Target or waterfall: partnership allocations.

In recent years, more and more partnership agreements have been drafted using the targeted capital account approach for allocating partnership items of income or loss (targeted capital approach) versus the typical Sec. 704(b) economic effect approach (waterfall approach). Deals are increasingly complicated, investors are increasingly savvy, and partnership agreements have become significantly more complex to adjust to investor demands. As partnership agreements have evolved, the income allocation and cash distribution provisions in these agreements have become more complicated as well. This item describes two approaches to allocating partnership items of income and loss.

Because of the increasing complexity of allocations in partnership agreements, many practitioners believe that the targeted capital approach for allocating income is a simpler, more user-friendly method to follow than the traditional waterfall approach. The increasing complexity of profit allocation and cash distribution provisions in traditional partnership agreements makes it easier for errors to be made when drafting agreements.

Some practitioners feel the targeted capital approach provides for allocations that more closely resemble the true economic realities of partnership agreements, as the allocations of partnership income/loss follow the cash distribution and liquidating provisions in the agreements. Other practitioners argue that the targeted capital approach would not be respected under the substantial economic effect provisions of Regs. Sec. 1.704-1.

Another perceived downside to the targeted capital approach is that often the partnership agreement does not adequately address nonrecourse deductions, depreciation recapture, and minimum gain. While there is some controversy among tax practitioners as to whether the targeted capital approach would be respected under Regs. Sec. 1.704-1, use of the targeted capital approach to allocations has become quite common when drafting partnership agreements because this method reflects the economic arrangements of the partners in the deal.

Agreement Using the Waterfall Approach

A typical partnership agreement drafted using a waterfall approach contains several tiers of income/loss allocations that define the priority in which partnership items of income/loss are to be allocated. These agreements also contain several tiers of cash distribution provisions that define how partnership cash gets distributed to the partners.

The agreement typically contains key provisions that extract language from the regulations to allow the allocations of the partnership to meet the substantial economic effect test, thus allowing the allocations to be respected under Sec. 704(b). Failure to follow the rules under Sec.

704(b) when drafting a partnership agreement can result in adjustments by the IRS to reflect what it believes is the economic arrangement of the partners.

An agreement using the waterfall approach might look like this:

1. Profit Allocations

* First, to reverse all cumulative allocations of net loss;

* Second, to the partners in proportion to their percentage interests (as defined in section x) until each partner receives a preferred return of 12% on his or her unreturned capital;

* Third, 75% to class A partners and 25% to class B partners until class A partners' capital account balances are increased to a level at which an immediate distribution of such capital account balance to a class A partner would cause a class A partner to receive a preferred return of 16%;

* Fourth, the balance 50% to class A partners and 50% to class B partners.

2. Loss Allocations

* First, among all partners to offset in reverse order all prior income allocations on a cumulative basis;

* Any remainder shall be allocated to the partners in proportion to their percentage interests (as defined in section x).

3. Cash Distributions

* First, 100% to the partners in proportion to their percentage interest (as defined in section x) until each partner receives a preferred return of 12%;

* Second, 75% to class A partners and 25% to class B partners until class A partners receive distributions that yield a preferred return of 16%;

* Third, the balance 50% to class A partners and 50% to class B partners.

Caution: Drafting partnership agreements is a legal matter that should be undertaken by legal counsel familiar with partnerships.

Agreement Using the Targeted Capital Approach

Companies that employ the targeted capital approach make income/loss allocations based on a determination of each partner's capital account balance at the end of the year--a target. Each partner's capital balance at the end of each year is determined by calculating how much cash each partner is entitled to upon liquidation of the partnership. In essence, the income/loss allocations are "backed into" by forcing the ending capital account balances to be what the partners would receive upon liquidation of the partnership.

Agreements written using the targeted capital approach do not contain the same Sec. 704(b) wording that is contained in a waterfall approach agreement.

An agreement using the targeted capital approach might look like this:

1. Profits and Losses

Net profits are first allocated to the partners having negative capital account balances, in proportion to their adjusted negative capital accounts.

The remaining profits or net losses shall be allocated to the partners to create capital account balances for the partners that are equal to the amount of cash that would be distributed under the cash distribution provisions of this agreement. If an allocation of net losses exceeds the positive capital account balances of the partners, the excess shall be allocated in accordance with the partners' percentage interests (as defined in section x).

2. Cash Distributions

* First, 100% to the partners in proportion to their percentage interests until each partner receives a preferred return of 12%;

* Second, 75% to class A partners and 25% to class B partners until class A partners receive distributions that yield a preferred return of 16%;

* Third, the balance 50% to class A partners and 50% to class B partners.

Caution: Drafting partnership agreements is a legal matter that should be undertaken by legal counsel familiar with partnerships.

Sec. 704(b) Regs.: Economic Effect

Partnership allocations will generally be respected under Sec. 704(b) if the allocations meet one of two tests:

1. The allocations have substantial economic effect; or

2. The allocations are in accordance with the partner's interest in the partnership.

The substantial economic effect analysis has two parts that evaluate whether an allocation both has economic effect and is substantial. The regulations maintain that the allocations will have economic effect if (1) the partners' capital accounts are maintained in accordance with the capital accounting rules; (2) upon liquidation, distributions are required to be made in accordance with positive capital account balances; and (3) there is an unconditional obligation to restore the deficit balance if a partner has a deficit capital account balance following the liquidation of his or her interest (also known as a deficit restoration obligation (DRO) (Regs. Sec. 1.704- l(b)(2)(ii)(b)).

If the allocations do not meet the economic effect test, the regulations provide an alternative economic effect test (Regs. Sec. 1.704-1(b)(2)(ii)(d)). Under the alternative test, allocations will be respected if the partners' capital accounts are maintained in accordance with the capital account maintenance rules under Sec. 704(b) and liquidating distributions are required to be made in accordance with positive capital account balances. Instead of a DRO, for allocations to qualify under the alternative test the agreement must include a qualified income offset provision. A qualified income offset provision maintains 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 partner's capital account as quickly as possible.

Sec. 704(b) Regs.: Substantiality

In addition to having to meet the economic effect provisions of the regulations, the partnership allocations must be "substantial" in order to be respected under Sec. 704(b) (Regs. Sec. 1.704-1(b) (2)). Substantiality largely requires a facts-and-circumstances analysis. Agreements should be reviewed to ensure that allocations are substantial--that is, according to the regulations, where there is "a reasonable possibility that the allocation.., will affect substantially the dollar amounts to be received by the partners from the partnership independent of tax consequences" (Sec. 1.704-1(b)(2)(iii)).

Partners' Interest in the Partnership

If allocations do not meet the substantial economic effect test, they are then determined according to Sec. 704(b) by looking at the partners' interests in the partnership, which involves taking into account all the facts and circumstances relating to the economic arrangement of the partners. Some of the factors considered include the partners' relative contributions to the partnership, the partners' interests in economic profits and losses (if different than in taxable income or loss), the partners' interests in cashflow and other nonliquidating distributions, and the partners' rights to distributions of capital upon liquidation.

Analysis

One practitioner argument, albeit simplified, against using the targeted capital approach is that the allocations in this approach do not meet the "substantial economic effect" test of Regs. Sec. 1.704-1 and may not be respected under IRS audit. Targeted capital approach partnership agreements are typically not written with a provision that liquidation will occur in accordance with positive capital accounts, nor do they contain a DRO or a qualified income offset provision. Practitioners who favor the targeted capital approach argue that the approach more closely reflects the economic arrangements of the partners in the partnership and for this reason should be respected because it reflects the partners' interests in the partnership. Although the targeted capital account approach might not satisfy the Sec. 704(b) regulations under the substantial economic effect test, it may qualify under the partners' interest in the partnership test. It should be noted that in newer targeted capital agreements, drafters make a conscious attempt to word the agreements to pass the substantial economic effect test.

Computing Income Allocations

Following are some examples of computing income allocations under the waterfall and targeted capital approaches.

Example 1--traditional waterfall approach: Partner A of AB Partnership contributes $100,000 cash to AB, and partner B contributes $50,000 cash. The partnership agreement dictates that profits are allocated to each partner first to the extent of a 5% cumulative annual preferred return on unreturned capital and second 50% to A and 50% to B. Losses are allocated first to the extent of positive capital account balances and second 50% to A and 50% to B. Cash is first disbursed to pay the preferred return, second to pay any unreturned capital, and last 50% to A and 50% to B. In year 1, AB had net income from ordinary operations of $60,000 and distributed the entire $60,000 in cash. Under this traditional waterfall allocation, the capital accounts would resemble Exhibit 1.

Profit allocations in year 1 to A would be $31,250 and to B would be $28,750, for a total income allocation of $60,000.

In year 2, the partnership has $10,000 of income and distributes $110,000. Profit allocations in year 2 to partner A would be $5,813 and to partner B would be $4,187, for a total income allocation of $10,000. (See Exhibit 2.)

Example 2--targeted capital account approach: Partner A of AB Partnership contributes $100,000 cash to AB and partner B contributes $50,000 cash. The partnership agreement states that net profits are first allocated to the partners having negative capital account balances, in proportion to their adjusted negative capital accounts. The remaining profits or net losses are allocated to the partners to create capital account balances for the partners that are equal to the amount of cash that would be distributed under the cash distribution provisions of the agreement. If an allocation of net losses exceeds the positive capital account balances of the partners, the excess is allocated in accordance with the partner's percentage interest. Cash is disbursed first to pay the preferred return (5% cumulative annual on unreturned capital), second to pay any unreturned capital, in proportion to the unreturned capital account balances, and last 50% to A and 50% to B. In year 1, AB had net income from ordinary operations of $60,000 and distributed the entire $60,000 in cash.

Under the targeted capital approach, the capital accounts would resemble Exhibit 3 prior to the current-year income allocation.

Total capital to target allocate would be $150,000, which is equal to the $150,000 initial contribution plus the $60,000 income allocation less the $60,000 current-year cash distribution. If the partnership were to liquidate with a balance of $150,000 of cash and capital, the first $65,000 would go to A as the return on capital that has yet to be distributed, and $32,500 would go to B. The remaining $52,500 would be split 50/50 in accordance with the final tier of cash distributions listed in the partnership agreement. Income allocations would therefore be $31,250 to A and $28,750 to B to force the ending capital to be $91,250 to A and $58,750 to B. (See Exhibit 4.)

In year 2, the partnership has $10,000 of income and distributes $110,000. (See Exhibit 5.)

Total capital to target allocate would be $50,000, which is equal to the $150,0.00 beginning balance plus the $10,000 income allocation less the $110,000 current-year cash distribution. If the partnership were to liquidate with a balance of $50,000 in the capital accounts, the balance would be allocated 50% to A and 50% to B because at this point in year 2, all the preferred return and capital amounts have been returned. Income allocations would therefore be $5,813 to A and $4,187 to B to force the ending capital to be $25,000 to A and $25,000 to B. (See Exhibit 6.)

Under both approaches, the income allocations are the same. However, if an error was made using the waterfall approach, the error would not self-correct in year 2. If an error was made using the targeted capital approach, the error would self-correct in year 2.

Although both approaches illustrated above produced the same result, many practitioners believe that the targeted capital account approach more clearly reflects the economic arrangement agreed to by the partners. It is up to the drafters, practitioners, and partners to determine which method works best for them.

Editor Notes

Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.

From Jennifer Seaton, CPA, MST, and Jeremy Henson, CPA, MST, Chicago, IL

Exhibit 1: Year 1 capital accounts in Example 1

                                      A          B        Total

Initial capital contribution       100,000     50,000    150,000
Tier 1 profit (preferred return)     5,000      2,500      7,500
Tier 2 profit (50/50)               26,250     26,250     52,500
Tier 1 cash (preferred return)      (5,000)    (2,500)    (7,500)
Tier 2 cash (return of capital)     35,000     17,500     52,500
End of year capital                 91,250     58,750    150,000

Exhibit 2: Year 2 capital accounts in Example 1

                                      A          B        Total

Beginning capital                   91,250     58,750    150,000
Tier 1 profit (preferred return)     3,250      1,625      4,875
Tier 2 profit (50/50)                2,563      2,562      5,125
Tier 1 cash (preferred return)     j3,250)     (1,625)    (4,875)
Tier 2 cash (return of capital)    (65,000)   (32,500)   (97,500)
Tier 3 cash (50/50)                  3,813      3,812      7,625
End of year capital                 25,000     25,000     50,000

Exhibit 3: Capital accounts prior to current-year income allocation
in Example 2

                                      A          B        Total

How cash would go on liquidation
Initial capital contribution       100,000     50,000    150,000
Current-year cash distribution      (5,000)    (2,500)    (7,500)
  (preferred return of 5% on
  initial capital)
Current-year cash distribution      35,000     17,500     52,500
  (return of capital)
Capital account prior to income     60,000     30,000     90,000
  allocation

Exhibit 4: Current-year income allocations in Example 2

                                           A          B        Total

Remaining return of capital initial      65,000     32,500     97,500
  contribution of $150,000 less
  $35,000 and $17,500 distributed)
Remainder 50/50                          26,250     26,250     52,500
Targeted end of year capital             91,250     58,750    150,000
Less: capital account prior to income    60,000     30,000     90,000
  allocation
Profit allocation                        31,250     28,750     60 000

Exhibit 5: Year 2 capital accounts in Example 2

                                           A          B        Total

How cash would go on liquidation
Year 2 beginning capital                 91,250     58,750    150,000
Current-year cash distribution           (3,250)    (1,625)    (4,875)
  (preferred return of 5% on $65,000
  and $32,500 unreturned capital)
Current-year cash distribution          (65,000)   (32,500)   (97,500)
  (return of remaining unreturned
  capital)
Current-year cash distribution            3,813      3,812      7,625
  (50/50)
Capital account prior to income          19,187     20,813     40,000
  allocation

Exhibit 6: Year 2 income allocation in Example 2

                                           A          B        Total

Remaining return of capital
  (it was all returned in year 1)             0          0          0
Remainder 50/50                          25,000     25,000     50,000
Targeted end of year capital             25,000     25,000     50,000
Less: Capital account prior to income
  allocation                             19,187     20,813     40,000
Profit allocation                         5,813      4,187     10,000