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partners, then the allocation will be recognized provided it has
substantial economic effect.16 Sec. 1.704-1(b)(1)(i), Income Tax
Regs. Substantial economic effect requires that (1) the
allocation have economic effect and (2) such effect is
substantial. Sec. 1.704-1(b)(1)(i) and (2), Income Tax Regs.
An allocation has economic effect if, and only if,
throughout the full term of the partnership, the partnership
agreement provides: (1) The partners’ capital accounts be kept in
accordance with the regulations; (2) liquidating distributions be
made in accordance with positive capital account balances; and
(3) a partner must be required to restore a deficit capital
account balance following the liquidation of the partnership or
of his interest in the partnership. Vecchio v. Commissioner,
supra at 189; sec. 1.704-1(b)(2)(ii)(b), Income Tax Regs. An
allocation does not have economic effect if it fails to satisfy
any of the three parts of the test. Vecchio v. Commissioner,
supra at 189. In the instant case, capital accounts were never
maintained; thus, the proffered allocations fail the economic
effect test.
The regulations under section 704 also provide an alternate
test for economic effect, contingent on satisfaction of
requirements (1) and (2) above. Sec. 1.704-1(b)(2)(ii)(d),
16The “substantial economic effect” test is applicable to
all partnership allocations, not just “special allocations”.
Hogan v. Commissioner, T.C. Memo. 1990-295.
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