Partnerships do not pay federal income tax. Instead, the partners of the partnership pay income tax on their distributive shares of the partnership’s income. Their distributive shares of income are determined under the partnership agreement, if the partnership agreement properly allocates the partnership’s income.
One method of allocating partnership income is the “targeted capital account” method. Thoughtful practitioners who use targeted capital accounts believe that method allocates items in accordance with the partners’ interest in the partnership under Treasury Regulation § 1.704-1(b)(3), or in accordance with the economic equivalence test under Treasury Regulation § 1.704-1(b)(2)(ii)(i). The Internal Revenue Service is not yet convinced, publicly anyway. The IRS has, however, added guidance for the targeted capital account method in its 2016-2017 Priority Guidance Plan.
Employing the targeted capital account method seems simple on the surface. Compute for each partner the difference between the amount that would be distributed to that partner on a liquidation as of the end of the allocation year minus that partner’s actual capital account balance as of the beginning of that year (adjusted for distributions and contributions during that year). Target allocations can be a lot more complex than they seem, even where the partnership has a relatively simple economic arrangement.
Practitioners use target capital accounts especially where some partners enjoy a preference on distributions. For example, assume A and B form a partnership AB on January 1, 2016. A contributes $1,800 cash and B contributes $200. Under the deal, cash is distributed as follows:
All to A until A is returned $1,600 of A’s contributed capital
50% to A and 50% to B until they are both returned all contributed capital,
the balance, 60% to A and 40% to B.
AB uses its $2,000 to buy land. It then enters into a land lease under which it realizes $200 of net income.
In 2016, AB had $200 of taxable income and realized $200 of cash. AB did not distribute cash to A or B during 2016. In that case, income would be allocated 60% to A and 40% to B. However, all $200 would be returned to A. So, B is allocated $80 of income, but receives no cash. In that case, B must use B’s own cash to pay income taxes on that $80 of income.
Enter tax distributions. The ideal tax distribution covers the spread between a partner’s tax on its distributive share of income for a given year and the cash distributed to it in that year under the economic deal.
The decision to pay tax distributions is well-intentioned. However, if the partnership is using targeted capital accounts, the person drafting the partnership agreement must exercise some care. At a minimum, the draftsperson should consider how the distributions change the economic deal and add provisions to correct the change – to restore the economics as much as possible. One remedy is to treat the tax distributions as a loan. In the example above, tax distributions to B can be treated as a loan to B that B is obligated to repay, regardless of the performance of the partnership.
In the alternative, the agreement can provide that B’s tax distribution is an advance on future distributions. However, if the partnership adopts that approach, it must consider how those distributions affect income allocations. If the partners do not want those distributions to affect income allocations, the agreement should include language such that the target capital account balances used to calculate income for income tax purposes will not be adjusted for these distributions.
The alternative approach is far less appealing to A. If things go really badly, the economics between A and B are irrevocably affected by the tax distribution. For example, assume that the land AB acquired becomes a Superfund site. That tax distribution that B received is likely money to which A is entitled under the deal. A would have no recourse against B to get that money back, unless B had a personal obligation to repay it.
The targeted capital account allocation looks like a nice way to avoid drafting complicated allocation provisions. They can be. However, they do not relieve us from understanding how allocations and distributions – including, and especially, tax distributions – work together.