Special Allocations of Percentage Depletion
By Professor Richard A.
Westin
University of Kentucky Law School, Lexington, KY
Partnership allocations have to meet a “substantial economic
effect” test to be respected for federal income tax purposes. If
they are not, the item or items being allocated under the partnership
agreement must be adjusted to reflect the partner's interest in the
partnership, based on their real sharing arrangement. This can be very
hard to do where there are special arrangements such as partnership
“flips” of profit and loss sharing ratios. Be that as it
may, that is the basic law.
The selection between cost and percentage depletion is made at the
partnership level, and is subject to the basic rules above.
The regulations1 place a
special limit here:
[t]o
the extent the percentage depletion in respect of an item of
depletable property of the partnership exceeds the adjusted tax basis
of such property, allocations of such excess percentage depletion are
not reflected by adjustments to the partners' capital accounts. Thus,
such allocations cannot have economic effect … and such excess
percentage depletion must be allocated in accordance with the
partners' interests in the partnership.
So what is one supposed to do in partnership tax and book
accounting terms if a partner contributed a property whose value
exceeds it basis and there is percentage depletion? The regulations
seem to be directed at deductions for depletion that have no impact on
book capital accounts and therefore lack “economic
effect.” This arises because the economic effect rules require
that contributed and distributed property be booked at their values,
not their bases. In the case of depletion, the regulations
demand:
Determining
amount of book items. The partners' capital accounts will not be
considered adjusted in accordance with this paragraph (b)(2)(iv)(g)
unless the amount of book depreciation, depletion, or amortization for
a period with respect to an item of partnership property is the amount
that bears the same relationship to the book value of such property as
the …depletion …computed for tax purposes with respect to
such property for such period bears to the adjusted tax basis of such
property. If such property has a zero adjusted tax basis, the book
depreciation, depletion, or amortization may be determined under any
reasonable method selected by the partnership.
This could produce serious uncertainty in the case where a partner
contributes a low or zero basis property. For this purposes, assume
the partnership selects the remedial allocation method of dealing with
built-in gains and losses. There seem to be two outcomes, depending on
how one reads the regulations:
1. The partnership allocates the percentage depletion deduction all
to the partner who did not contribute the property, and then grants an
allocation of a remedial deduction to the contributing partner to
offset his share of the book-tax disparity, with an identical
offsetting remedial allocation to the partner who contributed the
property. This accords with the purpose of the regulation, but looks
like a strained outcome; or,
2. Using the proportionality approach suggested in the regulation
that makes the allocation on the basis of relative gross income, it
seems the partners would share the depletion deduction in accordance
with their overall profit shares and the partnership would make a
remedial allocation of a deduction to the noncontributing partner and
a corresponding remedial allocation to the contributing partner.
Notice that allocations of excess percentage depletion could
potentially trigger a partner-level limit on deductions allowed under
the partnership taxation rules. However, §705(a)(1)(C) prevents
this problem by providing that a partner's basis in her partnership
interest increases by her cumulative distributive share of the excess
of the deductions for depletion over the basis of the property subject
to depletion, with the result that her share of the partnership's
depletion deduction initially reduces her basis, but the reduction in
turn declines to the extent of her distributive share of excess
depletion. Notice that this goes to basis issues, and does not seem to
be coordinated with the substantial economic effect rules. Some
clarification by the Treasury Department seems in order. Not every
mining partnership can afford to struggle with this murkiness.
For more information, in the Tax Management Portfolios, see Klig
and Sloan, 712 T.M., Partnerships -- Taxable Income; Allocation of
Distributive Shares, and Edwards, 610 T.M., Timber
Transactions, and in Tax Practice Series, see ¶2610,
Depletion, and ¶4090, Distributive Shares & Special
Allocations.
1
Regs. §1.704-1(b)(4)(iii).
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