Partnership Targeted Capital Accounts: Part 1


capital accountsTraditionally partnership agreements allocate income, gain, and loss by formula and provide for liquidating distributions based on the partners’ respective positive capital account balances. Such arrangements help ensure that the allocations comply with the “safe harbor” provisions set forth in the Treasury regulations under Internal Revenue Code (“IRC”) §704(b). Increasingly, however, partnership agreements provide for liquidating distributions determined by formula and allocate income, gain, and loss in any year so that the partners’ capital accounts reflect as closely as possible their expected liquidating distributions. This mathematically reverses the dependencies of the liquidating distribution and income, gain and loss variables. Instead of the cumulative distributions ultimately adhering to the cumulative tax allocations, the partnership allocates the tax items to reflect the expected distribution of cash. Such arrangements attempt to better reflect the intended economic arrangement among the partners. Practitioners typically refer to such allocation formulas as “targeted capital account” allocations.

Basic Concepts

Since the partnership may not liquidate for years the partnership agreement must provide some guidance as to how to calculate these expected liquidating distributions. Accordingly, such agreements typically assume a “hypothetical liquidation” at the end of the year based upon “book values.” By “book values” these agreements refer to such values within the meaning of the IRC §704(b) regulations rather than GAAP balances. These can also differ from the corresponding tax basis balances for various reasons. For example, when a partner contributes property with a built-in gain or loss the partnership “book value” equals the property’s fair market value (“FMV”) rather than its carry-over tax basis. Another common reason for the divergence arises because the IRC §704(b) regulations require a partnership to revalue its assets to FMV upon the admission of a new partner.

Example: Partnership AB has assets with a tax basis of $500,000 and liabilities of $200,000. Partners A and B each own 50% of the partnership and have tax basis capital accounts of $150,000 each.


Tax Basis

Assets 500,000
Liabilities 200,000
Capital – A 150,000
Capital – B 150,000

On December 30, 2017, X contributes $200,000 in cash to AB for a 25% partnership interest. As a result, the regulations under IRC §704(b) require the partnership to restate its assets to FMV. Implicitly, the FMV of AB’s total equity must equal $800,000 (= $200,000 ÷ 25%). The tax basis and IRC §704(b) “book” balances will appear as follows:


Tax Basis

Book Value





        700,000 1,000,000
Liabilities 200,000 200,000
Capital – A 150,000 300,000
Capital – B 150,000 300,000
Capital – X 200,000 200,000
700,000 1,000,000

Note that the IRC §704(b) book values do not equal their tax bases but also may not equal the GAAP balances.

If AB actually liquidated on December 31, 2017 A and B would expect to receive distributions of $300,000 each and X would receive $200,000. AB would also report a tax gain of $300,000 that it would allocate equally between partners A and B. This makes economic sense as Partner X has paid cash for its portion of the built-in tax gain and therefore should not also report a tax gain on the appreciation of the assets’ values that accrued prior to X’s entry into the partnership.

However, if AB remained a going concern it will allocate its 2017 operating taxable income assuming a “hypothetical liquidation” of the partnership at these “book” values as of 12/31/2017. The agreement refers to the hypothetical distributions as targeted capital account balances. Specifically, AB’s targeted capital account allocation provision requires allocations of 2017 taxable income so as to eliminate to the extent possible differences between the partners’ year-end tax basis capital accounts and their hypothetical distributions (targeted capital accounts).

This example presents a quite straightforward targeted capital account allocation calculation because AB distributes cash on a pro-rata basis and it revalued its assets at the end of 2017. Therefore, X does not have a difference between its targeted capital account ($200,000) and its ending tax basis capital account (also $200,000). Consequently, AB will allocate its entire 2017 operating taxable income between partners A and B resulting in the tax basis balance sheet shown above. However, in reality one rarely finds such a simple analysis because time lapses and such partnership agreements usually set forth complex distribution formulas. Part II of this blog will describe a more realistic targeted capital account scenario.

About The Author

Richard O'Brien

Richard O'Brien of Kurtz & Company, P.C. in Dallas Texas.