The AB partnership agreement satisfies the three basic requirements of the economic effect test of Reg. § 1.704-1(b)(2)(ii)(b). The AB partnership owns a portfolio of municipal bonds and a AAA Corporate bond with a variable rate of interest. At the beginning of last year, each investment had a value of $1,000 and each was expected to yield approximate income of $60. The partnership had net operating income from its business of $300 for the year. How will the tax exempt and taxable interest be allocated to the partners if the partnership agreement provides:
(a) A and B share equally in aggregate partnership income but A's share is deemed to consist first of interest on the municipal bonds? Assume that the bonds generate the expected amount of income of $60 each.
(b) A and B share equally in operating income but the interest on the municipal bonds is allocated solely to A and the taxable interest is allocated solely to B? Assume alternatively:
(i) The agreement on the allocation of interest is made before the beginning of last year and the municipal bonds and corporate bond in fact earn $60 each of interest, as expected. At the time the agreement is made, A and B are both in the 40% marginal bracket, but B has substantial investment interest carryovers under § 163(d).
(ii) The same as (i), except B had no investment interest carryover. However, during the year B incurred substantial investment interest expense.
(iii) Same as (i) but as it turns out the municipal bonds earn $60 interest and the corporate bond earns $80 in interest.