partnership income allocation

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• PARTNERS & PARTNERSHIPS

Target or Waterfall: Partnership Allocations

• Partnership & LLC Taxation

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:

• 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.
• 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).
• 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%

Sec. 704(b) Regs.: Economic Effect

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

• The allocations have substantial economic effect; or
• 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. 1.704-1(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 factsand- 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.

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 Allocation

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 $150,000 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.

EditorNotes

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

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or [email protected] .

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How are Partnerships Taxed: A Comprehensive Guide for Business Owners

• Banking & Finance
• Bookkeeping
• Business Operations
• Starting a Business

Partnerships are a popular business structure due to their flexibility and the ease with which they can be established. One important aspect to consider when forming a partnership is taxation. In the United States, partnerships are generally considered “pass-through” entities for tax purposes, which means that the partnership itself does not pay income tax. Instead, the income and deductions generated by the partnership are passed through to the individual partners who report their respective shares on their personal income tax returns.

The taxation of partnerships is distinct from that of corporations, where income is subject to taxation at both the corporate and individual levels. Partnership taxation involves a unique set of rules, forms, and filing deadlines, designed to ensure that each partner is taxed according to their ownership and participation in the business. To comply with these rules, partnerships must file an annual information return called Form 1065, which provides the IRS with detailed information about the partnership’s income, deductions, and distributions to partners.

Key Takeaways

• Partnerships are considered “pass-through” entities, and partners are taxed on their individual shares of the income.
• Partnerships must file Form 1065 annually to report income, deductions, and distributions.
• Understanding partnership taxation rules and filing requirements is essential for partners to accurately report income and avoid potential financial and legal consequences.

Overview of Partnership Taxation

Understanding partnership structures.

A partnership is a business structure that involves two or more people who run a trade or business together for profit. Common examples of partnerships include real estate investing partnerships, joint retail businesses, professional services firms like doctors, lawyers, and CPAs, and multi-member LLCs taxed as partnerships. It is crucial for entrepreneurs, business partners, and tax professionals to comprehend partnership taxation principles to navigate the tax implications efficiently.

Taxation Principles for Partnerships

Partnerships are considered “pass-through” entities for tax purposes. This means that the income, profits, and losses of the partnership are not taxed at the partnership level. Instead, they flow through to the individual partners who report their share of the partnership’s income, deductions, and credits on their personal income tax returns.

Here are some key elements to consider in partnership taxation:

• Allocating profit and loss: Partnerships should have a clear agreement on the allocation of profits and losses among partners. This allocation is typically based on the partners’ ownership interests or capital contributions, but it can also be customized to meet specific business needs.
• Tax deadlines: Partnerships are required to file an annual informational tax return (Form 1065) with the IRS. This form provides details about the partnership’s income, deductions, and credits. The deadline for filing Form 1065 is usually the 15th day of the third month following the end of the partnership’s tax year, i.e., March 15th for calendar-year partnerships.
• Personal tax implications: Each partner receives a Schedule K-1 from the partnership, which outlines their share of income, deductions, and credits. Partners must report this information on their individual income tax return and pay any taxes owed on their share of the partnership income.

In summary, understanding partnership structures and taxation principles is essential to managing a partnership’s tax obligations efficiently. By knowing the allocation of profits and losses, tax deadlines, and personal tax implications, partners can better navigate the complex tax landscape and ensure compliance.

Filing Requirements for Partnerships

Essential tax forms.

When dealing with partnership taxation, it is essential to familiarize yourself with the required tax forms. The primary form for partnerships is Form 1065 . This form, also known as the U.S. Return of Partnership Income, is used to report the partnership’s income, deductions, and credits. It is vital to ensure compliance with Form 1065’s requirements to avoid penalties and fulfill the partnership and its partners’ tax obligations.

Another critical form is Schedule K , which is a part of Form 1065. This schedule summarizes the partners’ shares of the partnership’s income, deductions, credits, etc. Each partner receives a Schedule K-1 , which shows their respective share of the partnership’s items. Subsequently, partners must report this information on their personal tax returns.

Annual Tax Filing Process

The annual tax filing process for partnerships involves a few crucial steps:

• Gather financial information : Collect all relevant financial data, including income, deductions, gains, losses, and other financial transactions throughout the year.
• Prepare Form 1065 : Use the financial information to complete Form 1065. Ensure that the income, deductions, and credits are accurately reported in detail.
• Prepare Schedules K and K-1 : Based on the information provided in Form 1065, calculate each partner’s share of the partnership’s items and complete Schedule K. Prepare individual Schedule K-1 forms for each partner, reflecting their specific shares.
• File Form 1065 and Schedule K-1 : File Form 1065 with the IRS by the specified deadline. Although electronic filing is optional for most partnerships, those with more than 100 partners are required to file electronically. Provide each partner with a copy of their Schedule K-1, which they must include in their personal tax returns.

Keep in mind that while the partnership files an annual information return (Form 1065) to report its operations, it does not directly pay income tax. Instead, the partnership “passes through” its profits or losses to each partner, who then reports their share on their personal tax returns. Compliance with these filing requirements is crucial for meeting both the partnership’s and the individual partners’ tax obligations.

Determining Partnership Income

Profit and loss allocation.

In a partnership, the income, deductions, and credits are allocated among the partners based on the terms agreed upon in the partnership agreement. Each partner’s share of profits and losses is known as their distributive share, which is reported on their individual tax returns.

To allocate profits and losses, start by examining the partnership agreement. This agreement should outline the specific percentage or ratio each partner receives. If the partnership agreement does not specify a ratio, profits and losses are evenly divided among all partners.

Some common allocation methods include:

• Fixed ratio : Profits and losses are allocated according to a predetermined ratio for each partner.
• Capital-based : Profits and losses are allocated based on the partner’s capital contribution or ownership percentage in the partnership.

It is essential to remember that the allocation method chosen must adhere to the partnership agreement and maintain consistency throughout the tax reporting period.

Distributive Share Calculations

Distributive shares are calculated based on each partner’s share of partnership income, deductions, and credits for the tax year. To compute a partner’s distributive share, follow these steps:

• Determine the partnership’s total income, deductions, and credits for the tax year. This information can be found on Form 1065, the U.S. Return of Partnership Income.
• Apply the profit and loss allocation method agreed upon in the partnership agreement to the total income, deductions, and credits.
• Calculate each partner’s share by multiplying their allocation percentage by the partnership’s total income, deductions, and credits.

For example, let’s say a partnership has $100,000 in income, and two partners have agreed to a 60/40 profit and loss allocation. Based on this agreement, Partner A would receive 60% of the income ($60,000), while Partner B would receive 40% of the income ($40,000).

It is crucial for partners to accurately calculate and report their distributive share on their individual tax returns to avoid IRS scrutiny. Partners must report their share of the partnership income, deductions, and credits, even if they did not receive any actual cash distributions during the tax year. This is because, in the eyes of the IRS, the partners are considered to have “constructively received” their share of the partnership income.

Deductions and Losses

Allowable business deductions.

Partnerships are entitled to various deductions that can reduce the taxable income. These deductions generally include:

• Cost of goods sold : The cost of producing or acquiring the goods or services a partnership sells. It includes material costs, labor expenses, and manufacturing overheads.
• Operating expenses : Expenses incurred as a result of a partnership’s normal business operations, such as rent, utilities, office supplies, and salaries.
• Start-up costs : Expenses incurred before a partnership begins its business operations, such as legal fees, market research, and advertising. These costs are typically capitalized and amortized over the course of several years.
• Product and advertising outlays : Expenses related to the promotion and marketing of a partnership’s products or services, such as advertising, public relations, printing, and marketing collateral.

It is crucial for partnerships to maintain accurate records and substantiate these deductions, as the IRS may require documentation during an audit.

Handling of Partnership Losses

Losses may arise when a partnership’s total deductible expenses, including business deductions and cost of goods sold, exceed its gross income. Partnerships report losses on Form 1065, and the losses flow through to the partners’ individual tax returns on Schedule K-1. The partners may use these losses to offset their other income sources, subject to certain limitations.

One such limitation is the basis limitation rule, which restricts a partner’s share of losses to the extent of their partnership basis. The Tax Cuts and Jobs Act (TCJA) added new provisions to § 704(d)(3)(A) for determining losses subject to the basis limitation. Additionally, partners in a partnership may be able to deduct 20% of their business income with the 20% pass-through deduction established under the TCJA. To take advantage of these deductions and navigate the limitations, partners should consult with a tax professional.

Tax Implications for Individual Partners

Self-employment tax responsibilities.

One major tax responsibility for individual partners in a partnership is the self-employment tax . In general, partners are considered self-employed and, as such, they’re subject to the self-employment tax. This tax consists of both Social Security and Medicare taxes. While employees usually split the payment of these taxes with their employers, partners must shoulder the entire tax burden themselves.

For general partners , their entire share of partnership income is subject to self-employment tax. However, for limited partners , only guaranteed payments for services are subject to self-employment tax. The self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. General partners must be prepared to pay this tax on their partnership income.

Reporting Partnership Income on Personal Taxes

Each partner in a partnership is responsible for reporting their share of partnership income on their individual income tax returns . To do this, partners receive a Form K-1 from the partnership. The Form K-1 provides partners with their share of the partnership’s income, deductions, and credits.

Here’s a brief overview of how to report partnership income on personal taxes:

• Obtain your Form K-1 from the partnership.
• Follow the instructions on the K-1 to report the income on your individual tax return.
• Use Form 1040 or 1040-SR to report your share of partnership income. You must also include any income subject to self-employment tax.
• Partners report their share of the partnership income on Schedule E (Form 1040). The Schedule E is for reporting supplemental income or loss, such as income from a partnership.

While reporting partnership income on personal taxes, it’s important to consider the Qualified Business Income Deduction . This deduction allows partners to take a deduction of up to 20% of their portion of business income, subject to limitations and qualifications. It’s strongly recommended to consult a tax professional to determine eligibility for this deduction.

In summary, understanding the tax implications for individual partners is crucial to managing partnership taxes effectively. Partners should be aware of their self-employment tax responsibilities and the process for reporting partnership income on their individual tax returns.

Special Considerations in Partnership Taxation

In this section, we will discuss some unique aspects of partnership taxation that affect limited liability entities and the impact of the Tax Cuts and Jobs Act on partnership taxation.

Limited Liability Entities and Taxation

Limited Liability Companies (LLCs) are popular business structures due to the legal protections and tax flexibility they offer. While an LLC can be taxed as a partnership, it can also choose to be taxed as a corporation. LLC owners, known as members, can enjoy the benefits of pass-through taxation, where the income, deductions, gains, and losses of the business flow through to the individual members’ tax returns.

Limited Partnerships (LPs) and Limited Liability Partnerships (LLPs) are also subject to partnership taxation, though they have unique characteristics. In LPs, limited partners have limited liability, meaning they are only liable for their own investment amount and not the actions of other partners. General partners, however, have unlimited liability. LLPs extend limited liability to all partners, shielding each from being personally liable for the actions of others.

While these entities typically enjoy the benefits of pass-through taxation, they must navigate the rules of Subchapter K of the Internal Revenue Code, which governs partnership taxation. To ensure compliance with these rules, it’s crucial to seek professional guidance.

Impacts of the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA), which took effect in 2018, brought about significant changes in partnership taxation. Some key impacts of the new tax laws include:

• Qualified Business Income Deduction : This new provision allows pass-through entities, including partnerships, to deduct up to 20% of their qualified business income (QBI), subject to certain limits and thresholds. This deduction can result in substantial tax savings for eligible partners.
• Changes in Depreciation Deductions : The TCJA amended the depreciation deduction rules, allowing for 100% bonus depreciation on certain qualified property through 2022, with a phase-out period through 2026. Additionally, the law increased the Section 179 expense limit.
• State and Local Tax Deduction Limitation : The TCJA imposed a $10,000 cap on the deduction for state and local taxes (SALT), which could affect partners residing in high-tax states. Certain strategies may be employed to minimize the impact of this limitation, but professional guidance is advised.

These changes brought by the TCJA have both positive and challenging aspects for partnership taxation. It’s essential for those involved in partnerships to stay updated on the current tax laws and seek professional advice to ensure compliant tax strategies.

Strategic Tax Planning for Partnerships

Partnerships, consisting of two or more individuals or entities joining together for a business venture, have unique tax considerations. Strategic tax planning can play a critical role in ensuring partners stay compliant and minimize their tax liabilities. This section will discuss some important aspects of strategic tax planning for partnerships.

Utilizing Tax Deductions

Partnerships can take advantage of various tax deductions that help reduce taxable income. Examples of common deductions include:

• Business expenses: Ordinary and necessary business expenses, such as rent, utilities, and office supplies, can be deducted on the partnership’s tax return (Form 1065).
• Section 179 expense deduction: This allows partnerships to deduct the cost of qualifying property, equipment, and software purchased or financed during the tax year. The maximum deduction for tax year 2023 is $1,070,000, with a phase-out threshold of $2,710,000.
• Charitable contributions: Partnerships can deduct contributions made to qualified charitable organizations. This deduction is passed through to the partners on their Schedule K-1, which is included with their individual tax returns.
• Retirement plan contributions: Partnerships can establish retirement plans for partners and employees, such as SEP-IRAs, SIMPLE IRAs, or 401(k) plans. Contributions made on behalf of partners and employees are generally tax-deductible.

Preparation for Tax Year End

As the tax year comes to an end, there are several steps that partnerships can take to prepare for tax filing and ensure compliance:

• Organize financial records: Maintaining accurate and organized records throughout the year allows for more efficient tax return preparation.
• Reconcile accounts: Ensure that bank accounts, credit card accounts, and other financial accounts are reconciled on a regular basis.
• Estimate tax liabilities: Partnerships should work with a tax preparer to estimate their current year tax liabilities and plan for the upcoming tax filing season. This process includes calculating estimated taxes that partners need to pay on their distributive shares of income throughout the tax year.
• Consider tax-savvy strategies: Implement tax-planning strategies to help reduce the partnership’s tax liability and the partners’ individual liabilities. Examples include accelerating expenses or deferring income to optimize taxable income, utilizing tax credits, and employing retirement plan contribution strategies.
• Consult with a tax professional: Working with an experienced tax professional who is knowledgeable about partnership taxation can help navigate the complex tax rules and regulations while providing valuable guidance on potential tax-saving opportunities.

By effectively utilizing tax deductions and preparing for the tax year-end, partnerships can ensure they meet their tax obligations while also maximizing potential tax savings.

Legal and Financial Responsibilities

Partnership agreements and tax liability.

A written partnership agreement is crucial for defining the legal and financial responsibilities of each partner within a business partnership. It outlines the terms for the distribution of profits and losses, impacting how partners file taxes and pay income tax. The partnership agreement also plays a significant role in determining the partnership’s tax responsibilities, particularly in filing Form 1065 and Schedule K-1 1 .

In the absence of such an agreement, partnerships may be subject to the provisions of the Uniform Partnership Act or relevant state laws, which can result in unintended tax consequences and liabilities. These laws generally dictate how profits and losses are allocated amongst partners.

State Law and Tax Regulation Compliance

Partnerships must comply with various tax regulations at both federal and state levels. The Internal Revenue Code governs federal tax requirements for partnerships. According to the IRS, partnerships must file an annual information return (Form 1065) to report income, deductions, gains, and losses from their operations 2 . However, partnerships do not pay income tax but instead “pass-through” profits or losses to their partners, who report their shares on personal tax returns 2 .

Partners are also required to pay estimated tax payments each quarter, typically in April, July, October, and January 3 . This requires partners to estimate the amount of tax they will owe for the year and make payments to the IRS and the appropriate state tax agency accordingly 3 . It is important to note that profits are taxed whether partners receive them or not, as the IRS mandates paying taxes on their “distributive share” 3 .

In addition to federal tax regulations, partnerships must also comply with state laws governing taxation. State tax regulations vary, so partners should familiarize themselves with the specific requirements of the state in which they operate their business. This may involve registering with the state tax agency, paying state-specific fees or taxes, and adhering to local partnership statutes.

In summary, a thorough partnership agreement helps delineate legal and financial responsibilities for partners in a business partnership, reducing the risk of unintended liabilities. Adherence to both federal and state tax regulations is crucial, as noncompliance can result in penalties and unforeseen financial burdens.

Frequently Asked Questions

What is the process for calculating taxable income in a partnership.

In a partnership structure, the taxable income is calculated at the partnership level. The net profit or loss is determined by deducting allowable expenses from the total revenue. This net amount is then allocated among the partners according to their respective ownership percentages or as agreed upon in the partnership agreement. Each partner is responsible for reporting their allocated share of the partnership’s income or loss on their individual income tax returns.

What are the key distinctions between partnership and corporate taxation?

The main distinction between partnership and corporate taxation lies in the way profits are taxed. Partnerships follow a “pass-through” taxation model, where the profits and losses pass directly to the partners who report them on their individual income tax returns. In contrast, corporations are taxed as separate entities, with profits being subject to corporate income tax. Additionally, when corporate profits are distributed to shareholders as dividends, they are taxed again at the shareholder’s individual income tax rate, resulting in double taxation.

Are partnerships subject to double taxation similar to corporations?

No, partnerships are not subject to double taxation like corporations. Partnership income is taxed only once—directly to the partners at their individual income tax rates. There is no separate tax levied on the partnership itself.

How does the income tax rate for a partnership differ from individual or corporate rates?

Partnerships do not have a separate income tax rate. The taxable income is allocated to each partner, who then pays tax on their share of the partnership income at their respective individual income tax rates. This differs from corporate taxation, where corporations pay tax at the corporate rate before distributing profits to shareholders as dividends, which are then taxed again at the individual level.

What are the primary tax disadvantages faced by a partnership structure?

One of the primary tax disadvantages of a partnership structure is the self-employment tax burden faced by general partners. General partners are responsible for paying both the employee and employer portions of Social Security and Medicare taxes on their share of partnership income. Additionally, partners may not be able to offset as much of their personal income with business losses, compared to corporations where net operating losses can be carried forward or backward to offset taxable income in other years.

In the context of a partnership, what factors contribute to the decision of being taxed as a partnership or corporation?

Several factors may influence the decision to be taxed as a partnership or corporation, including the desired level of liability protection, the potential for double taxation, and the ability to retain and reinvest earnings. Also, the ability to provide employee benefits and ease of transferability of ownership interests may impact the decision. It’s essential for partners to carefully consider these factors and consult with financial and legal professionals to determine the most suitable tax structure for their specific needs.

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Special Allocations of Profits and Losses in a Partnership

• June 26, 2019
• Business Law

When you have a business partnership (or an LLC that is treated as a partnership for federal income tax purposes), profits and losses typically need to be divided or allocated to the partners.

This is typically done in a way that corresponds with each of the partners’ percentages of business ownership.

If you want to divide or distribute profits in a way that does not correspond with the partners’ percentage interests in your business, then you need to look into something known as a special allocation.

You need to be very careful with partnership special allocations of profits and losses for purposes of taxation and the Internal Revenue Service (IRS).

Since special allocations can be used in some cases to avoid taxation, the IRS pays special attention to these situations.

If the IRS does not believe that the special allocation is legitimate, it can tax all of the partners according to their percentage interests in the business even if there is another agreement—such as your partnership agreement—that says otherwise.

To understand how special allocations work, it is essential to learn more about why they occur and how the IRS determines their legitimacy. It is also important to set up your special allocations with the help of a business law attorney . Contact us today!

Why Businesses Arrange for a Special Allocation

When you form a partnership, you will also create a partnership agreement (an operating agreement for an LLC). In a partnership, profits and losses typically get distributed to owners of the business based on their percentage interests in the partnership.

For example, imagine a business that has a partnership structure with four partners: Partner A, Partner B, Partner C, and Partner D. Each partner owns 25 percent of the business, or has a 25 percent interest in the partnership.

The U.S. Small Business Administration (SBA) makes clear that profits are passed through to the owners’ personal tax returns . In terms of typical taxation for a partnership, each partner will have profits and losses allocated according to his or her percentage interest in the business and then will pay taxes on those profits and losses .

In the above hypothetical example, each of the partners would be allocated profits and losses that correspond to 25 percent of the business’s profits and losses, and then would be taxed on that amount.

However, there are some situations in which there may be a need for a special allocation . For example, if Partner A provided all of the startup income for the business, the partnership agreement (or an operating agreement in an LLC) might stipulate that Partner A will be allocated 75 percent of the business profits and losses the first year.

This accounts for her initial investment, and the remaining three partners will be allocated equal percentages of the remaining 25 percent of the business profits and losses.

IRS Issues with Special Allocations and the “Substantial Economic Effect” Test

The above hypothetical scenario is a legitimate reason for a special allocation, but the IRS often looks closely at special allocations because they can be a way for the partners to avoid paying taxes.

For example, a special allocation could allocate a larger percentage of profits and losses to a partner who can pay fewer taxes due to his or her tax bracket.

Accordingly, the IRS looks at a special allocation to decide whether it has a “substantial economic effect.” If it does, the IRS allows the special allocation. The term “substantial economic effect” is a complicated one to understand. In short, the special allocation needs to be in line with the economic circumstances of the partners.

Given the complicated nature of special allocations, you should always work with an experienced business lawyer to ensure that the special allocation will pass muster with the IRS.

Contact a Business Law Attorney in Florida

If you are part of a partnership and you have questions about special allocations, it is extremely important to speak with a Florida business law attorney about how these work. You do not want to allocate profits and losses in such a way that violate rules of taxation.

An experienced Florida business lawyer at our firm can speak with you today about your business needs and can begin providing your partnership with information about tax law and special allocations. Contact BrewerLong today for more information about how we can help your business.

Michael Long

Michael Long, a distinguished Business and Litigation Attorney at BrewerLong, brings a unique blend of tenacity and insight to his practice, honed from his time as a decorated combat veteran in the Marines. Specializing in complex litigation, Michael adeptly navigates the intricacies of business break-ups, professional liability, and a wide array of disputes encompassing tax, trust, real estate, contract, intellectual property, and loan issues. His expertise extends to business counseling, where he skillfully handles commercial contracts, company creation, intellectual property challenges, and more. Michael’s approach is holistic; he leverages his transactional and litigation experience to foresee and tactically address both immediate and long-term client needs, ensuring practical, cost-effective solutions that maximize benefits while minimizing risks. His commitment to excellence is evident in his affiliations with prestigious organizations like the American Legion, Central Florida Christian Chamber of Commerce, and the Orange County Bar Association, among others. He’s a committed advocate, driven by a passion to deliver results and justice for his clients.

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What’s Unrealized About the Tax Treatment of Partnership Capital Shifts

Deborah L. Paul

Deborah L. Paul is a partner at Wachtell, Lipton, Rosen & Katz . She thanks Olivia Coates for her assistance.

In this report, Paul analyzes examples of partnership capital shifts and demonstrates that neither the Lehman theory, nor the guaranteed payment rules, nor the income allocation rules squarely address their proper tax treatment.

A prior version of this report was presented at the Tax Club on February 16 and at the Tax Forum on June 6. Paul acknowledges comments received at those presentations. However, the views expressed in this report are solely her own and do not, and are not intended to, represent the views of Wachtell, Lipton, Rosen & Katz or any other person.

Copyright 2022 Deborah L. Paul . All rights reserved.

I. Introduction

A. lehman : deemed payment theory, 1. entity theory of partnerships., 2. payments., 3. accrued., 4. guaranteed., c. income allocation approach, d. oid and preferred stock discount, iii. preferred discount: bargain purchase doctrine, iv. increasing common interest, v. conclusion.

Partnerships offer immense flexibility to parties intending to engage in a collaborative business or investment enterprise. Accordingly, they have long been a vehicle of choice. The federal income tax system seeks to facilitate the partnership form by imposing only a single layer of tax on partnership income — a noble but challenging endeavor.

Partnership income must be allocated annually among the partners even though not all the facts may be known as to which partner will ultimately enjoy the benefit of that income. As well, the fundamental concept that formation of a partnership is tax free under section 721 means that on formation of a partnership, a partner can, without current taxation, dispose of an economic interest in an asset that partner owns in favor of acquiring an economic interest in an asset owned by another partner. Two visions of a partnership’s nature have mediated these tensions: the entity theory and the aggregate theory. Both weave their way through subchapter K. The analysis of partnership capital shifts implicates the many tensions inherent in the noble project of subchapter K.

A partnership capital shift occurs when a partner’s economic interest in partnership capital increases and, correspondingly, another partner’s economic interest decreases. This report discusses three contexts: preferred partnership interest accruals, preferred partnership interest discount, and contingent increases in common equity. 1

Capital shifts implicate a host of concepts fundamental to federal income tax, including the realization requirement, bargain purchases, and the accrual method. They also implicate concepts fundamental to subchapter K, such as section 704(b) accounting, guaranteed payments, and the hybrid nature of partnerships as aggregates and entities. Not surprisingly, the treatment of capital shifts is unclear. Perhaps surprisingly, little authority on the subject exists outside the compensatory context. 2 In that context, regulations treat a capital shift in exchange for services as taxable to the service provider. But policies concerning compensation may differ from policies outside the compensatory context. As we shall see, competing intuitions come into play in the noncompensatory context.

Capital shifts often occur without a realization event in the traditional sense. Thus, in those cases, one could conclude that the capital shift does not give rise to income (or loss) at that time. But a competing view would deem a realization event generally under an aggregate theory of the partnership. Under yet another view, relying on an entity theory of partnerships, the capital shift would represent a guaranteed payment. But that view, too, could be questioned, both from the point of view of the realization requirement and the technical workings of the guaranteed payment rules. The section 704(b) regulations could require an allocation of income to address a capital shift — yet another aggregate theory approach. But capital shifts can occur in a partnership that does not earn income, raising a question about reliance on income allocations to address capital shifts. While each of these theories and approaches has merit, none squarely puts to rest the proper treatment of capital shifts.

II. Preferred Accretions

A fixed accretion on preferred partnership equity presents a paradigmatic case of a potential capital shift. That accretion may well represent an increase in wealth for the holder of the preferred partnership interest, implying taxable income for that partner. But because of the realization requirement, not all increases in wealth constitute taxable income. Thus, the observation that the accretion represents an increase in wealth does not resolve the question whether the accretion is or should be currently taxable. Consider the following case of an accreting return on a preferred partnership interest:

Example 1: Suppose A contributes $90 to Partnership AB for a preferred interest with a 10 percent cumulative return, and B contributes $10 to AB for a common interest. These rights are reflected in a distribution waterfall providing that the partnership is not required to make distributions but that any distributions must be made in accordance with the following priority: first to Partner A in the amount of its cumulative return, then to A in the amount of $90, and then to Partner B. B is thus entitled to the entire residual. At the end of year 1 (assuming no distributions have been made), A is entitled to the first $99 (equal to 110 percent of $90) of distributions. At the end of year 2 (assuming no distributions have been made), A is entitled to the first $108.90 (equal to 110 percent of $99) of distributions. Assume no distributions are made in either year 1 or year 2, and assume that neither partner has any deficit restoration obligation. Does A have any income inclusion, and does B have any deduction in year 1 or year 2 because of the 10 percent accretions?

Commentators have discussed this basic scenario, but no clear answer is availing. 3 Partner A appears to have an accretion to wealth each year as the 10 percent cumulates. At the end of year 1, it would appear that A is $9 wealthier than at the beginning of year 1 because A’s claim on partnership assets has increased by $9. At the end of year 2, A appears at first blush to be even wealthier by year 2’s 10 percent cumulation of $9.90. But this would not be the case (assuming the value of partnership assets has not changed) because aggregate contributions to the partnership were $100. If values have not changed, A’s $108.90 claim on partnership assets at the end of year 2 would exceed the $100 value of partnership assets. Indeed, even A’s apparent $9 increase in wealth in year 1 might not be factual if the value of partnership assets has decreased.

Increases in wealth themselves generally do not give rise to taxation because of the realization requirement. Indeed, one of the rationales for the realization requirement is that revaluing property every year would be burdensome. The determination whether Partner A has had an accretion to wealth in year 1 or year 2 depends on the value of the partnership’s assets. Thus, the case is a fair one for application of the realization requirement. It would appear that no realization event has occurred in year 1 or year 2 in connection with A’s annual increase in its claim on the partnership. No sale, exchange, distribution, or any other form of transaction or change in legal ownership of any asset has occurred. The analysis might stop at this point and conclude that A should not have an income inclusion resulting from the 10 percent accretions in year 1 and year 2. Yet that conclusion would be too quick because several counterarguments must be considered.

First, arguably, a deemed transfer of partnership assets or a partnership interest occurs in connection with a capital shift. Lehman , 4 the leading case addressing capital shifts, posits that an increase in one partner’s capital account and a corresponding decrease in another partner’s capital account are a realization event resulting in a deemed indirect transfer of partnership assets.

Under the partnership agreement, the taxpayers, husband and wife Harry and Florence Lehman , were each entitled to a $5,000 increase in their capital accounts once the other partners earned or received a specified amount of profits from the business. In that case, the same amount, a total of $10,000, was to be deducted from the capital accounts of the other partners. Harry was the sole general partner of the partnership, while Florence was one of four limited partners. Harry operated the business.

Analyzing the predecessor of section 61(a) , the Tax Court acknowledged that the aggregate $10,000 increase to the taxpayers’ capital accounts resulted from “the managerial efforts of Harry combined with good business conditions.” But the court stepped away from the notion that compensatory elements influenced its decision, stating that the court did not view it as “crucial whether the transfer to petitioners’ capital accounts was in fact ‘compensation’ for Harry’s services,” because “the increase resulted in a gain or profit” to the taxpayers. Thus, the court’s expressed concern was the taxpayers’ accession to wealth, regardless of any compensatory element.

Further, based on deemed steps, the court decided that a realization event had occurred. It distinguished the taxpayers’ case from a scenario involving “the unrealized increase in the value of a capital asset.” Instead, the court viewed the act of crediting the taxpayers’ capital accounts “by reason of transfers from” the other partners as a realization event. From the court’s perspective, the consequences should be the same as if three steps had occurred: (1) the partnership distributed $10,000 to the other partners; (2) those partners transferred the funds to the taxpayers; and (3) the taxpayers contributed the funds to the partnership. As stated by the court, “We think this situation should be no different in its tax consequences than if the partners had paid over to petitioner the $10,000 under an arrangement whereby petitioners agreed to use that sum to increase their investment in the partnership with a corresponding reduction in the capital shares of the other partners.” 5

Notably, as described, the Lehman theory would apply regardless of whether a partnership has gross or net income. Further, the theory does not depend on the occurrence of any transaction among the partners; it instead deems steps to occur. Finally, the Lehman theory does require that the partners from whom the capital is shifted have a proportionate share of partnership assets with a value equal to at least the amount of capital shifted. Otherwise, there would be no assets to deem to be transferred. 6

Applied to Example 1, the Lehman theory would deem that in year 1, $9 of capital was distributed to Partner B, transferred from B to Partner A in a taxable transaction, and then contributed by A to the partnership. In year 2, presumably only $1 of the accreted $9.90 would be deemed so transferred because (absent any change in the value of the partnership’s assets) only $1 of partnership capital remains for B’s benefit after year 1. Partnership capital would not be sufficient at the end of year 2 to pay A the full $9.90 of accretion (assuming values have not changed) because A’s claim, which would be $108.90 at that point, would exceed the partnership capital of $100.

One could challenge the Lehman theory. First, fair market values may differ from book capital. 7 The Lehman theory would seem to require an annual valuation to determine whether values have increased or decreased and thus whether partnership capital is available to shift. Suppose in Example 1 that at the end of year 1, the value of the partnership’s assets is only $60. Partner A already has a 100 percent proportionate interest in the $60 of partnership assets. It would seem that A should not have income under the Lehman theory despite the $9 increase in its claim on the partnership when there is no partnership capital for the benefit of other partners to shift to A.

One might counter that in many cases values remain unchanged or even increase, and that uncertainty in values should not prevent the government from collecting tax on what is often an accession to wealth. However, that argument assumes that the realization requirement should not apply. The very uncertainty about values is a rationale for the realization requirement. It is true that if realization has occurred, uncertainty about values does not prevent taxation. But that does not mean that realization should be deemed to occur, as under the Lehman theory, in the face of valuation challenges that the realization requirement was intended to avoid.

Second, the observation that preferred accretions can outstrip partnership capital available to be shifted, as occurs in year 2 in Example 1, further undercuts the premise that an accretion is an appropriate time to tax, because it highlights a disconnect between the business arrangement and the Lehman theory. In cases like Example 1, other partners’ contributed capital is generally not intended to be the source of payment of the preferred accretion. As a business matter, a preferred investor would not normally invest to obtain the other partners’ contributed capital, because the other partners’ contributed capital would often be insufficient to fund the preferred accretions over the long haul. In Example 1, Partner A is not looking to B’s $10 of capital to fund A’s annual 10 percent accretions over time, because B’s contributed capital is woefully insufficient to that task. Instead, business models for a preferred partnership investment would normally anticipate that the preferred accretions would be paid out of business profits, or a sale or other exit scenario. 8 This further throws into question an approach that would override the realization requirement. A simple-minded application of Lehman to the preferred accretion does imply current inclusion for the preferred holder in an amount up to the other partners’ capital (perhaps with an annual book-up or book-down), but it is not clear that the Lehman theory is appropriately applied.

B. Guaranteed Payment Theory

An alternative theory for the preferred accretions is that they represent guaranteed payments. Guaranteed payments are treated as ordinary income to the recipient and generally as an ordinary deduction to the partnership (which deduction may in turn be allocated among the partners). 9 Section 707(c) provides that to “the extent determined without regard to the income of the partnership, payments to a partner for . . . the use of capital shall be considered as made to one who is not a member of the partnership.” 10

Section 707(c) reflects an entity theory under which the partnership interacts with a partner that is a provider of capital just as the partnership would interact with a non-partner. 11 The Lehman theory, by contrast, relies on an aggregate theory under which one partner’s claim to partnership assets is shifted to another partner.

The guaranteed payment rules, like the Lehman theory, do not neatly resolve the treatment of the preferred accretion. Further, the partnership deduction (or capitalized expense) arising from a guaranteed payment may deter the IRS from embracing the guaranteed payment theory.

The legislative history of section 707(c) highlights the provision’s rejection of an aggregate theory in favor of an entity theory. Before the enactment of section 707(c) , partnerships had difficulty accounting for compensatory payments to partners that exceeded partnership income. Those payments would be treated as withdrawals of capital. Insofar as it was a withdrawal of the partner’s own capital, the payment would be tax free, but insofar as it was a withdrawal of another partner’s capital, the payment would be taxable to the recipient and deductible to the other partners — a capital shift theory similar to Lehman except that in Lehman , cash winds up in the partnership, whereas in the basic scenario addressed by section 707(c) , partnership cash is paid to, and winds up in the hands of, a partner.

Section 707(c) was intended to eliminate the complicated accounting associated with the prior-law capital shift approach by creating a partnership item of deduction and a partner item of income. As explained by the Senate Finance Committee :

The payment of a salary by the partnership to a partner for services again raises the problem as to whether the partnership is to be viewed as an entity or merely as an aggregate of the activities of the members. Under present law, fixed payments to a partner are not recognized as a salary but considered as a distributive share of partnership earnings. This creates obvious difficulties where the partnership earnings are insufficient to meet the salary. The existing approach has been to treat the fixed salary in such years as a withdrawal of capital, taxable to the extent that the withdrawal is made from the capital of other partners. Such treatment is unrealistic and unnecessarily complicated. The House bill provides that payment of a fixed or guaranteed amount for services is to be treated as salary income to the recipient and allowed as a business deduction to the partnership . . . [The Senate Finance] committee also extended this treatment to guaranteed interest payments on capital. 12

Thus, the guaranteed payment rules reject the aggregate theory underlying Lehman in favor of the entity theory of partnerships. Further, the guaranteed payment rules conceive a partnership item of deduction (or a partnership item that must be capitalized) that is in a sense notional. The partnership item characterizes an actual payment, but if the payment were conceived instead as a partnership distribution (either a distribution to the recipient of the guaranteed payment, as under the prior law described by the Finance Committee, or to the other partners, as under the Lehman theory), no such item of deduction would arise. A partnership distribution does not give rise to a partnership item of deduction, whereas a guaranteed payment does.

In this sense, the guaranteed payment rules are an exception to the ceiling rule, which limits allocations of income and loss to items actually realized by the partnership. 13 The view of guaranteed payments as exceptions to the ceiling rule should perhaps give one pause in finding guaranteed payments, because the partnership form is not generally intended to give rise to notional items. Further, introducing notional deductions into the system (along with notional income items) might give taxpayers unanticipated planning opportunities (for example, if the recipient of the guaranteed payment is tax-indifferent but the other partners are profitable and can benefit from the notional deduction).

Section 707(c) does not apply in the absence of payments. In most discussions of guaranteed payments, the existence of a payment is clear and the question is whether the payment was guaranteed. But in Example 1, a threshold question is whether the preferred accretion constitutes a payment for purposes of section 707(c) . At a minimum, a payment in the form of cash, a cash equivalent, or another type of partnership asset should be viewed as a payment for this purpose. Further, a payment in the form of partnership debt should also presumably be viewed as a payment for this purpose. But no such form of payment is made in the case of a preferred accretion. The only viable argument for a payment is that the partnership paid in the form of a partnership interest, but this argument is in tension with the realization requirement.

The term “payment” is not defined for purposes of section 707(c) , but it is defined in other contexts. For example, for purposes of the economic performance rules, a payment has:

the same meaning as is used when determining whether a taxpayer using the cash receipts and disbursements method of accounting has made a payment. Thus, for example, payment includes the furnishing of cash or cash equivalents and the netting of offsetting accounts. Payment does not include the furnishing of a note or other evidence of indebtedness . . . payment does not include a promise . . . to provide services or property in the future. 14

Likewise, for purposes of the installment sale rules, under section 453(f)(3) , payment does not include the receipt of evidence of indebtedness.

Those definitions of payment, excluding the payment or receipt of debt obligations, seem overly constrained for purposes of the guaranteed payment rules. Presumably, if the partnership furnished a note or other evidence of indebtedness to the preferred equity holder for the accretions, that would constitute a payment for purposes of section 707(c) . 15

In Example 1, not only does the partnership not pay Partner A cash or a cash equivalent, but the partnership also does not accrue a debt obligation to the partner. The partner does not have a creditor’s claim to the accretion. Instead, the amount that the preferred interest holder would be entitled to receive under the distribution waterfall is increased if the partnership chooses to make a distribution. When distributions are at the discretion of the board, as is typical, this increased tranche of the distribution waterfall is not a payable of the partnership. Economically, the preferred holder’s equity claim, albeit for a larger amount, remains subject to entrepreneurial risk and subject to a partnership decision on whether to pay distributions at all. 16

Presumably, a payment could also include a payment in the form of property other than cash or a partnership debt obligation. Payment could occur in kind in the form of a transfer of a partnership asset to the partner. But no such transfer has occurred in the case of the preferred accretion. All partnership assets remain in the partnership. Partner A has received only an increased claim on partnership assets. The notion that the increased claim on partnership assets could constitute a payment while the assets remain in the partnership seems inconsistent with the entity theory that underpins section 707(c) because it appeals to the partners’ interests in partnership assets.

Perhaps another way to put the argument for guaranteed payment treatment — in a manner more consistent with the entity theory — is that the partnership has paid Partner A in the form of an additional or increased partnership (capital) interest. 17 However, this argument seems hard to square with the realization requirement in the absence of a clearer statutory hook. It is not clear that a contingent right to receive partnership assets represented by an equity claim should constitute a payment for these purposes. Further, even if it could, the fact that the expansion of A’s rights comes about unilaterally and under the terms of the partnership interest undercuts the view that the accretion is a payment, because the right to the accretion was inherent in the instrument from the start. 18 Indeed, the argument for guaranteed payment treatment seems to presuppose that the expanded rights of the preferred partner represented by the accretion are a separate property right capable of being paid or transferred independently of the other rights inherent in the partnership interest — a debatable position.

The accrual method of accounting, too, undercuts the view that the accretion represents a payment. The timing for a partnership’s deduction of a guaranteed payment controls the timing for inclusion of the guaranteed payment by the partner that receives it. 19 Reg. section 1.707-1(c) stipulates that a “partner must include such payments as ordinary income for his taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments as paid or accrued under its method of accounting.”

Further, if an accrual-method partnership makes a guaranteed payment, the usual tests apply to determine the timing of the partnership’s deduction. Reg. section 1.461-1(a)(2) provides that a:

liability (as defined in section 1.446-1(c)(1)(ii)(B) ) is incurred, and generally is taken into account . . . in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

It is unclear when the all-events test would be treated as satisfied under the guaranteed payment theory in the case of a preferred partnership accretion. 20 First, putting aside for the moment the argument that the partnership has already paid by virtue of delivering a partnership interest, it appears that the partnership would not be entitled to deduct the preferred accretion currently, given the contingencies regarding whether the partnership will actually have to pay. 21 Not all the events have occurred to establish the fact of the liability because the partnership has not determined to make a distribution to reflect the accretion. 22 The partnership might never pay the accretion.

Further, the accretion does not appear to be a liability for purposes of the accrual rules. A liability includes “any item allowable as a deduction, cost, or expense,” as well as amounts required to be capitalized or taken into account in the cost of goods sold. 23 The regulations further provide:

The term “liability” is not limited to items for which a legal obligation to pay exists at the time of payment. Thus, for example, amounts prepaid for goods or services and amounts paid without a legal obligation to do so may not be taken into account by an accrual basis taxpayer any earlier than the taxable year in which those amounts are incurred. 24

Thus, although a liability can include something that has not yet crystallized into a legal obligation at the time of payment, the concept appears to cover only something that will eventually become a legal obligation, because the regulations refer to amounts for which a legal obligation does not exist “at the time of payment.” 25 The preferred partnership interest accretion will never crystallize into a legal obligation (other than perhaps for a brief period between the time it is declared and paid) because it is a claim in equity. Further, the distributions envisioned by the accretion depend on partnership assets remaining valuable enough to cover the accretion and on the partnership determining to pay distributions.

Thus, apart from the theory that payment is made in the form of a partnership interest, it appears that if the accretion represents a guaranteed payment, satisfaction of the all-events test might not occur before the partnership determines to distribute partnership assets to the preferred interest holder; no liability arises before then, and the determination to distribute is the fact that establishes liability. Under this view, the guaranteed payment theory would also defer the partner’s inclusion until the time of that distribution — a result that might seem counterintuitive to advocates of the theory. 26

But what of the argument that the partnership pays the preferred interest holder currently in the form of additional or increased capital interests in the partnership? Under that view, no liability need be found, because payment has already occurred in kind in the form of partnership equity. Indeed, as an analogy, corporations can deduct some payments made in the form of corporate stock. However, the argument that a partnership can make a guaranteed payment in the form of its own equity might seem circular. It gives one pause to apply such a strong version of the entity theory. To say that a partnership equity claim, which is weaker than a liability, can represent a payment seems inconsistent with the elaborate rules regarding when a partnership liability accrues. That is, if the partnership must work its way through the accrual rules to claim a deduction for a non-equity claim on the partnership, it seems inconsistent that an equity claim itself satisfies the tests for deductibility (subject to the economic performance requirements).

Section 707(c) applies to guaranteed payments, but guidance on what makes a payment guaranteed is scarce. Reg. section 1.707-1(c) , Example (2), implies a wait-and-see approach under which a partnership can earn its way out of guaranteed payment status. In Example 1 of this report, the requirement that a payment be guaranteed raises a further hurdle to applying the guaranteed payment theory to the preferred interest accretion.

In Example (2) of reg. section 1.707-1(c) , Partner C is entitled to receive 30 percent of partnership income (determined before taking into account any guaranteed payment) but not less than $10,000. In a year in which partnership income is $60,000, C is therefore entitled to receive $18,000 (the greater of $10,000 and 30 percent of $60,000) as C’s distributive share. None of the payment is considered a guaranteed payment. However, if partnership income were only $20,000, C would be entitled to $10,000 (the greater of $10,000 and 30 percent of $20,000), of which $6,000 is C’s distributive share of partnership income and $4,000 is a guaranteed payment.

Example (2) presupposes a single relevant tax year. In that year, the partnership earns income and makes a payment to the relevant partner. Its implications for more complex cases have been debated. For instance, is it appropriate under the reasoning of Example (2) to consider income over a multiyear period? Is only net income relevant, or also gross income? And for purposes of that reasoning, is it relevant whether the partner’s entitlements are expressed as a “greater of” formula, as distinguished from a fixed number or percentage, if the amount to which the partner is entitled exceeds partnership income?

Those questions are pertinent to the analysis of Example 1 of this report. Considered over the period during which the preferred equity is outstanding, the preferred interest accretions may well be less than aggregate partnership income, even if they exceed partnership income during the particular year of accretion. 27 Example (2) supports a wait-and-see approach under which the tax consequences of the accretion are analyzed in the year in which a distribution is in fact made, rather than in the year of the accretion. At the time of distribution, one would consider whether the distribution exceeds partnership income (whether for that tax year or perhaps cumulatively). The wait-and-see approach arguably reflects the business reality that the parties are waiting to see whether the preferred interest holder will get paid. Eventually, it will be known whether the payment to the preferred partner exceeds partnership income. Partnership assets might not be available to pay the accretion, because it is only a claim, albeit a senior claim, in an equity distribution waterfall. The preferred interest holder does not have creditors’ rights, and its claim is subject to significant entrepreneurial risk. Thus, one approach would be to wait until the preferred interest holder is paid (in cash or partnership assets) to determine whether that payment of the accretion is a guaranteed payment. 28

One could argue that it proves too much to say that the accretion is not a guaranteed payment for the use of capital on the basis that it is an equity claim, not a debt claim, on the partnership. The view that the accretion cannot be a guaranteed payment because it is not debt arguably undermines the very concept of a guaranteed payment for the use of capital because the premise of section 707(c) is that the payment is in fact to a partner. But a partnership can issue debt to a partner. Accretions could be so styled. The argument that the accretion is not a guaranteed payment because it is not a debt obligation does leave open the possibility that the guaranteed payment rules would apply to a scenario in which the return accretes as a debt obligation (or is paid annually in cash or with other partnership assets), even though the preferred partner’s claim to receive its original capital is equity. That is, if Partner A ’s right to the 10 percent accretions in Example 1 was a debt claim and its right to receive the original $90 was an equity claim, the right to accretions could be seen as a guaranteed payment. However, A’s 10 percent accretions are simply an increased right in the distribution waterfall.

If one believes that a payment occurred at the time of the accretion in the form of additional partnership interests, the analysis is presumably different. Future income would arguably be irrelevant, and instead, if one believes that Example (2) of reg. section 1.707-1(c) applies at all, the analysis would seem to be whether the partnership had income in the year of the accretion. But this approach disregards that there may be something unique about a payment in the form of partnership equity. The theory that payment occurs in the form of a partnership interest is arguably in tension with the concept that the payment could be guaranteed. The term “guaranteed” under section 707(c) means “determined without regard to the income of the partnership,” but the value of the partnership interest that is the putative means of payment is entirely dependent on partnership income in that its present value depends on expectations of future partnership income. Thus, it is questionable whether a payment in the form of partnership equity should be viewed as guaranteed.

Another approach to addressing the preferred accretion relies on an aggregate theory and would require special allocations of partnership income — perhaps only net income, perhaps gross income — to reflect the accretion. Neither the Lehman theory nor the guaranteed payment theory depends on the partnership earning any partnership income. As its name suggests, the income allocation approach does rely on partnership income. 29 Like the Lehman theory, the income allocation approach does not require a payment to a partner, but unlike the Lehman theory, it does not deem a payment to be made to a partner.

The income allocation approach finds support in the section 704(b) regulations. Those regulations seek to allocate income to a partner to reflect the partner’s rights on liquidation of the partnership. Under the “substantial economic effect” safe harbor, a partnership is required to liquidate in accordance with capital accounts. 30 Thus, in Example 1 of this report, because Partner A ’s rights under the distribution waterfall increase by $9 in year 1 and those rights would apply in the event of a liquidating distribution, the substantial economic effect safe harbor implies that any partnership income should be allocated to A up to the amount of A’s accretion. By the same token, the “partners’ interest in the partnership” (PIP) test allocates income based on the difference between (1) distributions that would be made if all partnership property were sold at book value and the partnership were liquidated at the end of the tax year and (2) distributions that would be made if all partnership property were sold at book value and the partnership were liquidated at the end of the prior tax year. 31 If Partnership AB in Example 1 were to liquidate at the end of year 1, A would receive $99, whereas if AB were to have liquidated a year earlier, A would have received only $90. This implies that under PIP, A should be allocated $9 of partnership income for year 1.

The income allocation approach seems like a middle ground, an attempt to handle a thorny issue using existing techniques. But it is not clear that it properly addresses the issue. If the concern is a capital shift, the response should not depend on the existence of partnership income, because the capital shift arises independently of partnership income.

Based on the substantial economic effect safe harbor or the PIP test, one might be tempted to allocate gross income to Partner A each year in the amount of A’s accretion. But that approach illustrates the disconnect between capital shifts and partnership income. Suppose that in Example 1, the partnership breaks even in year 1, incurring $9 of income and $9 of deduction. And suppose that partnership asset values have not changed. Allocating all the gross income to A equal to A’s accretion ($9 in year 1) would result in current taxation of A on the accretion and the equivalent of a deduction for Partner B in an equal amount. 32 But the rationale for doing this is unclear. Allocating all the gross income to A equal to A’s accretion would result in capital accounts equal to liquidating distributions if the partnership were to liquidate at the end of year 1. But whether that result is appropriate is the same debate this report has been discussing. The existence of gross income and gross deduction is incidental to the fundamental question whether, in a case in which A’s return is expected to arise from growth in the business, A should nonetheless be taxed currently. Gross income could well be less than $9 in year 1. Indeed, it could be zero, in which case the income allocation approach allocates no amount to A. The income allocation approach, at least in reference to gross income allocations, is a mechanism for creating an income inclusion to A, but it does not seem to add anything new to the analysis.

The income allocation approach in relation to gross income allocations is further highlighted by examining year 2 in Example 1. Partner A ’s accretion is $9.90 in year 2. Suppose that Partnership AB breaks even in year 2 as it did in year 1, but that in year 2 AB has $9.90 of gross income and $9.90 of deductions. Under both the substantial economic effect safe harbor (assuming no deficit restoration obligation for Partner B) and PIP, it appears that only $1 of gross income could be allocated to A, because B’s capital account is only $1 after year 1 (and the book value of the partnership assets remains $100). A would have the right on liquidation to all $100 of partnership assets. This result — that only $1 of gross income is allocated to A, and $1 of gross deduction is allocated to B — is consistent with the underlying Lehman theory of a deemed distribution of capital from B that is transferred to A. Still, even though the income allocation approach does not give rise to an allocation to A that exceeds B’s capital account, the approach, dependent as it is on the existence of gross income — which has nothing to do with the basic issue — seems to assume the conclusion.

If the partnership earns net income, the application of the section 704(b) regulations seems more straightforward, and it seems appropriate to allocate net income to Partner A to reflect the accretion. Indeed, in that circumstance, there may well have been no capital shift at all. Suppose that in year 1, Partnership AB has $9 of net income. The PIP test would allocate that $9 to A on the basis that A would receive $99 on a liquidation at the end of year 1 and only $90 on a liquidation a year earlier. The substantial economic effect safe harbor presumably would respect an allocation of $9 to either A or Partner B but would require liquidating in accordance with capital accounts. To reflect A’s right to $99 on liquidation, the partnership likely would allocate the $9 of partnership net income to A. The $9 net income for year 1, at least in theory, would be reflected in a $9 increase in the value of the partnership. That is, the value of the partnership would be $109 at the end of year 1. Similarly, if the partnership earns $9.90 of net income in year 2, the value of the partnership would, at least in theory and if values have otherwise not changed, be $118.90 at the end of year 2. Thus, there would appear to be no capital shift in these circumstances but rather a conventional application of the section 704(b) regulations.

Arguments for and against current inclusion of preferred partnership interest accretions can be made by reference to the original issue discount regime for debt instruments and the section 305(b)(4) and (c) regime for preferred stock. Although these comparisons provide context, none are dispositive.

The OID regime mandates current inclusion of OID on debt instruments on a constant yield basis. By analogy, one might argue that preferred partnership accretions should also be currently included. But the distinction between debt and equity seems pertinent and suggests that current inclusions might be inappropriate on preferred partnership equity because no legally enforceable right to the fixed accretions arises. 33

This then leads to an analogy to preferred stock subject to section 305(b)(4) and (c) because the claims of a preferred holder in a partnership and a holder of preferred stock are equity claims. Equity claims are more subject to the entrepreneurial risks of the business than debt claims and have no creditors’ rights, such as the right to force the issuer into bankruptcy. Section 305(b)(4) and (c) mandates current inclusion of specified accretions for preferred stock. Arguably, the same should be true for preferred partnership equity.

But a deeper look at section 305 reveals limitations on the requirement of current inclusion for preferred stock that may undercut the argument for current inclusion for partnership preferred equity accretions. Section 305 does not require current inclusions if the corporate issuer does not have earnings and profits. 34 Nor does section 305 require current inclusions for an excess of liquidation preference over issue price if the preferred stock has a perpetual term (and the issuer does not have a call right that is more likely than not to be exercised, and the holder does not have a put right). 35 Moreover, dividends are generally not taxable until declared. For cumulative preferred stock, section 305(c) arguably does not mandate current inclusions if at the time of issuance there was no intention to refrain from paying the preferred coupon on a current basis. 36 Thus, the regime applicable to preferred stock is weaker than the OID regime — perhaps an acknowledgment that a preferred stockholder has a weaker claim on the issuer than a debt holder. 37

Further, the notion that section 305(b)(4) and (c) does not apply to perpetual preferred (without a holder put or an issuer call) is pertinent to partnership preferred equity. The OID rules, applicable as they are to debt, presuppose a maturity of the instrument. The accreting OID will eventually be paid to the holder. The OID rules seek to smooth the income inclusions for debt instruments rather than bunch them all at the end, because the payday — the maturity date — draws closer over time. For perpetual preferred stock, the payday might never come. Instead, the receipt of payment for the accretions hinges on unanticipated conditions, such as a negotiated redemption of the preferred instrument or a sale or liquidation of the company. Likewise, preferred partnership equity often has no term, nor do holders generally have put rights. Issuers do have call rights in the sense that they can make distributions on the preferred, but when or whether that will occur will often be unknown and in any event not a decision of the preferred holder. In many cases, a preferred partnership interest holder has no real prospect of getting paid any time soon after issuance. Thus, the appropriate analogy may be to perpetual preferred stock, for which section 305 does not mandate current inclusions.

A fixed-income senior financial instrument is sometimes purchased together with an equity kicker in the form of a common interest or a warrant. If that so-called investment unit includes a debt instrument, section 1273(c)(2) determines an issue price for the investment unit and allocates that issue price between the debt instrument and the equity kicker. Although section 1273(c)(2) is not applicable to preferred partnership interests purchased together with other property, one would expect some form of allocation of the purchase price to apply. Thus, for a preferred partnership interest purchased together with a common interest in the partnership, the investor’s purchase price would be allocated between the preferred and the common interests. This can result in a potential capital shift at inception, raising questions similar to those discussed earlier about a preferred partnership interest accretion. But this scenario raises an additional twist concerning a bargain purchase, because the potential capital shift occurs at the moment of investment rather than with the passage of time.

Example 2: Suppose A contributes $9,000 to Partnership AB for a preferred interest and a common interest. Partner A ’s preferred interest has a senior claim of $9,000 and a 7 percent cumulative accretion. A’s common interest represents 10 percent (say, one unit) of the common equity of the partnership. Suppose B contributes $1,000 to AB for 90 percent (nine units) of the common equity. These rights are reflected in a distribution waterfall providing that the partnership is not required to make distributions but that any distributions must be made in accordance with the following priority: first to A in the amount of the accumulated accretion on the preferred, then to A in the amount of $9,000, and then 10 percent to A and 90 percent to B. Thus, A pays $9,000 for a preferred interest with a senior claim of $9,000 and 10 percent of the common, while B pays $1,000 for 90 percent of the common.

If the preferred interest is worth $9,000 and the one common unit purchased by Partner A is worth $100, then, consistent with the allocation principle of section 1273(c)(2)(B) , A’s purchase price should be allocated 99 percent to the preferred interest (equal to $9,000 divided by $9,100) and 1 percent to the common interest (equal to $100 divided by $9,100), or $8,901 to the preferred and $99 to the common.

If Partnership AB were to liquidate immediately after it was formed, Partner A would receive $9,100 under the distribution waterfall (equal to A’s senior claim of $9,000 plus 10 percent of the remaining $1,000), while Partner B would receive $900. Does A have any income inclusion, and does B have any deduction, as a result of these arrangements?

In Example 2, Partner A appears to receive the benefit of a bargain purchase. A paid $9,000 for preferred and common interests worth $9,100 in the aggregate. As in Example 1, there seems to be a capital shift from Partner B to A. But in Example 2, the shift occurs immediately upon formation of the partnership rather than with the passage of time. One might be tempted to apply the Lehman theory, the guaranteed payment theory, or the income allocation approach to require A to include an amount in income at the time of the partnership’s formation. Upon contribution, the preferred holder’s rights in the preferred interest ($9,000) are greater than the amount of purchase price allocated to the preferred interest ($8,901).

But bargain purchases are generally not taxable. 38 If a taxpayer is fortunate enough to buy something at a discount, the discount generally does not give rise to income until or unless the asset is sold. In Palmer , 39 the Supreme Court concluded that a purported sale of property by a corporation to its shareholders should be respected as a sale rather than recharacterized as a distribution of corporate earnings. The corporation had distributed stock subscription rights entitling shareholders to buy the underlying property at a price representing its value at the time the rights were issued. The value of the underlying property increased between the time the rights were issued and the time they were exercised. The Court held that the bargain purchase did not give rise to income to the bargain purchaser, stating that profits:

derived from the purchase of property, as distinguished from exchanges of property, are ascertained and taxed as of the date of its sale or other disposition by the purchaser. Profit, if any, accrues to him only upon sale or disposition, and the taxable income is the difference between the amount thus realized and its cost, less allowed deductions. It follows that one does not subject himself to income tax by the mere purchase of property, even if at less than its true value, and that taxable gain does not accrue to him before he sells or otherwise disposes of it. Specific provisions establishing this basis for the taxation of gains derived from purchased property were included in the 1916 and each subsequent revenue act and accompanying regulations. 40

Applying the principle of Palmer to Partner A , A should not be taxed on the receipt of preferred and common interests worth more than what A paid. Palmer rejects taxation of a purchaser at the time of purchase.

Absent a specific statutory regime changing the Palmer result, it seems difficult to rationalize an income inclusion for Partner A as a bargain purchaser. 41 Some statutory regimes do have that effect in other contexts. For debt purchased at a discount to its FMV, a holder may elect to accrue the discount into income. 42 But that is a specific statutory regime. The only potential statutory provision in subchapter K that could override Palmer ’s treatment of bargain purchasers is section 707(c) . As discussed earlier, the section 707(c) regime is an awkward fit for addressing capital shifts. The same issues would arise in this context as arise in Example 1 for preferred partnership interest accretions.

One could take the view that although Partner A has no inclusion upfront, income should be allocated to A each year to bring its capital account up to the amount A would receive on liquidation. As discussed, the section 704(b) regulations could so apply. Again, however, the rationale is questionable, especially for gross income allocations. If the concern is a capital shift, independent of whether the partnership earns income in any particular year, income allocations arguably should not be used to address the situation, although net income allocations could be more easily justified than gross income allocations.

Another scenario involves a common interest that grows over time.

Example 3: Suppose that A and B enter into a partnership, with A getting 25 percent of the common equity in exchange for $25 of cash and B getting 75 percent of the common equity in exchange for assets with an FMV of $75. Further, under the partnership agreement, if a specified contingency occurs, A’s percentage interest increases to 30 percent. Suppose that after several years, the contingency does occur, and A’s percentage interest therefore increases to 30 percent.

It would seem that a capital shift occurs in Example 3 when the contingency occurs. As discussed regarding Example 1, one could argue for income inclusion for Partner A under a Lehman theory, a guaranteed payment theory, or an income allocation approach. The same counterarguments can be made with some variations.

The argument to the effect that there is no realization event and that, as a result, the open transaction doctrine should apply, seems, if anything, even more forceful in Example 3. The shift happens unilaterally under the terms of the partnership agreement, with no action on the part of A, B, or the partnership. 43 The possibility that A’s partnership interest could grow to 30 percent was inherent in the partnership interest that A held from inception.

Similarly, the guaranteed payment theory seems less apposite in Example 3 than in Example 1, because the latter involved a fixed return. The guaranteed payment theory might apply to Example 3 if the additional or increased partnership interest is viewed as the payment. In that case, the value of the payment is (at least in theory) known, because it is the value of the additional or increased partnership interest at the time Partner A becomes entitled to it, and that amount is “paid” without regard to partnership income in that year. But this analysis highlights the uneasy fit between capital shifts and the guaranteed payment rules because it would treat a common partnership interest — whose value is unpredictable and dependent on partnership income — as a guaranteed payment.

Example 3 also raises an analogy to an option on a partnership interest. In the case of an option, the contingency that gives rise to an additional or increased partnership interest is the exercise of the option. An option holder would generally exercise the option if the value of the underlying partnership interest exceeds the strike price of the option. Because of the similarity to an option, an examination of the regime for taxing noncompensatory partnership options is warranted.

Indeed, the IRS applied an income allocation approach to address capital shifts in connection with the exercise of a noncompensatory option to acquire a partnership interest. Building on the historic treatment that exercise of an option is not a taxable event to the option holder, 44 the noncompensatory option regulations generally treat the exercise of a noncompensatory option as a nontaxable event. 45 However, for capital accounts to be considered to have economic effect, the partnership must revalue its assets immediately after the exercise of the option rather than before exercise. 46 Then the partnership must allocate unrealized items of income, gain, or loss to the exercising partner so that the capital account of that partner reflects the partner’s right to share in partnership capital (and the partnership must allocate any remaining unrealized items to the other partners to reflect the manner in which those items would be allocated among them if there were a taxable sale of partnership property). 47 If allocations of unrealized items are insufficient to cause the exercising partner’s capital account to equal that partner’s share of capital under the partnership agreement, the partnership reallocates partnership capital from the historic partners to the exercising partner. 48 Finally, the partnership makes corrective allocations to reflect all those capital account reallocations. 49 Those corrective allocations may well constitute taxable items.

Thus, in the absence of sufficient unrealized built-in gain, taxable items may be allocated to the exercising partner in the year of exercise or subsequent years. The noncompensatory option regulations therefore rely on an income allocation approach, first allocating items of built-in gain and then making further corrective allocations if needed.

In relying on an income allocation approach, those regulations reject the Lehman theory because they do not deem a taxable transfer of partnership assets to occur, and they reject a guaranteed payment theory because they do not deem a payment to be made in the form of a partnership interest or otherwise. Indeed, while the rejection of the guaranteed payment theory to address partnership options does not seem surprising, it also highlights that treating a payment to be made, for section 707(c) purposes, in the form of additional or increased partnership interest is an awkward fit. That payment could be deemed to have occurred in the case of the exercise of an option to acquire a partnership interest, but the IRS did not go in that direction. Presumably, the mechanics of the noncompensatory option regulations could be applied to Example 3 if one believed that an income allocation approach was appropriate in that situation. Indeed, as a potential model for addressing capital shifts, the mechanics of those regulations could be applied in other scenarios as well, but the administrative challenges could impede that wider application.

Capital shifts are increases in wealth to the partner to whom capital is shifted. But as observed at the outset, not all increases in wealth are taxed currently. As demonstrated, none of the conventional concepts for addressing capital shifts fits neatly. The realization requirement puts into question both the Lehman theory and the guaranteed payment theory. Moreover, the technical workings of the guaranteed payment rules seem ill-fitted to capital shifts. The income allocation approach depends on realization of income (perhaps a weak form of realization in the nature of a book-up) at the partnership level, but its rationale is questionable precisely because it addresses the phenomenon of capital shifts through a mechanism reliant on income in the partnership that is generally independent of the capital shift.

1  Capital shifts may also occur, for example, when a partner forfeits a partnership interest for failing to perform services over a prescribed period or defaulting on a capital call.

2  Reg. section 1.721-1(b)(1) (“The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61.”). See also Rev. Proc. 93-27 , 1993-2 C.B. 343 (distinguishing a receipt of profits interests for services from a receipt of capital interests).

3   See Terence Floyd Cuff, Drafting and Understanding Partnership and LLC Allocation and Distribution Provisions , section 9:16 (May 2021 update); Zhiyuan Zuo, infra note 13; New York State Bar Association Tax Section, infra note 20; Robert J. Gaughan Jr., Stephen A. Good, and Gregg Hanks, infra note 21; Richard M. Lipton, “Preferred Returns and ‘Phantom’ Income,” 19 J. Passthrough Entities 7 (2016); Noel P. Brock, infra note 8; Todd D. Golub, infra note 32; Jonathan R. Flora, “Venture Capital, Meet Capital Shift,” The M&A Tax Report 1 (Feb. 2008); Simon Friedman, “ Noncompensatory Capital Shifts: Rethinking Capital Accounts ,” Tax Notes , May 2, 2005, p. 597; Lewis R. Steinberg, infra note 26; and Steven R. Schneider and Brian J. O’Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,” 92 J. Tax’n (Jan. 2000). See also Brad Martinson, infra note 5.

4   Lehman v. Commissioner , 19 T.C. 659 (1953).

5   Compare Martinson, “ Taxation of Noncompensatory Capital Shifts ,” Tax Notes , Dec. 5, 2011, p. 1256, at 1259 (a capital shift constitutes a realization event but should not give rise to income until the partner to whom capital has been shifted has “complete dominion” over the shifted capital).

6  The Lehman court deemed cash, as distinguished from partnership assets, to move in a circle and thereby sidestepped a question whether the partners from whom capital is shifted should recognize gain or loss on the deemed transfer to the partners to whom capital is shifted.

7  Sheldon I. Banoff, “Partnership Ownership Realignments via Partnership Reallocations, Legal Status Changes, Recapitalizations and Conversions: What Are the Tax Consequences?” 83 Taxes 105, 167 (2005) (guidance is “nearly nonexistent” on the question whether capital, for purposes of analyzing capital shifts, is the partner’s tax basis capital, section 704(b) capital account, or mark-to-market value of its partnership interest).

8   See Brock, “ Targeted Partnership Allocations: Part II ,” The Tax Adviser , July 1, 2013 (if a partnership is expected to have ample profits to support preferred accretion, liquidation in accordance with capital accounts eliminates the capital shift issue).

9  Reg. section 1.707-1(c). A guaranteed payment is not automatically deductible, however, because it is subject to the usual rules for capitalization. Section 707(c) states that the treatment of a guaranteed payment as a trade or business expense under section 162(a) is “subject to section 263.” See also Cagle v. Commissioner , 539 F.2d 409 (5th Cir. 1976) (a guaranteed payment for services concerning a real estate partnership must be capitalized). Capitalization by the partnership does not result in deferral of the income inclusion. See Rev. Rul. 80-234 , 1980-2 C.B. 203 (inclusion of a guaranteed payment may not be deferred simply because the partnership was required to capitalize and amortize the payment).

10  Under section 707(c), this treatment applies only for purposes of sections 61(a) and 162(a). An investment partnership holding fixed-rate bonds and issuing preferred interests and common interests arguably does not give rise to a guaranteed payment if the coupon on the preferred partnership interest is payable only out of income on the underlying bonds. James M. Peaslee and David Z. Nirenberg, Federal Income Taxation of Securitization Transactions and Related Topics , at 75, 418 (2018) (so-called tender option bonds are payable solely out of interest on underlying municipal bonds; a preferred interest coupon payable only out of income earned by a securitization partnership is not a guaranteed payment).

11  The aggregate theory also comes into play, however, in that the determination whether a payment is a guaranteed payment appears to depend on whether there is partnership income. See the discussion of reg. section 1.707-1(c), Example (2), in Section II.B.4, infra .

12  S. Rep. No. 83-1622, at 92-94 (1954). See also Lloyd v. Commissioner , 15 B.T.A. 82 , 88 (1929) (salary paid out of a partner’s own capital is a nontaxable return of capital, but salary paid out of other partners’ capital is taxable to the recipient partner).

13   See Zuo, “A Gain Must Lie Where It Falls: Matching Tax With Economics in Subchapter K,” 11 Colum. J. Tax L. 103, 138 (2019) (an unlimited ability to designate guaranteed payments would repeal the ceiling rule and undermine “substantial economic effect” rules).

14  Reg. section 1.461-4(g)(1)(ii)(A).

15  William McKee, William Nelson, and James Whitmire, Federal Taxation of Partnerships and Partners , para. 14.03[2] (2022) (the recipient’s inclusion of a guaranteed payment hinges on the partnership accruing a deduction, not on payment).

16  Reg. section 1.721-1(b)(1) arguably provides a clue as to what constitutes a payment for section 707(c) purposes. That regulation’s main import is that a capital shift in exchange for services is treated as income under section 61. But it also applies to capital shifts in “satisfaction of an obligation.” The scant reference to obligations does not resolve the question, however. From the context, the reference to “obligation” might only be to obligations regarding services, because the other relevant sentences in that regulation address only services. Moreover, the preferred accretion is at best a highly contingent obligation because the partnership has no obligation to make a distribution.

17  Similarly, one could deem the partnership to have paid the partner a guaranteed payment in cash (or partnership assets) and the partner then to have recontributed the funds (or partnership assets), thus increasing the partner’s capital account. But a question is whether the guaranteed payment rules contemplate such deeming. Further, if partnership assets are deemed transferred, a question would arise as to whether the partnership recognizes gain or loss on the deemed transfer of its assets. See supra note 6.

18   Cf . reg. section 1.1001-3(c)(1)(ii) (an “alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument is not a modification” and hence is not a realization event). Further, the disguised sale regulations contemplate the possibility of a guaranteed payment that is retained by the partnership, rather than paid — a concept that seems inconsistent with guaranteed payments being paid in the form of additional preferred equity. See reg. section 1.707-4(c) (referring to guaranteed payments for capital that are “retained for distribution in a later year”).

19  Section 706(a) (the inclusion required by section 707(c) for a tax year of a partner is based on partnership items for the tax year of the partnership ending within or with the tax year of the partner).

20  Commentators have also questioned when economic performance occurs. Any of three rules could potentially apply: section 461(h)(2)(A)(iii) and reg. section 1.461-4(d)(3) (for a liability arising out of the taxpayer’s use of property, economic performance occurs ratably over the period the taxpayer is entitled to use the property); reg. section 1.461-4(e) (economic performance occurs as interest cost economically accrues); reg. section 1.461-4(g)(7) (when no other rule applies, economic performance occurs as payments are made in satisfaction of the liability). See NYSBA Tax Section, “ Report on Guaranteed Payments and Targeted Allocations ,” at 12-15 (Nov. 14, 2016) (the interest rule likely does not apply).

21   See Gaughan, Good, and Hanks, “Targeted Allocations,” 43 Real Est. Tax’n 140, 145 (2016) (a guaranteed payment would not create a current deduction in many situations).

22   See id ., at 145 (the rights on distribution of a partner to whom capital is shifted may be subject to entrepreneurial risks preventing the all-events test from being satisfied for an accrual-method partnership).

23  Reg. section 1.446-1(c)(1)(ii)(B).

25  The definitions of obligation and liability in the section 752 regulations are also not limited to debt. An obligation for section 752 purposes is “any fixed or contingent obligation to make payment” and includes, for example, contract obligations and obligations under a short sale. Reg. section 1.752-1(a)(4)(ii). A liability for section 752 purposes is narrower, arising “only if, when, and to the extent that incurring the obligation” creates basis, gives rise to an immediate deduction, or gives rise to a nondeductible expense that is also not chargeable to capital. Reg. section 1.752-1(a)(4)(i). The contingent rights inherent in the preferred accretion might qualify as an obligation under these terms but would not qualify as a liability. Cf. supra note 16, regarding the term “obligation.”

26  Treating the payment as a guaranteed payment, rather than a partnership distribution, could still have implications for character and source. See Steinberg, “Fun and Games With Guaranteed Payments,” 57 Tax Law. 533, 546-554 (2004) (the characterization of guaranteed payments is relevant for withholding purposes when paid to non-U.S. persons).

27  Gaughan, Good, and Hanks, supra note 21, at 145 (whether a shift actually occurs will not be known until disposition of the partnership assets).

28  Of course, the preferred partnership interest holder might not be paid all at once, which could complicate the inquiry. Further, although a wait-and-see approach would conform the timing of inclusion of a guaranteed payment to the timing of the receipt of cash or other partnership assets, guaranteed payment treatment would still affect character and source differently from distributive share treatment.

29  Analogously, section 305 generally requires income inclusions only if the corporate issuer has earnings and profits. Section 305(b) treats some distributions of stock as distributions of property to which section 301 applies. Section 301 would treat a distribution as a dividend only if the corporate issuer has E&P. Section 301(c)(1). A distribution exceeding E&P and basis also gives rise to gain under section 301. Section 301(c)(3).

30  Reg. section 1.704-1(b)(2)(ii)(b)(2).

31  Reg. section 1.704-1(b)(3)(iii).

32   Cf . Golub, “Target Allocations: The Swiss Army Knife of Drafting (Good for Most Situations — But Don’t Bet Your Life on It),” 87 Taxes 157, 166 (2009) (no authorities directly address whether gross income allocations are required).

33  The OID accretions may or may not precisely match the accreting legal claim of a holder of a debt instrument with OID.

34   See supra note 29.

35  Reg. section 1.305-5(b)(2) (a redemption premium is a section 305(c) constructive distribution if the issuer is required to redeem the stock at a specified time).

36  H.R. Rep. No. 101-964, at 1095 (1990) (Conf. Rep.) (“if at the time of issuance of cumulative preferred stock there is no intention for dividends to be paid currently, the IRS may treat such dividends as a disguised redemption premium”).

37  Consistently, not all increases in the proportionate interest of a common stockholder of a corporation are taxed. Section 305(b)(2) taxes disproportionate distributions of equity, but only if some shareholders receive cash or other property while others increase their proportionate interest. Reg. section 1.305-3(a).

38  Bargain purchases in the compensatory context are an exception. See section 83(a) and (b).

39   Palmer v. Commissioner , 302 U.S. 63 (1937).

40   Id. at 68-69. A narrower reading of Palmer would be that increases in value of underlying property between the time of contract and the time of closing do not give rise to income to a purchaser. See Brock, supra note 8 ( Palmer did not involve a bargain purchase because the strike price equaled the value at the time of contract). But the quoted language implies a broader reading to the effect that bargain purchases are in general not taxable events for the purchaser. Indeed, intuition supports that conclusion. Taxing bargain purchases would impose significant administrative burdens because arm’s-length purchases would routinely need to be analyzed to ascertain whether they were made for less than FMV.

41  Only in rare cases does a buyer have income upon purchase. Cf . James M. Pierce Corp. v. Commissioner , 326 F.2d 67 (8th Cir. 1964) (the seller was allowed a deduction, or reduction in amount realized, for deferred subscription income includable because of a sale, as if the seller paid that amount to the purchaser).

42  Section 1278(b). The market discount rules can apply to debt purchased upon issuance, because the issue price of debt issued for money is the “first price at which a substantial amount” of the debt instrument is sold for money. Reg. section 1.1273-2(a)(1). Some purchasers might pay less than the issue price to acquire the debt upon issuance.

43   See supra note 18.

44   See Helvering v. San Joaquin Fruit and Investment Co. , 297 U.S. 496 (1936) (an option holder does not acquire underlying property until exercise of the option); and Rev. Rul. 84-121 , 1984-2 C.B. 168 (payment of the option exercise price using property other than cash is a taxable disposition of property for the option holder).

45  Reg. section 1.721-2(a)(1). See American Bar Association Section of Taxation (individual members), “ Comments in Response to Notice 2000-29 ,” at 12 (Jan. 28, 2002) (exercise of an option to acquire a partnership interest from the partnership should be nontaxable regardless of whether the exercise results in a capital shift).

46  Reg. section 1.704-1(b)(2)(iv)(s)(1).

47  Reg. section 1.704-1(b)(2)(iv)(s)(2).

48  Reg. section 1.704-1(b)(2)(iv)(s)(3).

49  Reg. section 1.704-1(b)(2)(iv)(s)(4).

END FOOTNOTES

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Tax information for partnerships

A partnership is the relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.

Publication 541, Partnerships , has information on how to:

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Reporting partnership income

A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" profits or losses to its partners. Each partner reports their share of the partnership's income or loss on their personal tax return.

Partners are not employees and shouldn't be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partner. For deadlines, see About Form 1065, U.S. Return of Partnership Income .

Forms for partnerships

The partnership, as an entity, may need to file the forms below.

Annual return of income

• Form 1065, U.S. Return of Partnership Income

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Employment taxes may include Social Security and Medicare taxes and income tax withholding.

• Form 941, Employer's Quarterly Federal Tax Return
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26 U.S. Code § 704 - Partner’s distributive share

A partner’s distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this chapter, be determined by the partnership agreement.

Under regulations prescribed by the Secretary, rules similar to the rules of paragraph (1) shall apply to contributions by a partner (using the cash receipts and disbursements method of accounting) of accounts payable and other accrued but unpaid items. Any reference in paragraph (1) or (2) to the contributing partner shall be treated as including a reference to any successor of such partner.

A partner’s distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership year in which such loss occurred.

Any excess of such loss over such basis shall be allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership.

In determining the amount of any loss under paragraph (1), there shall be taken into account the partner’s distributive share of amounts described in paragraphs (4) and (6) of section 702(a).

In the case of a charitable contribution of property whose fair market value exceeds its adjusted basis, subparagraph (A) shall not apply to the extent of the partner’s distributive share of such excess.

In the case of any partnership interest created by gift, the distributive share of the donee under the partnership agreement shall be includible in his gross income, except to the extent that such share is determined without allowance of reasonable compensation for services rendered to the partnership by the donor, and except to the extent that the portion of such share attributable to donated capital is proportionately greater than the share of the donor attributable to the donor’s capital. The distributive share of a partner in the earnings of the partnership shall not be diminished because of absence due to military service.

For purposes of this subsection, an interest purchased by one member of a family from another shall be considered to be created by gift from the seller, and the fair market value of the purchased interest shall be considered to be donated capital. The “ family ” of any individual shall include only his spouse, ancestors, and lineal descendants, and any trusts for the primary benefit of such persons.

For rules in the case of the sale, exchange, liquidation, or reduction of a partner’s interest, see section 706(c)(2).

2017—Subsec. (d). Pub. L. 115–97 designated first and second sentences of existing provisions as pars. (1) and (2), respectively, inserted headings, and added par. (3).

2015—Subsec. (e). Pub. L. 114–74 substituted “Partnership interests created by gift” for “Family partnerships” in heading, redesignated pars. (2) and (3) as (1) and (2), respectively, substituted “this subsection” for “this section” in par. (2), and struck out former par. (1). Prior to amendment, text of par. (1) read as follows: “A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.”

2004—Subsec. (c)(1)(C). Pub. L. 108–357 added subpar. (C).

1997—Subsec. (c)(1)(B). Pub. L. 105–34 substituted “7 years” for “5 years” in introductory provisions.

1992—Subsec. (c)(1)(B). Pub. L. 102–486 substituted “is distributed (directly or indirectly)” for “is distributed”.

1989—Subsec. (c). Pub. L. 101–239 amended subsec. (c) generally. Prior to amendment, subsec. (c) read as follows: “Under regulations prescribed by the Secretary, income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. Under regulations prescribed by the Secretary, rules similar to the rules of the preceding sentence shall apply to contributions by a partner (using the cash receipts and disbursements method of accounting) of accounts payable and other accrued but unpaid items.”

1984—Subsec. (c). Pub. L. 98–369 amended subsec. (c) generally, substituting provisions directing that, under regulations prescribed by the Secretary, income, gain, loss, and deduction with respect to property contributed to the partnership by a partner be shared among partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution, and that similar rules apply to contributions by a partner (using the cash receipts and disbursements method of accounting) of accounts payable and other accrued but unpaid items for provisions which had directed that, if the partnership agreement so provided, depreciation, depletion, or gain or loss with respect to property contributed to the partnership by a partner would under regulations prescribed by the Secretary, be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution, and struck out provisions which had directed that in determining a partner’s distributive share of items described in section 702(a), depreciation, depletion, or gain or loss with respect to property contributed to the partnership by a partner would, except to the extent otherwise provided, be allocated among the partners in the same manner as if such property had been purchased by the partnership and that if the partnership agreement did not provide otherwise, depreciation, depletion, or gain or loss with respect to undivided interests in property contributed to a partnership would be determined as though such undivided interests had not been contributed to the partnership.

1978—Subsec. (d). Pub. L. 95–600 struck out provisions relating to adjusted basis of a partner’s interest.

1976—Subsec. (a). Pub. L. 94–455, § 213(c)(2) , substituted “except as otherwise provided in this chapter” for “except as otherwise provided in this section”.

Subsec. (b). Pub. L. 94–455, § 213(d) , among other changes, substituted “Determination of distributive share” for “Distributive share determined by income or loss ratio” in heading, in provisions preceding par. (1) “the partner’s interest in the partnership (determined by taking into account all facts and circumstances)” for “his distributive share of taxable income or loss of the partnership, as described in section 702(a)(9), for the taxable year”, and in par. (2) provision relating to a lack of substantial economic effect in a partnership agreement for provisions relating to the partnership agreement’s purpose being the avoidance or evasion of taxes.

Subsec. (c)(2). Pub. L. 94–455, § 1906(b)(13)(A) , struck out “or his delegate” after “Secretary”.

Subsec. (d). Pub. L. 94–455, § 213(e) , inserted provision relating to the determination of the adjusted basis of a partner’s liability where there is no personal liability and the applicability of such determination where section 465 of this title applies or the principal activity of the partnership is real estate investment.

Subsec. (f). Pub. L. 94–455, § 213(c)(3)(A) , added subsec. (f).

Pub. L. 115–97, title I, § 13503(b) , Dec. 22, 2017 , 131 Stat. 2141 , provided that:

Pub. L. 114–74, title XI, § 1102(c) , Nov. 2, 2015 , 129 Stat. 639 , provided that:

Pub. L. 108–357, title VIII, § 833(d)(1) , Oct. 22, 2004 , 118 Stat. 1592 , provided that:

Pub. L. 105–34, title X, § 1063(b) , Aug. 5, 1997 , 111 Stat. 947 , provided that:

Pub. L. 102–486, title XIX, § 1937(c) , Oct. 24, 1992 , 106 Stat. 3033 , provided that:

Pub. L. 101–239, title VII, § 7642(b) , Dec. 19, 1989 , 103 Stat. 2381 , provided that:

Pub. L. 98–369, div. A, title I, § 71(c) , July 18, 1984 , 98 Stat. 589 , provided that:

Amendment by Pub. L. 95–600 and enactment of provision set out as a note under this section by section 201(b)(2) of Pub. L. 95–600 applicable to taxable years beginning after Dec. 31, 1978 , see section 204(a) of Pub. L. 95–600 , set out as a note under section 465 of this title .

Amendment by section 213(c)(2), (c)(3)(A), (d) of Pub. L. 94–455 applicable in the case of partnership taxable years beginning after Dec. 31, 1975 , see section 213(f)(1) of Pub. L. 94–455 , set out as an Effective Date note under section 709 of this title .

Amendment by section 213(e) of Pub. L. 94–455 applicable to liabilities incurred after Dec. 31, 1976 , see section 213(f)(2) of Pub. L. 94–455 , set out as an Effective Date note under section 709 of this title .

Pub. L. 95–600, title II, § 201(b)(2) , Nov. 6, 1978 , 92 Stat. 2816 , as amended by Pub. L. 99–514, § 2 , Oct. 22, 1986 , 100 Stat. 2095 , provided that:

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Special partnership allocation lacks substantial economic effect

The Tax Court recently ruled in Clark Raymond & Co. PLLC et al. v. Commissioner ( No. 2265-19 ; T.C. Memo. 2022-105) on two issues that highlight the importance of partnership capital account maintenance.

Specifically, the Court ruled that an accounting firm’s clients were client-based intangibles that resulted in a property distribution to two exiting partners, and that a special allocation of income to the exiting partners lacked substantial economic effect since the partnership failed to properly maintain capital accounts in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv).

The case addressed Clark Raymond & Co., PLLC (CRC), an accounting firm, that received a notice of final partnership administrative adjustment (FPAA) for the taxable year ending Dec. 31, 2013. The adjustments made by the IRS in the FPAA that were brought before the Tax Court related to the existence and distribution of client-based intangibles and the allocation of income to the partners based on the partner’s interest in the partnership (PIP) pursuant to Treas. Reg. Sec. 1.704-1(b)(3).

Specifically, certain CRC clients ceased engaging CRC and retained a withdrawing partner’s services through a new partnership. The Tax Court, disagreeing with the IRS, determined that the clients of CRC were client-based intangibles capable of valuation and distribution.

To arrive at this conclusion, the Tax Court looked to the terms of the operating agreement — including one provision where the determination of the value of a client was defined as gross revenue invoiced to the client over the prior 12 months. The Tax Court also considered the terms of a dispute settlement that stated the withdrawing partners would be able to keep the clients that had retained their services in the new partnership and found this to support CRC’s ownership of client-based intangibles.

The court also disagreed with the manner in which the IRS redetermined the allocation of income among the partners based on the PIP rules. The Tax Court determined a revised income allocation considering additional items the IRS did not consider when determining the partner’s interest in the partnership.

CRC stated that the capital accounts of the withdrawing partners were driven negative after subtracting the value of the client-based intangibles distributed to them causing the application of the qualified income offset (QIO) provision included in the partnership agreement. Therefore, CRC made special allocations of ordinary income to the withdrawing partners.

The Tax Court determined that the partnership agreement did contain the appropriate provisions that would have otherwise met the alternate test for economic effect. However, the special allocation of income made by CRC cannot have economic effect since it failed to properly maintain the capital accounts of its partners in accordance with the partnership agreement and Treas. Reg. Sec. 1.704-1(b)(2)(iv). Having determined that CRC’s special allocation of income lacked substantial economic effect, the Tax Court stated that the allocations need to be redetermined in accordance with PIP.

Treas. Reg. Sec. 1.704-1(b)(3)(i) provides, in determining the partners’ interests in the partnership, factors to be considered, including: 

• The partners’ relative contributions to the partnership
• The interests of the partners in economic profits and losses
• The interests of the partners in cash flow and other non-liquidating distributions
• The rights of the partners to distributions of capital upon liquidation

The Tax Court also considered the allocation provisions, including a QIO, in the partnership agreement.

The court determined certain adjustments were needed to partner capital accounts prior to applying the QIO provision in the partnership agreement. Specifically, the court noted CRC did not increase the partners’ capital accounts by the value of the unrealized gain in the client-based intangibles prior to distribution in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv)(e).

CRC argued the client-based intangibles did not have unrealized gain since any unrealized gain associated with the client-based intangibles was included in the partners’ average annual value account balances that were not subject to Section 704(b). However, the Tax Court found CRC did not provide support for this assertion, or relevant authority that would relieve CRC from its capital account maintenance responsibilities under Treas. Reg. Sec. 1.704(b)(2)(iv).

The Tax Court, after increasing the partner capital accounts for the unrealized gain in the client-based intangibles under Treas. Reg. Sec. 1.704-1(b)(2)(iv)(e) and decreasing the partner capital accounts by the fair market value of the assets distributed to each partner, determined the QIO provision in the partnership agreement was triggered and income allocations were needed to bring certain partner capital accounts up to zero.

The Tax Court looked to the maintenance of capital accounts in determining how to treat the distribution of client-based intangibles and the amount of income that should have been allocated to partners.

This recent case highlights the increased scrutiny by the IRS on partnerships, and in particular, the importance of partnerships maintaining partner capital accounts over the full term of the partnership’s life in accordance with Treas. Reg. Sec. 1.704-1(b)(2)(iv).

Jose Carrasco

Senior Manager, Partnerships

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15.3 Compute and Allocate Partners’ Share of Income and Loss

The landscaping partnership is going well and has realized increases in the number of jobs performed as well as in the partnership’s earnings. At the end of the year, the partners meet to review the income and expenses. Once that has been done, they need to allocate the profit or loss based upon their agreement.

Allocation of Income and Loss

Just like sole proprietorships, partnerships make four entries to close the books at the end of the year. The entries for a partnership are:

• Debit each revenue account and credit the income section account for total revenue.
• Credit each expense account and debit the income section account for total expenses.
• If the partnership had income, debit the income section for its balance and credit each partner’s capital account based on his or her share of the income. If the partnership realized a loss, credit the income section and debit each partner’s capital account based on his or her share of the loss.
• Credit each partner’s drawing account and debit each partner’s capital account for the balance in that same partner’s drawing account.

The first two entries are the same as for a proprietorship. Both revenue and expense accounts are temporary accounts. The last two entries are different because there is more than one equity account and more than one drawing account. Capital accounts are equity accounts for each partner that track all activities, such as profit sharing, reductions due to distributions, and contributions by partners to the partnership. Capital accounts are permanent while drawing accounts must be zeroed out for each accounting period.

By December 31 at the end of the first year, the partnership realized net income of $50,000. Since Dale and Ciara had agreed to a 50:50 split in their partnership agreement, each partner will record an increase to their capital accounts of $25,000. The journal records the entries to allocate year end net income to the partner capital accounts.

Income Allocations

Not every partnership allocates profit and losses on an even basis. As you’ve learned, the partnership agreement should delineate how the partners will share net income and net losses. The partnership needs to find a methodology that is fair and will equitably reflect each partner’s service and financial commitment to the partnership. The following are examples of typical ways to allocate income:

• A fixed ratio where income is allocated in the same way every period. The ratio can be expressed as a percentage (80% and 20%), a proportion (7:3) or a fraction (1/4, 3/4).
• A ratio based on beginning-of-year capital balances, end-of-year capital balances, or an average capital balance during the year.
• Partners may receive a guaranteed salary, and the remaining profit or loss is allocated on a fixed ratio.
• Income can be allocated based on the proportion of interest in the capital account. If one partner has a capital account that equates to 75% of capital, that partner would take 75% of the income.
• Some combination of all or some of the above methods.

A fixed ratio is the easiest approach because it is the most straightforward. As an example, assume that Jeffers and Singh are partners. Each contributed the same amount of capital. However, Jeffers works full time for the partnership and Singh works part time. As a result, the partners agree to a fixed ratio of 0.75:0.25 to share the net income.

Selecting a ratio based on capital balances may be the most logical basis when the capital investment is the most important factor to a partnership. These types of ratios are also appropriate when the partners hire managers to run the partnership in their place and do not take an active role in daily operations. The last three approaches on the list recognize differences among partners based upon factors such as time spent on the business or funds invested in it.

Salaries and interest paid to partners are considered expenses of the partnership and therefore deducted prior to income distribution. Partners are not considered employees or creditors of the partnership, but these transactions affect their capital accounts and the net income of the partnership.

Let’s return to the partnership with Dale and Ciara to see how income and salaries can affect the split of net income ( Figure 15.3 ). Acorn Lawn & Hardscapes reports net income of $68,000. The partnership agreement has defined an income sharing ratio, which provides for salaries of $15,000 to Dale and $10,000 to Ciara. They will share in the net income on a 50:50 basis. The calculation for income sharing between the partners is as follows:

Now, consider the same scenario for Acorn Lawn & Hardscapes, but instead of net income, they realize a net loss of $32,000. The salaries for Dale and Ciara remain the same. Also, the distribution process for allocating a loss is the same as the allocation process for distributing a gain, as demonstrated above. The partners will share in the net loss on a 50:50 basis. The calculation for the sharing of the loss between the partners is shown in Figure 15.4

Concepts In Practice

Spidell and diaz: a partnership.

For several years, Theo Spidell has operated a consulting company as a sole proprietor. On January 1, 2017 he formed a partnership with Juanita Diaz called Insect Management.

The facts are as follows:

• Spidell was to transfer the cash, accounts receivable, furniture and equipment, and all the liabilities of the sole proprietorship in return for 60% of the partnership capital.
• The fair market value in the relevant accounts of the sole proprietorship at the close of business on December 31, 2016 are shown in Figure 15.5 .
• In exchange for 40% of the partnership, Diaz will invest $130,667 in cash.
• Each partner will be paid a salary – Spidell $3,000 per month and Diaz $2,000 per month.
• The partnership’s net income for 2016 was $300,000. The partnership agreement dictates an income-sharing ratio.
• Assume that all allocations are 60% Spidell and 40% Diaz.

Record the following transactions as journal entries in the partnership’s records.

• Receipt of assets and liabilities from Spidell
• Investment of cash by Diaz
• Profit or loss allocation including salary allowances and the closing balance in the Income Section account

Think It Through

Sharing profits and losses in a partnership.

Michael Wingra has operated a very successful hair salon for the past 7 years. It is almost too successful because Michael does not have any free time. One of his best customers, Jesse Tyree, would like to get involved, and they have had several conversations about forming a partnership. They have asked you to provide some guidance about how to share in the profits and losses.

Michael plans to contribute the assets from his salon, which have been appraised at $500,000.

Jesse will invest cash of $300,000. Michael will work full time at the salon and Jesse will work part time. Assume the salon will earn a profit of $120,000.

Instructions:

• What division of profits would you recommend to Michael and Jesse?
• Using your recommendation, prepare a schedule sharing the net income.

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IRS Regulation Brings Clarity to Apportioning Income for Partnerships with Changing Interests

August 10, 2015

By Jeff Winland, tax partner, and Tage Kelkar, tax associate

The IRS has recently released a new set of regulations, NPRM REG-109370-10, under Code Sec. 706(d), which set forth new choices for income allocations for partnerships with changing interests. The regulations create the varying interests rule, which recognizes that the annual income and expenses allocated to partners need to take into account changes in ownership during the year. The varying interests rule does not apply to most partnerships with changes to sharing ratios caused by agreements among partners that were partners for the entire partnership tax year. Certain service partnerships are also excluded.

The varying interests rule permits partnerships to employ either the interim-closing-of-the-books, “interim method,” or the proration method as their allocation method. The interim method is generally the default method. In this method, the partnership divides the year into segments based on the dates partnership interests changed. Partnership interests remain constant within each segment. Partnerships using the interim method may employ several conventions to determine the testing interval to determine whether an ownership change requiring an allocation change has occurred. If a variation occurs in the first half of a convention period, it is considered to occur at the beginning of the convention period. If the variation occurs in the second half, it is considered to happen at the end of the period.

The proration method may be selected if the partners agree. Under it, the partnership will divide its tax year into separate periods called “proration periods.”  Once these periods have been created, the partnership will prorate its tax items based on these periods. The proration method is less precise but also less cumbersome. The partnership’s items are prorated throughout the year.

The interim and proration methods are designed to make reporting easier. However, those methods do not lend themselves well to certain extraordinary items, such as a sale of capital assets. Under the Regulations, extraordinary items must be specifically allocated to the partners according to their interest at the time the item occurs. All items may be ratably allocated if the sum of all extraordinary items is less than $10 million and less than five percent of gross income. When the varying interest rule is applied to tiered partnerships, the daily allocation method is generally required for all of the tiers. This requirement can be waived if each upper-tier partnership owns less than 10 percent of the lower-tier partnership and the sum of upper-tier partnership ownership is less than 30 percent.

These regulations should assist in clarifying how income and deductions are allocated among partners by instilling some certainty into the proration process.

For questions or more information, contact  Jeff Winland  at  [email protected]  or 770-353-3108.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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One of the advantages of operating a business as a partnership is the right to make special allocations of tax items among the partners. You have the same opportunity if you run your business as an LLC that’s treated as a partnership for federal tax purposes.

In this article, the term partnership will cover an LLC that’s treated as a partnership for tax purposes, and the term partner will cover an LLC member who is treated as a partner for tax purposes. Onward.

What Is a Special Tax Allocation?

A special tax allocation is an allocation of an item of partnership loss, deduction, income, or gain among the partners that’s disproportionate to the partners’ overall ownership interests.

The best measure of a partner’s overall ownership interest is the partner’s stated interest in partnership distributions and capital, as stated in the partnership agreement.

Example. An allocation of 80 percent of a partnership’s 2020 tax loss to Partner A, whose stated ownership is only 25 percent, is a special allocation of the tax loss.

Pass-Through Taxation

After the partnership allocates its tax items among the partners, the allocated amounts (including any special allocations) are passed through to the partners on their annual Schedules K-1 received from the partnership.

Each partner then takes the passed-through amounts reported on Schedule K-1 into account on the partner’s federal income tax return (Form 1040 for an individual partner).

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Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts (Portfolio 712)

This Portfolio analyzes the tax considerations relating to the determination of a partnership’s taxable income and loss and the allocation of such income and loss among its partners.

Description

Bloomberg Tax Portfolio, No. 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts , analyzes the tax considerations relating to the determination of a partnership’s taxable income and loss and the allocation of such income and loss among its partners. Because a partnership is not a taxable entity, but instead flows through its income and losses to its partners, partnership taxable income and loss (or items thereof) are treated as received directly by the partners in their respective portions (or distributive shares) of each item.

In general, partnerships are granted substantial flexibility in allocating items of partnership income and loss among their partners. If, however, the partnership agreement does not provide for the allocation of such items or such allocation does not have “substantial economic effect,” the determination of the partners’ distributive shares is made in accordance with the partners’ interests in the partnership (taking into account all facts and circumstances). This Portfolio discusses extensively §704(b) and the regulations thereunder, which contain detailed rules for the determination of the partners’ distributive shares.

The Portfolio also describes the special rules regarding the allocation of tax items in respect of appreciated or depreciated property contributed to a partnership and regarding the apportionment of allocations between transferors and transferees that are necessitated by a mid-year transfer of an interest in a partnership (including the sale or exchange of an interest, liquidation of an interest, death of a partner, admission of a new partner, transfers to and from corporations, and gifts and intra-family sales of partnership interests). It also discusses the unique treatment of guaranteed payments (generally salaries and interest-type payments to partners) under §707(c).

Related discussions of partnership topics may be found in 710 T.M., Partnerships — Conceptual Overview (classification of partnerships and determination of partnership income), 711 T.M., Partnerships — Formation and Contributions of Property or Services , and 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination (effect on the allocation of partnership profits and losses upon the sale or exchange of partnership interests).

Table of Contents

I. Introduction II. Computation of Partnership Income III. Partners’ Distributive Shares IV. Allocations Pursuant to the Partnership Agreement – Section 704 V. Tax Allocations in Respect of Contributed Property – Sections 704(c) and 737 VI. Guaranteed Payments

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Tax issues to consider when a partnership interest is transferred.

By Colleen McHugh - Co‑Partner‑in‑Charge, Alternative Investments

There can be several tax consequences as a result of a transfer of a partnership interest during the year. This article discusses some of those tax issues applicable to the partnership.

Adjustments to the Basis of Partnership Property Upon a transfer of a partnership interest, the partnership may elect to, or be required to, increase/decrease the basis of its assets. The basis adjustments will be for the benefit/detriment of the transferee partner only.

• If the partnership has a special election in place, known as an IRS Section 754 election, or will make one in the year of the transfer, the partnership will adjust the basis of its assets as a result of the transfer. IRS Section 754 allows a partnership to make an election to “step-up” the basis of the assets within a partnership when one of two events occurs: distribution of partnership property or transfer of an interest by a partner.
• The partnership will be required to adjust the basis of its assets when an interest in the partnership is transferred if the total adjusted basis of the partnership’s assets is greater than the total fair market value of the partnership’s assets by more than $250,000 at the time of the transfer.

Ordinary Income Recognized by the Transferor on the Sale of a Partnership Interest Typically, when a partnership interest is sold, the transferor (seller) will recognize capital gain/loss. However, a portion of the gain/loss could be treated as ordinary income to the extent the transferor partner exchanges all or a part of his interest in the partnership attributable to unrealized receivables or inventory items. (This is known as “Section 751(a) Property” or “hot” assets).

• Unrealized receivables – includes, to the extent not previously included in income, any rights (contractual or otherwise) to payment for (i) goods delivered, or to be delivered, to the extent the proceeds would be treated as amounts received from the sale or exchange of property other than a capital asset, or (ii) services rendered, or to be rendered.
• Property held primarily for sale to customers in the ordinary course of a trade or business.
• Any other property of the partnership which would be considered property other than a capital asset and other than property used in a trade or business.
• Any other property held by the partnership which, if held by the selling partner, would be considered of the type described above.

Example – Partner A sells his partnership interest to D and recognizes gain of $500,000 on the sale. The partnership holds some inventory property. If the partnership sold this inventory, Partner A would be allocated $100,000 of that gain. As a result, Partner A will recognize $100,000 of ordinary income and $400,000 of capital gain.

The partnership needs to provide the transferor with sufficient information in order to determine the amount of ordinary income/loss on the sale, if any.

Termination/Technical Termination of the Partnership A transfer of a partnership interest could result in an actual or technical termination of the partnership.

• The partnership will terminate on the date of transfer if there is one tax owner left after the transfer.
• The partnership will have a technical termination for tax purposes if within a 12-month period there is a sale or exchange of 50% or more of the total interest in the partnership’s capital and profits.

Example – D transfers its 55% interest to E. The transfer will result in the partnership having a technical termination because 50% or more of the total interest in the partnership was transferred. The partnership will terminate on the date of transfer and a “new” partnership will begin on the day after the transfer.

Allocation of Partnership Income to Transferor/Transferee Partners When a partnership interest is transferred during the year, there are two methods available to allocate the partnership income to the transferor/transferee partners: the interim closing method and the proration method.

• Interim closing method – Under this method, the partnership closes its books with respect to the transferor partner. Generally, the partnership calculates the taxable income from the beginning of the year to the date of transfer and determines the transferor’s share of that income. Similarly, the partnership calculates the taxable income from the date after the transfer to the end of the taxable year and determines the transferee’s share of that income. (Note that certain items must be prorated.)

Example – Partner A transfers his 10% interest to H on June 30. The partnership’s taxable income for the year is $150,000. Under the interim closing method, the partnership calculates the taxable income from 1/1 – 6/30 to be $100,000 and from 7/1-12/31 to be $50,000. Partner A will be allocated $10,000 [$100,000*10%] and Partner H will be allocated $5,000 [$50,000*10%].

• Proration method – this method is allowed if agreed to by the partners (typically discussed in the partnership agreement). Under this method, the partnership allocates to the transferor his prorata share of the amount of partnership items that would be included in his taxable income had he been a partner for the entire year. The proration may be based on the portion of the taxable year that has elapsed prior to the transfer or may be determined under any other reasonable method.

Example – Partner A transfers his 10% interest to H on June 30. The partnership’s taxable income for the year is $150,000. Under the proration method, the income is treated as earned $74,384 from 1/1 – 6/30 [181 days/365 days*$150,000] and $75,616 from 7/1-12/31 [184 days/365 days*$150,000]. Partner A will be allocated $7,438 [$74,384*10%] and Partner H will be allocated $7,562 [$75,616*10%]. Note that this is one way to allocate the income. The partnership may use any reasonable method.

Change in Tax Year of the Partnership The transfer could result in a mandatory change in the partnership’s tax year. A partnership’s tax year is determined by reference to its partners. A partnership may not have a taxable year other than:

• The majority interest taxable year – this is the taxable year which, on each testing day, constituted the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50%.

Example – Partner A, an individual, transfers his 55% partnership interest to Corporation D, a C corporation with a year-end of June 30. Prior to the transfer, the partnership had a calendar year-end. As a result of the transfer, the partnership will be required to change its tax year to June 30 because Corporation D now owns the majority interest.

• If there is no majority interest taxable year or principal partners, (a partner having a 5% or more in the partnership profits or capital) then the partnership adopts the year which results in the least aggregate deferral.

Change in Partnership’s Accounting Method A transfer of a partnership interest may require the partnership to change its method of accounting. Generally, a partnership may not use the cash method of accounting if it has a C corporation as a partner. Therefore, a transfer of a partnership interest to a C corporation could result in the partnership being required to change from the cash method to the accrual method.

As described in this article, a transfer of a partnership interest involves an analysis of several tax consequences. An analysis should always be done to ensure that any tax issues are dealt with timely.

If you or your business are involved in a transfer described above, please contact your Marcum Tax Professional for guidance on tax treatment.

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Five Steps to Sorting Out Your Asset Allocation

Investing decisions can be daunting, but following this five-step process can make it easier to figure out how to allocate your investments.

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Maintaining a stable and secure income is an essential financial priority for retirees. Risks such as inflation, stock market fluctuations and unexpected expenses can pose threats to retirement security and cause sleepless nights. Fortunately, retirees and people approaching retirement can take steps to help ensure their retirement income remains secure.

One essential component of retirement security: strategic consideration of investments.

While investing is a complex topic and can be intimidating, there are steps just about everybody can take to manage their investments. Once the following steps are taken, making asset allocation decisions for how you divide your money between stocks, bonds and/or cash in a way that balances returns and safety according to your comfort and needs becomes easier. Asset allocation is one of the most important investment decisions.

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Step #1: Determine the character of your income.

You should take into account income from both your employment and other sources. And “character” refers to how steady and secure your income may be. Income that is uncertain or volatile might call for a lower-risk investment portfolio, and a more secure, steady income might be able to withstand a riskier portfolio that offers higher potential returns.

Step #2: Assess your risk tolerance.

Once you’ve figured out your income’s character, you should take stock of how tolerant you are of the potential ups and downs of investment returns. For instance, oftentimes, portfolios with a greater chance of high returns in the long run experience more ups and downs from year to year, and higher returns are not guaranteed.

You should be honest with yourself about your tolerance for potential volatility and the accompanying risk.

Step #3: Consider your risk capacity and your risk tolerance together.

Risk capacity refers to how well your finances can bear risk. If you have a high tolerance for risk, but your income and other financial resources wouldn’t be able to recover adequately if the market takes a downturn , you’ll need to carefully balance your need to stay financially secure and your preference for risk-taking.

Step #4: Decide how to allocate your funds.

Allocation of funds means figuring out where to put them, usually in stocks, bonds and/or cash. For example, if you want to potentially earn more, and both you and your funds can withstand greater risk, you might choose to have more stocks than bonds in your portfolio.

On the other hand, if you want to avoid as much risk as possible and are willing to earn less on your investments, make sure your portfolio has more bonds . Savvy investors make allocation decisions before thinking about specific investments.

Asset classes are the building blocks of asset allocation. There are three basic classes: stocks, bonds and cash. Below is a summary of the asset classes:

As listed in the table above, each asset class poses its own risk. Investment risks tend to fit into these categories:

• Inflation. This refers to a decline in a currency’s purchasing power.
• Interest rate fluctuations. Interest rates change in response to economic conditions, and these affect bond prices. For instance, generally, when interest rates rise, bond prices fall.
• Stock market volatility. If investors expect a good economy in the near future, the stock market tends to rise. On the other hand, if investors feel wary or negative about the economy’s prospects, the stock market tends to fall.
• Individual companies’ stocks . Good news about a company can make its stock price go up faster than the rest of the stock market, while bad news can do the opposite.
• Currency risks. Currencies from different countries and regions fluctuate in relation to one another and can impact the U.S. dollar’s purchasing power.

Diversification — dividing investment funds between a variety of stocks and/or bonds — is a good strategy to reduce risk. Diversification won’t eliminate risks, however. If the stock market drops, a diversified portfolio will likely drop, too.

Step #5: Choose how to implement your asset allocation decisions.

You can choose to make your investment decisions a reality by using a pre-packaged method, a customized solution or a combination of these approaches.

Mutual funds and exchange-traded funds ( ETFs ) pool investors’ money in stocks, bonds and other assets. Both are pre-packaged solutions and managed by professional fund managers.

A customized or self-directed approach enables you to design your own asset allocation strategy, choosing among several mutual funds, ETFs, bonds, government Treasury bonds and notes, real estate or individual securities, to create a portfolio aligned with your preferences.

A financial plan provides a good framework to help you choose your asset allocation target by quantifying a spending plan and setting savings and investment return targets. It can also help you see the potential impact of investment risks, expenses and tax implications.

When taking the self-directed approach, you’ll need to choose specific investments once you’ve decided on an asset allocation target. Below are a few things to consider:

• Active vs passive mutual funds. Active mutual funds are actively managed by a portfolio manager, usually to achieve returns higher than the market average (though this isn’t guaranteed). These funds tend to have higher costs due to the activities performed by the fund manager. Passive mutual funds (such as indexed mutual funds and ETFs) typically mirror the structure and performance of a specific market index, such as Standard & Poor’s 500 index. These funds tend to have lower costs.
• The impact of investment costs on potential returns and tax implications.

You don’t have to be completely on your own if you decide on the customized or self-directed approach to asset allocation. A financial adviser can help you design and implement your investment mix.

Find out more about asset allocation and learn practical considerations and advice on related topics from retirement professionals in the Society Of Actuaries Research Institute’s Asset Allocation: A Roadmap to Investing and other briefs located at Managing Retirement Decisions .

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA .

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Carol is a retirement actuary who retired after a 30-plus-year career of consulting with corporations, non-profits and governmental employers on their employee retirement programs. She is a member of the Society of Actuaries Committee on Post Retirement Needs and Risks, the Aging and Retirement Strategic Research Program and the Research Executive Committee providing leadership, project oversight and speaking and media work for the research produced by the committees. She has a focus of interest on managing risks in retirement for individual retirees and increasing retirement financial literacy so people can retire with a secure lifetime of income.

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