## Facts

- A limited partnership was formed in 1982 to acquire and operate a horse-racing track (Penn National Race Course).
- The partnership had two partners: a corporate general partner and an individual limited partner; the general partner was owned through a family-controlled entity related to the limited partner.
- The buyers acquired the track for roughly $9.97 million and assumed an $8 million mortgage.
- The partnership agreement allocated 99% of partnership losses to the limited partner and 1% to the general partner.
- The agreement initially allocated profits 99% to the general partner and 1% to the limited partner, later amended to allocate profits 60% to the general partner and 40% to the limited partner.
- Liquidation proceeds were to be distributed in accordance with the partners’ interests in net profits.
- For tax years 1983–1986, the partnership reported losses and allocated them 99/1 to the limited partner and general partner, allowing the limited partner to claim most deductions while the general partner obtained little or no tax benefit.
- The IRS issued a final partnership administrative adjustment asserting the loss allocations were disproportionate and should be reallocated.
- The tax matters partner petitioned the Tax Court under TEFRA procedures to determine whether the allocations had substantial economic effect and, if not, the proper allocation.

## Issues

1. Whether the allocation of 99% of partnership losses to the limited partner and 1% to the general partner had substantial economic effect under I.R.C. § 704(b) and the regulations.
2. If the allocation lacked substantial economic effect, how the partnership’s losses should be allocated in accordance with the partners’ interests in the partnership under § 704(b).

## Decision

- The Tax Court sustained the Commissioner’s determination.
- The court held the 99% loss allocation to the limited partner lacked substantial economic effect under § 704(b).
- The court reallocated the partnership’s 1983–1986 losses in accordance with the partners’ interests in the partnership.
- On these facts, the court determined the partners’ interests were best reflected by their relative capital contributions and allocated losses accordingly.

## Legal Principles

- Under I.R.C. § 704(b), partnership items are allocated according to the partnership agreement only if the allocations have substantial economic effect.
- An allocation must reflect actual economic consequences among partners; allocations that primarily change tax results without materially changing economic burdens and benefits fail § 704(b).
- In evaluating economic effect, courts consider the relationship among capital accounts, liquidation rights, and whether partners bear the economic burden associated with allocated losses.
- If an allocation lacks substantial economic effect, items must be allocated in accordance with the partners’ interests in the partnership, determined from the facts and circumstances.
- Relative capital contributions may be used as a proxy for partners’ interests where agreement allocations do not reflect the partnership’s actual economic arrangement.

## Conclusion

The Tax Court disregarded a partnership’s 99/1 loss allocation because it did not correspond to meaningful economic consequences under § 704(b), and it reallocated the losses based on the partners’ relative capital contributions as the best measure of their interests in the partnership.


PNRC Ltd. P’ship v. Comm’r, 66 T.C.M. (CCH) 265 (T.C. 1993)