One of the major tax concerns of the 1980s was abusive tax shelters. The Sec. 704(b) economic effect regulations were drafted at that time in response to the perceived abuses of limited partnership tax shelters, whereby taxpayers were taking losses for which they bore no underlying economic responsibility. The intent of the Sec. 704(b) regulations is to ensure that the profits or losses attributable to a partnership investment are allocated to the partners in accordance with the underlying economics in the deal. The premise of the regulations is that if allocations of profit or loss drive the cash that an investor receives in liquidation, there will be economic effect to the allocations.
Practitioners are very careful to draft agreements that comply with the safe harbors found in the Sec. 704(b) regulations. If these safe harbors are not met, the IRS has the authority to redetermine the allocations of partnership profits and losses to be consistent with the partners’ interests in the partnership. Investors have a strong desire to ensure that allocations of income, deductions, and cash match their economic arrangement so that they are not open to IRS redetermination. As such, drafters are ever mindful to ensure that allocations are in compliance with the regulations.
The equity structure of investments has become increasingly complex. In a typical partnership agreement, commonly referred to as a layer cake agreement, the tax allocations and cash distribution provisions are written in different sections. Such an agreement first determines the income and loss allocations to the investors and then determines the final cash to investors after applying the agreement’s income and loss provisions. The intention of this approach is to conform to the overall economic arrangement. If not carefully drafted—and even more carefully applied by practitioners—a layer cake allocation can result in a final distribution of cash at liquidation that does not match the intended business arrangement of the investors.
Target allocations were created as a response to the complexity of layer cake agreements. Target allocations can be simpler for practitioners to draft and apply than traditional layer cake allocations. Thus, target allocations may be a better way to ensure that investors receive both the cashflow and the tax allocations that correspond to their economic agreement.
This item discusses what target allocations are and how they are mechanically applied to determine income allocations during a year. It then reviews the current Sec. 704(b) regulations and the constraints they place on target allocations. Finally, it examines some special issues with target allocations, including preferential returns, nonrecourse deductions, and the concerns of tax-exempt investors.
Target Allocations: How Do They Work?
Target allocations utilize a methodology that is different from that used under a layer cake approach. Under the latter approach, final liquidating distributions are made in accordance with positive capital account balances, taking into account income and loss allocations that have been made over the years of a partnership’s operations. In contrast, target allocation provisions are written so that the annual tax allocations follow the annual application of the cash distribution waterfall provisions in the partnership agreement. Investors may prefer this approach because they are typically more concerned with the amount of cash they will receive during the course of an investment and thus may more easily understand the annual tax allocations.
Under this approach, each partner’s capital account balance at the end of each year is determined by computing how much cash the partner would receive in a hypothetical book value liquidation of the partnership. This cash amount is the targeted capital amount. Using the targeted capital figure, the necessary amount of each year’s partnership income or loss is “plugged” to make the actual capital account balance of each partner equal the target capital amount. Consider the following simple example:
Example 1: Partners A and B each contribute $100 to partnership AB. The distribution provisions provide that A is to receive a 10% noncompounding preferred return on her outstanding capital. Next, A will receive a return of capital and B will receive a return of his capital, and any additional amounts will get split evenly. The net income in year 1 is $50. Thus, at the end of year 1 there will be $250 to distribute ($200 initial capital and $50 of year 1 profits).
The target capital would be computed as follows: The first $10 of distributable cash goes to A, which equals her preferred return. The second $100 goes to A as her return of capital; the next $100 goes to B as his return of capital; the remaining $40 gets split evenly—$20 each to A and B. Accordingly, the target capital for A at the end of year 1 is $130, and the target capital for B at the end of year 1 is $120.
As this example illustrates, target allocations appear to reflect the economic arrangement because the income allocations are derived from the partnership’s cashflow provisions. However, target allocations appear to fail the safe-harbor economic effect tests in the regulations, at least if the regulations are strictly applied. Because target allocations can be relatively simple to draft and apply and appear to comply with the policy concerns of the Sec. 704(b) regulations, practitioners have asked the IRS to update the regulations to ensure that target allocations are respected.
Regulatory Issues with Target Allocations
Under the Sec. 704(b) regulations, allocations will be respected if they have substantial economic effect (SEE) or if the allocations are in accordance with the partners’ interest in the partnership (PIP). If allocations comply with one of the safe harbors in the Sec. 704(b) regulations, the IRS will respect them.
Substantial economic effect involves a two-part analysis to determine that an allocation has economic effect and that the allocation is substantial. In order to have economic effect:
Capital accounts must be properly maintained in accordance with rules contained in the regulations;
Liquidating distributions must be made in accordance with positive capital account balances; and
Partners must be required to restore a deficit capital account balance by having a deficit restoration obligation (DRO).
If there is not a DRO in the partnership agreement, as is generally the case with a limited liability company, there is an alternative economic effect test that allows for a qualified income offset provision in the place of a DRO. A qualified income offset provides that if a partner unexpectedly receives a distribution or loss allocation that causes the partner’s capital account to go below zero, that partner will be allocated items of income and gain in an amount sufficient to eliminate the deficit balance in the partners’ capital account as quickly as possible.
Allocations that fail the economic effect test may still be deemed to have economic effect under the economic effect equivalence test. Under this test, allocations are deemed to have economic effect provided that, at the end of each tax year, a liquidation of the partnership would produce the same economic results to the partners that would occur if the three requirements to satisfy the economic effect test had been met.
The second prong of the economic effect test is that the allocations must be substantial in order to be respected. To be substantial, there must be a reasonable possibility that an allocation will substantially affect the dollar amounts the partnership provides to the partners, independent of tax consequences.
Target allocation agreements are not written so that partners actually liquidate in accordance with their positive capital account balances. They are written to follow cash distributions over the course of a deal rather than just cash proceeds at liquidation. Since a target allocation agreement does not contain the important language of “liquidating in accordance with positive capital account balances,” it would not pass the safe-harbor economic effect tests.
When an allocation does not satisfy SEE, it will be reallocated in accordance with PIP. PIP is a facts-and-circumstances test relating to the partners’ economic agreement. The regulations provide that under PIP four factors must be considered:
The partner’s relative capital contributions;
The partner’s interests in the partnership’s economic profits and losses;
The partner’s interests in nonliquidating distributions; and
The partner’s rights to distributions upon liquidation.
The PIP rules utilize a comparative liquidation test, based on the maintenance of positive capital accounts and final liquidation in accordance with those positive capital accounts. Nevertheless, many practitioners believe that target allocations could meet the PIP test under a liberal reading, even though there is no actual final liquidation provision in a target allocation agreement. This is an area where practitioners would like to see guidance from the IRS. Many believe that the target approach to income allocation accurately reflects the partners’ economic interest in the partnership, but they would like IRS assurance on that point. Even if targeted allocations were generally respected, there could still be certain specific situations in which problems could arise. Several of these are addressed below.
Nonrecourse Deductions
One area that needs to be separately analyzed under any type of agreement is nonrecourse deductions. The SEE regulations apply principally to recourse deductions, which are those deductions that are driven by contributed capital or personal economic risk associated with a recourse liability. Nonrecourse deductions are those for which the partners receive a deduction but do not bear the economic risk of loss associated with them. An example of this would be a building encumbered by a nonrecourse debt that creates depreciation deductions. The partners receive a tax deduction for depreciation while the lender bears the economic risk of loss relative to the decline in value of a building; the building would go back to the lender if the partnership could not make the debt payment obligations. If a building is encumbered by a nonrecourse debt, no partner would have to personally repay the lender if the debt payments went unpaid by the partnership. The lender would take back the building to satisfy the liability.
There are special provisions in the regulations related to nonrecourse deductions because they inherently lack economic effect. In order for a nonrecourse deduction allocation to be respected it must be, or be deemed to be, in accordance with PIP. For an allocation to satisfy the “deemed PIP” standard provided for in the regulations, the partnership must make liquidating distributions in accordance with capital accounts, the nonrecourse deductions must be allocated in a manner reasonably consistent with other allocations that have substantial economic effect, and there must be a minimum gain chargeback provision in the partnership agreement. In a typical layer cake agreement, the allocations of nonrecourse deductions are carved out of the regular allocation provisions because of the need to satisfy the deemed PIP test. Target allocations of nonrecourse deductions likewise need to be carved out of a target allocation agreement. In a target allocation agreement, however, nonrecourse deductions might not satisfy the requirements of a deemed PIP because liquidating distributions are not made in accordance with positive capital accounts, and other allocations arguably would not meet the SEE tests, so there could be no comparison under the second prong of the PIP test. For these reasons, practitioners would like the IRS to clarify what is needed in a target allocation agreement for nonrecourse deductions to be respected.
Potential Problems with Preferred Returns
A second problematic situation occurs when one partner receives a preferred return but there is not enough current-year taxable income to meet it. Consider the following example:
Example 2: A and B are partners in partnership AB. A contributes $100 for her preferred interest and has a 10% preferred return of $10 each year. B contributes $100 for his common interest. A receives her preferred return and capital back prior to B receiving his capital back. In year 1, the partnership earns $8 of net income. In year 1, the partnership falls short of the $10 preferred return to allocate by $2, since the net income is only $8.
In a hypothetical liquidation scenario, there would be $208 to distribute ($200 initial capital plus $8 year 1 cash profits), with the first $110 (preferential treatment of $10 preferred return plus $100 return of capital) going to A and the second $98 (the remaining capital) going to B. In order to make the target allocation match the economics of the deal, A should be allocated $10 of income, but there is only $8 of net income to allocate.
Should $10 of gross income be allocated to A and $2 of gross expense to B? Should the $2 shortfall be characterized as a guaranteed payment to A? Should $8 of net income be allocated to A with the understanding that a correction will occur in the future? Unfortunately, there is no clear answer.
Tax-Exempt Investors
There are some situations in which target allocations probably should not be used at all. One such situation is a deal that includes tax-exempt investors. If the investors are trying to satisfy the requirements of the “fractions rule” under Sec. 514, there may be a problem with using target allocations. The fractions rule mandates that each allocation of the partnership must have substantial economic effect. Since target allocations may fail the substantial economic effect test in the Sec. 704(b) regulations, it may be inappropriate to use target allocations in this situation.
In July 2010, IRS associate chief counsel Curt Wilson said, “The Internal Revenue Service is ‘comfortable’ with partnerships using targeted capital allocations in partnership agreements and could issue guidance to assist taxpayers electing to utilize them” (Joyce, “IRS ‘Comfortable’ with Partner Allocations, May Issue Guidance, Agency Official Says,” BNA Daily Tax Report G-1 (July 13, 2010)). Many commentators would like to see the IRS issue such guidance. In September 2010, the New York State Bar Association Tax Section sent its specific recommendations in this area to the IRS. Hopefully, the IRS will issue guidance in the near future to relieve the uncertainty in this area for both taxpayers and tax practitioners.