Partnership Taxes

Partnership Targeted Capital Accounts: Part II

Partnership Targeted Capital Accounts: Part II


Part I explained the basic concept behind the targeted capital account approach to allocating partnership taxable income and loss. The example used in Part I assumed a simple factual pattern where the partnership admitted a partner on 12/30/2017 in exchange for a $200,000 capital contribution. The example explained how the targeted capital account approach allocates taxable income based on an assumed hypothetical liquidation of the partnership at year-end assuming the value of the partnership’s assets equal their Internal Revenue Code §§704(b) or (c) “book” values. The targeted capital approach allocates current taxable income or loss so as to bring the partners’ tax basis capital account balances as closely into alignment as possible with their expected hypothetical liquidating distributions.

In that example the partnership’s tax and “book” basis balance sheets as of 12/31/2017 were as follows.

Targeted Capital Accounts and Preferred Returns

The example in Part I described a partnership with relatively simple pro rata allocation and distribution terms. But partnerships commonly employ the targeted capital approach when their agreements provide for preferred distributions to the partners (e.g., tiered or “waterfall” distribution formulas). We can use the financial facts in the balance sheets above to illustrate the general concept in a more complex allocation environment.

Example: The partnership agreement includes the following provisions:


Partnership Taxes

  • Each year the partnership computes partner Preferred Return Amounts equal to 10% of each partner’s unreturned capital contributions. These amounts accumulate in each partner’s Preferred Return Account. That is, the annual Preferred Return resembles annual interest accrued on the “principal” in the form of the unreturned capital contributions.
  • The partnership distributes cash in the following order of preference:

1. To each partner until they have received their unreturned Preferred Return Account in full.

2. To each partner until they have received a full return of their capital contributions.

3. Finally, to the partners according to their percentages (e.g., 25% for X and 75% collectively for A and B).

Targeted Capital Accounts

The agreement computes the partners’ Targeted Capital Accounts as the amounts they would hypothetically receive had the partnership sold its assets at “book” value and liquidated at the end of the tax year.

Taxable Income or Loss Allocations

The partnership allocates taxable income or loss for the year among the partners so as to eliminate as quickly as possible any differences between the partners’ Targeted Capital Account balances and their year-end tax basis capital accounts.


The partners had unreturned Preferred Return Account and contribution balances as follows.

During 2018 the partnership had taxable income before depreciation of $100,000 and net operating cash flow of that same amount. It used the cash flow to pay down its liabilities. The partnership recorded “book” depreciation of $100,000 and tax depreciation of $50,000. Therefore, it had 2018 taxable income of $50,000 (= $100,000 in operating income less $50,000 of tax depreciation).

The “book” hypothetical liquidation proceeds at 12/31/2018 equals $800,000 as follows.


The Targeted Capital Account balances equal that portion of the $800,000 that each partner would receive in a hypothetical distribution at book values.

In this case the presumed fair market value of the partnership assets did not change from 2017 while the Preferred Return Account grew by $56,000 during 2018 (= 10% x $560,000 in unreturned contributions). Thus the hypothetical liquidation would leave $56,000 in contributions unreturned. The partnership would therefore allocate the “second tier” distributions pro rata (“pari passu”) among the partners based upon their beginning unreturned contribution balances. Note that since the presumed value of the partnership did not change in 2018, partner X’s targeted capital account remains unchanged from 12/31/2017. In addition, X’s targeted capital balance continues to equal X’s tax basis capital. As such, the partnership will allocate the entire $50,000 in taxable income equally between A and B.

Suppose instead the partnership generated $200,000 in operating income and cash flow that it used to retire its liabilities. The partnership will have generated $150,000 in taxable income (= $200,000 less $50,000 in tax depreciation) and a $900,000 hypothetical distribution as follows.

The partnership will hypothetically distribute the liquidation proceeds as follows.

The differences between the partners’ Targeted Capital Account and tax basis capital balances are as follows.

The agreement requires the partnership to “allocate the taxable income or loss for the year among the partners so as to eliminate as soon as possible differences between the partners’ Targeted Capital Account balances and their year-end tax basis capital accounts.”

One could interpret the foregoing to mean that the partnership allocations should follow an ordering formula (i.e., a “step function” in mathematical terms). Under this interpretation, the partnership would allocate the income sequentially based on relative gross discrepancies until all partners have equal gross discrepancies and thereafter on an equal basis. In our example the partnership would allocate the entire $150,000 of taxable income equally between A and B because even after such allocations their balance differences would still exceed X’s $31,000 difference (e.g., $184,000 – [$150,000 x 50%] > $31,000 in the case of either partner A or B).

On the other hand, by “allocation” the agreement could mean a percentage allocation based on the partners’ relative differences between their tax capital and Targeted Capital Account balances.

  • Partner excess targeted capital = Partner hypothetical distribution – Partner tax capital.
  • Partnership excess targeted capital = Partnership hypothetical distribution – Partnership tax capital.
  • Partner allocation % = Partner excess targeted capital ÷ Partnership excess targeted capital.

This alternative methodology is not an unreasonable interpretation of the partners’ economic intent. But note that in any given year this does not result in immediate changes in the partners’ pre and post-allocation relative excess targeted capital percentages assuming the partners’ percentage shares of the hypothetical distribution remain constant. This will remain the case until such time as tax capital equals targeted capital. This results from the allocation formula’s lack of independent variables.1 Rather any subsequent changes in the relative percentages will result from underlying changes in the variables used to calculate the targeted capital account (hypothetical distribution) amounts.

This serves to point out that a partnership should draft its agreement using mathematically unambiguous and precise language so as to avoid potential later controversies of interpretation. Allocating 100% of the taxable income to A and B does reduce the absolute differences between the partners’ targeted capital and their tax basis capital accounts. But allocating income based on relative excess targeted capital likewise reduces these absolute discrepancies albeit at a slower rate. The question becomes: Does the latter formula, however reasonable, comport with the partners’ intent that the allocation of taxable income must reduce the differences between targeted and tax basis capital “as soon as possible” or “as quickly as possible”?

Part III of this article will discuss other potential or speculative factual circumstances that the partnership agreement by its terms should anticipate.


Comparison of Allocations Based on Percentages of Relative Excess Targeted Capital versus Accelerated Special Allocations to Partners with Disproportionate Excess Targeted Capital

About The Author

Richard O'Brien

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