As the tax laws affecting partnerships have become increasingly complex, limited partnership or limited liability company (LLC) operating agreements that have attempted to keep abreast of these changes have become increasingly difficult to decipher. They are therefore incomprehensible to many lawyers and their clients. Section 704(c) of the Internal Revenue Code of 1986, as amended (the Code), requires that allocations of taxable income, gain, loss, and deductions must have substantial economic effect (SEE) to be respected. (Failure to comply with the SEE regulations may permit the IRS under I.R.C. § 704(c) to reallocate these tax items in a way that reflects the partners’ interest in the partnership (PIPs).) Extensive regulations provide a list of requirements for meeting this requirement, for example, Reg. § 1.704-1, which includes requiring that liquidating distributions be made in accordance with partners’ capital accounts. Reg. § 1.704-1(b)(2)(ii)(b)(2). Client concerns that these requirements may distort their business arrangements led to adoption of targeted tax allocation provisions as an alternative way to make tax allocations, a method not yet sanctioned by the IRS. After explaining these tax allocation requirements and provisions, this article will also explain the need to require distributions to partners to ensure they have cash to pay their taxes and required provisions to grapple with recently adopted enhanced IRS audit powers. In this article, any reference to partnerships includes LLCs that are usually treated as partnerships for tax purposes.
Reasons for the Tax Allocation Rules. Partnerships are not taxpayers. Each year, a partnership’s taxable income, gain, loss, and deductions are allocated to its partners, who then include those allocations on their own tax returns and pay any required tax that is due. I.R.C. § 702(a) (a partner gets Schedules K-1, K-2, and K-3 setting forth detailed information). Some partnerships provide that all contributions to the partnership and all partnership distributions are made among the partners based on a fixed percentage interest assigned to each partner. In such cases, tax allocations could be made based on those same percentage interests over the life of the partnership, which is referred to as “straight-up” allocation that may satisfy the SEE requirement.
Many partnership agreements, however, have more complex distribution provisions. Distributions may provide that a preferred return is first paid to the cash-contributing partners and then excess cash flow is distributed among all partners based on certain sharing ratios that may change over time. Straight-up allocations do not work for these more complex deals.
In the past, some partnerships also disproportionately allocated substantial tax losses to certain partners, which allocations had no economic reality. For example, a tax-exempt entity and a taxable investor formed a partnership with each having a 50 percent requirement to contribute capital to the partnership and a 50 percent right to all distributions. Because the tax-exempt partner could not use tax losses generated in the early years of the partnership’s existence, tax losses would be allocated 100 percent to the taxable investor, but with no change in how the cash flow may be shared. This special tax loss allocation did not alter how partnership distributions were to be made (i.e., they were still made 50–50 between the two partners), so this special allocation had no basis in economic reality. These actions were abusive and required action by the IRS.
Adoption of Tax Allocation Regulations. In the late 1980s, the IRS found a way to stop these abuses by adopting detailed regulations creating guidelines for when allocations will have SEE. Reg. § 1.704-1. If SEE is lacking, the IRS can reallocate taxable income and loss in a way that matches the PIP. In the example discussed above, these rules require losses to be allocated 50–50 (that is, the IRS would assert each partner had a 50 percent PIP and tax losses should be made in accordance with that 50 percent sharing ratio) unless the partner getting the loss allocation takes some risk that this allocation will alter the 50–50 sharing of distributions upon liquidation of the partnership, as discussed below.
Partnership tax losses that satisfy the SEE rules also are subject to added tax hurdles before they can be used to offset other taxable income. Tax losses can be used to offset non-partnership income only to the extent of the partner’s basis for the partnership interest. I.R.C. § 704(d)(1) (for example, if a partner has a $10,000 basis for its partnership interest and the partnership allocates a $100,000 loss to that partner, only $10,000 of that loss can be used to offset non-partnership income; the remaining $90,000 of losses are suspended and carried over to the next year, when they can be used if added basis is then created (such as by contributions to the partnership or partnership income from the next year allocated to that partner)), (d)(2). The inclusion of a partner’s share of partnership debt in the partner’s basis for its partnership interest often means this rule is not an obstacle to using tax losses. Id. § 752(1). For example, in a 10-partner partnership, each partner initially contributes $10,000 cash to the partnership for a 10 percent partnership interest, which gives each partner a $10,000 basis for its partnership interest. The partnership then borrows, on a nonrecourse basis, $900,000 and uses that borrowed money and the $100,000 aggregate cash contributed by all its partners to buy a $1,000,000 rental real estate property. Each partner is allocated 10 percent of the $900,000 nonrecourse debt, or $90,000, which can then be added to the basis of each partner’s interest in the partnership. As a result, the basis of each partner’s interest in the partnership is now $100,000 ($10,000 attributed to the cash capital contribution and $90,000 attributed to its share of partnership debt). In this case, a $100,000 loss can be allocated to a partner who has a $100,000 basis and without running afoul of this basis limitation rule. Also, the passive activity loss rules (I.R.C. § 469) and the at-risk rules (id. § 465) may limit use of partnership tax losses. The PAL rules may apply to a real estate partnership and, in that case, allow only passive losses to offset passive income and not active business income or portfolio income, which is investment income such as dividends, interest, and capital gains. A person may be a partner in two real estate partnerships, however, and have a $10,000 loss from one partnership and $10,000 worth of income from another partnership. If the passive loss rules apply to both partnerships, then the $10,000 passive loss can offset the $10,000 passive income. For real estate partnerships, the at-risk rules may not limit use of losses if the partnership has only qualified nonrecourse financing, which is often the case. Id. § 465(b)(6). There is also a broadly drafted partnership anti-abuse rule that is an added weapon the IRS may apply to an abusive situation. Reg. § 1.701-2. Despite these limitations, tax losses are still valuable to many investors.
Basic Requirements to Comply with Regulations. The SEE regulations create three requirements for allocations to have SEE:
Reg. § 1.704-1(b)(2)(ii)(b), (d). To comply with the first requirement, a capital account is maintained for each partner. Id. § 1.704-1(b)(2)(iv). The capital account of a partner is increased by (1) the amount of cash and the fair market value (FMV) of property contributed by the partner to the partnership and (2) such partner’s share of partnership taxable income and gain allocated to the partner. A capital account of a partner is decreased by (1) the amount of cash and the FMV of property distributed by the partnership to the partner; and (2) such partner’s share of partnership taxable loss and deductions allocated to the partner. These are the primary ingredients of a capital account, but other adjustments also are made because property contributed to the partnership is reflected in the capital account at its FMV, rather than its tax basis, and book depreciation rather than tax depreciation is used in making future adjustments to capital accounts.
In the past, to comply with the second requirement, partnership agreements generally included a provision that distributions made in liquidation of the partnership were made in accordance with the partners’ capital accounts. These agreements provided that the partnership will liquidate after it has sold off all or substantially all of its assets. As discussed below, when targeted tax allocations are adopted, liquidating distributions usually no longer follow capital account balances.
With respect to the third requirement, a deficit restoration obligation provides that upon liquidation of the partnership, a partner who has a deficit in the partner’s capital account (i.e., the capital account is a negative number) must contribute cash to the partnership equal to such deficit, and further requires that such cash would then be distributed to other partners having positive capital accounts. In practice, most partners reject having a deficit restoration obligation since such a provision may require the partner to go out of pocket and contribute cash to the partnership.
The QIO provision was included as an alternative requirement that does not expose the partner to economic risk. A QIO provision requires a partner who “unexpectedly” receives an adjustment, allocation, or distribution that causes or increases a deficit balance in such member’s capital account (in excess of any limited amount of such deficit that such member is obligated to restore) to be allocated income and gain in an amount and manner sufficient to eliminate such deficit balance as quickly as possible. Reg. § 1.704-1(b)(2)(ii)(d). In practice, the QIO is routinely included in partnership agreements but rarely ever used. Adoption of a QIO also requires the agreement to generally prevent a loss from being allocated to a partner if that partner’s capital account would then go negative while another partner’s capital account is positive, subject to certain other adjustments.
Allowable Special Allocations of Tax Losses Under the Regulations. Based on the SEE regulations, if a special allocation of a tax loss is desired, then that loss must reduce that partner’s capital account, and that capital account must govern how liquidating distributions are made. The effect of these rules is that a partner receiving a special allocation of loss must be subject to some real economic loss that may result in liquidation of the partnership, as illustrated below.
A and B form a partnership. Each partner contributes $500 to the partnership in which they are equal 50–50 partners. The partnership uses the $1,000 cash to buy depreciable property. In the first year, the partnership incurs a $100 taxable loss because of $100 of depreciation claimed on its assets. That depreciation lowers the tax basis of the property from $1,000 to $900. If that $100 loss is specially allocated to B, then the capital account of B gets reduced to $400 (i.e., $500 cash contribution minus $100 loss) yet A’s capital account stays at $500.
If the partnership sells its assets for $900 cash at the start of the second year, no taxable gain will be recognized on the sale because the $900 sale price matches the $900 adjusted tax basis of the property. If the partnership liquidates, then the $900 of cash liquidating distributions must follow capital accounts so that A gets $500 cash yet B gets only $400 cash. B was subjected to the $100 tax loss in the first year, but B then gets $100 less cash on liquidation of the partnership, so the allocations have SEE and are respected by the IRS.
If the liquidating distribution did not follow capital accounts and the partners split the cash distributed in the liquidation in equal shares (50–50) so that A and B each get $450 cash, then the special allocation of the $100 loss to B did not have SEE. In that case, the IRS would reallocate that $100 loss in the first year equally between the partners to match their 50 percent interest in the partnership. As a result, $50 of the loss would be reallocated to A and only the remaining $50 allocated to B. After that reallocation, the capital accounts of both partners would be $450 (i.e., $500 initial cash contribution minus $50 loss), which matches the cash that each is to receive upon liquidation of the partnership.
Compliance with the SEE regulations thus exposes a partner who receives a special allocation of loss to the risk of getting less cash on liquidation of the partnership. That risk may be reduced if there is an expectation that the property will be sold in the future at a taxable gain (that is, a price higher than its tax basis). In that case, the partnership agreement can contain both (1) a special allocation of loss to a partner and (2) a special allocation of gain on a sale of partnership property to the partner who enjoyed the earlier special allocation of tax loss up to the amount of the earlier tax loss.
In this example involving a special loss allocation in the first year, if the property was sold for $1,000 at the start of the second year, then the partnership recognizes a $100 taxable gain (i.e., $1,000 sale price minus $900 tax basis). The partnership agreement could specially allocate the $100 gain to B to offset the effect of the first year $100 loss allocation. B’s capital account would then be increased to $500 ($400 at the start of year two increased by the $100 gain). If the partnership then liquidated, then the $1,000 cash could be shared $500 to A and $500 to B as that would match their capital accounts.
If the property is sold for more than $1,000 (such as $1,200), then there is $300 taxable gain to allocate on the sale ($1,200 sale price minus $900 basis). The first $100 of gain would be allocated to B to offset the prior $100 loss allocation, and the excess $200 gain would be allocated in the basic 50–50 sharing ratio so that $100 is allocated to A and $100 is allocated to B. In that case, the capital accounts of A and B would each be $600 after taking into account these gain allocations, and the cash distributed in liquidation could be split $600 to A and $600 to B to match their capital accounts.
Concerns with Technical Compliance with the Regulations. These SEE tax allocation provisions caused two main concerns for investors.
First, tax was shaping how cash would be distributed in liquidation, because the regulations require that capital accounts, as determined under tax rules, determine how liquidating distributions are made. For many investors, their investment in the partnership was not driven by taxes or a desire to enjoy tax losses but rather by economics. If these tax allocations did not work properly, investors may not get the economic returns on their investments that they expected.
Second, even in deals that did not have any special allocations of tax losses, many partnerships contain complex distribution provisions. With this added complexity in how cash is shared comes a matching complexity in how taxable income, gain, loss, and deductions are shared among the partners, which led to so-called waterfall allocations, which are a series of steps in how to allocate income and loss. For example, taxable income first can be allocated to partners entitled to a preferred return on their capital, and thereafter, taxable income may be allocated reflecting rights to further distributions. These waterfall allocations can become even more complex because an allocation of taxable income should not be made to a partner to reflect a cash distribution made to a partner that is intended to be a return of invested capital. Those waterfall tax allocations affect capital accounts, which in turn governs the cash the investors get when the partnership is liquidated.
For example, the business deal may be that partnership distributions (that is, cash flow from operation of the real estate project or from its sale) are shared as follows:
The resulting tax allocation provisions can contain several matching levels of how tax allocations are made that may use a 99–1 percent ratio, a 90–10 percent ratio, and an 80–20 percent ratio or some other ratio. Since these tax allocations are reflected in capital accounts, every investor (or counsel) must carefully review these tax allocation provisions to make sure they reflect the economic deal of the partners and do not distort it.
Alternative-Targeted Tax Allocations. As a result, many clients who had no intention to avoid paying taxes wanted to (1) eliminate the requirement to have liquidating distributions made in accordance with capital accounts; (2) shorten the tax allocation provisions; and (3) ideally, do both. The “targeted” tax allocation provision was the way found to address those concerns. Rather than having detailed steps on how taxable income and loss may be allocated, the basic tax allocation provision is reduced to one paragraph, which generally reads as follows:
Partnership Profit or Loss for any fiscal year (or portion thereof) shall be allocated in a manner so as to cause the Partners’ ending Capital Accounts (after adjusting for such allocations) to equal the amount they would receive if the Partnership were to sell all of its assets for their book value, pay all Partnership liabilities and liquidate pursuant to the liquidation provisions set forth in this Partnership Agreement.
In summary, this targeted tax allocation provision requires that at the end of each year, tax allocations for that year are made such that, after taking these allocations into account in computing capital account balances, those adjusted capital account balances (i.e., the target) will equal what the partners are to receive under the basic distribution provisions of the partnership agreement assuming (1) all partnership properties are sold at their book value; (2) all partnership liabilities are paid; and (3) any remaining cash is distributed to the partners in accordance with how distributions are to be made when the partnership liquidates. Use of book value does not require the partnership to compute and obtain an appraisal to determine the FMV of its properties; rather, the partnership uses the book value of its assets that are maintained on its financial records, which simplifies the computation.
A favorable effect of the targeted tax allocation provision is that the partnership agreement does not provide that liquidating distributions are made to match capital accounts. Rather, the agreement has a clear direction regarding how cash is to be distributed in liquidation of the partnership that does not rely on tax concepts; this approach can make clients feel more comfortable that their partnership agreement matches their economic expectation. This approach, however, does not comply with the regulatory requirement for liquidating distributions to follow capital accounts, and the IRS has not yet made any announcement as to whether targeted allocations may be respected. Nonetheless, these targeted allocations may be respected because the tax allocations are to match up with the intended cash distributions; therefore, there is real economic significance to this provision that should have SEE or, alternatively, reflect the PIPs.
Targeted tax allocations put pressure on the accountants that prepare and file the partnership’s tax return as they are not given clear step-by-step directions as to how to allocate tax items. Each year, the accountants must go through the task of making sure they apply the tax allocations correctly so that the capital accounts wind up at the targeted level. If the accountants make an error, then the IRS can correct the tax allocations. By contrast, if capital accounts governed how liquidating distributions are made, then the IRS may accept those tax allocations without question, but the capital accounts may be at a level that does not match the economic deal of the partners and may distort liquidating distributions. For many investors, the risk of an IRS audit and a possible tax adjustment is of less concern than the risk of getting cash coming out of the partnership in the wrong manner if capital accounts determine how cash is to be distributed on liquidation of the partnership.
Targeted capital accounts are not perfect for every deal. For example, if there are pension fund investors in a real estate partnership, those investors generally want the partnership to avoid generating unrelated business taxable income (UBTI), which is taxable to those investors despite their general tax exemption. Although use of leverage by the partnership to acquire its property may generate UBTI, there is an exemption from UBTI for pension fund investors and certain other tax-exempt entities if the tax allocations satisfy the “fractions rule” set forth in I.R.C. § 514(c)(9)(E) and the tax allocations have SEE. In that case, targeted tax allocations likely do not work to satisfy this requirement, and liquidating distributions should be made in accordance with capital account balances.
Although it is possible to specially allocate taxable losses among the partners (as discussed earlier), the partnership agreement generally will have to provide that liquidating distributions are made in accordance with capital accounts to ensure that special loss allocations are respected. Also, targeted tax allocations may need to be supplemented to address what happens when property is contributed to a partnership and the FMV of the property on the date of contribution does not equal its tax basis. In that case, I.R.C. § 704(c) and the regulations thereunder add another set of special allocation rules that need to be addressed. For example, if a partner leaves the partnership before year-end, there is a need to close the books of the partnership and apply targeted allocations at that time, which gets complex.
After the end of the year, a partner gets Schedules K-1, K-2, and K-3 from the partnership stating the partner’s share of partnership income, gain, loss, or deductions for that year, and the partner must then pay any tax due. That partner may not have received any cash distribution from the partnership, however, and must then pay out of pocket the cash needed to pay taxes on any income or gain allocated to the partner. This concern is especially important for minority partners, who often have no control over whether distributions will be made by the partnership.
To ensure each partner has cash to pay taxes, the partnership agreement should require the partnership to make annual cash distributions to partners to give them cash to pay their taxes (tax distributions). The tax distribution will typically equal the amount of taxable income allocated to a partner multiplied by the effective federal, state, and local tax rates applicable to the partner. There are several issues that should be considered in drafting a tax distribution provision:
The Bipartisan Budget Act of 2015 (BBA) dramatically overhauled the rules applicable to audits of partnerships. Pub. L. No. 114-74, 129 Stat. 584 (Nov. 2, 2015). The BBA’s new centralized partnership audit regime generally provides for determination of adjustments (and assessments and collections of tax attributable to such adjustments) at the partnership level. The centralized partnership audit regime is effective for tax years beginning on or after January 1, 2018.
Before the BBA’s new audit regime, an IRS audit of a partnership had the potential to result in a disallowance of tax losses claimed by a partnership or an increase of taxable income of the partnership. But the IRS was then generally forced to collect any unpaid taxes from each of the partners, which severely restricted the ability of a partnership tax audit to actually collect unpaid taxes. By contrast, the BBA audit regime provides that once the IRS has issued a Notice of Final Partnership Adjustment, the partnership must now pay the taxes due directly to the IRS, subject to certain limited exceptions. I.R.C. § 6221(a). The most notable exception that eliminates the need for the partnership to pay the tax assessment applies if the partnership makes a “push-out” election, which shifts the responsibility to those persons who were partners for the year to which the tax adjustment relates. Id. § 6226(a). If a person becomes a partner in an existing partnership that may be subject to audit for a prior year, it is generally advisable to request that the partnership make the push-out election. If the election is not made and the partnership must pay the tax assessment, then that newly admitted partner is bearing some of the cost of that tax assessment that relates to a time period before becoming a partner. The one downside of making the election is that the interest rate for which past tax and penalties are to be collected will be the corporate rate, rather than the individual rate, regardless of the type of partner. Reg. § 301.6226-3(c). This interest rate will be calculated as the short-term applicable federal rate plus five percent (versus the three percent used for individuals).
Another major change is that to ensure the IRS has a single point of contact with the partnership to handle a tax audit, a partnership representative must be appointed to deal with the IRS in the audit. If that partnership representative is not an individual, a designated individual must then be appointed to deal with the IRS. I.R.C. § 6223(a); Reg. § 301.6623-1(b)(3)(ii). (Pre-BBA law provided for appointment of a tax matters partner (TMP) to deal with the IRS on audits, but the TMP had far less powers. For partnerships that were in existence before 2018, the TMP may still be relevant for audits of a pre-2018 year. For the partnership, this point of contact has the important power to settle the audit with the IRS.)
These new audit rules make it important for the partnership agreement to incorporate a tax audit provision that should address several issues, including:
Tax allocation provisions can become very complex. Although targeted tax allocations may not be the perfect fit for all situations, they can be a good practical choice to reflect the tax requirements and the business deal of the partners. In addition, adoption of tax distributions and audit provisions is also appropriate. The bottom line is that a tax advisor may need to be consulted to incorporate these provisions, but when a meeting with that adviser takes place, real estate lawyers can now have a better understanding of what the tax advisor is recommending and ensure tax does not distort their client’s business deal or leave their client short-changed if the client must pay taxes or deal with a tax audit.
