7740 / How are partnership income, gains, losses, deductions, and credits allocated among partners?

The purpose of the substantial economic effect test is to “prevent use of special allocations for tax avoidance purposes, while allowing their use for bona fide business purposes.”² Regulations provide that generally an allocation will not have economic effect unless the partners’ capital accounts are maintained properly, liquidation proceeds are required to be distributed in accordance with the partners’ capital account balances and, following distribution of such proceeds, partners are required to restore any deficits in their capital accounts to the partnership. The economic effect will generally not be considered substantial unless the allocation has a reasonable possibility of affecting substantially the dollar amounts received by partners, independent of tax consequences. Allocations are insubstantial if they merely shift tax consequences within a partnership tax year or are likely to be offset by other allocations in subsequent tax years.³