A New Look at Partnership Allocations

By Daniel Gayer January 3, 2016

(How Targeted Capital Accounts Sync Partnership Tax Results with Economic Reality)

The choice to do business in an entity taxed as a partnership is often driven by the great flexibility available in the world of partnership taxation. Skilled tax advisors can craft agreements and business structures to achieve a wide range of tax and business results. The challenge posed by this flexibility is to craft partnership agreements and tax strategies in such a way that the tax results match the partners’ intent in the underlying economic deal.

In theory, partnership tax law is intended to make taxable income and deductions flow to the partners that bear the economic risks in the partnership. In practice, this result can be difficult to achieve because the allocations of income and deductions upon which a partner’s tax liability are based do not necessarily match the distributions of cash. Without proper tax planning and good drafting of partnership agreements, one partner can end up getting the majority of the cash, while another ends up with most of the tax bill.

In an attempt to do a better job of aligning taxable income allocations with the partners who will receive the economic benefits when the partnership is profitable and/or the partnership liquidates, tax practitioners in recent years have shifted to making allocations of taxable income based on target capital accounts. Under the target capital account approach, the partners agree to a cash distribution waterfall, which is then included in the partnership agreement. The waterfall defines the order in which available cash will be distributed to the partners when cash is available for distribution during the life of the partnership from profitable operations, financing transactions, or other sources. It also defines how available cash and other property will be distributed when the partnership liquidates.

Once the partners agree to the distribution waterfall, the partnership then calculates the amount that each partner would receive according to the distribution waterfall if the partnership liquidated at the end of the tax year and all assets were sold at their year-end book value. This calculation establishes the “target” – the amount that each partner’s capital account should equal in order for that partner to receive the amount that the partners agreed to via the distribution waterfall if the partnership were to liquidate. Once the target is identified, taxable income and loss are allocated to the partners in such a way as to force their ending capital accounts to equal the target amounts.

The use of target capital accounts is still an emerging trend in the world of partnership taxation. Even though some tax practitioners began using this approach over 20 years ago, the IRS has yet to issue a ruling explicitly agreeing to the use of target capital accounts, which differs in some respects from more complex methods of partnership tax allocation used previously. Nevertheless, target capital accounts are now widely used, and IRS officials have informally indicated that they are comfortable with this approach.

Target allocations provide partners with a powerful tool to ensure that the business reality drives the tax result, and not the other way around as too often occurs. If you have questions or wonder how target allocations could impact and benefit your business, please contact Dan Gayer or Henry Rinker at 1.800.244.7444.