Target Capital Account Allocations
By: Thomas M. DiPiazza, Jr., Esq.
1) The Concept of Target Capital Account Allocations
(a) Applies only to entities that are treated as partnerships for income tax purposes.Examples: limited liability companies; limited partnerships; general partnerships.
(b) Although the concept has limitations, it has become an accepted alternative to the "layer cake" allocation approach, particularly in complex economic settings or those in which the financial condition of the business is not predictable.
(c) If an LLC (or other entity treated as a partnership for tax purposes) is uncomfortable with the risk that liquidating based on capital account balances might produce the wrong economic result, using target capital account provisions in the partnership agreement is often a reasonable alternative to the traditional "layer cake" allocation approach which allocates profits and losses in multiple tiers.The goal is to match as closely as possible the capital accounts to the intended economic arrangement among the partners.
2. General Principles of Allocation
(a) Partners may provide in the agreement how the partnership's profits and losses will allocated among the partners.The allocation of profits and losses should be contrasted with the agreement among the partners as to how cash from operations or cash from capital events (i.e. such as a refinancing or sale of the business) will be distributed to the partners.
(b) This flexibility is tempered by a requirement that the agreed upon allocations must have "substantial economic effect."The goal of requiring substantial economic effect is to provide that the allocation of profits and losses will have a corresponding economic impact on the partners.If the allocations provided in the agreement do not have "substantial economic effect", the IRS may reallocate the profits and losses among the partners based on each partner's interest in the partnership determined after taking into account all the facts and circumstances.Because this is a very uncertain standard, many partnerships will attempt to satisfy the substantial economic effect test, particularly where the tax allocations are important to the transaction.
3. Substantial Economic Effect Test
(a) IRS has issued extensive regulations addressing the substantial economic effect test.The overriding purpose is to assure that allocations of profits and losses have a direct economic impact on exactly what the partner ultimately is distributed.
Example: A and B form a 50-50 limited liability company that is taxed as a partnership for income tax purposes.Each contributes the same amount of cash and A and B have identical capital accounts upon formation.They agree that all operating and liquidation distributions will be distributed equally, and that all profits will be allocated to A and all losses will be allocated to B.This allocation does not satisfy the substantial economic effect test since B's allocation of losses does not have any effect on B's distributions.The correct allocation of profits and losses would be 50-50 to A and B.
(b) Three key requirements in the regulations to have substantial economic effect include:
(i) Capital accounts must be maintained in accordance with complex rules.Generally, a partner's capital account is increased by cash and property (net of liabilities) contributed to the partnership and by the partner's share of profits, and decreased by losses, and distributions.
(ii) Liquidating distributions must be made based on capital account balances.
(iii) Partners with a deficit capital account balance must be obligated to restore that deficit balance.
Many partnerships will fail the third requirement since most investors don't want an obligation to restore a negative capital account.Allocations can still be treated as satisfying this third requirement if the agreement contains qualified income offsets and minimum gain chargeback provisions. While common, these special provisions generate increased complexity.
For many partnerships, there is difficulty in meeting the second requirement (i.e. the obligation to liquidate based on capital account balances). This is particularly the case where there is a concern that the capital account balances on liquidation will not reflect the business deal of the partners.
Historically, practitioners have attempted to mitigate this concern by carefully drafting allocation provisions with the intent of insuring that allocations will produce the right capital account balances consistent with the partners' economic expectations.So-called "layer cake" allocations have been, and still are, used. They provide multiple tiers of allocations. For example: losses to certain members followed by the allocation of profits to those same members to the extent of prior losses; allocations to preferred members equal to their preferred return; allocations to the common members, etc.
4. Target Capital Account Allocations
(a) As an alternative to the layer cake approach of allocations, the "target capital account" approach involves allocating profits and losses among the partners in whatever manner is necessary to cause their respective capital accounts to be equal to the amount the members would receive if the partnership sold all of its assets for book value and liquidated.This approach is intended to force the capital accounts to correspond to the agreed business deal.The "target capital account" approach is not sanctioned by IRS regulations and the IRS has been silent on whether it will be respected.
(b) The "target capital account" approach is not the best solution in every case and may, in fact, be inappropriate.Some nonexclusive circumstances where it may not be appropriate include:
(i) Allocation of significant front-end losses - In those cases where the allocation of the front-end losses are important selling points to an investor, the risk of the reallocation of losses is a negative selling feature.In that case, the traditional layer cake approach may be preferable.
(ii) Preferred Returns - Where preferred returns on capital (i.e. a yearly cumulative preferred return of 10% on invested capital) are involved, the holder of the preferred return may be allocated income before the return is actually paid.This can be avoided by using a layer cake method and allocating income to the extent that the preferred return has been paid.
(iii) Simple Deals - If the partners contribute identical capital and the allocations and distributions are made in proportion to their contributed capital, there is no need to use complex "targetcapital account" allocations.
(iv) Large Partnerships - If there are many partners, an IRS challenge to the Forms K-1 may present a substantial administrative burden.
(v) Varying Distribution Provisions - If the partnership has different distribution provisions for distributions attributable to operations and distributions on liquidation, the target capital account allocations will default to the liquidation provisions even though liquidation may not occur for quite some time.
(vi) Tax Exempt Partners - If the partnership has tax-exempt members the specter of a reallocation of income may be a negative selling point. Accordingly, the "target capital account" approach may not be appropriate.
