Target or waterfall: partnership allocations.

• Author: Seaton, Jennifer

In recent years, more and more partnership agreements have been drafted using the targeted capital account approach for allocating partnership items of income or loss (targeted capital approach) versus the typical Sec. 704(b) economic effect approach (waterfall approach). Deals are increasingly complicated, investors are increasingly savvy, and partnership agreements have become significantly more complex to adjust to investor demands. As partnership agreements have evolved, the income allocation and cash distribution provisions in these agreements have become more complicated as well. This item describes two approaches to allocating partnership items of income and loss.

Because of the increasing complexity of allocations in partnership agreements, many practitioners believe that the targeted capital approach for allocating income is a simpler, more user-friendly method to follow than the traditional waterfall approach. The increasing complexity of profit allocation and cash distribution provisions in traditional partnership agreements makes it easier for errors to be made when drafting agreements.

Some practitioners feel the targeted capital approach provides for allocations that more closely resemble the true economic realities of partnership agreements, as the allocations of partnership income/loss follow the cash distribution and liquidating provisions in the agreements. Other practitioners argue that the targeted capital approach would not be respected under the substantial economic effect provisions of Regs. Sec. 1.704-1.

Another perceived downside to the targeted capital approach is that often the partnership agreement does not adequately address nonrecourse deductions, depreciation recapture, and minimum gain. While there is some controversy among tax practitioners as to whether the targeted capital approach would be respected under Regs. Sec. 1.704-1, use of the targeted capital approach to allocations has become quite common when drafting partnership agreements because this method reflects the economic arrangements of the partners in the deal.

Agreement Using the Waterfall Approach

A typical partnership agreement drafted using a waterfall approach contains several tiers of income/loss allocations that define the priority in which partnership items of income/loss are to be allocated. These agreements also contain several tiers of cash distribution provisions that define how partnership cash gets distributed to the partners.

The agreement typically contains key provisions that extract language from the regulations to allow the allocations of the partnership to meet the substantial economic effect test, thus allowing the allocations to be respected under Sec. 704(b). Failure to follow the rules under Sec.

704(b) when drafting a partnership agreement can result in adjustments by the IRS to reflect what it believes is the economic arrangement of the partners.

An agreement using the waterfall approach might look like this:

1. Profit Allocations

   * First, to reverse all cumulative allocations of net loss;

   * Second, to the partners in proportion to their percentage interests (as defined in section x) until each partner receives a preferred return of 12% on his or her unreturned capital;

   * Third, 75% to class A partners and 25% to class B partners until class A partners' capital account balances are increased to a level at which an immediate distribution of such capital account balance to a class A partner would cause a class A partner to receive a preferred return of 16%;

   * Fourth, the balance 50% to class A partners and 50% to class B partners.

2. Loss Allocations

   * First, among all partners to offset in reverse order all prior income allocations on a cumulative basis;

   * Any remainder shall be allocated to the partners in proportion to...