A challenge encountered by tax practitioners when attempting to draft target partnership allocations is how to deal with nonrecourse liabilities. The target allocation provision may satisfy the nonrecourse deduction safe harbor if allocations under the target allocation provision are deemed to have economic effect on account of economic effect equivalence. Explicit allocations of nonrecourse deductions then should be respected. Whether this argument works is a matter of conjecture.

Author Terence Cuff writes: The target allocation provision is unlikely to satisfy the nonrecourse deduction safe harbor if allocations under the target allocation provision do not satisfy the economic effect equivalence test. Failure to satisfy economic effect equivalence will create substantial doubt that explicit special allocations of nonrecourse deductions will be respected. Nonrecourse deductions then should be allocated in accordance with partners' interests in the partnership. What that means often is in doubt. Failure to satisfy the nonrecourse deduction safe harbor calls into question whether allocation of nonrecourse deductions under the target allocation provision or outside of the target allocation provision will be respected.

Many advisors will seek to specially allocate nonrecourse deductions in drafting a target allocation provision, despite the uncertainty over whether those special allocations of nonrecourse deductions will be respected for tax purposes. Doubts about the status of allocations of nonrecourse deductions complicate the use of target allocation provisions. The effectiveness of special allocations of nonrecourse deductions often will be in doubt. Advisors seeking certainty that allocations of nonrecourse deductions will be respected should consider the advisability of a target allocation provision.

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The Allocation Regulations contain two relevant definitions that operate for purposes of IRC Section 704:

Definition of nonrecourse liability. "Nonrecourse liability" means a nonrecourse liability as defined in Reg. Section 1.752-1(a)(2) or a Reg Section 1.752-7 liability (as defined in Reg. Section 1.752-7(b)(3)(i)) assumed by the partnership from a partner on or after June 24, 2003.

Definition of partner nonrecourse debt. "Partner nonrecourse debt" or "partner nonrecourse liability" means any partnership liability to the extent the liability is nonrecourse for purposes of Reg Section 1.1001-2, and a partner or related person (within the meaning of Reg Section 1.752-4(b)) bears the economic risk of loss under Reg Section 1.752-2 because, for example, the partner or related person is the creditor or a guarantor. 

The lack of parallelism between the definition of "nonrecourse liability" under the Section 704 and the definition of "partner nonrecourse liability" under Section 704 is interesting. The definition of "partner nonrecourse liability" depends on the liability being nonrecourse for purposes of the IRC Section 1001 regulations. The definition of "nonrecourse liability" under the IRC Section 704 regulations does not expressly reference Section 1001 and depends exclusively on the IRC Section 752 regulations. Whether this distinction was intended by the draftsmen is a matter that thoughtful advisors will debate.

Some target allocation provisions allocate nonrecourse deductions as part of Net Profits and Net Losses, even though chargeback allocations under the minimum gain chargeback are allocated separately from the target allocation provision. This scheme can result in different ratios of allocations of Net Income and Net Losses between partners from year to year. This can result in annually shifting allocations of nonrecourse deductions. Annually shifting allocations of nonrecourse deductions are not legally infirm, but this scheme shifting allocations of nonrecourse deductions may not make sense to the partners. Most advisors prefer a single ratio for allocating nonrecourse deductions that is invariable over time, if that single ratio is permitted.

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