An Overview of Selected Aspects of Federal Taxation of Partnerships and Its Application to Leasing


By Lloyd A. Haynes, Jr.

Vice President, GATX Capital Corporation




Ty C. Schultz

Associate Director, GATX Capital Corporation


As original published in the Fall 1999 (Volume 26 Number 6) issue of the

Leasing and Financial Services Monitor


            A partnership is an often-discussed and widely used structure, which potentially offers various tax benefits to the investors in tax-oriented leases.  Since the tax aspects of a partnership are the least understood and most complex issue facing many who are considering the use this structure, the focus of this article will be on giving an overview of the federal tax consequences of such a structure and its application to a leveraged lease.  There are many non-tax reasons why taxpayers may enter into partnerships, including: accounting (for example, off-balance sheet treatment), risk sharing (one possibility: allocating residual and other risks between partners), greater diversification (perhaps pooling airplanes owned or to be acquired by others with your own), pooling of purchasing power (a possible benefit might be a discount for placing a larger single order), etc.  Unfortunately, it will become apparent as we look at partnership tax law that these non-tax motivations are generally clearer and easier to understand than the evaluation of possible tax motivations for entering into a partnership.  Indeed, the tax rules which must be followed by partnerships are often so murky and complex that, even within the same law firm, different tax counsel may arrive at different conclusions as to what is or isn’t allowable.  Any reader planning on entering into a partnership will need to confer with his tax attorneys to insure the tax outcome he is seeking should, in fact, be accomplished.  The reader should also understand that the authors of this article do not intend to imply that a partnership structure is always the best solution.  Depending upon the particular facts and circumstances surrounding a particular transaction, some other structure may be more attractive and appropriate for the economic, accounting, tax, or other objectives of the potential participants.  However, since partnerships are so widely used, having a better understanding of them is useful.  Too often a partnership is truly a “black box” to individuals who as a result only have a vague perception that certain tax benefits are being realized without understanding the mechanisms underlying the anticipated benefits.  Having a more in-depth knowledge of the intricacies of partnership tax rules and their application will allow one to better evaluate the potential risks and rewards that can realistically be expected to result from the application of tax rules governing partnerships.




            Subchapter K of the Internal Revenue Code (the “Code”) (§§ 701-761) and the Treasury regulations pertaining thereto determine the taxation of partners and partnerships.  A partnership itself is not a taxable entity; rather it passes through to the partners their respective shares of items of income and loss, which are then reported on their tax returns.  Subchapter K governs the ways in which this can be accomplished.


            This article will not be an in depth discussion of all the complexities of partnerships and their taxation, but merely an overview of their potential benefits and the difficulties which exist.  Hopefully, after the reader has completed the article, he will have gained more appreciation for why partnerships are used and what is meant by “disproportionate allocation” within partnerships.  The allowance under the tax Code of “special allocations” among partners is often viewed as allowing unfettered reallocation of taxable income and losses among partners.  As will be seen, this is not the case.  If anything the one thing which will become clear from reading this article is that the tax law applicable to partnerships is often unclear.


What Constitutes a Partnership?


            There are a number of forms of partnerships provided for under state law, including general partnerships, limited partnerships, limited liability companies (“LLCs”), and limited liability partnerships (“LLPs”).  Each form of partnership has its own pluses and minuses.  For our purposes, all that matters is that the business entity is recognized for tax purposes as a partnership.  In this regard the tax law (§ 761(a) and §1.761-1(a)) is very liberal.  Under § 761(a) a partnership is defined to include “a syndicate, group, pool, joint venture, or other unincorporated organization through, or by means of which any business, financial operation, or venture is carried on and which is not within the meaning of this Title, a corporation or trust or estate.”  This broad definition means that two taxpayers that never intended to be partners, but rather just co-owners of an asset, might be classified as such.  Until recent years, taxpayers wishing to be treated as being within a partnership needed to insure the partnership could not be viewed as a corporation.  Briefly, the IRS looked to four characteristics attributable to a corporation: (1) continuity of life, (2) centralized management, (3) limited liability, and (4) free transferability of ownership interests.  If a partnership met three of these four characteristics it would be reclassified by the IRS as a corporation.  More recently the regulations have been modified to provide for a “check the box” approach to determining the way in which a business entity will be viewed for tax purposes.  As a general rule, a business entity now will be treated for tax purposes by the IRS as its chooses to be treated, thus making the outlined characteristics of a corporation less relevant, if not meaningless, for tax purposes.


Forming a Partnership


            The formation of a partnership rarely results in a gain or loss for the partners.  This is because taxpayers contributing property to a partnership are viewed as merely changing the form of its ownership to a partnership interest, not as having disposed of it.


            Significant provisions of the Code with respect to formation of a partnership are:


·         Section 721: Nonrecognition.  In general, this protects partners or the partnership from having to recognize any gain or loss upon exchange of property for a partnership interest.

·         Section 722: Outside Basis.  The basis of the partnership interest received by a partner is that taxpayer’s basis in contributed  property at the time of contribution, plus any cash contributed, less cash or basis of property received, plus any gain recognized.  In general, the holding period of contributed property in a partner’s hands carries over to the partnership interest received in return (some items such as cash, inventory, and services do not have holding periods).

·         Section 723: Inside Basis.  The partnership’s basis in contributed property is equal to that of the contributing partner and the partnership can add the contributing partner’s holding period to its own.


Several important nuances with respect to partnership formation need to be addressed.  They are:


·         Precontribution Gain or Loss.  Under § 704(c)(1)(A) precontribution gain or loss associated with property must be allocated to the contributing partner.

·         Contribution of Depreciable Property.  §§ 1245 and 1250 protect a contributing partner against recapture of depreciation on contributed property.  The partnership will be subject to recapture of depreciation at a later date in an amount equal to the depreciation taken by the contributing partner and any depreciation taken by the partnership.  The partnership, in essence, steps into the shoes of the contributing partner on property for depreciation purposes.

·         Section 752: Liabilities.  Each partner is given credit in his outside basis for his share of the partnership liabilities.  As a general rule, non-recourse indebtedness is allocated among the partners in the same fashion as profits.  This is based on the theory that repayment of the non-recourse indebtedness will come from partnership profits.  Contributions of encumbered assets result in a deemed cash distribution to the extent the contributing partner is relieved of a portion of his obligation.  Depending upon circumstances (see below) this deemed distribution might be considered taxable income to the contributing partner.

·         Partnership Tax Years.  The partnership must choose a tax year.  Under § 706, in most cases, the partnership will have a tax year ending on the same date a majority (partners representing over 50% of profits and capital) of partners’ tax years end.  Alternate rules exist which may be applied in certain circumstances.


Partnership Outside Basis Adjustments


            Under § 705 a partner is required to increase or decrease his outside basis in the partnership based upon allocations of income or loss allocated to him by the partnership.  The allocated income or loss will be incorporated into each partner’s own individual tax return.  Thus, if a partner is allocated income of $100, his outside basis in the partnership increases by $100 (i.e., his basis in his interest in the partnership).  This is to avoid double taxation if he later sells his partnership interest.  Presumably, if the income is not distributed to him his partnership interest now has a value $100 higher.  Likewise, if he is allocated a loss of $100 his outside basis in the partnership is reduced by $100.  This will avoid him being able to recognize a loss twice.  To the extent distributions are made to a partner, his basis in his partnership interest is reduced by the amount of the distribution.  Distributions are considered a return of capital and non-taxable until a partner has reduced his basis to zero.  Beyond that point any distributions will be considered a taxable gain and will not result in reducing the basis of the partner’s interest in the partnership below zero.  One might note that tax-exempt income allocated to a partner increases his basis in his partnership interest by the amount allocated.  This is to avoid later subjecting what was tax exempt income to income tax.


Partnership Capital Accounts (Inside Basis)


            The rules for maintaining capital accounts (i.e., the partnership’s internal measurement of partner’s capital balances, as opposed to a partner’s external or outside basis in his partnership interest) are dealt with next.  The IRS addresses these rules under § 1.704-1(b)(2)(iv).


            We start by noting a fundamental concept of accounting, that for a business:


                                    Assets = Liabilities + Equity


The equity component of this equation is represented by the partners’ capital accounts.  The capital accounts reflect property contributions by partners net of any associated liability, distributions, and any income or loss incurred.


            There are two capital account balances, which need to be reflected by the partnership.  One is a book balance and one is a tax balance.  It should be emphasized that when we speak of book balances here we do not mean GAAP books, but rather book accounting as dictated by Treasury regulations.  The book balance may or may not equal the tax balance due to situations under which the partnership revalues assets so that they are no longer valued based upon historic cost (which will generally be carried forward for tax purposes regardless of any revaluation).  This will be discussed further as we go along.


            Items, which result in adjustments to partnership book capital balances, are:


·         Contributions.  To the extent a partner contributes cash or property that partner’s book capital account balance will be increased.  This increase will reflect the fair market value (“FMV”) of the property (less any associated liabilities), not its historic cost.

·         Operating Income (Loss).  Each partner’s book capital account will be increased by each year’s book income and decreased by each year’s book losses.  Depreciation is integral to the calculation of the income or loss for the year.  For book purposes Treasury regulations require that depreciation be taken in a way consistent with tax depreciation.

·         Distributions.  Distributions are the mirror image of contributions.  Therefore, any property distributed is measured at FMV less any associated liabilities.  Although no gain or loss is recognized for tax purposes, FMV must be used for book purposes.


The implications of the above may be illustrated by using an example related to equipment leasing.  Assume there are two partners, “A” and “B”.  Assume that Partner A contributes equipment with an FMV of $1,000,000 and a tax basis of $200,000 (i.e., it has been partially depreciated).  Under § 723 the partnership inherits a tax basis of $200,000.  Partner A recognizes no gain or loss upon the contribution.  However, his outside basis in the partnership is now $200,000 under § 722.  Assume Partner B contributes $500,000 to the partnership.  The balance sheet of the partnership now looks as follows:


                                               Assets                                          Liabilities & Capital


                                      Tax                 Book                              Tax                       Book


Cash                          500,000           500,000

Equipment                  200,000        1,000,000


Liabilities                                                                                              0                           0


Capital Accounts

            A                                                                                    200,000             1,000,000

            B                                                                                    500,000                500,000

                                   _______       ________                          _______            ________

                                   700,000        1,500,000                          700,000             1,500,000


Observe that, in a situation where no liabilities exist, each partner’s book balance reflects his inside basis and his tax basis reflects his outside basis.  Note that under § 704(c) upon any disposition of the equipment by the partnership, the first $800,000 of any tax gain will have to be allocated to Partner A for tax purposes in order to reconcile the disparity in the partnership capital account balances.  Otherwise, income originally attributable to Partner A would have to be shared by Partner B.  Thus, if the partnership were to immediately dispose of the equipment contributed by Partner A for $1,000,000, Partner A would be allocated $800,000 of gain for his tax capital account.  This would increase it to the $1,000,000 which would be reflective of the FMV of the equipment used for book purposes.  Partner B would be allocated no tax gain associated with the sale.


            The revaluation of equipment in our example is due to the marking up of the equipment contribution by Partner A to FMV.  Other circumstances can arise which would cause the partnership to revalue assets, but are beyond the scope of this article.


Partnership Allocations


            The next area to deal with is the allocation of taxable income and loss among the partners.  Under § 704(a) the general rule of thumb is that all income, gains, losses, deductions, or credits are allocated to partners based upon the partnership agreement.  However, the partnership agreement is not permitted to make allocations totally unfettered by Subchapter K.  In general, under § 704(a) “special allocations” (i.e., those which diverge from the partner’s proportionate interests reflected in their respective capital accounts) will be respected.  However, in order to be respected, under § 704(b) the partners have to show that the reallocations of income and loss among themselves has “substantial economic effect” (“SEE”).  In other words, the partners may choose to allocate taxable income and loss among themselves in a way which is economically advantageous to themselves given their differing tax positions, however the partners need to be able to show that the reallocations they made have SEE independent of any tax savings that may be realized.


            The evolution of the concept of SEE was based on Congress’s stated intention that while special allocations should not be made for tax avoidance or evasion, they would be respected if they have SEE and are not merely a way of reducing certain partners’ income tax liabilities without affecting their shares of partnership income.  Although technically SEE is not required to prove (nor does it insure a finding of) no intent to avoid paying taxes, it provided the courts with a practical benchmark against which to judge the issue of whether or not tax avoidance was the motivating factor in special allocations within a partnership.


            How can SEE be judged?  A major factor to be evaluated is:


·         Capital Accounts.  In order for an special allocation to have SEE it must have a meaningful impact on the partners’ capital accounts.  More specifically, if the partnership were to be liquidated one must show that the special allocations would actually affect the cash distributions made to the partners.  If the partnership agreement contains provisions that require adjustments to the partners’ capital accounts under certain circumstances that effectively negate an original special allocation, then it will not be respected.  Thus if, for example, all depreciation were allocated to partner A and none to partner B, but otherwise there was no effect on any other economic aspects of the partnership, there would be no SEE.  This will be elaborated on more as we go along.


Although other parts of Subchapter K govern allocations, such as § 704(c), § 706 (c), and § 743(b), § 704(b) is by far the most important.  Under § 1.704 the IRS has divided its position on allocations into four major parts.  They are:


1.      Definition of SEE and Establishment of the Safe Harbor.  As a general rule, if an allocation has SEE it will be respected, if not the item will be reallocated in accordance with each partner’s “interest in the partnership.”  There are two tests that must be met to prove SEE.  If they are met, the partnership allocations fall within the safe harbor provided by the regulations.  They are:


·         Meaningful Capital Accounts to Prove Economic Effect.  This first test is relatively mechanical and easy to meet.  To prove economic effect the partnership must maintain meaningful capital accounts utilizing a strict set of rules.  There are three alternate tests to prove an allocation has economic effect.  They are:

i.         Basic Test for Economic Effect.  If the partnership agreement meets three requirements an allocation will have economic effect:  These are:

1)      Capital Account Requirement.  The partnership must maintain its capital accounts in accordance with § 1.704-1(b)(2)(iv).  In other words, as outlined above.

2)      Liquidation Requirement.  Liquidating distributions must be made in line with the positive balances in the partners’ capital accounts.

3)      Deficit Makeup Requirement.  A partner must unconditionally be obligated to make up any deficit in his capital account that exists after the partnership has been liquidated.  This can be accomplished either by a clause in the partnership agreement or the operation of state or local law.

¨       This means that a partner can be allocated losses and deductions without limit since they will be considered to have economic effect.  This makes sense because the partner allocated these losses will have to make up any deficit caused by them at some point.

ii.       Alternate Test for Economic Effect.  In recognition of the fact that the reason for existence of limited partnerships is to limit the losses limited partners are exposed to, the IRS created this test.  Under it an allocation has economic effect if:

1)      The partnership agreement meets the first two requirements under the Basic Test.

2)      Qualified Income Offset (“QIO”) Provision Requirement.  The partnership agreement can provide for an obligation on the part of a partner to make up deficits in his capital account up to a limited amount.  No allocation of losses or deductions can be made if it would create a deficit in a partner’s capital account balance in excess of his QIO obligation.

¨       An unforeseen event, such as an unanticipated distribution, could create an excessive capital account deficit problem.  The IRS deals with this by requiring that any unexpected capital account deficits in excess of the QIO be eliminated as soon as possible through income allocations.

iii.      Economic Effect Equivalence Test.  This test is meant for a general partnership that technically does not meet the Basic Test.  Under § 1.704-1(b)(2)(ii)(i) one can still fall within the safe harbor rules for economic effect if a partnership allocation is deemed to have economic effect.  If as a practical matter the partnership’s allocations create the same economic effect to the partners as would have occurred if it had met all the requirements of the basic test, they will be deemed to have economic effect.  This test is the least important of the three since meeting it would seem to remove the need for SEE.  The allocations required would appear to track the partners’ interests almost definitionally.


·         Substantiality.  The second is to show that the economic effect of an allocation is “substantial.”  In other words, a partnership must be able to demonstrate that special allocations have an effect other than tax savings to prove they have a substantial effect.  In all instances, the value-equals-basis rule (i.e., a partnerships’ assets are irrefutably presumed to have a value equal to their basis, or book value if different from basis) applies.  By its nature, the issue of substantiality is less clear-cut than economic effect.  Considering substantiality entails:

i.         General Rule.  Under § 1.704-1(b)(2)(iii)(a) the partnership must be able to demonstrate that (a) special allocation(s) are reasonably likely to substantially affect the dollar amounts received by the partners independent of the tax consequences.  If this cannot be shown, the allocations will not be substantial and will have to be reallocated taking into account the partners’ individual interests in the partnership.  The regulations give two examples of common situations that would not be considered substantial.

1)      Shifting Tax Consequences.  The economic effect of a partnership’s special allocation within a tax year is not substantial if at the time the partnership agreement is put in place it is likely that:

¨       The net impact on the partners’ capital accounts for the tax year on a pre-tax basis will not cause them to differ significantly from what they would have been without the special allocations.

¨       Given the individual circumstances of the partners, their total tax liability for that tax year is reduced from what it would have been without the special allocation.

2)      Transitory Allocations.  These are analogous to Shifting Tax Consequences except that this scenario covers multiple tax years.  The transitory rule only applies if, at the time the original and offsetting allocations are incorporated into the partnership agreement, it is probable the original allocation will be largely offset within five years.  In this instance, if, at the time the partnership agreement and its associated allocations are put in place, it is probable that:

¨       The net impact on the partners’ capital accounts on a pre-tax basis over the tax years in question will not cause them to differ significantly from what they would have been without the special allocations.

¨       Given the individual circumstances of the partners, their total tax liability for the tax years in question is reduced from what it would have been without the special allocation.

ii.       After-tax Exception.  § 1.704-1(b)(2)(iii)(a) provides for an after-tax exception to the general rule.  In applying this rule the five-year rule does not apply.  This rule states that the economic effect of a special allocation is not substantial if, at the time it is provided for in the partnership agreement it is likely to enhance the economics of at least one partner while leaving no other partner worse off on an after-tax basis


2.      Definition of “Partners’ Interests in the Partnership.”  This part provides the default rules by which allocations will be made when the safe harbor is not met.


3.      Special Rules When SEE is Not Applicable.  The major area of interest here relates to non-recourse debt.  Since the partners are not liable for repayment of non-recourse debt, its required allocation among the partners is viewed as unclear.  Allocations of non-recourse debt will be deemed to have met the SEE safe harbor if special rules are followed.  If not, it will be reallocated according to the partners' interests in the partnership as determined under 1.704-1(b)(3).  The safe harbor requirements are:

·         Partnership Agreement must Meet the Basic or Alternate Test for Economic Effect.

·         Consistent Allocations of Nonrecourse Deductions.  The nonrecourse deductions must be allocated under the partnership agreement in a manner consistent with the allocation of some other significant item related to the property securing the debt.

·         Minimum Gain Chargeback Provision Required.  I

i.         Partnership Minimum Gain (“PMG”).  This is the minimum gain the partnership would realize if the asset securing nonrecourse indebtedness were disposed of.  In general, this will be equal to the excess of the nonrecourse indebtedness of the partnership over and above its tax basis in the asset securing the indebtedness (however, this may not be the case in circumstances previously discussed where the book value of the partnership differs from tax basis because of adjustments made to reflect the FMV of the property).  Another complicating factor which can lead to PMG is secondary nonrecourse financing.  If such secondary nonrecourse financing is used to make a distribution to the partners, to the extent it caused an increase in PMG it is considered a nonrecourse distribution.

ii.       Nonrecourse Deductions (“NRDs”).  NRDs are nonrecourse deductions associated with nonrecourse indebtedness for which no partner bears the economic burden.  NRDs are equal to the increase in PMG during a tax year less nonrecourse distributions.  In general, NRDs are related to the cost recovery (i.e., tax depreciation) deductions taken on the property securing the nonrecourse indebtedness.

iii.      Partner’s Share of PMG.  PMG is allocated among partners in accordance with the allocation of NRDs and nonrecourse distributions to him.  As a result, a partner’s share of the partnerships PMG will be equal to the sum of NRDs allocated to him plus nonrecourse distribution less the partner’s share of decreases in PMG.

iv.     Minimum Gain Chargeback (“MGC”) Provision).  This requires, in general, that if there is a net decrease in PMG in a tax year then each partner must be allocated an amount of income equal to his share of the decrease in PMG.  There are four exceptions to this rule:

1)      Conversions and Refinancing.  To the extent a partner becomes liable for nonrecourse indebtedness no MGC is required.  The partner is now bears the economic burden for NRDs previously taken.

2)      Contributions of Capital.  Similar logic to 1) applies in a situation where a partner contributes capital which is used to repay nonrecourse indebtedness.

3)      Revaluations.  Special provisions are made for situations where assets are revalued.  This is beyond the scope of this article.

4)      Waiver.  If the partnership feels that the MGC could distort the economics of the partnership, it may request a waiver.

·         Required Respect for Material Allocations and Capital Account Adjustments Under § 1.704-1(b).


4.      Examples Illustrating Application of the Rules.  This simply consists of expository examples provided by the IRS to further clarify the application of the rules governing SEE.


Note that SEE merely provides a safe harbor; an allocation’s failure to meet the requirements of SEE does not mean it will not be respected for tax purposes.  Should a reallocation occur, as a general rule it will be in accordance with the partners’ interests in the partnership.  Either the IRS or the taxpayer can rebut this approach based upon facts and circumstances.


Further Discussion Related to Contributions of Property and § 704(c)


            When a partner contributes depreciable property, allocation of built in gain or loss is somewhat complex.  If a depreciable asset is held over time the allocation of income and depreciation deductions associated with the asset can result in shifting of income between partners depending on the disparity between FMV and tax basis.  § 704(c) deals with this by providing three methods of  adjusting for depreciation disparity between book and tax among the partners: the traditional method, the traditional method with curative allocations, and the remedial allocation method.  It is important for the reader to be aware this issue exists and to incorporate it into any partnership analysis which may involve contributions of property by partners which involves a deviation of tax basis from book FMV.  However, for purposes of this article we will just highlight it as an issue and leave it to the reader to further investigate it if warranted.  Be aware as well, however, that while the partnership is allowed to elect the method to be used, each option can have significant economic implications for the partners depending on the tax situation of each.  As a result, depending on the tax parameters of the partners, the IRS can challenge the selection under the general anti-abuse rule of § 1.704-(3)(a)(10).  This basically says that if the partners choose an allocation method that substantially reduces the PV of the partner’s aggregate tax liability then it may be disallowed.


Disguised Sales and Exchanges (§ 707(a)(2)(B)


            A contribution by one partner of an asset followed by a distribution could be viewed as a sale. Thus if Partner A contributes $1,000,000 in property and Partner B contributes $500,000 in cash which is distributed to Partner A, it could be viewed as if Partner A made a $500,000 asset sale to Partner B.  Treasury sought under § 707(a)(2)(B) to deal with situations where two transfers are considered to be sufficiently related to be considered a sale. The general rule is that a property contribution and a related distribution will be considered a sale only if:


1.      The transfer of money or property to the partner contributing property only occurred because of the property he transferred to the partnership; and

2.      If the transfer is not simultaneous, it is unrelated to the entrepreneurial risks of the partnership’s operations.


If the transfers are simultaneous they very likely to be regarded as sales.  There are two important presumptions incorporated into the regulations:


1.      Transfers made within two years of each other are presumed to constitute a sale.

2.      Transfers made more than two years apart are presumed not to constitute a sale.


Provisions are made such that facts and circumstances may be able to rebut sale treatment regardless of these presumptions.  If a transaction is appropriately structured it may be possible for a partner to monetize contributed assets without generating a tax liability through distributions of cash contributed by other partners or the use of debt.  One should confer with his tax counsel if he has such an objective.


Anti-Abuse Rules


            When all else fails the IRS can turn to the anti-abuse rules incorporated into the regulations.  In January 1995 the Treasury  issued a regulation under § 701 which stated that (§ 1.701-2(b)):


…if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner which is inconsistent with Subchapter K, the Commissioner can recast the transaction for federal tax purposes….


The reader should review the application of the anti-abuse principles in the regulations when considering any partnership structure.


An Example to Help Clarify Points in the Article


            Finally, let’s try to better understand what we have covered by using an example.  In this example we will assume that rail equipment is to be acquired which will be subject to a twenty year leveraged lease.  Table I shows the assumptions for determining a market based pricing of lease rents.  Table II summarizes the assumptions applicable to a similar lease done with the same PV of the rents for a partnership where 50% of the capital is allocated to a regular taxpayer (the “Regular Taxpayer” partner) and the other 50% to a taxpayer that is assumed to be an NOL (net operating loss) (the “NOL Taxpayer” partner) taxpayer whose marginal tax rate is assumed to be 0%.  No judgment is meant to be implied as to whether or not the partnership is viewed as offering the optimal way for the NOL Taxpayer to make use of its NOL carryforward.  In a further simplifying assumption, we will assume that the NOL Taxpayer’s NOL carryforward is about to expire over the next few years, so it needs to find ways of generating income to allow it to make use of its NOL carryforwards.  Even though pretax and after-tax yield might be viewed as the same for the NOL Taxpayer, it will be assumed that the NOL taxpayer has studied the partnership opportunity represented here and decided it is economically attractive.  Despite the fact the focus of this article is on the application of federal tax law to a partnership, it is worthwhile to focus for a moment on the economic implications of the partnership structure for the partners.  This, after all, is generally (along with the accounting, risk sharing, etc. reasons outlined above) a major motivating factor in choosing to enter into a partnership.  Although the after-tax MISF yield to the NOL partner is only 5.9%, compared to the higher 7% rate assumed on the debt in the leveraged lease (again, bearing in mind that, if the NOL were to invest in the debt instead, we are assuming it would view its pretax and after-tax returns as both being 7%), it is assumed the potential residual upside and the yield enhancement it will provide justify the investment in its analysis.  Likewise, the 5% MISF yield received by the Regular Taxpayer is simply the market yield to a regular taxpayer he would have received anyway.  However, the Regular Taxpayer will generate a dramatically larger sinking fund balance than would normally be the case on which he can earn an incremental return (due to his being allocated 100% of the depreciation write-offs on his 50% partnership position).  What can be concluded here as to the economic benefit of the partnership to the partners?  For the NOL Taxpayer an individual as opposed to joint (through a partnership) investment in a leveraged lease would be unattractive because the tax shelter generated in the early years of such a lease is of no use to him.  A market priced lease would generate an after-tax MISF yield significantly lower than the 5% assumed to be received by a typical lessor in the market.  Here the NOL Taxpayer receives a yield significantly above that.  In addition, while a traditional investment such as a loan might generate income to offset his expiring NOL carryforward with a somewhat higher guaranteed yield, depending on the arrangement the partners strike on the residual he can potentially receive a residual upside play in an equipment lease partnership arrangement that results in a much higher yield overall than he could have obtained otherwise - perhaps hundreds of basis points higher.  In the meantime, by front-loading his allocation of partnership income he is still being allowed to make use of his expiring NOLs.  Finally, while the Regular Taxpayer’s purported after-tax MISF yield is merely the 5% rate he would normally receive, everyone will recognize the value of the cash temporarily thrown off by his allocation of 100% of the depreciation write-offs and deferred allocation of income from rent income less interest expense.  This will push his yield significantly above what it would have been, the magnitude depending upon how aggressive he wants to be in his assumed return on sinking fund balances.  Indeed, depending upon the value imputed to the sinking fund balances there might be room for the partners to agree to adjustments to the partnership arrangement to share this benefit with the NOL Partner and further enhance his yield.

            Let’s try to examine the example in the context of the partnership taxation discussion above.  Table III shows the allocation of items to the partnership individual capital accounts based upon the assumptions contained in Table II.  Note that all depreciation write-offs have been allocated to the Regular Taxpayer on the value-equals-basis presumption and the fact that 100% of the anticipated residual income and cash flow has been allocated to this partner.  The IRS has indicated that allocations of NRDs are acceptable as long as the allocation is reasonably consistent with another significant item related to the property that has SEE.  In a similar vein, the example assumes that non-recourse debt interest deductions are allocated in the same proportion as an income item with SEE, in this case rent.  Thus in the early years we allocate 100% of the rental income and non-recourse debt interest expense to the NOL Taxpayer and in later years to the Regular Taxpayer.  During the transition year, year 2, the allocation of rent income and non-recourse expense is split between the two taxpayers such that it will eventually lead to each partner being allocated 50% of the partnerships income.  Likewise, looking at Table V, we see that although 100% of partnership cash distributions are made first to the NOL Taxpayer and then to the Regular Taxpayer such that each ends up with 50% of the cash distributions.  The projected tax payments by the partners are shown in Table VI.  Table VII shows the partners’ projected after-tax cash flows and associated economic return (MISF) yield analysis.


            A few additional interesting points should be made.  In order to avoid problems with PMG and minimum gain chargeback (MGC), we allocated all taxable income associated with rent income and interest expense to the NOL Taxpayer in the early years.  In later years this allows us to allocate 100% of this income to the Regular Taxpayer so that his allocation of partnership income is always in excess of the required MGC.  In addition, although we balance out allocations and distributions between the partners over the life of the lease so that each is allocated 50% of all taxable income of the partnership and each receives 50% of the distributions from the partnership, one need not worry about transitory allocations since the term over which this occurs is twenty years (i.e., over five years).  The biggest concern to be faced would be the After-tax Exception.  Is one partner better off on an after-tax PV basis without the other partner being worse off?  For purposes of this article we will assume this not to be the case for tax purposes.  There are certainly interesting issues around determining this for which the answers are unclear.  What is the appropriate discount rate?  As is well recognized, when you look at a real leveraged lease with its many after-tax cash flows (positive and negative - and remember on a daily basis there can be negative cash flows for paying taxes as well as net rent positive cash flows) there is a possible IRR root for every change in sign between cash flows.  Thus variations in the discount rate, even relatively small ones, can potentially lead to different conclusions as to whether NPV is positive or negative for a taxpayer.  Another issue is what is the benchmark against which a partner being better or worse off is measured?  Not all tax attorneys would necessarily agree upon this for any particular case.


            Hopefully as the reader studies these tables in the context of the prior discussion they will help clarify in his mind the interpretation of the material.




            While an article of this kind by its very nature cannot completely cover all the aspects of federal taxation of partnerships, it is to be hoped the reader has gained some insight into important factors that need to be considered.  When you combine the complexities of partnership taxation with things such as cross-border issues, net operating losses, the alternative minimum tax (“AMT”), and/or § 467 rules on structuring lease rental streams, the true challenge of creating an optimal structure becomes apparent.







† “MISF” stand for Multiple Investment with Sinking Fund.  Traditionally lessors have computed their return on investments in leases using what is known as the MISF yield.  This is analogous to an IRR except that when investment is negative (due tax benefits temporarily generating after-tax excess cash flow sufficient to pay investment down below zero) an assigned sinking fund rate is use, often 0%.

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