-15-
Conceptually, if a partner has a positive capital account on
the date of liquidation, the partnership owes him that amount. If,
however, the partner has a negative capital account on the date of
liquidation, the partner in theory owes that amount to the
partnership--or, as a practical matter, to those partners having
positive capital accounts.
c. The Three Tests of Economic Effect
The regulations governing the economic effect of partnership
allocations contain three tests that in a sense serve as "safe
harbors". Partnership allocations are deemed to have economic
effect if they are made pursuant to a partnership agreement that
meets the requirements of any one of these tests. An understanding
of how these tests operate helps to establish the background for
the parties' contrasting arguments.
(1) The Basic Test
The basic test for economic effect is set forth in the
regulations. Section 1.704-1(b)(2)(ii)(b), Income Tax Regs.,
provides, in general, that an allocation will have economic effect
if the partnership agreement contains provisions that require: (1)
The determination and maintenance of the partners' capital accounts
are to be in accordance with the rules of section 1.704-
1(b)(2)(iv), Income Tax Regs.; (2) upon liquidation of the
partnership, the proceeds of liquidation are to be distributed in
accordance with the partners' positive capital account balances;
and (3) upon liquidation of the partnership, all partners having a
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