The targeted allocations approach: a basic primer.

• Author: Wong, Alan

This item discusses a growing trend in the allocation provisions of partnership agreements in which limited partnerships have been adopting a targeted allocation approach through which "tax follows cash." Under the targeted allocation model, the distribution provisions of the partnership agreement effectively govern all distributions made by the partnership. The allocation provisions of the partnership agreement require the partnership to imagine a hypothetical liquidation of the partnership at year end and therefore require the allocation of income or loss to reflect the "true" economics of the partnership. However, one notable trouble spot regarding the targeted allocations approach appears when the actual cashflow of the partnership does not match the respective allocations of taxable income to the partners--specifically the general partner.

Background

The allocation provisions of many partnership agreements have historically relied on the Sec. 704(b) safe-harbor economic effect regulations and provided that income or loss would first be allocated to the partners' capital accounts and then, after such allocations, cash or other property would be distributed in proportion to each respective partner's capital accounts. In other words, under this traditional allocation approach, "cash follows tax." Partnership agreements are drafted focusing first on the cashflows. Second, income and loss allocations follow the cashflows. Third, final distributions are made in accordance with the capital accounts.

When the partnership has a simple economic arrangement, the traditional allocation approach is a fairly straightforward exercise. However, when the economic arrangements become more complicated, the allocation and distribution provisions of the partnership agreement also become much more complicated. In such a case, the distribution provisions must reflect the economic arrangements reached between the limited partners and the general partner. The allocation provisions must also reach such economic arrangements, but because of the complexities involved in partnership book and tax accounting, the allocation provisions may not be aligned with the distribution provisions.

It appears that the targeted allocations approach (also referred to as the targeted capital, target allocations, or forced allocations approach) grew as a response to the traditional allocations approach, which often gave rise to unanticipated economic results that the partners may...