Target allocations.

• Author: Weber, Neal A.

One of the major tax concerns of the 1980s was abusive tax shelters. The Sec. 704(b) economic effect regulations were drafted at that time in response to the perceived abuses of limited partnership tax shelters, whereby taxpayers were taking losses for which they bore no underlying economic responsibility. The intent of the Sec. 704(b) regulations is to ensure that the profits or losses attributable to a partnership investment are allocated to the partners in accordance with the underlying economics in the deal. The premise of the regulations is that if allocations of profit or loss drive the cash that an investor receives in liquidation, there will be economic effect to the allocations.

Practitioners are very careful to draft agreements that comply with the safe harbors found in the Sec. 704(b) regulations. If these safe harbors are not met, the IRS has the authority to redetermine the allocations of partnership profits and losses to be consistent with the partners' interests in the partnership. Investors have a strong desire to ensure that allocations of income, deductions, and cash match their economic arrangement so that they are not open to IRS redetermination. As such, drafters are ever mindful to ensure that allocations are in compliance with the regulations.

The equity structure of investments has become increasingly complex. In a typical partnership agreement, commonly referred to as a layer cake agreement, the tax allocations and cash distribution provisions are written in different sections. Such an agreement first determines the income and loss allocations to the investors and then determines the final cash to investors after applying the agreement's income and loss provisions. The intention of this approach is to conform to the overall economic arrangement. If not carefully drafted--and even more carefully applied by practitioners--a layer cake allocation can result in a final distribution of cash at liquidation that does not match the intended business arrangement of the investors.

Target allocations were created as a response to the complexity of layer cake agreements. Target allocations can be simpler for practitioners to draft and apply than traditional layer cake allocations. Thus, target allocations may be a better way to ensure that investors receive both the cashflow and the tax allocations that correspond to their economic agreement.

This item discusses what target allocations are and how they are mechanically applied to determine income allocations during a year. It then reviews the current Sec. 704(b) regulations and the constraints they place on target allocations. Finally, it examines some special issues with target allocations, including preferential returns, nonrecourse deductions, and the concerns of tax-exempt investors.

Target Allocations: How Do They Work?

Target allocations utilize a methodology that is different from that used under a layer cake approach. Under the latter approach, final liquidating distributions are made in accordance with positive capital account balances, taking into account income and loss allocations that have been made over the years of a partnership's operations. In...