Targeted partnership allocations.

• Author: Brock, Noel P.

Partnerships afford the greatest flexibility to business owners to craft an entity that tracks any complex economic deal they can conceive. Along with this flexibility, however, comes complexity. Partnership tax law is charged with taxing these complex business arrangements conceived by business owners.

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Partnership taxation has been referred to as the most complex area of the tax law. (1) At the heart of this complexity is the requirement that the tax consequences of a partnership's operations inure to the benefit or detriment of those partners who are economically at risk--a union of tax consequences and economic consequences. (2) Historically, drafters of partnership agreements guaranteed this union by requiring that (1) the partnership maintain a separate capital account for each partner that tracked each partner's economic rights in the partnership and (2) the partnership liquidate in accordance with those capital accounts. (3)

For partnerships liquidating in accordance with the partners' capital accounts, partnership allocations were, and still are, drafted to attempt to cause the partners' ending capital accounts to achieve the desired economic deal (so-called safeharbor, or layer cake, allocations (4)).

A partnership "allocation" is simply a division of each item of income, gain, loss, deduction, and credit of the partnership between and among the partners. An allocation is not to be confused with a distribution of cash; and allocations and distributions do not necessarily go hand-in-hand. Also, the income or loss that is allocated in a partnership agreement is Sec. 704(b) book income or loss--not taxable income or loss. Most partnership agreements, however, require that taxable income or loss be allocated in the same manner as Sec. 704(b) book income or loss. For purposes of this article, unless indicated otherwise, the terms "partnership allocation" or "partnership allocations" mean allocations of partnership Sec. 704(b) book income or loss, but with the assumption that the partnership agreement requires that partnership taxable income or Loss be allocated in the same maimer as partnership Sec. 704(b) book income or loss.

Starting in the early 1990s, however, a new method of wedding the partnership's tax and economic consequences arose (socalled targeted, or forced, allocations (5)). Under this new method, a partnership liquidates not in accordance with partner capital accounts but, instead, in accordance with a negotiated distribution waterfall that reflects exactly the partners' economic deal. A "distribution waterfall" is just what the name implies. It is the order in which any cash available to distribute is distributed. For example, a distribution waterfall might read as follows:

Cash available for distribution shall be distributed as follows: first, to Partner A equal to the amount Partner A has contributed to the partnership; second, to Partner B equal to the amount Partner B has contributed to the partnership; and, thereafter, equally to Partner A and Partner B. A partnership's distribution waterfall embodies the partners' economic deal because it dictates how the partners will share all cash distributed by the partnership.

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 be 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 targeted allocations, and very few contain safe-harbor allocations. While this distinction may seem like an exercise in semantics, the consequences of drafting partnership allocations in one manner or the other can be significant to both the drafter and the tax return preparer.

This two-part article first discusses the rules governing safe-harbor allocations. Next, it discusses the rules governing targeted allocations and reasons for the use of targeted allocations. In next month's issue, part II discusses some issues targeted allocations raise and recommends guidance the IRS should issue.

Safe-Harbor Allocations

As stated above, when drafting safe-harbor allocations, the goal is to draft a set of allocations that will cause the partners' ending capital account balances to achieve a given economic deal and then to liquidate the partnership in accordance with those balances. Because allocations of partnership profit or loss increase or decrease, respectively, the partners' capital accounts, and because the partnership will ultimately be liquidated in accordance with the partners' ending capital accounts, in all but the simplest of partnership arrangements, it is difficult to correctly draft safe-harbor allocations so that the partners' ending capital accounts achieve the partners' desired economic deal.

Under Secs. 704(a) and (b), allocations of partnership income, gain, loss, deduction, or credit between or among the partners6 are generally respected so long as the allocations to each partner (1) are set forth in the partnership agreement and (2) have substantial economic effect. Practitioners often refer to partnership allocations that satisfy these conditions as being "safe-harbor" allocations, because the allocations are drafted to satisfy the safe harbor in the regulations.

A primary advantage of safe-harbor allocations (as opposed to targeted allocations) is that, if properly drafted, they will generally be respected by the IRS and the courts. (7) So, what does it take for the allocation to have substantial economic effect (i.e., to satisfy the safe harbor in the regulations)? The test for whether an allocation has substantial economic effect is really a two-part test. (8) First, the allocation must have economic effect. Second, the allocation must be substantial. This article next discusses each part of the test in order.

Economic Effect: Three Ways to Win

If a partnership agreement provides for allocating an item of income, gain, loss, deduction, or credit to a partner, there are three ways in which the allocation can have economic effect under the Code and regulations. (9) First, an allocation will have economic effect if the allocation satisfies three strict requirements discussed below under the basic test for economic effect. Second, an allocation will have economic effect if it satisfies the alternate test for economic effect. Third, an allocation will have economic effect if, taking into account all the facts and circumstances, the allocation reaches the same result as if the three strict requirements were contained in the partnership agreement. These three tests for economic effect are explained in the next three sections.

Basic test for economic effect: A partnership allocation generally satisfies the basic test for economic effect "if, and only if, throughout the full term of the partnership, the partnership agreement" (10) satisfies three strict requirements. First, capital accounts must be maintained in accordance with the regulatory requirements. Second, partnership liquidating distributions are required to be made "in all cases" in accordance with the partners' positive capital account balances (after taking into account all adjustments, if any, for the partnership tax year during which the liquidation occurs). Third, any partner having a deficit in his or her capital account after taking into account all...