Understanding the effect a partnership agreement has on allocations.

• Author: Owen, Sheila A.

Generally, partnerships have a written partnership agreement that sets out the partners' duties and the allocation to those partners of the partnership's tax and economic items. Sec. 704(a) provides that this agreement governs the allocation of taxable income, gain, loss, deduction, and credit among the partners. This may create a trap for the uninitiated because it seems to give the partners greater power to govern the allocation of partnership tax items than they actually have.

In reality, tax allocations cannot be made independently of the corresponding economic results and, in fact, merely follow the related economic allocations made under the partnership agreement. In the event that the partnership agreement's tax allocations do not have substantial economic effect, or if the agreement is silent concerning tax allocations, then the tax allocations must be in accordance with the partners' interests in the partnership (PIP) rules (Sec. 704(b)). In the case of a family partnership, rules regarding partnership interests created by gift in Sec. 704(e) must be met as well.

Allocations of economic results

Sec. 704 governs only the allocation of tax items and not the allocation of economic items. The tax laws cannot govern how partners agree to divide the partnership's economic results. Therefore, the partnership agreement is the final word on the allocation of economic items among the partners.

When reviewing a partnership agreement to determine the economic arrangement between the partners, it is important to look at all sections that impact the actual dollars to be contributed by or distributed to the partners. Special attention should be given to sections of the agreement dealing with:

* Capital contributions;

* Capital calls;

* Distributions of cash, including preferred returns;

* Requirements for funding deficits;

* Responsibility for partnership liabilities; and

* Liquidation provisions.

What constitutes the partnership agreement?

For purposes of the substantial economic effect test, the term "partnership agreement" is broadly defined. In addition to the actual document itself, the regulations provide that the partnership agreement also includes all oral and written agreements among the partners, or between one or more partners and the partnership, concerning the partnership's affairs. Examples of such documents include loan and credit agreements, assumption agreements, indemnification agreements, subordination agreements, and...