Understanding ‘target capital account’ allocations

When forming a partnership, the partners have discretion when it comes to negotiating the business arrangement. However, considerations aren’t always given to both the economics of the deal and its tax consequences.

Problems often arise between which partner will include the partnership’s income or loss in their taxable income versus which will receive the cash or property distributions. (Please note: For purposes of this article, the same considerations will apply to members of a limited liability company (LLC) as a partnership.)

Section 704 of the Internal Revenue Code is the key provision that governs partnership tax allocations. The general rule states that partners may describe in their agreement how the partnership's profits and losses will be allocated among the partners; however, it must have "substantial economic effect,” meaning if a partnership agreement allocates profits or losses to a partner, that allocation must have economic impact on that partner as well.

As an example, assume Anna and Brian form a partnership and contribute cash, 75% and 25%, respectively. They agree all distributions will be shared proportionately, however profits and losses should be allocated 100% to Brian.

Even though Anna and Brian signed a partnership agreement that provides for this disproportionate income allocation, the allocation lacks tax economic substance. Anna and Brian share distributions on a 75%-25% basis, and for tax purposes they need to be allocated their proportionate share of partnership profits and losses.

Here are the three requirements that must be satisfied in order to have substantial economic effect:

  • Capital accounts must be maintained in accordance with Section 704(b)
  • Liquidating distributions must be based on positive Section 704(b) capital account balances
  • There must be a provision in the operating agreement that addresses partners with a deficit balance at liquidation, either a Qualified Income Offset (QIO) or a Deficit Restoration Obligation (DRO). Most partners will not agree to a DRO.

"Layer cake" allocations

The traditional way of dealing with the requirement of substantial economic effect was to draft allocation provisions that produced the right capital account balances. These types of allocations are referred to as "layer cake" allocations because there are multiple tiers of allocations.

An example of this is the following from a sample LLC agreement:

First, to the Members who have previously been allocated Net Losses, in proportion to the amount of Net Losses so allocated until the aggregate Net Income allocated to each such Member is equal to the aggregate Net Losses allocated to that Member; Second, to the Members to the extent of and in the amount of the distributions made until aggregate Net Income allocated to each Member is equal to the distributions made to each Member; Third, to the Managing Member to the extent of and in the amount of the distributions made until the aggregate Net Income allocated to such Managing Member is equal to the amount of such distributions made to such Managing Member; Fourth, to the Members in accordance with their respective Percentage Interests. 

“Target allocations” provisions

In recognition of the difficulty of drafting traditional Section 704(b) allocations to match the cash waterfall, partnership agreements have moved away from layer cake allocations to “targeted capital account” provisions instead.

Target allocations are intended to provide investors with allocation of profits and loss as if a hypothetical liquidation were to occur at the end of the partnership’s tax year. A target allocation is governed by specifics in the operating agreement and intended to force income and loss allocations to drive the capital accounts to line up with the agreed-upon business deal.
This type of provision reads like the following example from an LLC agreement:

Profits, losses, and, to the extent necessary, individual items of income, gain, loss or deduction of the Company shall be allocated among the Members in a manner such that the Capital Account of each Member, immediately after making such allocation, is, as nearly as possible, equal (proportionately) to the hypothetical distributions that would be made to such Member if the Company were dissolved, its affairs wound up and its assets sold for cash equal to their Book Value( Section 704(b), all Company liabilities were satisfied, and the net assets of the Company were distributions to the Members immediately after making such allocation.

Here's specific guidance to determine the allocations under this provision:

  • First, calculate federal taxable income, including any book-to-tax-adjustments.
  • Second, convert taxable income into Section704(b) book income. An example of an adjustment would be depreciation on Section 704(c) assets.
  • Third, calculate total end-of-year Section 704(b) book capital for the LLC using Section 704(b) book income calculated above. Include current year contributions, distributions or transfers in partnership interests.
  • Fourth, determine if there’s any cash waterfall distribution priority per the terms of the partnership agreement using a hypothetical liquidation.
  • Fifth, allocate ending Section 704(b) book capital among the members to determine the end-of-year target capital for each member under the term of the cash distribution provisions. Include cash waterfall priorities, if any, and be sure to review the agreement to understand whether gross revenue or expense items are assigned to the target.
  • Sixth, calculate the income or loss allocation needed for each partner in order to arrive at their end-of-year target capital.
    • If any of the partners’ capital accounts become a deficit, review whether a gain will need to be recognized per the agreement.
  • Seventh, book Section 704(c) adjustments, if any, to convert current year profit and loss allocations from Section 704(b) book income to taxable income.

On the other hand, the target capital account allocation method isn’t ideal for every business. Scenarios in which this allocation method wouldn’t be preferential include:

  • If the partnership is expected to generate losses that will cause negative capital accounts, target capital account allocations will become extremely complex and will lose their appeal.
  • If the partnership differentiates between operating distributions and liquidating distributions, target capital account allocations will always default to liquidating distributions since they’re based on a hypothetical liquidation.
  • If the partnership has tax-exempt members that must comply with Section 514(c)(9)(E), the target allocation approach might not satisfy the "fractions rule."

Targeted allocations are not without complexity as they’re based on hypothetical liquidation, which gives rise to phantom income allocated to the carried interest partner, which necessitates tax distribution and clawback provisions. The former is designed to cure the phantom income and the latter to cure the prepaid carry. The tax adviser needs to be aware of and address these issues after discussion with the partners, as these provisions will affect the economics of the deal.

Target capital allocations have become the most prominent structure used in partnership operating agreements today. Contact us today for help or guidance in interpreting, drafting or modeling out your target capital allocations.

Authors

Bonni Zukof, Senior Manager
Jacqueline Liu, Senior Manager