Sherri and Todd are equal Partners in the ST Partnership. Both Partners expect to have the same marginal tax bracket for several years, but Sherri has a Net Operating Loss Carry-Forward that will expire at the end of ST's second year.
Sherri and Todd agree to allocate all the Partnership net taxable income to Sheri for the Partnership's first two tax years. Beginning in the third year, Partnership net taxable income is allocated to Todd, until the amount of income allocated to Sherri in the first two years is offset.
The Partnership Agreement requires capital accounts to be maintained in accordance with the §1.704-1(b)(2) Regulations, liquidating distributions to be made in accordance with positive Capital Account Balances and provides an unqualified obligation for Partners to restore deficits in their Capital Accounts within the time limits set out in the Regulations.
The ST Partnership's income is primarily from highly rated corporate bonds, which are expected to produce enough income in the 3rd through 7th Partnership Tax Years to offset the allocation of income to Sherri in the first two years.
Do the allocations have Substantial Economic Effect?
If the IRS determines the allocations lack Substantial Economic Effect what is the effect upon Sherri and Todd's reported income (loss) from the Partnership?