Flexibility in retroactive partnership agreement amendments.
Sometimes at the end of the partnership's tax year (or beyond that time), partners may wish to retroactively change their arrangement for the year. In some circumstances, the partners make these changes simply to adjust their economic deal, but often the changes are intended to address potential tax problems discovered in preparation of the partnership's tax return. In many situations, Sec. 761(c) will permit such changes, but that flexibility is not without limits.
How Much Flexibility Is There?
According to Sec. 761(c), a partnership agreement includes any modifications made prior to or at the time prescribed for filing the partnership return for the tax year (not including extensions) that are agreed to by all the partners or adopted as otherwise required by the partnership agreement. Such modifications ordinarily relate back to the beginning of the tax year for which the return is due to be filed.
The alteration of rights and obligations among the partners can have many effects. Most typically, the partnership agreement will be altered to amend the profit and loss sharing ratios for the prior year. Although the retroactive amendment under Sec. 761 (c) can relate only to the partnership's prior tax year, the IRS appears to have permitted partners to adjust, for a tax year, the sharing of unrealized appreciation in partnership assets even when the unrealized appreciation spans several years (Letter Ruling 9821051).
Alterations of profit or loss may be made for a number of reasons, including to recognize the relative value of the services provided by the partners in the prior year. Obviously, a change in the partnership's profit and loss sharing ratios will alter the reported taxable income or loss. Such a change can also have other ancillary effects, such as changing the way nonrecourse liabilities may be shared among the partners under Sec. 752 (Regs. Sec. 1.752-3(a)(3)).
But what limits may exist on the use of retroactive amendments to change the partners' tax situation? With respect to changing the allocation of income or loss, there would appear to be two primary limitations.
* The amendments must provide for allocations that will have substantial economic effect or that will be recognized as in accordance with the partners' interests in the partnership (Sec. 704(b)).
* When there has been an admission of new partners or an additional contribution of capital by existing partners, Sec. 706(d) operates to limit the reallocation of partnership items. Partnership agreements cannot be modified to retroactively allocate partnership income or loss to a partner when the income or loss accrued prior to the partner's entry into the partnership. Moreover, an existing partner may not receive retroactive reallocations for additional capital contributions. This "varying interests" rule of Sec. 706(d) also affects retroactive allocations when a partner's interest in the partnership has been reduced.
What limits may exist for altering the sharing of liabilities among partners? As mentioned above, to the extent that the sharing of profits and losses is properly amended, that may affect the sharing of nonrecourse liabilities. In addition, when a partnership liability is already treated as a Sec. 752 recourse liability because a partner has the risk of loss for the liability, it may be possible for partners to alter their risk sharing for the liability. It appears that this result could be accomplished by retroactively modifying the partners' deficit restoration obligations to reallocate responsibility among the partners for the economic loss that the partner with the preexisting risk of loss otherwise would have to bear (see, e.g., IRS Non-Docketed Service Center Advice Review TL-N-1611-96 (4/5/96), 1996 WL 33325672). Such a shifting of recourse liabilities (or qualified nonrecourse liabilities) could also affect a partner's at-risk basis under Sec. 465.
It is far less clear, however, that a partnership agreement could be retroactively amended to cause a partnership liability to be treated as a Sec. 752 recourse liability when, as of year end, no partner actually bore personal responsibility for the debt. See, e.g., Hubert Enterprises Inc., TC Memo 2008-46 (partners retroactively amended the partnership agreement to take on a deficit restoration obligation and purportedly conveyed rights to partnership creditors for amounts that ultimately might be contributed; the amendment, however, occurred after the time required under Sec. 761(c)). Such a change would go beyond merely altering the deal made among partners and would affect third parties who are not parties to the partnership agreement. There appears to be no authority directly addressing this situation, and the scenario may be beyond the intended scope of Sec. 761(c).
How Formal Does the Modification Need to Be?
Modifications for a particular tax year will be given effect if agreed to by all the partners or adopted as otherwise required by the partnership agreement. Modifications may be oral provided they are made in conformity with the partnership agreement or are otherwise binding among the partners. Obviously, relying on oral modifications can be risky. They require sufficient evidence to prove that there has in fact been a modification and that it was timely. Partnership returns and Schedules K-l, Partner's Share of Income, Deductions, Credits, etc., consistent with the modifications may help support the inference that the agreement has been modified, as would testimony and consistent actions among the partners. In the long run, however, it is far preferable to have a written modification if at all possible.
Timely modifications to a partnership agreement can allow partners to engage in a measure of self-help to change their economic and tax situations. The flexibility is not without limits, but by operating within these limits, tax advisers may be able to address potential problems for their clients that might be unsolvable if limited by the terms of the partnership agreement that existed at the end of the partnership's tax year.
FROM DEBORAH SWANN, J.D., AND JIM SOWELL, J.D., LL.M., WASHINGTON, DC
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|Author:||Swann, Deborah; Sowell, Jim|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2008|
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