Orrisch v. Commissioner
55 T.C. 395; 1970 U.S. Tax Ct. LEXIS 23 (1970)
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Rule of Law:
A special allocation of a partnership tax item, such as depreciation, will be disregarded if its principal purpose is the avoidance of tax. To be recognized, the allocation must have substantial economic effect, meaning it must actually affect the dollar amount of the partners' shares of the total partnership income or loss, independent of tax consequences.
Facts:
- In May 1963, Stanley and Gerta Orrisch and Domonick and Elaine Crisafi formed a partnership to purchase and operate two apartment buildings.
- The Orrisches made a larger initial cash contribution than the Crisafis ($26,500 vs. $12,500), but the partners' oral agreement was to share all profits and losses equally.
- From 1963 to 1965, the partnership incurred losses, primarily from accelerated depreciation, which were divided equally among the partners.
- During this period, the Orrisches had substantial taxable income from other sources that could be offset by the partnership losses, whereas the Crisafis reported no net taxable income.
- In early 1966, the partners orally amended their agreement to allocate 100% of the partnership's depreciation deductions to the Orrisches for 1966 and subsequent years.
- All other items of partnership income and expense were to remain split equally.
- The amendment also provided that if the property were sold at a gain, the specially allocated depreciation would be 'charged back' to the Orrisches' capital account, and they would be liable for the tax on that portion of the gain.
Procedural Posture:
- Stanley and Gerta Orrisch (petitioners) filed joint federal income tax returns for 1966 and 1967, claiming deductions based on the special allocation of depreciation from the partnership.
- The Commissioner of Internal Revenue (respondent) issued a notice of deficiency, determining that the special allocation's principal purpose was tax avoidance and should be disregarded.
- The Commissioner reallocated the partnership's depreciation deduction equally between the Orrisches and the Crisafis.
- The Orrisches filed a petition with the United States Tax Court, a court of first instance for federal tax disputes, to challenge the Commissioner's determination of deficiencies.
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Issue:
Does a special allocation of all partnership depreciation to one partner lack substantial economic effect and have tax avoidance as its principal purpose under I.R.C. § 704(b) if, upon the potential sale of the property, the partners intend to distribute the proceeds equally, without regard to the capital account deficits created by the allocation?
Opinions:
Majority - Featherston, Judge
Yes. A special allocation of a tax item lacks substantial economic effect and will be considered to have a principal purpose of tax avoidance if it does not correspond to the underlying economic arrangement of the partners. The court found that the special allocation of depreciation to the Orrisches was adopted for a tax-avoidance purpose, not a business purpose. The evidence showed the Orrisches had substantial income to offset with the deductions, while the Crisafis did not. The crucial factor was the lack of 'substantial economic effect.' An allocation has economic effect only if it 'may actually affect the dollar amount of the partners’ shares of the total partnership income or loss independently of tax consequences.' Here, if the property were sold at a gain sufficient to cover the depreciation, the 'chargeback' provision would restore the partners' capital accounts, and the proceeds would be split equally. The only net effect would be a shift in tax liabilities—a current deduction for the Orrisches in exchange for a future capital gains tax, and tax relief for the Crisafis. The true test of economic effect is determining who bears the economic burden of the depreciation if the property is sold for less than its original cost. The court found no evidence that the Orrisches agreed to bear this loss; rather, it concluded the partners intended to divide all assets equally upon dissolution, irrespective of capital account balances. Therefore, the special allocation did not affect the partners' actual dollar shares and must be disregarded.
Analysis:
This case is a foundational decision in partnership tax law, establishing the 'substantial economic effect' doctrine as the primary test for the validity of special allocations under former I.R.C. § 704(b). The court's analysis moved beyond mere formal adjustments to capital accounts, focusing instead on whether the tax allocation reflected a corresponding allocation of economic risk and reward. The opinion's emphasis on who bears the economic burden of a deduction if the asset declines in value became a cornerstone of the doctrine. This decision heavily influenced the subsequent, more detailed Treasury Regulations that mandate capital account maintenance and liquidation according to capital account balances to ensure allocations have economic substance.
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