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40 Tax Law. 121 (1986-1987)


Partnership income and deductions are allocated according to the amount and the character of each partner's distributive share. This article examines the ways in which the section 704(b) regulations apply the "substantial economic effect" test to character allocations. It argues that it is important to distinguish allocations of character from allocations of amounts to understand these regulations. This is because tests that the regulations apply to character issues have to do with source-measurement correspondence and proration, while amounts are determined according to economic effect in the capital account sense. Although the regulations' rules for character allocations purport to define "substantiality," those rules have nothing to do with whether the economic effect of an allocation is large or small, which is why one allocation can have a "substantial economic effect" while a different but economically identical allocation does not. The author contends that in practice "partner's interest in the partnership" test may assume more importance than "substantial economic effect." This is because only the most sophisticated partnerships will keep their capital accounts according to the requirements of the substantial economic effect test. The allocations of other partnerships will be judged by the "partner's interest in the partnership" standard, which imposes no formal limits on allocations.



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