As discussed in part I of this article in the June issue, starting in the early 1990s, a new method of wedding a partnership’s tax and economic consequences arose (so-called targeted, or forced, allocations 1 ). Under this new method, a partnership liquidates not in accordance with partner capital accounts but, instead, in accordance with a negotiated distribution waterfall 2 that reflects exactly the partners’ economic deal. Once the economic deal (i.e., the distribution waterfall) is drafted, the partnership’s allocations are then drafted to force the income or loss over the life of the partnership to be allocated so that each partner’s ending capital account balance equals what it must to allow the partnership to liquidate in accordance with the distribution waterfall while simultaneously ensuring that each partner’s ending capital account balance is reduced to zero as a result of the final partnership liquidating distribution (i.e., force partnership allocations to follow the economic deal).
Today, nearly all partnership agreements contain these targeted, as opposed to safe-harbor, allocations. Part I of this article discussed the rules governing safe-harbor allocations and the rules governing targeted allocations. It also addressed some reasons that targeted allocations are used more often than safe-harbor allocations. There are a number of unresolved issues regarding targeted allocations, however, that this part II discusses.
Perhaps the biggest issue surrounding the use of targeted allocations is that, despite their widespread use, the IRS has never issued guidance on them. Instead, practitioners generally rely on targeted allocations being in accordance with the “partners’ interest in the partnership” (PIP). Very generally, any time a partnership allocation does not comply with the safe harbor in the Treasury regulations, the partnership’s items of income, gain, loss, deduction, and credit must be allocated in accordance with each partner’s interest in the partnership. 3
The Sec. 704 regulations provide a set of rules (the PIP rules) for determining how allocations must be divided between or among the partners when the allocations do not comply with the safe harbor. The PIP rules generally require that items of income, gain, loss, deduction, and credit be allocated among the partners in the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to each item (i.e., they require the taxable income to follow the economic deal). 4 Suffice it to say that PIP is a subjective standard and, in all but the simplest of economic arrangements, provides little assurance how the IRS or a court might determine a partnership’s items of income, gain, loss, deduction, and credit should be allocated. 5
There are countless unresolved issues in applying PIP. One issue is whether PIP applies to gross items of income, gain, loss, and deduction, or whether it applies on a net basis.
Example 1: A two-partner partnership (Partnership AB ) that does not comply with the safe-harbor rules allocates interest income 60% to Partner A and 40% to Partner B , but allocates all other items of income, gain, loss, and deduction to Partner A and Partner B 50/50.
Under this scenario, Partner A ’s and Partner B ’s interest in the partnership will differ depending on whether PIP is computed on an item-by-item or a net basis. While the PIP rules are relatively clear that PIP may vary between different items, 6 they do not provide guidance regarding how PIP is determined when partners’ interests vary between and among partnership items. 7 It is not uncommon for partnership agreements to provide that the partners will share certain items of income, gain, loss, deduction, or credit differently from how (1) the partners share other items of income, gain, loss, deduction, or credit or (2) the partners share partnership net income excluding those items they have agreed to share differently.
Another unresolved issue when applying PIP is whether a taxpayer may include in partnership Sec. 704(b) income 8 any unrealized appreciation in partnership property. Presumably the answer to this is “no” because to allow inclusion would likely violate the tax accounting 9 and the tax year 10 requirements, and because the capital account maintenance rules limit the circumstances under which a partnership must or may revalue its capital accounts even if it elects to do so (and each such circumstance requires an event to become operative). 11
Additionally, if taxpayers were allowed to include unrealized appreciation in Sec. 704(b) book income, but were not allowed to include the same amount in taxable income, then almost every partnership agreement must be rewritten, because the common definition of Sec. 704(b) book income begins with the partnership’s taxable income as its starting point. Assuming the answer is “no,” however, as discussed in more detail immediately below, purported preferred returns in accrual-basis partnerships adopting targeted allocations may instead properly be treated as guaranteed payments or taxable capital shifts and not as allocations of partnership profit.
These are two of many unresolved issues taxpayers encounter when applying PIP, but a more detailed analysis of issues arising from the application of PIP to determine a partner’s share of partnership profit or loss is beyond the scope of this article. 12
As mentioned briefly above, partnership agreements containing targeted allocations (as contrasted with safe-harbor allocations) may unintentionally result in purported preferred returns being classified as guaranteed payments or taxable capital shifts. A simple example will help demonstrate the issue.
Example 2: Assume Partners A , B , and C formed ABC Partnership on Jan. 1, 2012, with A contributing $990 for 99% of the common interests, B contributing $10 for 1% of the common interests, and C contributing $1,000 for all of the single class of preferred interests. The preferred interest earns a 10% annual return, which is cumulative and compounds annually (i.e., if there is not sufficient distributable cash to satisfy the preferred return in a given year, it carries over to the following year accruing interest at a 10% compound annual interest rate).
The partnership contains a targeted allocation provision that reads as follows:
Partnership Profit or Loss shall be allocated in a manner to cause the Partners’ ending Capital Accounts to equal the amount they would receive if the Partnership were to sell all of its assets for Book Value and liquidate pursuant to the liquidation waterfall set forth in Section 4.1 of this Agreement.
Partnership profit or loss is typically defined in the partnership agreement to mean taxable income as adjusted for certain items required or permitted by the partnership tax rules to arrive at Sec. 704(b) book income. Please note that it is “net” profit or “net” loss that is being allocated here—not “gross” profit or “gross” loss, or items thereof. An alternative drafting of this provision might read as follows: “Partnership Profit or Loss (or items thereof) shall be allocated . . . ” If the allocation did allow for allocations of items constituting profit or loss, then the outcome would be entirely different. 13
Section 4.1 of the Agreement reads as follows:
At the discretion of the Managing Partner, Distributable Cash shall be distributed to the Partners as follows:
(i) First, to the Preferred Interest Holder(s) to the extent of and in proportion to the Unpaid Preferred Return;
(ii) Second, to the Preferred Interest Holder(s) to the extent of and in proportion to the Unpaid Preferred Capital;
(iii) Third, to the Common Interest Partners to the extent of and in proportion to each Common Interest Holder’s Unpaid Common Capital; and
(iv) Finally, 50% to the Common Interest Partners in proportion to the Common Interest Holders’ respective Percentage Interests and 50% to the Preferred Interest Holder(s) in proportion to the Preferred Interest Holders’ respective Percentage Interests.
See the exhibit for definitions of terms employed in this partnership agreement.
Distributions upon liquidation of ABC Partnership are not made in accordance with the partners’ positive capital accounts (as is the case with safe-harbor allocations), but instead are made under Section 4.1 of the Agreement. Assume that during the first year of operations, ABC Partnership earned $80 of profit. Assume further that, over the life of ABC Partnership, the partners anticipate that ABC Partnership will generate ample profits to pay Partner C all of his unpaid preferred return and unpaid preferred capital. ABC Partnership adopts the accrual method of accounting for federal tax purposes. 14 Finally, each of A, B, and C are individual U.S. citizens and, thus, ABC Partnership reports its income on the calendar year for U.S. federal tax purposes. 15
Even though ABC Partnership earned only $80 of profit, if ABC Partnership were to liquidate at the end of 2012, then Partner C , the preferred interest partner, would be entitled to a $100 preferred return, plus his $1,000 capital contribution. The $20 shortfall in profits needed to make Partner C whole at the end of the 2012 tax year must necessarily come from the capital of Partner A and Partner B , who would receive only $980 total on liquidation of ABC Partnership at the end of 2012.
Because ABC Partnership did not liquidate at the end of 2012, however, and has no intention of liquidating until many years later, the question becomes what to report on ABC Partnership’s 2012 tax return, including the partners’ Schedules K-1 (reporting each of A’s, B’s, and C’s items of ABC Partnership’s income, gain, loss, deduction, and credit). (As mentioned above, each taxpayer, including a partnership, must file a tax return in accordance with its tax year, which for ABC Partnership is the calendar year. 16)
The proper treatment of the $20 shortfall may depend, in the first instance, on whether ABC Partnership makes a distribution and, if so, whether it distributes more than $80 to Partner C. If ABC Partnership makes a distribution to Partner C of more than the $80 profit, then the excess (up to $20) should be a guaranteed payment to Partner C. 17
Conversely, if there is no distribution to Partner C in excess of the $80 profit earned by ABC Partnership during 2012, then the $20 shortfall may constitute an accrued but unpaid guaranteed payment, but it likely constitutes a taxable capital shift from Partner A and Partner B to Partner C . A capital shift is a shift in capital interests between partners where no cash changes hands—in some cases these shifts are taxable.
If ABC Partnership makes a distribution to Partner C in excess of $80 during the 2012 tax year, then the excess is likely properly treated as a guaranteed payment. Sec. 707(c) provides that “[t]o the extent determined without regard to the income of the partnership, payments to a partner for services or for the use of capital shall be considered as made to one who is not a member of the partnership.”
The Tax Court considered a guaranteed payment as a payment for services for the first time in the case of Falconer, 18 in which F.A. Falconer and Stella Breazeale formed a partnership with Breazeale contributing all of the capital. Each partner was paid $150 per week as compensation for services rendered. Falconer did not report any of the partnership payments in 1957 and 1958 as income, arguing that the payments the partnership made were actually loaned to him by his partner, Breazeale. Falconer had executed a promissory note payable to Breazeale, in an amount that exceeded the sum of the payments the partnership made to him in 1957 and 1958, but the note was executed after the partnership had terminated. 19 The IRS argued that the payments to Falconer constituted guaranteed payments for services under Sec. 707(c).
The Tax Court agreed that the payments to Falconer constituted guaranteed payments. In so holding, the court recognized that the partnership had been operating “at a loss and, consequently, it was necessary to make the guaranteed salary payments out of the capital Stella Breazeale had contributed” (emphasis added) and that “[t]his leads us inescapably to the conclusion that the amounts received by [Falconer] from the partnership under the terms of the agreement are guaranteed payments without regard to the income of the partnership and, as such, are includable in his gross income.” 20
Unlike in Falconer, the payment in the ABC Partnership example is made for contributed capital—not for the performance of services. However, Sec. 707(c) applies equally to “payments to a partner for services or for the use of capital.” Here, like Falconer, though, any amount paid to Partner C above $80 is determined without regard to the income of the partnership, because the partnership earned only $80 profit. 21 Thus, although the Falconer case involved a payment for services—not for the use of capital—the outcome should be the same where the payment is for the use of capital, because Sec. 707(c) applies to both. 22
Many partnerships, particularly investment partnerships, suffer losses on certain investments and make profits on other investments, but usually earn an overall profit throughout the life of the partnership. However, tax law does not allow the parties to wait until the end of the partnership’s life to determine the incidents of taxation regarding purported preferred returns recharacterized as guaranteed payments. Instead, each partner must include guaranteed payments as ordinary income for the tax year within or with which ends the partnership tax year in which the partnership deducted the payments as paid or accrued under its method of accounting. 23 While the proper tax period in which a partner must recognize a guaranteed payment for the use of capital may be different from the proper tax period in which a partner must recognize guaranteed payments for services, leading commentators disagree regarding the proper tax period in which taxpayers should report guaranteed payments for services. 24
Thus, it is unclear whether the regulations under Sec. 707 or the Sec. 83(b) rules govern the timing of guaranteed payment inclusion by the service provider partner. Also, the economic performance rules for accrual may also alter the timing of inclusion in income by Partner C (the purported preferred interest partner) and deduction or capitalization by ABC Partnership. 25 A detailed discussion of the application of the economic performance rules to a guaranteed payment for the use of capital by an accrual-basis partnership is beyond the scope of this article. 26
To the extent the $20 shortfall is treated as a guaranteed payment, while it is not clear which rules apply to determine the year of inclusion, it is not possible to wait until ABC Partnership liquidates to determine whether, over the life of ABC Partnership, it will generate sufficient profits to support Partner C ’s preferred return. Both the annual accounting period rule and the guaranteed payment year of inclusion rule dictate that a determination of whether distributions (or accruals) made to Partner C constitute guaranteed payments be made at the end of each tax year.
To the extent that the total distributions to Partner C during the 2012 tax year do not exceed $80, the $20 shortfall is likely a taxable capital shift. The IRS has not yet provided detailed guidance regarding whether shifts in partner capital constitute taxable income to the recipient partners and a deduction to the partner or partners whose capital is depleted by the shift. 27 Moreover, there is little authority on the subject.
The most frequently cited case addressing the proper tax treatment of a capital shift is Lehman. 28 In Lehman, the taxpayers (husband and wife) were members of a limited partnership whose agreement provided that the taxpayers were each entitled to receive as a credit on the partnership books the sum of $5,000 to be deducted from the capital of the other partners after the other partners received partnership profits totaling $50,000. The partnership achieved the benchmark, and the taxpayers received a $10,000 credit on the partnership’s books, which was deducted from the capital of the other partners. The court held that the $10,000 credit represented ordinary income to the taxpayers. In so holding, the court stated:
We think this situation should be no different in its tax consequences than if the partners had paid over to petitioners the $10,000 under an arrangement whereby petitioners agreed to use that sum to increase their investment in the partnership with a corresponding reduction in the capital shares of the other partners. 29
Thus, the Tax Court has held shifts of capital between and among partners to be a taxable event. In the example of ABC Partnership set forth in Example 2, Partner C is guaranteed to receive both (1) his initial capital contribution and (2) his preferred return before the common interest partners receive any payment. Thus, the entire amount of the $20 shortfall would be paid from the common interest partners’ capital accounts if the partnership were to liquidate at the end of 2012. Had any portion of the shortfall been paid from Partner C’s capital (as where, e.g., the common interest partners’ entire capital had been depleted either from operating losses or from prior shifts of capital to Partner C), then presumably Partner C would be taxable only to the extent the shortfall depletes some partner’s capital other than Partner C’s capital. 30
If Partner C has a guaranteed payment of $20 or a taxable capital shift of $20 at the end of 2012, then the Common Interest Partners should receive an offsetting $20 deduction, unless the amount paid or accrued to Partner C was capital in nature to ABC Partnership. Guaranteed payments are either partnership deductions or must be capitalized under Secs. 162 and 263. 31 Presumably, the deduction, if any, for the guaranteed payment should be allocated to the common interest partners. Because the common interest partners stand last in line to receive liquidation proceeds, they must be allocated losses first to deplete their capital before the preferred interest partner’s capital is reduced for ABC Partnership’s losses. Taxable capital shifts should be treated similarly. 32 Finally, presumably the $20 deduction or loss should be allocated entirely to the common interest partners since they suffered the economic consequences of the loss as a result of the capital shift.
The deduction of the guaranteed payment creates a circularity issue in that the $20 guaranteed payment is deductible in computing profits. Thus, profits would be reduced by the $20 guaranteed payment, thereby creating another shortfall. Practitioners who encounter agreements containing a distribution waterfall as set forth in Example 2 above should be aware of this issue and ask the agreement’s drafter to clarify the ambiguity in the allocation and distribution provisions of the partnership agreement.
If the Tax Court’s holding in Lehman is correct, the IRS should provide guidance that accrued but unpaid shifts of capital between and among partners are properly taxable as capital shifts. Many practitioners and commentators suggest, however, that a shift of partner capital is properly taxable only if it is compensatory (i.e., the shift is to compensate the recipient partner for services rendered). Under this argument, the unpaid $20 shortfall owed to Partner C might not constitute a taxable capital shift because Partner C did not provide any services to ABC Partnership but, instead, received the $20 for the use of his capital. However, the court in Lehman held that “[w]e do not think it is crucial whether the transfer to petitioners’ capital accounts was in fact ‘compensation’ for [petitioner]’s services.” 33 Those same practitioners and commentators would likely argue that the shift of capital in Lehman was compensatory and, thus, the statement regarding noncompensatory shifts of capital by the Tax Court in Lehman is dicta (and, therefore, is not controlling law because that issue was not before the court).
Many practitioners and commentators also argue that the accrued but unpaid preferred return is not a taxable capital shift but is, instead, a bargain purchase by the preferred interest partner, and they cite to authorities holding that a bargain purchase does not constitute income. 34 Also, if the proper view of the transaction is that of a bargain purchase and the preferred interest partner is the partner in control of the transaction and the filing of the partnership’s tax return, which is often the case, then has the preferred interest partner breached some fiduciary duty owed to the other partners by entering into such a bargain purchase arrangement? 35 The answer might depend on the moment in time a fiduciary duty arises.
A full discussion of the issue is beyond the scope of this article. Majority preferred interest partners who are concerned about the issue, though, should consider having models prepared to present to the minority partners showing that, under certain circumstances, minority partner capital may be used to satisfy the preferred interest partner’s preferred return. Similarly, if the $20 shortfall is treated as a bargain purchase, then no deduction would accrue to the common interest partners.
Although the Lehman case can be distinguished based on whether the shift is compensatory or noncompensatory, the better view is that the accrued but unpaid $20 shortfall is a taxable capital shift as of the end of the 2012 tax year. 36 The annual accounting requirement dictates that the purported preferred return must be accounted for at the end of each tax year. To the extent partnership profits for any given tax year are not at least equal to the preferred return, the shortfall must be respected and properly reported on the partnership’s and the partners’ tax returns. It is not possible to wait until the partnership completes all of its business to determine the tax treatment of an item occurring in a prior tax year. To allow taxpayers to postpone determining the tax consequences arising throughout the life of a partnership until the final year of the partnership’s existence would completely ignore the annual accounting requirement.
Some practitioners may argue that a capital shift is not a realization event for Partner C , because Partner C has not received any cash and under the partnership agreement has no right to the cash until the partnership actually liquidates. Where a partnership agreement contains a safe-harbor allocation scheme, this argument holds. However, a targeted allocation scheme requires the partnership to walk through a hypothetical liquidation at the end of each tax year to determine how to allocate the partnership’s items of income, gain, loss, and deduction. To make the cash go where it must when partnership profits are insufficient in any given tax year, a capital shift must occur (at least at that moment in time). It seems a stretch to say, on the one hand, the partnership should be treated as if it liquidated for purposes of determining how to allocate profit or loss but, on the other hand, there has been no actual liquidation, so do not treat the partnership as having liquidated for purposes of determining whether there has been a guaranteed payment or a taxable capital shift.
Other practitioners argue that the partnership is expected to have ample profits to support the preferred return over the life of the partnership. The response to this argument is to liquidate in accordance with partner capital accounts, and the issue disappears. Moreover, in addition to requiring that the liquidation be in accordance with partner capital accounts, drafters can eliminate the issue entirely in a number of ways, although each requires a change in the partners’ economic deal. Generally, the preferred interest partner must give up some protection that the preferred return will be paid in order to eliminate the issue. A slight modification to the distribution waterfall would eliminate the possibility of a shortfall. For example, ABC Partnership’s targeted allocation provision could be modified to read as follows:
Partnership Profit or Loss [or items thereof] shall be allocated in a manner to cause the Partners’ ending Capital Accounts to equal the amount they would receive if the Partnership were to sell all of its assets for Book Value and liquidate pursuant to the liquidation waterfall set forth in Section 4.1 of this Agreement.
The bracketed language operates to convert what was a “net” profit or loss allocation into a “gross” profit or loss allocation. 37 Thus, even if ABC Partnership earned only $80 profit in 2012, the allocation provision above would dictate that $100 of profit (even gross items of income) be allocated to Partner C . Because ABC Partnership earned only $80 of profit during 2012, though, allocating $100 of profit to Partner C would cause there to be a $20 loss allocated to the common interest partners—the same overall result as achieved above under the net profit allocation provision (i.e., $100 total income to Partner C and $20 loss, or deduction, to Partner A and Partner B , equals an overall profit of $80). Thus, a gross income allocation provision would cause Partner C to recognize $20 more income and give Partner A and Partner B each a $10 loss. 38 Note also that this is exactly the same result achieved when the shortfall is treated as a guaranteed payment or a taxable capital shift—$100 income to Partner C and $10 deduction to each of Partners A and B .
Alternatively, the distribution waterfall may be amended to require that A and B receive full payment of their capital before payment of the unpaid preferred return. Assuming sufficient gross income, any of these other modifications would ensure that under no circumstance will Partner C ’s preferred return be paid from Partner A ’s and Partner B ’s capital. Partner C likely will not want to make either modification, however, because Partner C has more assurance of receiving the preferred return with the distribution waterfall originally set forth. Stated differently, the Partner C ’s of the world want a guarantee that they will be repaid their capital before any other partner receives a penny from the partnership, but want to hold off on determining the tax consequences until all the partnership’s activities are finalized to see whether there has been sufficient profit throughout the life of the partnership to cover Partner C ’s cumulative preferred return.
The IRS should issue guidance clarifying the proper treatment of a profit shortfall for any given tax year where the partnership agreement contains targeted allocations and a cumulative preferred interest payable before every partner’s capital account balance has been repaid and the partnership adopts the accrual method of accounting.
One consequence of a drafter’s choice to use targeted allocations in a partnership agreement is that the allocations do not necessarily comply with the safe-harbor rules. Because targeted allocations do not comply with the safe harbor, the IRS on audit, or a court during litigation, will look to the partners’ interest in the partnership in determining whether the purported allocations are correct. Because this determination is highly factual, only in the case of relatively straightforward economic deals will taxpayers have comfort that their allocations will be respected. Any agreement containing special allocations of particular items of gross income or deduction generally should not use targeted allocations, because of the uncertainty of applying the facts-and-circumstances test to determine partners’ interest in the partnership.
Certain provisions require that partnership allocations have substantial economic effect before the allocations are afforded special treatment. For example, the “fractions rule” of Sec. 514(c)(9)(E) (which prohibits disproportionate allocations of income to a tax-exempt partner) requires, among other things, that each of the partnership’s allocations have substantial economic effect before a partnership’s allocations will be considered to comply with the fractions rule.
Similarly, the nonrecourse debt allocation safe-harbor regulations require that, throughout the full term of the partnership, the partnership agreement must allocate nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse debt. 39
Putting aside the substantiality requirement as before, practitioners debate whether it is possible to satisfy the economic effect requirement (of the two-part substantial economic effect requirement) under any one of the three tests for economic effect outlined in part I of this article (on p. 376 of the June issue), if a partnership uses targeted allocations. It is clear, however, that all three tests for economic effect must be satisfied at least annually. 40
As discussed in part I of this article, the basic test for economic effect has three strict requirements (the big three) each of which must be contained in the partnership agreement from inception. 41 One of those requirements is that the partnership must liquidate in accordance with the partners’ positive capital accounts. Because targeted allocations do not liquidate in accordance with partners’ positive capital accounts, presumably targeted allocations do not satisfy the basic test for economic effect.
Another of those requirements is that any partner with a deficit capital account balance at liquidation be unconditionally obligated to restore the deficit. Members of limited liability companies and partners in limited liability partnerships and limited partnerships rarely agree to restore any amount beyond what they have contributed to the entity. Because most partnerships today are formed as limited liability entities whose members or partners are never liable for more than the capital each member or partner has contributed, it is unlikely that most partnerships can satisfy the deficit restoration obligation requirement. 42
Like the basic test for economic effect, the alternate test for economic effect also requires that the partnership liquidate in accordance with the partners’ positive capital account balances. 43 Because targeted allocations liquidate in accordance with a distribution waterfall instead of in accordance with partners’ positive capital account balances, presumably targeted allocations do not satisfy the alternate test for economic effect. Some practitioners, though, believe it is possible for targeted allocations to satisfy the alternate test for economic effect if the targeted allocations are drafted to work in tandem with a qualified income offset. 44 As a safeguard, it is also advisable to provide in the partnership agreement of any limited liability entity that no distribution may cause any partner’s capital account to go negative.
The economic effect equivalence test generally requires that, as of the end of each partnership tax year, a liquidation of the partnership would produce the same economic results to the partners as if each requirement of the big three were satisfied regardless of the partnership’s economic performance. 45 Practitioners are divided regarding whether targeted allocations can satisfy the economic effect equivalence test for economic effect. 46
The better view is that, under the appropriate circumstances, targeted allocations should satisfy the economic effect requirements of other Code provisions, such as the fractions rule and the nonrecourse debt safe harbor. The IRS should promulgate regulations or issue other guidance clarifying whether targeted allocations can ever have economic effect. 47
These are only a few issues arising with the use of a targeted allocation provision. A full discussion of these issues is beyond the scope of this article. 48
Today, targeted allocations are the standard in the partnership community. They appear to be here to stay. To properly track the partners’ economic interest in the partnership and prepare an accurate partnership tax return, it is crucial to identify the kind of allocation scheme used in the partnership agreement. While targeted allocations provide the advantage of ensuring the partners’ economic deal is preserved, they introduce tax uncertainty into the partnership arrangement for all but the simplest of economic deals.
Targeted allocations also place the burden on tax return preparers to determine how to allocate profit and loss between and among the partners, unless the preparer insists that the drafter provide a more detailed allocation scheme for use in preparing the partnership tax return and, in particular, in allocating partnership items between and among the partners. Drafters and return preparers should take care to understand the allocation scheme each partnership uses and which scheme is more appropriate under the particular circumstances. Drafters of partnership agreements should collaborate with each taxpayer’s tax return preparer to ensure that the tax return preparer understands the deal being drafted and agrees with its tax treatment before the partnership agreement is executed. Otherwise, the disagreement might not surface until the tax return preparer is preparing the first partnership tax return some months later.
If the tax return preparer is not consulted during the drafting phase, the tax return preparer should consult with the drafter(s) of a partnership agreement when necessary to clarify any ambiguities therein, including the issues raised in this article. Even though targeted partnership allocations are the predominant allocation method contained in partnership agreements today and have been for a number of years, no guidance has been issued to date. The IRS should issue guidance on targeted partnership allocations so that taxpayers are not left in the dark about a number of ambiguous issues, including, but not limited to, those raised in this article.
1 Although both terms are used interchangeably in practice, this article refers to these kinds of partnership allocations as targeted allocations. In the author’s experience, nearly all partnership agreements drafted today contain targeted, as opposed to safe-harbor, allocations.
2 See p. 375 of the June 2013 issue of The Tax Adviser for a discussion of the “distribution waterfall.” A partnership’s distribution waterfall embodies the partners’ economic deal because it dictates how the partners will share all the cash the partnership distributes.
4 Regs. Sec. 1.704-1(b)(3).
5 Many practitioners believe, however, the partnership should follow all, or nearly all, the rules set forth under the safe-harbor provisions of the Sec. 704 regulations to ensure that the non-safe-harbor allocations satisfy the PIP rules.
6 Regs. Sec. 1.704-1(b)(3)(i) (stating that references to PIP signify “the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated”) (emphasis added).
7 See Banoff, “Identifying Partners’ Interest in Profits and Capital: Uncertainties, Opportunities, and Traps,” in Practising Law Institute, Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Ch. 86-1 (2011) (Banoff, “Profits and Capital”) (among other things, identifying 25 potential approaches to measuring partnership profits and 10 potential approaches to measuring partners’ interest in partnership capital).
8 That is, Sec. 704(b) “book” income. See the discussion on p. 378 of the June issue.
9 While taxpayers have some leeway in adopting an accounting method, Sec. 446(a) requires that any method adopted result in “[t]axable income [being] computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” With limited exceptions, GAAP prohibits taking unrealized appreciation into account until a realization event occurs. See Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises , ¶83 (December 1984) (stating that “[r]evenues and gains generally are not recognized until realized or realizable” and “[r]evenues are not recognized until earned.”). Moreover, the Code adopts a similar realization rule in Sec. 61(a)(3) (gross income includes “gains derived from dealings in property”) and Sec. 1001 (the formula to compute gain or loss from dealings in property). Similar to GAAP, though, there are limited instances where the Code requires income to be recognized before it is realized, see, e.g., Sec. 475. Importantly, the general rule under both GAAP and federal income tax law is for income to be recognized only after it has been realized. The few exceptions to the general rule under both sets of rules are narrowly crafted to apply to taxpayers who trade certain property frequently.
10 See, e.g., Burnet v. Sanford & Brooks Co ., 282 U.S. 359, 365 (1931) (holding that the essence of any system of taxation is to produce revenue ascertainable and payable at regular intervals and allow application of practical accounting, assessment, and collection methods). See also Sec. 441(a) (“Taxable income shall be computed on the basis of the taxpayer’s taxable year.”) and Secs. 441(b), (c), and (d) (defining the term “taxable year” to generally mean either a calendar year or the annual period on the basis of which a taxpayer regularly computes his income in keeping his books).
11 See, e.g., Regs. Secs. 1.704-1(b)(2)(iv)(e), (f), (g), and (m).
12 For a more detailed analysis of the issues in applying PIP to determine each partner’s share of partnership profit or loss, see, e.g., Banoff, “Profits and Capital”; Banoff, “FAQ-Filled Guidance on Computing a Partner’s Interest in Profits, Losses, and Capital—Part 1,” Ch. 87-1, and “Part 2,” Ch. 88-1; Carman, “In Search of Partners’ Interests in the Partnership: The Alternative to Substantial Economic Effect,” Ch. 89-1; Kean, “A Partner’s Interest in the Partnership for Purposes of Section 704(b),” Ch. 85-1; all in Practising Law Institute, Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances (2011); and Eggers, “PIP Is Not a Panacea,” 7-6 J. Passthrough Entities 27 (November-December 2004).
13 See discussion in the section “Treatment of the Profit Shortfall” below.
14 Secs. 446 and 448.
15 See Sec. 706(b)(1)(B) and Regs. Sec. 1.706-1 for a discussion of permitted and required taxable years for partnerships. A partnership must generally adopt the tax year of its partners (assuming each of its partners has the same tax year). See also Sec. 441(g) (generally requiring individual taxpayers to adopt a calendar year).
17 Some may argue the $20 shortfall can constitute a guaranteed payment only to the extent of an actual distribution to Partner C. See Sec. 707(c) (“To the extent determined without regard to the income of the partnership, payments to a partner”) (emphasis added). But see Regs. Sec. 1.707-1(c) (clearly indicating that a guaranteed payment need not be paid, but may merely be “accrued”). Thus, the $20 shortfall may properly be treated as a guaranteed payment whether or not actually paid. But see Sec. 461(h), which may affect the timing of the guaranteed payment deduction.
18 Falconer, 40 T.C. 1011 (1963).
19 The partnership paid Falconer a total of $9,000, and the promissory note was in the amount of $9,862.50.
20 Falconer, 40 T.C. at 1016.
21 It is not entirely clear, however, what constitutes “income of the partnership” for purposes of Sec. 707(c). See, e.g., Pratt, 64 T.C. 203 (1975) (holding that management fee payments to partners based on a percentage of “gross” rental income received by the partnership are not guaranteed payments because they are based on “income of the partnership”); Rev. Rul. 81-300, 1981-2 C.B. 143 (holding that payments for services based on gross income may be treated as guaranteed payments if, based on all the facts and circumstances, the payment is determined to be compensation rather than a share of partnership profits). See also McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶14.03[1][a] (Warren, Gorham & Lamont 3d ed. 1996) (McKee) (discussing the “net” versus “gross” income issue regarding guaranteed payments).
22 In this regard, see, e.g., General Counsel Memorandum (GCM) 37512 (4/26/78) (analysis of a guaranteed payment for the use of capital) and GCM 36702 (4/12/76) (same). Also, the payment to Partner C is not simply a return of capital because Partner C continues to be entitled to be repaid its entire $1,000 capital contribution in addition to its 10% annual preferred return.
23 Regs. Sec. 1.707-1(c) and Sec. 706(a) (“In computing the taxable income of a partner for a taxable year, the inclusions required by Sec. 702 and Sec. 707(c) with respect to a partnership shall be based on the income, gain, loss, deduction, or credit of the partnership for any taxable year of the partnership ending within or with the taxable year of the partner.”) (emphasis added). See also Regs. Secs. 1.706-1(a)(1) and (2).
24 Compare McKee at ¶5.05 n. 176 and surrounding text (suggesting that the Sec. 83(b) rules trump the Sec. 707(c) regulations) and id. at ¶5.02[8][c] (stating that the timing rules of Sec. 83 and the existing Sec. 707(c) regulations present an “irreconcilable conflict”) with Willis et al., Partnership Taxation, ¶4.05[3][b] (Thomson/RIA 2012) (questioning whether the Sec. 83(b) rules should apply to compensatory transfers of partnership interests). See also Prop. Regs. Sec. 1.83-3 (proposing to define “property” for purposes of Sec. 83(b) to include partnership interests).
25 See Sec. 461(h) and Regs. Sec. 1.461-4(d).
26 For more in-depth discussion of guaranteed payments (both for services and for the use of capital), including the possible application of the economic performance rules thereto, see, e.g., Sloan and Sullivan, “Deceptive Simplicity: Continuing and Current Issues With Guaranteed Payments, Strategies for Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings,” in Practising Law Institute, Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Ch. 87-1 (2011), and Steinberg, “Fun and Games With Guaranteed Payments,” 57 Tax Law. 533 (Winter 2004). For a case applying the economic performance rules to a guaranteed payment, see Jolin, 869 F.2d 1491 (6th Cir. 1989), aff’g T.C. Memo. 1985-287.
27 See, e.g., Schneider and O’Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,” 92 J. Tax’n 13 (Jan. 2000) (discussing the lack of guidance regarding the proper tax treatment of capital shifts in partnership transactions). There is guidance regarding capital shifts of corporations—at least in connection with exchanges of cash or property for stock or securities of a corporation. See Regs. Sec. 1.351-1(b)(1).
28 Lehman, 19 T.C. 659 (1953).
30 See, e.g., Lloyd , 15 B.T.A. 82 (1929) (holding that an amount paid to a partner out of other partners’ capital constitutes taxable income to the recipient partner but that “to the extent it was paid out of his own capital, it represents a return of capital and is not subject to tax”). Cf. GCM 38133 (10/10/79) (finding payments to be guaranteed payments even though, under the facts, a part of each payment must have been from the partners’ own capital).
31 See Regs. Sec. 1.707-1(c) (holding that a guaranteed payment results in either a deduction or must be capitalized based on the application of Secs. 162 and 263 to the payment).
32 Regarding the proper tax treatment to the partners whose capital is depleted as the result of a shift in capital to another partner, see, Lloyd, 15 B.T.A. 82 (1929) (holding that the partners whose capital was depleted because of a compensatory shift in partner capital are entitled to deductions because “[t]hese capital depletions are ordinary and necessary expenses incurred in carrying on the business of each petitioner, and, as such, are deductible in computing their respective net incomes”).
33 Lehman, supra note 28.
34 See, e.g., American Bar Association Panel Outline, “Whose Money Is It? Capital Shifts and Their Taxability” (citing Palmer v. Helvering , 302 U.S. 63 (1937) (a corporate case involving a sale of property by a corporation to its shareholders)). The Palmer case did not involve a bargain purchase, however, because the Court held that the “strike price” of the purchase rights granted were at the then fair market value of the stock being sold. Subsequent events caused the disparity in value. Therefore, any reference to a bargain purchase in the Palmer case is dicta and should not be relied upon by taxpayers.
35 In this regard, see, e.g., Bishop and Kleinberger, Limited Liability Companies: Tax and Business Law, ¶14.05 (Thomson/RIA 2012) (discussing fiduciary duties in Delaware limited liability companies and suggesting that it is “inconceivable that the [Delaware] legislature would have” intended the Delaware legislation to be completely free of fiduciary duties given that both general partners of a Delaware limited partnership and the directors of a Delaware corporation have duties of care and loyalty).
36 That is, if the unpaid portion of the cumulative preferred return is not properly treated as an accrued but unpaid guaranteed payment. See the discussion in the text following note 17 on p. 467.
37 See the text following Example 2.
38 This result also places a preferred interest partner in parity with the holder of an original issue discount instrument under Secs. 1271 through 1275—two economically similar instruments.
39 Regs. Sec. 1.704-2(e)(2).
40 See Regs. Secs. 1.704-1(b)(2)(ii)(b) (requirement must be satisfied throughout the life of the partnership); 1.704-1(b)(2)(ii)(d) (same); and 1.704-1(b)(2)(ii)(i) (requirement must be satisfied “as of the end of each partnership taxable year”).
41 See the discussion of the basic test for economic effect on p. 376 of the June issue .
42 For further discussion of this issue, see Cuff, “Several Thoughts on Drafting Target Allocation Provisions,” in Practising Law Institute, Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances, Ch. 66-1 (2011) (Cuff on Targeted Allocations).
43 See the discussion of the alternate test for economic effect on p. 376 of the June issue.
44 See Cuff on Targeted Allocations.Regs. Sec. 1.704-1(b)(2)(ii)(i).
45 Regs. Sec. 1.704-1(b)(2)(ii)(i).
46 See Cuff on Targeted Allocations (discussing practitioner views).
47 Even if targeted allocations have economic effect, they still must be substantial to be respected. See “Certain Safe Harbors Require Partnership Allocations to Have ‘Substantial Economic Effect’” above.
48 For a fuller discussion of these issues, see, e.g., Cuff on Targeted Allocations; Cuff, “Target Allocations and the Redemption of a Member,” 37 J. Real Estate Tax’n 60 (First Quarter 2010) (suggesting that accountants are struggling to understand targeted allocation provisions); Cavanagh, “Targeted Allocations Hit the Spot,” 129 Tax Notes 89 (Oct. 4, 2010); Golub, “How to Hit Your Mark Using Target Allocations in a Real Estate Partnership,” 50 Tax Management Memorandum 403 (Sept. 28, 2009); New York State Bar Association, Tax Section, Comment Letter to Treasury, “Partnership Target Allocations,” reprinted in 2010 TNT 185-18 (Sept. 23, 2010).
EditorNotes
Noel Brock is an assistant professor at West Virginia University and a former partner and partnership tax practice leader at Grant Thornton’s Washington National Tax Office. He also serves on the AICPA Partnership Tax Technical Resource Panel. The opinions in this article are solely those of the author and not necessarily those of his organizations. This article is for general guidance only, and does not constitute the provision of tax or legal advice. For more information about this article, contact Prof. Brock at noel@noelpbrock.com.