MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Respondent issued petitioner a notice of final partnership administrative adjustment (FPAA) on behalf of PNRC Limited Partnership (PNRC LP) asserting that its losses for the taxable years 1983, 1984, 1985, and 1986 were disproportionately distributed between the general partner and the limited partner. 1 This case is before the Court pursuant to petitioner's petition under section 6226 2 for readjustment of the partnership items set forth in the FPAA. The issue for decision is whether petitioner's allocation of its losses 99 percent to the limited partner and 1 percent to the general partner has substantial economic effect. We find for respondent and hold that the partnership's losses must be reallocated in accordance with the partner's interests in the partnership.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations and attached exhibits are incorporated herein by this reference. Petitioner, PNRC Corporation (PNRC), is the tax matters partner of PNRC LP. 3
PNRC LP is a partnership between Peter D. Carlino (Carlino) as limited partner and PNRC as general partner. Carlino organized both PNRC and PNRC LP in December 1982 as part of the transaction described below. During the years at issue, PNRC was wholly owned by the Carlino Family Partnership (CFP), a limited partnership controlled by Carlino and his family. CFP was formed under the Uniform Limited Partnership Act of Pennsylvania. Throughout the years at issue, CFP was owned 4 percent by Carlino as general partner, 8 percent by his wife as a limited partner, and 88 percent by their eight children, each owning an 11 percent limited partnership interest. Carlino is a successful businessman 4 who has been involved in various racetrack businesses from the late 1960s to the years at issue.
Penn National Race Course (Penn National) is a thoroughbred racetrack located in Grantville, Pennsylvania. From 1972 to 1982, Carlino leased Penn National, through an entity known as the Mountainview Thoroughbred Racing Association (Mountainview). 5Carlino offered to renew the lease but the principals of Penn National asked Carlino to buy the racetrack, which he agreed to do if he could find financing. Prior to purchasing Penn National, Carlino knew it had a history of losses but he had made a profit there for the 10 years of the lease. Carlino was interested in buying Penn National so that he would continue to have a place to run his races. He believed that the debt on Penn National needed to be restructured in order to enable the racetrack to become profitable.
On October 25, 1982, Carlino in his individual capacity entered into an agreement to purchase Penn National from Pennsylvania National Turf Club, Inc. (Turf Club), which, in part, would require Carlino to assume an $ 8,000,000 mortgage from First Pennsylvania National Bank, N.A. (First Pennsylvania). 6 This agreement was never concluded. On December 30, 1982, Carlino assigned to Dauphin County Industrial Development Authority, a body politic and corporate (Dauphin County IDA), his right to purchase Penn National under the October 25, 1982 agreement. 7 On the same day, Dauphin County IDA purchased Penn National from Turf Club, and assumed liability on the $ 8,000,000 mortgage with First Pennsylvania from Turf Club. 8
On December 30, 1982, CFP and PNRC LP, the newly organized partnership (Buyers), 9 entered into an installment agreement with Dauphin County IDA (Seller) whereby Buyers agreed to purchase Penn National from Seller for $ 9,970,000, part of which consideration was assumption of the $ 8,000,000 mortgage from First Pennsylvania. 10 In connection with the installment sale, the following persons and entities signed a Guaranty Agreement on the $ 8,000,000 mortgage with First Pennsylvania: Carlino, his wife, CF, Peter D. Carlino & Associates, Inc., 11 PNRC, and Mountainview.
On December 30, 1982, PNRC LP and CFP (Lessors) entered into two leases with Turf Club and Mountainview (Lessees) whereby: (1) Lessees agreed to share the operation of and conduct races at Penn National, and (2) Mountainview leased from Lessors certain Penn National facilities to use in connection with the races. On the same day, Lessors assigned their rights in these leases to Dauphin County IDA as additional collateral for their obligations.
The PNRC LP partnership agreement (the Agreement) allocates losses 1 percent to the general partner, PNRC, and 99 percent to the limited partner, Carlino. The original Agreement allocated profits 99 percent to the general partner and 1 percent to the limited partner. The Agreement was amended 3 days later, on December 31, 1982, to provide for an allocation of 60 percent of any profits to the general partner and 40 percent to the limited partner. The Agreement does not reflect the parties' capital contributions.
The Agreement further provides that upon termination of the partnership, the general partner shall either sell the partnership's assets and distribute the net proceeds or distribute the partnership property to the partners in proportion to their percentage interests. The Agreement provides that any reference to a partner's percentage interest is to his interest in net profits. PNRC LP sustained losses in all of the years at issue, which it allocated as follows:
| | General Partner -- | Limited Partner -- |
| | PNRC Corporation | Peter Carlino |
| Year | Loss | 1% | 99% |
| 1983 | ($ 194,355) | ($ 1,944) | ($ 192,411) |
| 1984 | ($ 831,909) | ($ 8,319) | ($ 823,590) |
| 1985 | ($ 227,431) | ($ 2,274) | ($ 225,157) |
| 1986 | ($ 526,976) | ($ 5,270) | ($ 521,706) |
PNRC LP was initially capitalized with $ 420,000. The partnership information returns and financial statements for 1982 and 1983 reflect that the general partner, PNRC, contributed $ 300,000 (71.4 percent of the initial capital) and the limited partner, Carlino, contributed $ 120,000 (28.6 percent of the initial capital). 12Carlino loaned the partnership $ 358,346 in 1984. This loan was reclassified on the books of the partnership as additional capital. Because of this additional capital contribution, the partnership's capital for 1985 and 1986 was allocable 38.6 percent to PNRC and 61.4 percent to Carlino. Respondent reallocated the losses on the basis of the capital ownership of each of the partners, as follows:
| General Partner -- | Limited Partner -- |
| Year | PNRC Corporation | Peter Carlino |
| 1983 | 71.4% | 28.6% |
| 1984 | 71.4% | 28.6% |
| 1985 | 38.6% | 61.4% |
| 1986 | 38.6% | 61.4% |
OPINION
Although the facts of this case are complicated, the issue for decision is straightforward: Did the allocation of 99 percent of the losses of PNRC LP to Carlino, the limited partner, have substantial economic effect? The record illustrates that Carlino had a longtime interest in horseracing and probably would not have entered into the transaction at issue if the principals of Penn National had accepted his offer to renew their lease. However, they did not accept the offer, and Carlino chose to engage in the purchase and lease transaction described above. We turn to the issue of whether the partnership's loss allocations can stand.
Section 704(a) generally provides that a partner's distributive share of any item of income, gain, loss, deduction, or credit is determined by the partnership agreement. Section 704(b) provides that a partner's share of any such item is determined according to the partner's interest in the partnership, taking into account all the facts and circumstances, if the allocation of the item under the partnership agreement does not have "substantial economic effect". Sec. 704(b).
Section 1.704-1(b), Income Tax Regs., provides a process for determining if an allocation has "substantial economic effect". The current version of this paragraph is effective for taxable years beginning after December 31, 1975. Sec. 1.704-1(b)(1)(ii), Income Tax Regs. However, for partnership taxable years beginning after December 31, 1975, but before May 1, 1986, an allocation that is not otherwise respected under this paragraph of the regulations will nevertheless be respected under section 704(b) if the allocation has substantial economic effect or is in accordance with the partners' interests in the partnership as these terms have been interpreted under the relevant case law, the legislative history of the applicable section of the Tax Reform Act of 1976, and the applicable provisions of the regulations under section 704(b) that were in effect for taxable years beginning before May 1, 1986. Id. Thus, before turning to the prior version of the regulation, this Court must determine whether the partners' allocation of losses has substantial economic effect under the current version.
To have substantial economic effect, the allocation must have "economic effect" and such economic effect must be "substantial". Sec. 1.704-1(b)(2)(i), Income Tax Regs.13 In order to have economic effect under the basic test, the partnership agreement must provide, throughout the full term of the partnership: (1) For the determination and maintenance of the partners' capital accounts in accordance with the provisions of section 1.704-1(b)(2)(iv), Income Tax Regs.; (2) that upon liquidation of the partnership, all liquidating distributions must be made in accordance with the positive capital account balances of the partners; and (3) that if a partner has a deficit balance in his capital account following liquidation of his interest in the partnership, he is unconditionally obligated to restore the amount of this deficit balance by the end of the taxable year or within 90 days after the date of such liquidation, whichever is later. Sec. 1.704-1(b)(2)(ii)(b), Income Tax Regs. The Agreement does not have these provisions. In fact, the Agreement expressly provides that the general partner shall never be obligated to pay the limited partner or the partnership the amount of any deficit in its capital account. Thus, the allocation does not pass the basic test for economic effect.
The regulation also provides an alternate test for economic effect, contingent on satisfaction of items (1) and (2) above, which PNRC LP does not satisfy. 14Sec. 1.701-1(b)(2)(ii)(d), Income Tax Regs. Thus, the loss allocation fails the alternate test for economic effect.
Allocations that lack economic effect under the provisions discussed above may nevertheless be deemed to have economic effect if, as of the end of each taxable year, a liquidation of the partnership would produce the same economic results to the partners as if the requirements of the basic test for economic effect were met, regardless of the performance of the partnership. Sec. 1.704-1(b)(2)(ii)(i), Income Tax Regs. Because the Agreement provides that upon termination of the partnership, partnership property will be distributed to the partners in proportion to their interests in net profits, that is, 60 percent to the general partner and 40 percent to the limited partner, even a liquidation after one year of operation would not produce the same results to the partners as if the Agreement met the basic test for economic effect. That is, partly because the general partner contributed 71.4 percent of the initial capital and the limited partner contributed 28.6 percent, liquidating distributions to each partner will not equal the balance each has in his capital account. Thus, the allocation fails this "economic effect equivalence" test as well.
Although the allocation lacks substantial economic effect under the current regulation, 15 the next question is whether the allocation has substantial economic effect under the provisions of the applicable paragraph of the regulation in effect for taxable years beginning before May 1, 1986, the relevant case law, and the relevant legislative history of the Tax Reform Act of 1976. Sec. 1.704-1(b)(1)(ii), Income Tax Regs.16
The Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1520, 1548, first codified the "substantial economic effect" test, formerly a factor in the applicable regulation. Ogden v. Commissioner, 788 F.2d 252, 260 (5th Cir. 1986), affg. 84 T.C. 871 (1985). 17The Joint Committee Explanation of the change provides: The Act provides that an allocation of overall income or loss * * *, or of any item of income, gain, loss, deduction, or credit * * *, shall be controlled by the partnership agreement if the partner receiving the allocation can demonstrate that it has "substantial economic effect," i.e., whether the allocation may actually affect the dollar amount of the partner's share of the total partnership income or loss independent of tax consequences.
Staff of Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976, 1976-3 C.B. (Vol. 2) 107; see also id. at 107 n.6. Thus, petitioner bears the burden of proving that the loss allocation has substantial economic effect. Id.; McGuffey v. Commissioner, T.C. Memo. 1989-267.
Guided by this explanation, the courts developed a "capital accounts analysis" to determine whether an allocation had substantial economic effect. Under this analysis, a partner's allocation must be reflected in his capital account, which must govern distributions in liquidation, and any partner whose capital account reflects a deficit must have an obligation to restore the amount of the deficit. Ogden v. Commissioner, supra at 261; Allison v. United States, 701 F.2d 933, 939 (Fed. Cir. 1983); Goldfine v. Commissioner, 80 T.C. 843, 852-853 (1983). Where a partner does not have the obligation to restore any deficit in his capital account upon liquidation, the other partner or partners would bear part of the economic cost of the allocations that caused the deficit. Ogden v. Commissioner, supra at 261; Elrod v. Commissioner, 87 T.C. 1046, 1084 (1986); Orrisch v. Commissioner, 55 T.C. 395, 403-404 (1970), affd. per curiam 31 AFTR 2d. 1069 (9th Cir. 1973). In the instant case, liquidation proceeds were not required to be distributed in accordance with capital account balances. Rather, distributions were to be made in accordance with each partner's interest in net profits. Because each partner's interest in profits differed substantially from his interest in losses, and the partnership sustained losses in all the years at issue, the capital accounts would reflect numbers very different from the amount of any distribution in liquidation. In addition, as discussed above, it appears that in this case neither partner has an obligation to restore a capital account deficit.
Petitioner argues that Carlino's guarantee of the $ 8,000,000 mortgage held by First Pennsylvania and then by Fidelity Bank provides him with the economic risk of loss. We disagree. First, the creditors could look to the racetrack itself for satisfaction of the liability. Second, if that did not satisfy the liability, Carlino is only one of five co-guarantors; there is no assurance that he, rather than someone else, would have paid off the mortgage if necessary. Third, the debtors were not insolvent during any of the years at issue. A guarantor may not be ultimately liable on a debt he guarantees absent insolvency of the debtor. Goldfine v. Commissioner, 80 T.C. 843, 854 (1983). Fourth, the key issue in this case is whether Carlino had an obligation to restore a negative capital account balance on liquidation, not whether Carlino ultimately may pay the mortgage. Petitioner has cited no authority to support his novel proposition that a guarantee of a liability creates substantial economic effect where economic effect is otherwise lacking.
In Allison, 701 F.2d at 940, the taxpayer made a similar "economic burden" argument. The Court of Appeals for the Federal Circuit rejected this argument "that the critical question is not the relationship between capital account balances and distributions to partners * * * but is 'who would bear the economic burden of loss * * * if the drilling venture produced all dry holes?'" Allison v. United States, supra at 940. The court stated, "This is an incorrect analysis by taxpayer." Id. The court later specified that, under the capital accounts analysis, "The crucial question always is the effect of the special allocation on 'the dollar amount of the partners' shares of the total partnership income and loss independently of tax consequences.'" Id. at 941.
We have considered petitioner's other arguments and find them similarly to be without merit. Thus, the allocation of 99 percent of PNRC LP's losses to Carlino lacks substantial economic effect. Accordingly, section 704(b) requires the losses to be reallocated in accordance with the partners' respective interests in the partnership. This is a facts and circumstances inquiry. Among the factors to consider in determining the partners' interests in a partnership are the partners' relative contributions to the partnership, their respective interests in profits and losses, if different from taxable income and loss, cash flow, and their distribution rights upon liquidation. Ogden v. Commissioner, supra at 264; sec. 1.704-1(b)(3)(ii), Income Tax Regs.; Joint Committee Explanation, supra at 108; 2 Willis, Pennell & Postlewaite, Partnership Taxation, sec. 103.03, at 103-5 (4th ed. 1993). In this case, the partners' contributions to the partnership are the most indicative of their interests in the partnership. 18 Thus, the losses should be allocated as follows:
| General Partner -- | Limited Partner -- |
| Year | PNRC Corporation | Peter Carlino |
| 1983 | 71.4% | 28.6% |
| 1984 | 71.4% | 28.6% |
| 1985 | 38.6% | 61.4% |
| 1986 | 38.6% | 61.4% |
To reflect the foregoing,
Decisions will be entered for respondent in docket Nos. 13897-91 and 13898-91. Because of respondent's concession with respect to Carlino's additional capital contribution in 1985, decisions will be entered under Rule 155 in docket Nos. 13899-91 and 13900-91.