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.
Guidance on the Use of Targeted Allocations
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 artide. (12)
How to Treat Purported Preferred Returns
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 yea; 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 on the facing page 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...