Partnership Targeted Capital Accounts

Partnership Targeted Capital Accounts: Part III

Introduction

Part I of this article described the overall concept behind the targeted capital account approach to allocating taxable income and loss. Part II presented a general example of how a targeted capital account analysis functions when a partnership agreement provides for preferences with respect to partnership distributions. This Part III will address a variety of potential other fact patterns that the partnership should contemplate when drafting an agreement that employs targeted capital accounts.

The allocation section of the partnership agreement should, of course, contain all of the standard safeguard arrangements such as the minimum gain chargeback and qualified income offset provisions. However, these agreements often use terms that require income or loss allocations that eliminate partner excess targeted capital “as quickly as possible” or “as soon as possible.” There is a vagueness to such terms that can create uncertainties as to their application in certain factual scenarios. This Part III will provide examples of certain such factual circumstances.

Example: Taxable Loss Allocations

The partnership has the following tax and book basis balance sheets at year end.

A, B, and C are equal one-third partners. C was admitted to the partnership five years after its formation causing the partnership to “book-up” its assets pursuant to the regulations under Internal Revenue Code §704(b).

The partnership distributes cash to the partners in the following order:

  1. In amounts up to the partners’ unreturned Preferred Return balances.
  2. In amounts up to the partners’ unreturned capital contributions.
  3. Pro-rata based on partnership percentages (i.e., 33.33% each).

The unreturned contribution and Preferred Return balances equaled the following at year-end.

The partnership uses targeted capital accounts to allocate taxable income and losses. Under a hypothetical liquidation the partnership would distribute $7,000,000 (the book equity amount) as follows.

The partnership agreement allocates both taxable income and loss so as to eliminate differences between the partners’ hypothetical distributions (targeted capital) and their tax basis capital accounts “as soon as possible.”

Each partner’s percentage share of the total targeted capital in excess of total tax capital is as follows.


The partnership allocates the taxable loss based on those percentages.


Therefore, the post-allocation differences in the partners’ targeted and tax capital will equal the following.


As explained in Part II of this article this method leaves each partner’s percentage share of the total targeted capital in excess of total tax capital unchanged after the allocations of income or loss.

This methodology, however seemingly reasonable and consistent, actually increases the “inter-partner” discrepancies in excess targeted capital.


A, B, and C share equally in the hypothetical liquidation proceeds but the excess targeted capital balances of A and B increased by four times that of C, a result that seems at odds with the partners’ presumed general intent. As pointed out in Part II of this article, basing income allocations on the partners’ percentage shares of total partnership excess targeted capital will reduce the partners’ individual excess amounts over time but at a slower rate than a more direct method. But when a partnership incurs a loss the inverse occurs.

The agreement could specifically address this situation by requiring special allocations of the loss so as to bring the ratios of the partners’ tax basis capital to total capital into alignment with their percentage shares of the hypothetical liquidation as quickly as possible. For example, in this example the partnership agreement could require the partnership to allocate the entire taxable loss to C.


However, the agreement could provide another allocation formula that accomplishes the same goal but over a longer length of time depending on the partners’ intent. But, regardless of the method chosen, the agreement should specifically state the partners’ intent in anticipation of such scenarios.

Example: Positive and Negative Capital Accounts

Partner Dx has a negative tax basis capital account of $200,000. Partners A through Z (“AZ”) have a collective positive tax basis capital account of $1,200,000 with all partners having identical balances. The partnership calculates a hypothetical liquidating distribution of $10,000,000. The partnership agreement entitles Dx to receive 30% of the distribution or $3,000,000. Thus Dx has excess targeted capital of $3,200,000. The AZ partners will receive equal shares of the remaining $7,000,000 of the hypothetical distribution. The AZ group therefore has excess targeted capital of $5,800,000 of which each member of the group has identical shares. The partnership has total excess targeted capital of $9,000,000 (= $10,000,000 – $1,200,000 + $200,000). Dx’s percentage share of the total excess therefore equals 35.6% (= $3,200,000/$9,000,000) and that of the AZ group equals 64.4%. The partnership agreement allocates taxable income and loss so as to eliminate the partners’ excess targeted capital amounts “as soon as possible.” The partnership interprets that to mean it should allocate income and loss on the basis of the partners’ respective excess targeted capital balance percentages. The partnership had a tax loss for the year of $1,000,000.


The partners’ excess targeted capital percentages remain the same after the loss allocation (35.6% and 64.4%) for the reasons discussed earlier. However, the allocation actually increases the excess targeted capital of the partner with the negative tax capital account, Dx. But also note that it does the same for the partners with positive capital accounts, the AZ group. Would this have represented the partners’ original intent had they contemplated this scenario while drafting the partnership agreement?

There are at least two alternative interpretations of the term “as soon as possible.” For example, the partnership could first allocate the loss to the partners with positive capital until their tax basis capital account ratios equal their respective percentage shares of the hypothetical liquidating distribution (or 30%/70% in our example) and thereafter pro rata based on those same distribution percentages.


In our example, this reduces Dx’s excess targeted capital percentage from 35.6% to 32.0%, an amount closer to its 30% share of the hypothetical distribution.

Alternatively, the agreement could require the partnership to allocate gross income to the partners with negative capital accounts to bring their relative excess targeted capital percentages into alignment with their percentage shares of the hypothetical liquidation and then allocate the remaining items using that same methodology. Our example assumes the partnership generated gross income of $300,000 and had deductions of $1,300,000.


In this example the methodology results in the partners’ excess targeted capital percentages exactly equaling their percentage shares of the hypothetical distribution. However, this will not necessarily always be the result. For example, if the partnership had no gross income during the year your gross income calculation would be identical to that performed under the first alternative where the AZ group receives a 100% allocation of the net taxable loss.

One could justify using either of these alternative allocation formulas. Partnership agreements often contain a provision authorizing the tax matters partner to allocate taxable income or loss to reflect the partners’ intent in ambiguous situations. However, the partnership agreement should anticipate such situations and provide a clear and explicit guidance as to how to allocate income and loss when they occur. Deferring to the tax matters partner to subjectively interpret such terms “as quickly as possible” or “as soon as possible” only invites potential contention. For example, partner Dx could dispute the gross income allocation above by asserting the tax matters partner had “artificially” allocated it income and lacked the authority to do so. In contrast, an agreement that specifically anticipates this scenario would settle the issue.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas.
https://www.linkedin.com/in/drquintana