More on the “Qualified Income Offset”

In response to some after-class questions, here’s some followup discussion of the “qualified income offset.” Recall problem 1(d) on page 161, with our additional facts thrown in that the partnership has borrowed $50,000, has put it in a bank account, and need not make any payments of principal for several years. Assume that the debt is properly allocated one-half to each partner under section 752(a). Here’s what the balance sheet looked like at the end of year 6:

	Assets			Liabilities
	Inside Basis	Book Value	Debt		50,000
Building	80,000	80,000		Outside Basis	Book Value
Cash	50,000	50,000	A	105,000	80,000
			B	25,000	0
			Total equity	130,000	80,000
Total assets	130,000	130,000	Total liabs.	130,000	130,000

Let’s say that AB distributes $5,000 to each of A and B during year 7; the distribution could not reasonably have been foreseen at the end of year 6. In year 7, AB has no income or deductions except for $20,000 depreciation, which now must pass through to A because B has run out of capital account. Here is how the balance sheet would look at the end of year 7:

	Assets			Liabilities
	Inside Basis	Book Value	Debt		50,000
Building	60,000	60,000		Outside Basis	Book Value
Cash	40,000	40,000	A	80,000	55,000
			B	20,000	(5,000)
			Total equity	100,000	50,000
Total assets	100,000	100,000	Total liabs.	100,000	100,000

Tracking through the year-to-year changes, the building’s basis and book value declined by $20,000; cash decreased $10,000 because of the distribution; each partner’s basis and capital account was reduced by her respective $5,000 distribution, and A’s basis and capital account additionally dropped by $20,000 for the depreciation deduction.

Note that B has received $5,000 in cash, with no capital account and no obligation to pay it back. Thus, for some reason known only to A and B, A has decided to allow B to take assets out of the partnership in excess of his share. In effect, with the distribution, B got some of A’s money. The regulations under section 704(b) don’t like this state of affairs, and they want to see B report income as soon as possible. The qualified income offset assures this. This provision in the partnership agreement says that AB must be allocated income for the year “in an amount necessary to eliminate such deficit balance as quickly as possible.” Treas. Reg. § 1.704-1(b)(2)(ii)(d) (third sentence from end).

Say in year 8, AB has $50,000 of gross income, $50,000 of deductions other than depreciation, and $20,000 of depreciation; the depreciation is now allocable all to A because B has run out of capital account. Assume no distributions (or principal repayment on the debt) in year 8. The qualified income offset requires that the first $5,000 of gross income be allocated all to B; thus, B will have $25,000 of deductions and $30,000 of gross income. A will have $25,000 of nondepreciation deductions and only $20,000 of gross income. Thus, B winds up with $5,000 of income (both for tax purposes and for capital account purposes) while A has a loss of $25,000. If it hadn’t been for the qualified income offset and B’s capital account deficit, the results would have been a wash for B and a $20,000 loss for A.

Therefore, A is disadvantaged from an economic standpoint, because of the qualified income offset, as opposed to the 50-50 allocation of nondepreciation items that the partners may have been contemplating. (Of course, on the facts of our problem, the partnership agreement said that all of the depreciation was to be allocated to B, and there is no way that that allocation is going to be allowed.)

In any event, at the end of year 8, the AB balance sheet looks like this:

	Assets			Liabilities
	Inside Basis	Book Value	Debt		50,000
Building	40,000	40,000		Outside Basis	Book Value
Cash	40,000	40,000	A	55,000	30,000
			B	25,000	0
			Total equity	80,000	30,000
Total assets	80,000	80,000	Total liabs.	80,000	80,000

The regulations are happy, because B’s capital account is now out of negative territory. But between the $5,000 distribution to B with no capital account and the $5,000 allocation of income to B under the qualified income offset, B’s economic results are $10,000 more favorable than one might have otherwise expected. At this point, A’s capital account should be $40,000 ahead of B’s, not just $30,000.

Things can be turned around in A’s favor, however, if AB has a better year in year 9. Say in year 9, AB has $80,000 of gross income, $70,000 of deductions other than depreciation, and $20,000 of depreciation allocable all to A. Assume no distributions (or principal repayment on the debt). The partnership agreement can allocate an extra $5,000 of gross income to A, thus causing A to “catch up” from the adverse effect of the qualified income offset. A will have $35,000 of nondepreciation deductions and $45,000 of gross income (plus all $20,000 of depreciation). B will have $35,000 of nondepreciation deductions and only $35,000 of gross income. The disadvantage to A will therefore be fixed.

The balance sheet at the end of year 9 would look like this:

	Assets			Liabilities
	Inside Basis	Book Value	Debt		50,000
Building	20,000	20,000		Outside Basis	Book Value
Cash	50,000	50,000	A	45,000	20,000
			B	25,000	0
			Total equity	70,000	20,000
Total assets	70,000	70,000	Total liabs.	70,000	70,000

If in year 10, things go the way they did in years 1 through 5, the results are the same as in year 6 (the operating loss goes to A), and the balance sheet at the end of the year looks like this:

	Assets			Liabilities
	Inside Basis	Book Value	Debt		50,000
Building	0	0		Outside Basis	Book Value
Cash	50,000	50,000	A	25,000	0
			B	25,000	0
			Total equity	50,000	0
Total assets	50,000	50,000	Total liabs.	50,000	50,000

As noted in class, even without a “qualified income offset,” the allocation of all of the depreciation to B for the first five years would probably pass muster under the “facts and circumstances” test of section 704(b). But if a “qualified income offset” is included, the allocation will clearly prevail under section 704(a). And it appears that any injustice that the “qualified income offset” creates can be corrected in future years by counterbalancing allocations.

Created by: bojack@lclark.edu

Update: 22 Feb 09

Expires: 31 Aug 09