Partnership Tax Allocations: The Basics, 0517 COBJ, Vol. 46 No. 5 Pg. 39

AuthorWalter Schwidetzky, J.

46 Colo.Law. 39

Partnership Tax Allocations: The Basics

Vol. 46, No. 5 [Page 39]

The Colorado Lawyer

May, 2017

Tax Law

Walter Schwidetzky, J.

Partnership Tax Allocations: The Basics

This article discusses the basic rules for partnership tax allocations and identifies when practitioners should consult with experts in this area.

This article endeavors to help practitioners who are not partnership tax allocation experts identify when they should consult with those with that expertise. The partnership-allocation Treasury Regulations have been called “a creation of prodigious complexity . . . essentially impenetrable to all but those with the time, talent, and determination to become thoroughly prepared experts on the subject.”1 This article is written for those, to date at least, without that time and determination. At the same time, the article provides an introduction to the partnership tax allocation rules for those contemplating making the requisite investment of time and determination.

The term “partnership,” for purposes of this article, means a tax partnership.2 A tax partnership typically includes state law partnerships and limited liability companies (LLCs) with two or more members.[3] The term “partner” may also refer to an LLC member.

Regarding tax law generally, there is almost no rule without an exception. Accordingly, half the sentences in this article could begin with the words “typically” or “generally”; generally, they don’t.

The Partnership Entity

A partnership is a flow-through entity, meaning that the entity is not taxed. Rather, income and deductions are passed through to the partners. Thus, a mechanism needs to exist for determining each partner’s allocable share of partnership income and deductions. IRC § 704(b) and the Treasury Regulations generally allow partners a great deal of flexibility in this regard. The allocations do not necessarily have to be proportional to the underlying ownership of the partnership interests.4 For example, someone who is otherwise a 50% partner could be allocated 90% of depreciation deductions. Or. all losses could initially be allocated to the “money partners,” with subsequent income allocated to them to the same extent as losses; subsequently income is allocated 50% to the money partners and 50% to the promoters. (This is sometimes called a “flip”; flips are quite common.)

As discussed in more detail below, if all of the partners’ interests in the partnership do not change and their s hares of recourse and nonrecourse debt match their partnership interests, a practitioner can often forgo consulting an expert and inserting complex allocation language into the partnership agreement. To illustrate, in LLC ABC, the members’ interests are, and always will be, A 40%, B 35%, and C 25%, and their shares of LLC debt, recourse or nonrecourse, match those interests. Thus, if the members guarantee an LLC debt (making the debt recourse to them), they guarantee it in such a way that their bottom-line liability (assuming everyone is reasonably expected to fulfill his or her obligation) matches their LLC interests.5 Note that it is preferable if all partners contribute cash. If they contribute appreciated or depreciated property, that does not in and of itself create a risk of violating the IRC § 704(b) Treasury Regulations, but it does trigger IRC § 704(c) and its Treasury Regulations. IRC § 704(c) and its Treasury Regulations are complex. An important feature is that, generally, tax gain or loss inherent in contributed property must be allocated to the contributing partner. If the agreement is silent on IRC § 704(c), the partners default into the “traditional method,” which may not be preferable.6

The overwhelming majority of the provisions in the Treasury Regulations are meant to address circumstances other than the one described in the example. The Treasury Regulations endeavor to permit partners to vary allocations for legitimate business reasons, while disallowing allocations that primarily have a tax-avoidance motive. That is a difficult line to draw and makes for complex Treasury Regulations. Many of the IRC’s partnership provisions were created before most of the people reading this article were born, at a time when partnerships were usually vehicles for small businesses. Businesses of any size were typically either C corporations or S corporations. C corporations are subject to two levels of tax, one on corporate taxable income and a second on dividends. Tax rates in the 1960s on C corporations could be over 50%, and top tax rates on dividends paid to individuals varied from around 90% in 1960 to around 70% in 1970, making double taxation a big problem. An S corporation has one level of tax, at the shareholder level, but there is no (or at least no sufficient) means of varying allocations among shareholders.7

But taxpayers often wanted flexibility in their business arrangements. Starting in the 1960s, non-publicly traded businesses increasingly moved to limited partnerships, which afford taxpayers both one level of tax at the partner level and the ability to vary allocations. Most “tax shelters” from this era were limited partnerships. In some ways, Congress and the IRS have been playing catch-up ever since. Had Congress seen this coming, it might have constructed the partnership tax rules differently. But it did not. From time to time, commentators have proposed ways of getting the genie back into the bottle and radically changing the partnership tax rules to make them less flexible, less subject to abuse, and often more S corporation-like. But those efforts, to date, have always come to naught.8 Numerous anti-abuse rules, however, have been added to the Code and Treasury Regulations, making partnership taxation one of the most complex areas in all of taxation (no mean feat). But the fundamental structure of partnership taxation has not changed.

This article takes a “gentle” look at the Treasury Regulations to provide a basic understanding of the derivation of the complex tax provisions sometimes seen in partnership agreements. Often these provisions cannot be avoided, and practitioners need to consult a tax professional to ensure an agreement says what it needs to say. But complex tax provisions can sometimes be avoided, as discussed below.

Substantial Economic Effect Rules

To oversimplify a bit, under IRC § 704(b), allocations must either be “in accordance with the partner’s interest in the partnership” or have “substantial economic effect.”9 The Treasury Regulations contain detailed rules on when a n allocation has substantial economic effect, and say little about when an allocation is in accordance with a partner’s interest in the partnership. As the name suggests, an allocation has substantial economic effect if it has a genuine after-tax, economic effect on the partner to whom the allocation is made. Given the detailed provisions in the Treasury Regulations, the substantial economic effect rules constitute what tax professionals call a “safe harbor,” meaning taxpayers know they are safe if they comply with these rules. If they do not, they cannot know with confidence that their allocation regimen will pass muster (though sometimes they can be confident it will not).

One might assume this reality would force taxpayers to comply with the safe harbor provisions, and often it does. But in larger deals it is probably the norm that tax professionals consciously choose to not comply with the safe harbor, hoping that either the IRS or a court can be persuaded that the allocations are in accordance with the partners’ interests in the partnership, notwithstanding the lack of a clear definition in this regard. (There are often good reasons for this choice, which are beyond the scope of this article.) This choice likely will not have to be defended, however, because the odds of being audited are low, and there have been a relatively small number of cases on this issue, some won and some lost by taxpayers. The more the allocation is primarily about saving taxes and the less it is driven by genuine business considerations, the more likely it is that the taxpayer will lose.10

Capital Accounts

Given that the Regulations focus on economic effect, a method is needed to measure a partner’s economic investment in the partnership. “Capital accounts” perform this function. Partnerships that wish to formally comply with the substantial economic effect rules must have a provision in the partnership agreement that requires the partnership to keep capital accounts in accordance with the Treasury Regulations. Because the concern here is with economic rather than tax impacts, the rules for keeping capital accounts are quite different from the rules for computing partners’ tax bases in their partnership interests.

Under the Treasury Regulations, a partner’s capital account is increased by (1) the amount of money contributed to the partnership; (2) the fair market value of property contributed to the partnership (net of liabilities secured by the property); and (3) allocations of partnership income and gain, including tax-exempt income. A partner’s capital account is decreased by (1) the amount of money distributed to the partner; (2) the fair market value of property distributed to the partner (net of liabilities secured by the property); and (3) allocations of expenditures of the partnership that can neither be capitalized nor deducted in computing taxable income (usually, this will be zero—an example is a tax penalty for failing to file a tax return); and (4) allocations of partnership losses and deductions.11

Note that a partner’s capital account does not include that partner’s share of partnership liabilities. But under IRC § 752, the partner’s tax...

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