Targeted Partnership Allocations on the Rise

When working with partnership formation agreements for traditional partnerships and Limited Liability Companies, it has become increasingly more common to see a preference for targeted partnership allocations versus the more traditional agreement that liquidates based on positive partner capital accounts. This type of partnership has become popular for real estate partnerships, as it paints a clear picture of the partnership and investment in the property.

Many investors favor the concept of targeted partnership allocations, as they get a long-term picture of what they are going to receive over the course of the partnership. Under this method, the partnership liquidates in accordance with a negotiated distribution “waterfall” that reflects the partners’ economic deal. During the life of the partnership, the partners’ allocations are drafted to ultimately force the capital accounts to allow this final liquidation waterfall, resulting in a zeroing out of the capital accounts.

The execution of targeted allocation partnership agreements can be tricky and requires annual calculations to ensure the end result will be as planned. Each year, the hypothetical sale of all partnership assets at book value and payment of all partnership liabilities must be calculated. The remaining hypothetical cash is then distributed according to the negotiated waterfall provisions, and the actual taxable income or loss of the partnership is then allocated to the partners following this result. Depending on how the agreement is structured, a singular year’s partnership allocations may end in different results for federal and state tax purposes, which can add to the complexity of compliance.

Unlike a targeted partnership allocation, a more traditional agreement liquidates based on positive capital accounts. Typically, the partnership will maintain capital accounts for each partner and track each partner’s economic rights within the partnership. Upon liquidation of the partnership, individual partners may end up with a negative or positive capital account, which would translate into gain or loss upon termination.

Section 704 of the Internal Revenue Code provides a general rule that partners may provide in their agreement on how the partnership’s items of income and loss will be allocated among its partners. This general rule is tempered by the requirement that the agreed upon allocations must have “substantial economic effect.” If the allocations provided in the agreement lack substantial economic effect, the IRS may reallocate the profits and losses. Because this is such an amorphous standard, most partnerships try to satisfy the substantial economic effect test, thereby precluding the IRS from reallocating profits and losses upon audit.

Unlike the language used in traditional partnership agreements, targeted allocations may not meet the standard of having substantial economic effect. The IRS has yet to issue official guidance on targeted partnership allocations, which opens the door for misinterpretation and confusion. In response to the lack of guidelines, the American Institute of CPAs recently sent a draft revenue ruling on targeted partnership allocations to the IRS in hopes they will issue clarifying regulations.

Please contact me at (805) 963-7811 or bforeman@bpw.com if you have questions regarding your partnership agreement or if you are looking to establish a new LLC.