they need not consider the tax consequences to an owner of the partner that result from the allocation. This position is inconsistent with the policies underlying the substantial economic effect rules, because it would allow a partnership to make tax-advantaged allocations if the tax advantages of the allocations accrue to an owner of a partner, rather than to the partner itself.

These proposed regulations provide that the interaction of a partnership allocation with the tax attributes of owners of look-through entities must be taken into account when testing the substantiality of the allocation to a partner that is a look-through entity. For this purpose, look-through entities include partnerships, S corporations, trusts, certain controlled foreign corporations, and entities that are disregarded for federal tax purposes, such as qualified subchapter S subsidiaries under section 1361(b)(3), entities that are disregarded under §§301.7701-1 through 301.7701-3 of the Procedure and Administration Regulations, or qualified real estate investment trusts (REIT) subsidiaries within the meaning of section 856(i)(2). In general, look-through entities are entities that flow certain tax consequences through to their owners. Although regulated investment companies (RICs) and REITs have certain flow through characteristics, the regulations do not include them in the list of look-through entities, because the Treasury Department and the IRS believe that the burdens of a rule requiring taxpayers to look through these entities in determining the substantiality of partnership allocations generally would outweigh the benefits of such a rule. However, if necessary, RICs and REITs or other look-through entities may be added to the list of look-through entities in future guidance. Comments are requested regarding the treatment of controlled foreign corporations as look-through partners for purposes of §1.704-1(b)(2)(iii)(a)(2) of these proposed regulations. Specifically, comments are requested concerning whether the rule should be limited to those situations in which the controlled foreign corporation owns greater than a threshold minimum percentage interest in the partnership, or only by taking into account the tax attributes of those U.S. shareholders of the controlled foreign corporation owning above a threshold percentage of the stock of the controlled foreign corporation.

The regulations also provide that the interaction of a partnership allocation with the tax attributes of the consolidated group must be taken into account when testing the substantiality of the allocation to a partner that is a member of a consolidated group. A member of a consolidated group is a member of a group filing (or required to file) consolidated returns for the tax year. See §1.1502-1(h).

The proposed regulations clarify that for purposes of §1.704-1(b)(2)(iii)(a)(1), the after-tax economic consequences of a partner resulting from an allocation or allocations must be compared to the after-tax economic consequences to that partner if the allocation or allocations were made in accordance with the partners’ interests in the partnership. The proposed regulations also remove the per capita presumption in §1.704-1(b)(3)(i), which reaches the correct result in very few cases. Finally, the regulations include an example illustrating a fact pattern to which, apart from the application of section 704(b), other sections may apply.

These regulations are generally proposed to apply for partnership taxable years beginning on or after the date on which final regulations are published in the Federal Register. No inference is intended as to the tax consequences of partnership allocations made in taxable years beginning before the effective date of these regulations.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulation does not impose a collection of information on small entitles, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for February 15, 2006, at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name on the building access list to attend the hearing, see the FOR FURTHER INFORMATION CONTACT portion of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments must submit written or electronic comments by January 25, 2006, and an outline of the topics to be discussed and the time to be devoted to each topic (a signed original and eight (8) copies) by January 25, 2006. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.704-1 is amended as follows:

1. Paragraph (b)(1)(ii)(a) is amended by adding a sentence at the end of the paragraph.

2. Paragraph (b)(1)(iii) is amended by revising the first three sentences and adding a new fourth sentence.

3. Paragraphs (b)(2)(iii)(a), is redesignated as paragraph (b)(2)(iii)(a)(1) and revised.

4. New paragraph (b)(2)(iii)(a)(2) is added.

5. The last two sentences of paragraph (b)(3)(i) are removed.

6. Paragraph (b)(5) Example 29 and Example 30 are added.

The additions and revisions read as follows: