Several Thoughts on Drafting Target Allocation Provisions

Transcription

1 Several Thoughts on Drafting Target Allocation Provisions Terence Floyd Cuff Loeb & Loeb LLP Los Angeles, California Copyright, 2009, Terence Floyd Cuff, All rights reserved Table of Contents 1. Simplicity Considerations for Target Allocation Provisions Drafting the Target Allocation Provision Nonrecourse Liabilities Exculpatory Liabilities Qualified Income Offset Economic Effect Alternative Test of Economic Effect Economic Effect Equivalence Test Partners Interests in the Partnership Substantiality Net versus Gross Item Allocations Capital Shifts Deficit Restoration and Contribution Obligations Conclusion

2 A cow says Moo. A sheep says Baa. Three singing pigs say La La La! 1 So begins Moo, Baa, La La La! 2 a book for young readers. Wonderful illustrations of a cow mooing, a sheep baaing and three little pigs singing La La La accompany the text of Moo, Baa, La La La!. A young child reading or being read his first book grasps the message and can participate enthusiastically in the mooing, baaing, and singing. A young child can easily understand precisely what it means. The communication is perfect and altogether charming. The task of drafting partnership agreements 3 and particularly target allocations is to be as clear and understandable as the delightful text of Moo, Baa, La La La! Partnership agreements particularly allocations in partnership agreements much too often lack the clarity of a young children s book. The result too often is that advisors must puzzle over what the partnership agreement or partnership allocations mean. This too often results in matters going awry. The situation sometimes resembles the results of a children s rhyme about a Mr. Humpty Dumpty. Many lawyers find drafting partnership allocations unappealing. The task can be complicated and time consuming. Opportunity abounds for making costly errors. Clients do not appreciate the delicacy of the drafting process. Clients do not understand why the work should be so expensive. Many lawyers look for ways to simplify the drafting. Shortcuts too often have inconvenient results. Several competing models of drafting partnership allocations of income, gain, loss, and deduction have evolved. One model of drafting partnership allocations of income, gain, loss, and deduction specifies allocations of income and loss items. This model of allocations credits these items to or debits these items fro m partners capital accounts. This model distributes the cash proceeds of the liquidation of the partnership in accordance with capital accounts so determined. Another model of drafting partnership allocations of income, gain, loss, and deduction specifies how cash will be distributed from operations and in liquidation of the partnership. This model then allocates income and loss items to partners capital accounts so that these capital accounts will conform to the cash distribution scheme in liquidation. 1 Sandra Boynton, Moo, Baa, La La La! (Little Simon 1982). 2 Id. 3 This article arbitrarily will mix the terms partnership, limited liability company, and LLC. It also will mix the terms partner and member. A limited liability company normally is taxed as a partnership unless the entity elects to be taxed as a corporation. 2

3 A third model of drafting partnership allocations of income, gain, loss, and deduction might allocate income and loss items in accordance with percentages and similarly distributes cash from operations and cash from liquidation in accordance with the same percentages. A fourth model of partnership allocations of income, gain, loss, and deduction simply allocates income and loss items in accordance with partners interests in the partnership. A fifth model might specify how cash is distributed from partnership operations and in liquidation of the partnership and say absolutely nothing about how tax items of income, gain, loss, and deduction are allocated. This Article concerns the second model of partnership allocations of income, gain, loss, and deduction. This model is commonly is referred to as target allocations. This model of allocations of income, gain, loss, and deduction is not necessarily superior to or inferior to the other models. Target allocations currently are the rage with many draftsmen. Target allocations are the rage with draftsmen whether they much understand how their target allocation provisions work or not. Key characteristics of target allocations are: the partnership does not explicitly liquidate in accordance with capital accounts but rather liquidates in accordance with stated percentages, explicit tiers, etc., that do not depend explicitly on capital account balances, and allocations of income and loss items are made in such a manner that capital accounts are adjusted to be consistent with the plan for liquidating distributions of cash. A target allocation provision might first, determine how the partnership would distribute cash on a hypothetical liquidation and then, allocate income, gain, loss, and deduction (based on a hypothetical sale of all assets at book value) to adjust capital accounts so that they equal the amount of cash that the partnership would distribute to a partner on a hypothetical liquidation. This Article seeks to explore issues in drafting target allocation provisions by examining a variety of target allocation provisions. These target allocation provisions do not reflect an approved form. No format for partnership allocations of income, gain, loss, and deduction is best or proper or right. 4 4 The tax laws will not respect some ways to draft partnership allocations of income, gain, loss, and deduction. The tax laws will not respect allocations of income, gain, loss, and deduction if the allocations fail to have substantial economic effect, do not satisfy the alternate test of economic effect, do not satisfy the economic effect equivalence test, and are not in accordance with partners interests in the partnership. 3

4 This Article will not provide advisors with the perfect target allocation provision. No single target allocation provision is perfect or appropriate for all circumstances. Every advisor using a target allocation provision should use a target allocation provision that he himself has drafted, that he understands, and that he judges appropriate for the circumstances of a particular partnership agreement. Also, advisors should recognize that the state of knowledge of drafting target allocation provisions is dynamic as advisors are increasingly informed by experience. These clauses are net yet perfect. These clauses will improve as the tax law matures. This Article is not a template for paper dolls to enable the reader to cut and paste from its examples of target allocation provisions. Examples in this Article are designed to help to guide the reader better to understand target allocation provisions, to refine them, to improve them, and ultimately to forge a target allocation provision much better than anything in this Article. This is a participatory exercise. Do not cut and paste form language from this Article or from any other Article without fully understanding the language and judging that the language is appropriate to your circumstances. There is peril in cutting and pasting language that comes across your desk from other firms partnership agreements. Target allocation provisions in many partnership agreements even agreements drafted by large, prestigious law firms with offices high up in tall buildings often are deficient. Target allocation provisions are complex and difficult to draft. Target allocation provisions also are provisional on current knowledge. That are not static. They improve with further thought and greater knowledge and experience. The function of this Article is to help advisors better to understand some of the considerations in drafting a target allocation provision. Equipped with that understanding, advisors should be able to draft a better target allocation provision themselves. Treasury and the Internal Revenue Service drafted Treasury Regulations concerning partnership allocations 5 ( Allocation Regulations ) and regulations concerning allocations of deductions attributable to nonrecourse debt 6 ( Nonrecourse Deduction Regulations ) prior to prevalence of target allocation provisions. This time was prior to prevalence of limited liability companies. Neither the Allocation Regulations nor the Nonrecourse Deduction Regulations expressly address target allocation provisions. The failure of the Allocation Regulations and Nonrecourse Deduction Regulations expressly to consider the tax effects of limited liability companies leaves considerable doubt concerning the status of target allocation provisions under these two regulations. Nonrecourse deductions create special issues (discussed below) when a partnership uses a target allocation provision. A special allocation of nonrecourse deductions outside of the target allocation provision may not qualify under the Nonrecourse Deduction Regulations. 5 Treas. Reg Treas. Reg

5 An allocation of nonrecourse deductions under the target allocation provision may not qualify under the Nonrecourse Deduction Regulations. The prevalence of target allocation provisions and their tax uncertainty suggests that the Internal Revenue Service should make advice on target allocation provisions a high priority. A good case can be made that target allocation provisions generally should be approved for tax purposes, provided that anyone can decide how properly to draft target allocation provisions. 1. Simplicity. The perceived simplicity of the target allocation provision is considerably overstated. Target allocation provisions can be complex when one considers the complexity of all of the relevant definitions. Drafting a compliant target allocation provision can be every bit as difficult as drafting layer cake allocations. Draftsmen often do not understand the target allocation provisions that they use in their partnership agreements. This can lead to inconvenient results. The target allocation provision can ask demanding theoretical questions of tax law that are not currently properly resolved. A draftsman of a partnership agreement can elect to say nothing about partnership allocations of income, gain, loss, and deduction. No law says that the partnership agreement must specify how to allocate items of income, gain, loss, and deduction. The tax laws will allocate items of income, gain, loss, and deduction in accordance with partners interests in the partnership if the partnership agreement does not allocate these items in accordance with the Allocation Regulations. A draftsman perhaps may do as good a job in drafting a partnership agreement by merely describing the cash distribution scheme and accepting the standard of in accordance with partners interests in the partnership as he would by drafting a target allocation provision. A simple allocation provision might read: Clause 1. The partnership shall allocate all items of income, gain, loss, and deduction for federal, state, and local income tax purposes in accordance with partners interests in the partnership. Consider using the somewhat amorphous general standard of in accordance with partners interests in the partnership rather than a form target allocation provision that may not work well and that you do not understand. This scheme is superior to using a complex target allocation provision that you do not understand. The draftsman who uses a target allocation provision that he does not understand invites danger. Another simple allocation provision might read: 5

6 Clause 2. The partnership shall allocate all items of income, gain, loss, and deduction for federal, state, and local income tax purposes 50 percent to partner A and 50% to partner B. Allocation provisions that liquidate by capital account in appropriate circumstances can be shorter, simpler, and more understandable than target allocation provisions (particularly when one includes the cumbersome definitions that accompany some target allocation provisions). Allocation provisions that liquidate by capital account sometimes can reflect the economic deal more accurately than badly drafted provisions that explicitly state the liquidation scheme without reference to partners capital accounts. These allocation provisions do risk getting allocations wrong, with the result that the liquidating distribution scheme may not accord with the partners deal. This can produce some embarrassment. Perhaps the majority of draftsmen of partnership and LLC agreements perceive that the best approach is to use target allocation provisions in drafting allocations of income, gain, loss, and deduction in a broad range of situations. This Article addresses drafting those target allocation provisions. The tax field has not produced a commonly accepted standard model for drafting target allocation provisions. Some reader of this Article perhaps will draft the new standard target allocation provision. Draftsmen should consider principles discussed in this Article in drafting their target allocation provisions. The perfect target allocation provision is a work in progress. Do not imagine that any provision presented in this Article is the perfect target allocation provision. That perfect target allocation provision still is to be drafted. The reader may correct that deficiency. 2. Considerations for Target Allocation Provisions. These are useful issues to consider in drafting a target allocation provision for a partnership agreement: Take into account the difference between allocations of book items and allocations of tax items. ( Book items are items of income, gain, loss, and deduction that directly adjust capital accounts computed under the principles of Section (b)(2)(iv).) Take into account latent effects of future allocations under the minimum gain chargeback and partner minimum gain chargeback. Have a separate minimum gain chargeback, partner minimum gain chargeback, and perhaps a qualified income offset. 6

7 Carve out partner nonrecourse deductions and do not allocate them under the target allocation provision. 7 Possibly carve out nonrecourse deductions and do not allocate them under the target allocation provision. Possibly carve out exculpatory deductions and do not allocate them under the target allocation provision. 8 Exclude specially allocated items from the definitions of Net Profits and Net Losses if the target allocation provision allocates Net Profits and Net Losses. 9 Consider allocating items of gross income and items of gross loss under the target allocation provision rather than items of net income and items of net loss. Make the target allocation provision flexible enough to address book -up adjustments. Consider situations in which there are not sufficient income items so that the target allocation provision can equalize hypothetical capital accounts and target capital accounts. 7 The draftsman perhaps also should carve out and specially allocate income that reverses exculpatory deductions and specially allocate these items. 8 See T.D. 8385, 56 Fed. Reg (December 27, 1991) ( A partnership may have a liability that is not secured by any specific property and that is recourse to the partnership as an entity, but explicitly not recourse to any partner (exculpatory liability). Section (b)(3) of the final regulations defines nonrecourse liability by referring to the definition of nonrecourse liability in the regulations under section 752. Under that definition, an exculpatory liability is a nonrecourse liability. The application of the nonrecourse debt rules of section more specifically, the calculation of minimum gain may be difficult in the case of an exculpatory liability, however, because the liability is not secured by specific property and the bases of partnership properties that can be reached to the lender in the case of an exculpatory liability may fluctuate greatly. Section does not prescribe precise rules addressing the allocation of income and loss attributable to exculpatory liabilities. Taxpayers, therefore, are left to treat allocations attributable to these liabilities in a manner that reasonably reflects the principles of section 704(b). Commentators have requested that the treatment of allocations attributable to exculpatory liabilities under the nonrecourse debt rules be clarified. The Service and the Treasury solicit further suggestions on the appropriate treatment of allocations attributable to these liabilities. Suggestions should take into account the practical concerns of partnerships as well as the Service s concerns about the proper allocation of loss and gain items attributable to these liabilities. ). 9 If the draftsman carves out and specially allocates exculpatory deductions and income that reverses exculpatory deductions, these items should be excluded from the definition of Net Profits and Net Losses and should not be allocated under the target allocation provision. 7

8 Consider the effects of minimum gain and partner minimum gain on the target capital account. Consider the effects of obligations of partners to make future capital contributions to the partnership on the target allocation provision. 3. Drafting the Target Allocation Provision. Consider this example. Example 1. Ephriam, Balthasar, and Mordechia form Gilgamesh Investments, LLC, a real estate investment limited liability company. Each has a 1/3 rd interest in profits and losses. This is the initial balance sheet of Gilgamesh (entries at AB are at adjusted tax basis): AB Assets Cash $3,000,000 Total Assets $3,000,000 Liabilities & Capital Nonrecourse Liabilities $0 Capital Ephriam $1,000,000 Capital Balthasar $1,000,000 Capital Mordechia $1,000,000 Total Liabilities & Capital $3,000,000 The task is to draft allocations in the Gilgamesh limited liability company agreement. The limited liability company agreement could say something like Clause 3: Clause 3. All items of income, gain, loss, and deduction for tax purposes are allocated 1/3 rd to each member. Clause 3 might be a satisfactory scheme of allocations of income, gain, loss, and deduction. This is an article about target allocation provisions. This formulation will not do at all for our current purposes. Another approach would be to draft: Clause 4. All items of income, gain, loss, and deduction for tax purposes are allocated among the members in accordance with partners interests in the partnership. Clause 4 is technically accurate. The partnership accountants may be disappointed that Clause 4 provides them with little guidance concerning how to complete the partnership s tax return. Whatever the case, Clause 4 is not a target allocation provision. Clause 4 is not the allocation scheme that we currently wish to discuss. 8

9 An impatient reader can use Clause 4 in drafting partnership and LLC agreements. He can be absolutely legally correct. He can read this Article no further. He perhaps use can his time more productively reading Moo, Baa, La La La! 10 or Goodnight Moon 11 or Make Way for Ducklings 12 or perhaps Where the Wild Things Are 13 to his children. Consider: what am I allocating under the target allocation provision? This is a nontrivial question. A range of possibilities exists. Target allocation provisions often allocate net taxable income or net taxable loss of the partnership. A draftsman might draft a simple target allocation provision like this: Clause 5. The Company shall allocate all of its net taxable income or net taxable loss (as the case may be) in such a manner that (after these allocations have been made) each Member s Capital Account shall be equal to (to the extent possible) the hypothetical amount that the Company would distribute to this Member if the Company sold all of its assets for their adjusted tax bases (or, for the amount of nonrecourse liabilities secured by these assets, if nonrecourse liabilities exceed adjusted tax basis), first applied the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company s method of accounting), and then distributed the remaining net proceeds of this sale in accordance with Section y.y [the liquidating distribution provision]. Clause 5 does not handle partner nonrecourse deductions satisfactorily. Clause 5 will fail if the partnership has partner nonrecourse deductions. The partnership agreement should allocate partner nonrecourse deductions to the partner who bears the economic risk of loss of these deductions. The clause needs to be modified on account of latent minimum gain and partner minimum gain. Clause 5 also should account for the possibility that a partner has an unconditional obligation to make capital contributions to the partnership. Clause 5 does not perform well when the partnership has nontaxable income, such as taxexempt interest. Clause 5 may not perform satisfactorily when the partnership prefers profit distributions to one partner to return-of-capital distributions to another partner. Clause 5 does not define nonrecourse liabilities. The term nonrecourse liabilities requires definition. Nonrecourse liabilities means different things in different contexts. The Nonrecourse Deduction Regulations allocate partner nonrecourse deductions to the partner who bears the economic risk of loss. 10 Sandra Boynton, Moo, Baa, La La La! (Little Simon 1982). 11 Margaret Wise Brown & Clement Hurd, Goodnight Moon (Harper 1947). 12 Robert McCloskey, Make Way for Ducklings (Viking 1941). 13 Maurice Sendak, Where the Wild Things Are (Harper & Row 1963). 9

10 The partnership computes net taxable income or net taxable loss for the year. The partnership looks at tax capital accounts at the end of the year but before income or loss allocations at the end of each year. Assume that the partnership has $50,000 in net taxable income for the year. Assume that the partnership has this balance sheet at the beginning of the year: AB at Beginning of Year Assets Cash $3,000,000 Total Assets $3,000,000 Liabilities & Capital Nonrecourse Liabilities $0 Capital Ephriam $1,000,000 Capital Balthasar $1,000,000 Capital Mordechia $1,000,000 Total Capital $3,000,000 This spreadsheet shows the allocation of the $50,000 in net taxable income under Clause 5: 10

11 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Target Capital Account Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Assets Cash $3,000,000 $50,000 $3,050,000 $3,050,000 Total Assets $3,000,000 $3,050,000 $3,050,000 Liabilities & Capital Nonrecourse Liabilities $0 $0 $0 Capital Ephriam $1,000,000 $1,000,000 $1,016,667 $16,667 $1,016,667 Capital Balthasar $1,000,000 $1,000,000 $1,016,667 $16,667 $1,016,667 Capital Mordechia $1,000,000 $1,000,000 $1,016,667 $16,667 $1,016,667 Total Capital $3,000,000 $3,000,000 $3,050,000 $3,050,000 Total Liabilities & Capital $3,000,000 $3,000,000 $3,050,000 Total Unallocated Income $50,000 $50,000 11

12 The partnership looks at hypothetical capital accounts at the end of the year immediately before the allocation of net taxable income under the target allocation provision. The partnership has $50,000 in net taxable income to allocate. The partnership has $3,050,000 in net assets based on a sale of assets at book value. The partnership looks to the partnership agreement and determines how the partnership would distribute cash on a constructive liquidation. The partnership agreement allocates net taxable income to the partners in such a way that those hypothetical capital accounts (after the allocation under the target allocation provision) will equal the cash distributions that the partners would have received on liquidation (target capital accounts). The partnership might have had a net taxable loss rather than net taxable income. Assume that the same partnership suffered a $30,000 net taxable loss rather than earned $50,000 in net taxable income. The partnership has the same beginning of the year balance sheet. This spreadsheet shows the allocation of the $30,000 in net taxable loss under Clause 5: 12

13 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Target Capital Account Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Assets Cash $3,000,000 ($30,000) $2,970,000 $2,970,000 Total Assets $3,000,000 $2,970,000 $2,970,000 Liabilities & Capital Nonrecourse Liabilities $0 $0 $0 Capital Ephriam $1,000,000 $1,000,000 $990,000 ($10,000) $990,000 Capital Balthasar $1,000,000 $1,000,000 $990,000 ($10,000) $990,000 Capital Mordechia $1,000,000 $1,000,000 $990,000 ($10,000) $990,000 Total Capital $3,000,000 $3,000,000 $2,970,000 $2,970,000 Total Liabilities & Capital $3,000,000 $3,000,000 $2,970,000 $2,970,000 Total Unallocated Income ($30,000) ($30,000) 13

14 The partnership looks at hypothetical capital accounts at the end of the year immediately before the allocation of net taxable loss. The partnership has $30,000 in net taxable loss to allocate. The partnership has $2,970,000 in net assets based on a sale of assets at book value. The partnership looks to the partnership agreement. The partnership determines how the partnership would distribute the $2,970,000 in cash on a constructive liquidation. Net taxable loss is allocated to the partners in order that hypothetical capital accounts after the allocation under the target allocation provision will equal the distributions that the partners would have received on liquidation. The partnership might have nonrecourse liabilities in excess of adjusted tax basis. The partnership might have this balance sheet (with the nonrecourse liability secured by the real estate) at the beginning of the year: AB at Beginning of Year Assets Cash $600,000 Equipment $1,200,000 Real Estate $4,500,000 Total Assets $6,300,000 Liabilities & Capital Nonrecourse Liabilities $6,200,000 Capital Ephriam $33,333 Capital Balthasar $33,333 Capital Mordechia $33,333 Total Capital $100,000 Total Liabilities & Capital $6,300,000 The partnership has $327,000 in net taxable income to allocate for the fiscal year. This spreadsheet shows the allocation of the income for the fiscal year: 14

15 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Hypothetical Adjustment to Capital Accounts from Nonrecourse Liabilities Over Basis (Minimum Gain) Capital Accounts After Nonrecourse over Basis (Minimum Gain) Adjustment But Before Income Allocation Target Capital Account Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Assets Cash $600,000 $327,000 $927,000 $2,127,000 Equipment $1,200,000 $1,200,000 Real Estate $4,500,000 $4,500,000 Total Assets $6,300,000 $6,627,000 $2,127,000 Liabilities & Capital Nonrecourse Liabilities $6,200,000 $6,200,000 $0 Capital Ephriam $33,333 $33,333 $566,667 $600,000 $709,000 $109,000 $709,000 Capital Balthasar $33,333 $33,333 $566,667 $600,000 $709,000 $109,000 $709,000 Capital Mordechia $33,333 $33,333 $566,667 $600,000 $709,000 $109,000 $709,000 Total Capital $100,000 $100,000 $1,800,000 $2,127,000 $327,000 $2,127,000 Total Liabilities & Capital $6,300,000 $6,300,000 $1,800,000 $2,127,000 15

16 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Hypothetical Adjustment to Capital Accounts from Nonrecourse Liabilities Over Basis (Minimum Gain) Total Unallocated Income $327,000 $327,000 Total Cash Earnings $327,000 Nonrecourse Liabilities Over Tax Basis $1,700,000 Capital Accounts After Nonrecourse over Basis (Minimum Gain) Adjustment But Before Income Allocation Target Capital Account Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation 16

17 The first column of numbers shows the starting balance sheet. The second and third columns of numbers, respectively, show net taxable income for the year and increases in cash holdings for the year. (The schedule and partnership operations have been simplified.) The partnership earned $327,000 in income and increased its cash holdings by $327,000. The fourth column of numbers shows the closing balance sheet prior to allocation of the $327,000 in net taxable income. The fifth column of numbers hypothetically allocates the latent gain from nonrecourse liabilities over tax basis to the partners (which is the only gain that the partnership would recognize if the partnership disposed of all assets in the hypothec sale at adjusted tax basis) to closing hypothetical capital accounts (pre-operating income allocation). The sixth column of numbers hypothetically increases the partners hypothetical capital accounts on account of the latent gain from nonrecourse liabilities over tax basis. The seventh column of numbers shows the target capital accounts (the amount that each partner would receive on the hypothetical sale and liquidation). The eighth column of numbers shows the allocation of net taxable income among the partners so that the income allocation would increase hypothetical capital accounts (adjusted by nonrecourse liabilities over adjusted tax basis [or minimum gain]) to equal the amount that each partner would receive on the hypothetical sale and liquidation. The ninth column of numbers shows the partners hypothetically determined hypothetical capital accounts after the allocation under the target allocation provision of net taxable income for the year. Target allocation provisions sometimes allocate net book items of the partnership. Book items are items that adjust capital accounts under the Allocation Regulations. 14 A simple target allocation provision might be drafted like this: 14 See Treas. Reg (b)(2)(iv). 17

18 Clause 6. The Company shall allocate all of its Net Income or Net Loss (as the case may be). This allocation shall be made in such a manner that (after these allocations have been made) each Member s Capital Account shall be equal to (to the extent possible) the hypothetical amount that the Company would distribute to this Member if (a) the Company sold all of its assets for their book values (or, for the amount of nonrecourse liabilities or partner nonrecourse liabilities secured by these assets, if nonrecourse liabilities or partner nonrecourse liabilities exceed book values) (b) first applied the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company s method of accounting), and then (c) distributed the remaining net proceeds of this sale in accordance with Section y.y [the liquidating distribution provision]. For this purpose: (d) Book value means book value as used in Treasury Regulations Section (b)(2)(iv). (e) Net Income means the positive net amount of all book items (other than Contributions and liabilities) that increase or decrease capital accounts under Treasury Regulations Section (b)(2)(iv) if that net amount produces a net increase to capital accounts, and Net Loss means the negative net amount of all book items (other than Distributions and liabilities) that increase or decrease capital accounts under Treasury Regulations Section (b)(2)(iv) if that net amount produces a decrease to capital accounts. 7: We might redraft the target allocation provision more carefully as provided in Clause Clause 7. The Company shall allocate all of its items of book income and book loss. This allocation shall be made in such a manner that (after these allocations have been made) each Member s Capital Account shall be equal to (to the extent possible) the hypothetical amount that the Company would distribute to this Member on a Hypothetical Sale and Liquidation. 18

19 For this purpose, (a) Hypothetical Sale and Liquidation means a hypothetical transaction in which the Company (i) sells all of its assets for their book values (or, for the amount of nonrecourse liabilities or partner nonrecourse liabilities secured by these assets, if nonrecourse liabilities or partner nonrecourse liabilities exceed book values), (ii) first applies the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company s method of accounting), and then (iii) distributes the remaining net proceeds of this sale in accordance with Section y.y [the liquidating distribution provision]. (b) Book value with respect to any asset means the asset s book value for purposes of Treasury Regulations Section (b)(2)(iv). (c) Items of book income mean all items (other than Contributions and liabilities) that increase capital accounts under Treasury Regulations Section (b)(2)(iv). (d) Items of book loss mean all items (other than Distributions and liabilities) that decrease capital accounts under Treasury Regulations Section (b)(2)(iv). (e) Items of book income and book loss shall be computed by excluding items allocated under the minimum gain chargeback, or under the partner minimum gain chargeback, and also by excluding items allocated as nonrecourse deductions, partner nonrecourse deductions, or exculpatory deductions. (f ) Each Member s share of items of book income and book loss shall be comprised of a ratable share of the items that are components of book income and book loss to the extent consistent with the other terms of this Section x.x and except to the extent that the Code requires otherwise. ( g) Capital Accounts shall be determined for this purpose (i) after adjustments for any specially allocated items, contributions, or distributions and (ii) as if any net book income or net book loss that the Company would have recognized on this hypothetical sale (such as under the minimum gain chargeback or partner minimum gain chargeback) has been recognized and (other than items allocated under this Section y.y) credited to or debited from (as the case may be) the Members Capital Accounts, and 19

20 (iii) by increasing the Capital Account of each Member on account of the amount that the Member would be required to pay or to contribute on account of the Members obligations to make payments or contributions to the Company that would fall due on account of the liquidation of the Company or that would be treated as obligations to restore the Member s deficit Capital Account under Treasury Regulations (b)(2)(ii)(b)(3) (net of the amount of these payments or contributions that the Company would return to the Member on the Hypothetical Sale and Liquidation) (but not including a deemed deficit restoration obligation on account of minimum gain or partner minimum gain [which is already treated as fully recognized for this purpose under paragraph (e)(ii)]). (h) Nonrecourse liabilities and partner nonrecourse liabilities shall be determined under Treasury Regulations Section (a)(4)(i). The partnership agreement then should contain a separate minimum gain chargeback, partner minimum gain chargeback, qualified income offset, and allocation of partner nonrecourse deductions. These provisions might be drafted simply: Clause 8. This Agreement incorporates by reference, as if fully set forth in this Agreement, the minimum gain chargeback set forth in Treasury Regulations Section (f ), the partner minimum gain chargeback as set forth in Treasury Regulations Section (i), and the qualified income offset set forth in Treasury Regulations Section (b)(2)(ii)(d) as if those provisions were explicitly set forth in this Agreement. Clause 9. All partner nonrecourse deductions shall be allocated to the Member that bears the economic risk of loss for the liability in accordance with Treasury Regulations Section (i)(1). Clause 10. All nonrecourse deductions shall be allocated x% to Ephriam, y% to Balthasar, and z% to Mordechia. Clause 11. All exculpatory deductions shall be allocated x% to Ephriam, y% to Balthasar, and z% to Mordechia, except as otherwise may be required by Section 704. Clause 7 contemplates separate allocation of nonrecourse deductions, partner nonrecourse deductions, and exculpatory deductions. The partnership agreement should have a provision allocating tax items of income, gain, loss, and deduction in accordance with Section 704(c)(1)(A) and its principles. Clause 7 attempts to replicate what would happen on an actual sale and liquidation: Clause 7 applies both to traditional income and loss items and to book -up items. 20

21 Clause 7 is based on allocations of items of gross income and gross deduction rather than net income and net loss. Clause 7 addresses situations in which the partnership may not have sufficient net income or net losses in order to cause hypothetical capital accounts to equal target capital accounts. Gross item allocations may be required under partners interests in the partnership where net item allocations do not cause hypothetical capital accounts to equal target capital accounts. This is the target: the hypothetical amount that the Company would distribute to the member if o o o the Company sold all of its assets for their book values (or, for the amount of nonrecourse liabilities or partner nonrecourse liabilities secured by these assets, if nonrecourse liabilities or partner nonrecourse liabilities exceed book values), first applied the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company s method of accounting), and then distributed the remaining net proceeds of this sale in accordance with the liquidating distribution provision. Clause 7 does not simply use nonrecourse liabilities without defining the term. The parenthetical where liabilities exceed book value refers to both nonrecourse liabilities and partner nonrecourse liabilities. These liabilities are defined by cross-reference to the Treasury Regulations Section (a)(4)(i). These items are allocated outside of Clause 7 and necessarily will be recognized and adjust capital accounts on a liquidating sale. Clause 7 defines book value unambiguously by reference to the Allocation Regulations. Clause 7 defines items of book income and items of book loss by reference to items that adjust capital accounts maintained in accordance with the Allocation Regulations. Clause 7 excludes book items allocated under the minimum gain chargeback and the partner minimum gain chargeback, and nonrecourse deductions, partner nonrecourse deductions, and exculpatory deductions. These items are allocated elsewhere in the partnership agreement. Clause 7 hypothetically credits to Capital Accounts the amounts hypothetically recognized under the minimum gain chargeback and partner minimum gain chargeback on the Hypothetical Sale and Liquidation. 21

22 Shares of book income and book loss are comprised of a ratable share of book income and book loss to the extent reasonably possible. Clause 7 determines Capital Accounts after o recognition of any specially allocated items. o contributions and distributions for the year. o recognition of items under minimum gain chargeback and partner minimum gain chargeback. o after the net capital contribution that the partner would be expected to make on liquidation of the partnership, considering qualifying deficit restoration obligations (but not considering deemed deficit restoration obligations on account of minimum gain or partner minimum gain in order to avoid double counting). The adjustment for restoration obligations may be in error. The law on this question is not altogether. The standard for deficit restoration provisions and capital contribution provisions perhaps should just refer to the rules of partners interests in the partnership. This is a matter for the future to resolve. The alternative test of economic effect provides for these adjustments to capital accounts in determining what losses we can allocate to a partner: (4) Adjustments that, as of the end of such year, reasonably are expected to be made to such partner s capital account under paragraph (b)(2 )(iv)(k) of this section for depletion allowances with respect to oil and gas properties of the partnership, and (5 ) Allocations of loss and deduction that, as of the end of such year, reasonably are expected to be made to such partner pursuant to section 704(e)(2 ), section 706(d ), and paragraph (b)(2 )(ii) of section 751-1, and (6 ) Distributions that, as of the end of such year, reasonably are expected to be made to such partner to the extent they exceed offsetting increases to such partner s capital account that reasonably are expected to occur during (or prior to) the partnership taxable years in which such distributions reasonably are expected to be made "(other than increases pursuant to a minimum gain chargeback under paragraph (b)(4)(iv)(e) of this section or under section ( f ); however, increases to a partner s capital account pursuant to a minimum gain chargeback requirement are taken into account as an offset to distributions of nonrecourse liability 22

23 proceeds that are reasonably expected to be made and that are allocable to an increase in partnership minimum gain)" under section ( f ). 15 It seems quite plausible that these adjustments should be made in determining capital accounts for purposes of computing target allocations. This question is left to the future to explore. Regulations to date do not provide guidance. Too many target allocation provisions use the term nonrecourse liabilities in the target allocation provision without defining nonrecourse liabilities. This leaves the term ambiguous. A well-drafted target allocation provision carefully defines what it means by nonrecourse liabilities and partner nonrecourse liabilities by reference to Nonrecourse Deduction Regulations or the Section 1001 regulations Nonrecourse Liabilities. The target allocation provision may satisfy the nonrecourse deduction safe harbor if allocations under the target allocation provision are deemed to have economic effect on account of economic effect equivalence. Explicit allocations of nonrecourse deductions then should be respected. Whether this argument works is a matter of conjecture. The target allocation provision is unlikely to satisfy the nonrecourse deduction safe harbor if allocations under the target allocation provision do not satisfy the economic effect equivalence test. Failure to satisfy economic effect equivalence will create substantial doubt that explicit special allocations of nonrecourse deductions will be respected. Nonrecourse deductions then should be allocated in accordance with partners interests in the partnership. What that means often is in doubt. Failure to satisfy the nonrecourse deduction safe harbor calls into question whether allocation of nonrecourse deductions under the target allocation provision or outside of the target allocation provision will be respected. 15 Treas. Reg (b)(2)(d )(4), (5 ), (6 ). 16 Clause 7 defines nonrecourse liabilities in terms of Treasury Regulations Section These regulations determine whether a liability is nonrecourse for purposes of determining an amount realized. Liabilities that are nonrecourse for purposes of Section 1001 are not necessarily precisely the same liabilities that are nonrecourse for purposes of Section 704 and Section 752. There is no statutory or regulatory definition of nonrecourse liabilities under Section A nonrecourse liability is a liability that creates an amount realized on sale or exchange equal to the full amount of the liability, even where the liability exceeds the fair market value of the security. Adjusting target capital accounts in accordance with the principles of the Allocation Regulations is a sensible approach. Nonrecourse deductions produce minimum gain. This minimum gain is based on Section 704 principles for nonrecourse liabilities. Partnership nonrecourse deductions produce partner nonrecourse debt minimum gain,. This partner nonrecourse debt minimum gain is based on Section 704 principles for partner nonrecourse liabilities. Both minimum gain and partner minimum gain create deemed capital account deficit restoration obligations. These deficit restoration obligations should be a factor in drafting the target allocation provision. 23

24 Many advisors will seek to specially allocate nonrecourse deductions in drafting a target allocation provision, despite the uncertainty over whether those special allocations of nonrecourse deductions will be respected for tax purposes. Doubts about the status of allocations of nonrecourse deductions complicate the use of target allocation provisions. The effectiveness of special allocations of nonrecourse deductions often will be in doubt. Advisors seeking certainty that allocations of nonrecourse deductions will be respected should consider the advisability of using a target allocation provision. Section 752 regulations define a nonrecourse liability : A partnership liability is a nonrecourse liability to the extent that no partner or related person bears the economic risk of loss for that liability under section By contrast, A partnership liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under section This constitutes a logical partition. A partnership liability necessarily is either a recourse liability or nonrecourse liability under the Section 752 regulations. Economic risk of loss is determined under Treasury Regulations Section Extensive rules are set forth in this regulation. The general standard for measuring economic risk of loss is based on the extent that (if the partnership constructively liquidated) the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner Treas. Reg (a)(2). 18 Treas. Reg (a)(1). 19 Treas. Reg (b)(1) ( (b) Obligation to make a payment. (1) In general. Except as otherwise provided in this section, a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner. Upon a constructive liquidation, all of the following events are deemed to occur simultaneously: (i) All of the partnership s liabilities become payable in full; (ii) With the exception of property contributed to secure a partnership liability (see section (h)(2)), all of the partnership s assets, including cash, have a value of zero; (iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor s right to repayment is limited solely to one or more assets of the partnership); (iv) All items of income, gain, loss, or deduction are allocated among the partners; and (v) The partnership liquidates. ). 24

25 An obligation to make a payment is measured based on a facts and circumstances test. The analysis is based on all statutory and contractual obligations relating to the partnership liability. 20 Special rules apply where a partner or related person is a lender. Regulations provide generally that: A partner bears the economic risk of loss for a partnership liability to the extent that the partner or a related person makes (or acquires an interest in) a nonrecourse loan to the partnership and the economic risk of loss for the liability is not borne by another partner. 21 A special rule can apply when a partner is a lender. The general rule that treats the lending partner as bearing the economic risk of loss of a nonrecourse loan that the partner lends to the partnership does not apply if a partner or related person whose interest (directly or indirectly through one or more partnerships including the interest of any related person) in each item of partnership income, gain, loss, deduction, or credit for every taxable year that the partner is a partner in the partnership is 10 percent or less, 20 Treas. Reg (b)(3), (4), (5) ( (3) Obligations recognized. The determination of the extent to which a partner or related person has an obligation to make a payment under paragraph (b)(1) of this section is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for purposes of applying this section, including: (i) Contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or to other partners, or to the partnership; (ii) Obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership; and (iii) Payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law, including the governing state partnership statute. To the extent that the obligation of a partner to make a payment with respect to a partnership liability is not recognized under this paragraph (b)(3), paragraph (b) of this section is applied as if the obligation did not exist. (4) Contingent obligations. A payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs. (5) Reimbursement rights. A partner s or related person s obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or a person who is a related person to another partner. (6) Deemed satisfaction of obligation. For purposes of determining the extent to which a partner or related person has a payment obligation and the economic risk of loss, it is assumed that all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. ). 21 Treas. Reg (c)(1). 25

26 makes a loan to the partnership which constitutes qualified nonrecourse financing within the meaning of Section 465(b)(6) (determined without regard to the type of activity financed). 22 A parallel rule applies when a partner is a guarantor of partnership debt. The general rule concerning economic risk of loss does not apply if a partner or related person whose interest (directly or indirectly through one or more partnerships including the interest of any related person) in each item of partnership income, gain, loss, deduction, or credit for every taxable year that the partner is a partner in the partnership is 10 percent or less, guarantees a loan that would otherwise be a nonrecourse loan of the partnership and 22 Treas. Reg (d)(1). See I.R.C. 465(b)(6) ( Qualified nonrecourse financing treated as amount at risk. For purposes of this section (A) In general. Notwithstanding any other provision of this subsection, in the case of an activity of holding real property, a taxpayer shall be considered at risk with respect to the taxpayer s share of any qualified nonrecourse financing which is secured by real property used in such activity. (B) Qualified nonrecourse financing. For purposes of this paragraph, the term qualified nonrecourse financing means any financing (i) which is borrowed by the taxpayer with respect to the activity of holding real property, (ii) which is borrowed by the taxpayer from a qualified person or represents a loan from any Federal, State, or local government or instrumentality thereof, or is guaranteed by any Federal, State, or local government, (iii) except to the extent provided in regulations, with respect to which no person is personally liable for repayment, and (iv) which is not convertible debt. (C) Special rule for partnerships. In the case of a partnership, a partner s share of any qualified nonrecourse financing of such partnership shall be determined on the basis of the partner s share of liabilities of such partnership incurred in connection with such financing (within the meaning of section 752). (D) Qualified person defined. For purposes of this paragraph (i) In general. The term qualified person has the meaning given such term by section 49(a)(1)(D)(iv). (ii) Certain commercially reasonable financing from related persons For purposes of clause (i), section 49(a)(1)(D)(iv) shall be applied without regard to subclause (I) thereof (relating to financing from related persons) if the financing from the related person is commercially reasonable and on substantially the same terms as loans involving unrelated persons. (E) Activity of holding real property For purposes of this paragraph (i) Incidental personal property and services The activity of holding real property includes the holding of personal property and the providing of services which are incidental to making real property available as living accommodations. (ii) Mineral property The activity of holding real property shall not include the holding of mineral property. ). See I.R.C. 49(a)(1)(D)(iv) ( (iv) Qualified persons For purposes of this paragraph, the term qualified person means any person which is actively and regularly engaged in the business of lending money and which is not (I) a related person with respect to the taxpayer, (II) a person from which the taxpayer acquired the property (or a related person to such person), or (III) a person who receives a fee with respect to the taxpayer s investment in the property (or a related person to such person). ). 26

27 which would constitute qualified nonrecourse financing within the meaning of Section 465(b)(6) (without regard to the type of activity financed) if the guarantor had made the loan to the partnership. 23 The Nonrecourse Deduction Regulations contain complex special rules for determining economic risk of loss with respect to a nonrecourse liability with interest guaranteed by a partner Treas. Reg (d)(2). 24 Treas. Reg (e) ( (e) Special rule for nonrecourse liability with interest guaranteed by a partner. (1) In general. For purposes of this section, if one or more partners or related persons have guaranteed the payment of more than 25 percent of the total interest that will accrue on a partnership nonrecourse liability over its remaining term, and it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if the partnership fails to do so, then the liability is treated as two separate partnership liabilities. If this rule applies, the partner or related person that has guaranteed the payment of interest is treated as bearing the economic risk of loss for the partnership liability to the extent of the present value of the guaranteed future interest payments. The remainder of the stated principal amount of the partnership liability constitutes a nonrecourse liability. Generally, in applying this rule, it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if, upon a default in payment by the partnership, the lender can enforce the interest guaranty without foreclosing on the property and thereby extinguishing the underlying debt. The guarantee of interest rule continues to apply even after the point at which the amount of guaranteed interest that will accrue is less than 25 percent of the total interest that will accrue on the liability. (2) Computation of present value. The present value of the guaranteed future interest payments is computed using a discount rate equal to either the interest rate stated in the loan documents, or if interest is imputed under either section 483 or section 1274, the applicable federal rate, compounded semi-annually. The computation takes into account any payment of interest that the partner or related person may be required to make only to the extent that the interest will accrue economically (determined in accordance with section 446 and the regulations thereunder) after the date of the interest guarantee. If the loan document contains a variable rate of interest that is an interest rate based on current values of an objective interest index, the present value is computed on the assumption that the interest determined under the objective interest index on the date of the computation will remain constant over the term of the loan. The term objective interest index has the meaning given to it in section 1275 and the regulations thereunder (relating to variable rate debt instruments). Examples of an objective interest index include the prime rate of a designated financial institution, LIBOR [London Interbank Offered Rate], and the applicable federal rate under section 1274(d). (3) Safe harbor. The general rule contained in paragraph (e)(1) of this section does not apply to a partnership nonrecourse liability if the guarantee of interest by the partner or related person is for a period not in excess of the lesser of five years or one-third of the term of the liability. (4) De minimis exception. The general rule contained in paragraph (e)(1) of this section does not apply if a partner or related person whose interest (directly or indirectly through one or more partnerships including the interest of any related person) in each item of partnership income, gain, loss, deduction, or credit far every taxable year that the partner is a partner in the partnership is 10 percent or less, guarantees the interest on a loan to that partnership which constitutes qualified nonrecourse financing within the meaning of section 465(b)(6) (determined (footnote continued on the next page) 27

28 Contingent obligations to make payments are generally disregarded under the Section 752 regulations in determining economic risk of loss. 25 Reimbursement rights can cause a reallocation of economic risk of loss under Section One of the controversial aspects of the Section 752 economic risk of loss rules is an unlimited presumption of solvency of the partner. A partner is deemed able to satisfy any obligation to make a payment to satisfy an obligation to a partnership, regardless of the partner s actual assets. 27 The Allocation Regulations contain two relevant definitions that operate for purposes of Section 704: (3) Definition of nonrecourse liability. Nonrecourse liability means a nonrecourse liability as defined in section (a)(2) or a liability (as defined in (b)(3)(i)) 28 assumed by the partnership from a partner on or after June 24, without regard to the type of activity financed). An allocation of interest to the extent paid by the guarantor is not treated as a partnership item of deduction or loss subject to the 10 percent or less rule. ). 25 Treas. Reg (d)(4)( (4) Contingent obligations. A payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs. ). This may seem like an overly technical rule. This rule can affect how items are allocated under a sophisticated target allocation provision. Sophisticated target allocation provisions often provide for adjustments for capital contribution obligations and deemed capital contribution obligations. 26 Treas. Reg (d)(5)( (5) Reimbursement rights. A partner s or related person s obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or a person who is a related person to another partner. ). 27 Treas. Reg (d)(6). ( Deemed satisfaction of obligation. For purposes of determining the extent to which a partner or related person has a payment obligation and the economic risk of loss, it is assumed that all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. See paragraphs (j) and (k) of this section. ). 28 See Treas. Reg (a)(4) ( (4) Liability defined. (i) In general. An obligation is a liability for purposes of section 752 and the regulations thereunder ( liability), only if, when, and to the extent that incurring the obligation (A) Creates or increases the basis of any of the obligor s assets (including cash); (B) Gives rise to an immediate deduction to the obligor; or (C) Gives rise to an expense that is not deductible in computing the obligor s taxable income and is not properly chargeable to capital. (ii) Obligation. For purposes of this paragraph and , an obligation is any fixed or contingent obligation to make payment without regard to whether the (footnote continued on the next page) 28

29 (4) Definition of partner nonrecourse debt. Partner nonrecourse debt or partner nonrecourse liability means any partnership liability to the extent the liability is nonrecourse for purposes of section , and a partner or related person (within the meaning of section (b)) bears the economic risk of loss under section because, for example, the partner or related person is the creditor or a guarantor. 29 There is an interesting lack of parallelism between the definition of nonrecourse liability under the Section 704 and the definition of partner nonrecourse liability under Section 704. The definition of partner nonrecourse liability depends on the liability being obligation is otherwise taken into account for purposes of the Internal Revenue Code. Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps. ). See Treas. Reg (b)(3)(i)( (3) liability. (i) In general. A liability is an obligation described in (a)(4)(ii) to the extent that either (A) The obligation is not described in (a)(4)(i); or (B) The amount of the obligation (under paragraph (b)(3)(ii) of this section) exceeds the amount taken into account under (a)(4)(i). (ii) Amount and share of liability. The amount of a liability (or, for purposes of paragraph (b)(3)(i) of this section, the amount of an obligation) is the amount of cash that a willing assignor would pay to a willing assignee to assume the liability in an arm s-length transaction. If the obligation arose under a contract in exchange for rights granted to the obligor under that contract, and those contractual rights are contributed to the partnership in connection with the partnership s assumption of the contractual obligation, then the amount of the liability or obligation is the amount of cash, if any, that a willing assignor would pay to a willing assignee to assume the entire contract. A partner s share of a partnership s liability is the amount of deduction that would be allocated to the partner with respect to the liability if the partnership disposed of all of its assets, satisfied all of its liabilities (other than liabilities), and paid an unrelated person to assume all of its liabilities in a fully taxable arm s-length transaction (assuming such payment would give rise to an immediate deduction to the partnership). (iii) Example. In 2005, A, B, and C form partnership PRS. A contributes $10,000,000 in exchange for a 25% interest in PRS and PRS s assumption of a debt obligation. The debt obligation was issued for cash and the issue price was equal to the stated redemption price at maturity ($5,000,000). The debt obligation bears interest, payable quarterly, at a fixed rate of interest, which was a market rate of interest when the debt obligation was issued. At the time of the assumption, all accrued interest has been paid. Prior to the partnership assuming the obligation, interest rates decrease, resulting in the debt obligation bearing an above-market interest rate. Assume that, as a result of the decline in interest rates, A would have had to pay a willing assignee $6,000,000 to assume the debt obligation. The assumption of the debt obligation by PRS from A is treated as an assumption of a (a)(4)(i) liability in the amount of $5,000,000 (the portion of the total amount of the debt obligation that has created basis in A s assets, that is, the $5,000,000 that was issued in exchange for the debt obligation ) and an assumption of a liability in the amount of $1,000,000 (the difference between the total obligation, $6,000,000, and the (a)(4)(i) liability, $5,000,000). ). 29 Treas. Reg (b)(3), (4). 29

30 nonrecourse for purposes of the Section 1001 regulations. The definition of nonrecourse liability under the Section 704 regulations does not expressly reference Section 1001 and depends exclusively on the Section 752 regulations. Whether this distinction was intended by the draftsmen is a matter that thoughtful advisors will debate. Some target allocation provisions allocate nonrecourse deductions as part of Net Profits and Net Losses, even though chargeback allocations under the minimum gain chargeback are allocated separately from the target allocation provision. This scheme can result in different ratios of allocations of Net Income and Net Losses between partners from year to year. This can result in annually shifting allocations of nonrecourse deductions. Annually shifting allocations of nonrecourse deductions are not legally infirm, but this scheme shifting allocations of nonrecourse deductions may not make sense to the partners. Most advisors prefer a single ratio for allocating nonrecourse deductions that is invariable over time, if that single ratio is permitted. Nonrecourse deductions perhaps can be addressed through a special allocation of nonrecourse deductions; nonrecourse deductions then are excluded from Net Income and Net Loss. The exclusion provision might be: For this purpose, Net Income and Net Loss shall be computed by excluding items allocated under Section 704(c)(1)(A), under the minimum gain chargeback, under the partner minimum gain chargeback, or under the qualified income offset, and also by excluding items allocated as nonrecourse deductions or as partner nonrecourse deductions. Whether the Nonrecourse Deduction Regulations permit a special allocation of nonrecourse deductions when the partnership uses a target allocation provision is a matter of conjecture and some dispute. Some advisors are concerned that the target allocation provision will not satisfy the requirements of economic effect and the requirements of the Nonrecourse Deduction Regulations for allocations of nonrecourse deductions. This creates uncertainty concerning whether explicit special allocations of nonrecourse deductions outside of the target allocation provision will be respected for tax purposes. Whether allocations of nonrecourse deductions within the target allocation provision will be respected is uncertain. Some advisors will avoid using a target allocation provision when they require certainty that allocations of nonrecourse deductions will be respected. Many advisors are uncertain whether special allocations of nonrecourse deductions will be permitted when the partnership uses a target allocation provision, but a significant proportion of these advisors optimistically provide for special allocations of nonrecourse deductions. The Nonrecourse Deduction Regulations provide: Allocations of nonrecourse deductions are deemed to be in accordance with the partners interests in the partnership only if 30

31 (1) Throughout the full term of the partnership requirements (1) and (2) of section (b)(2)(ii)(b) are satisfied (i.e., capital accounts are maintained in accordance with section (b)(2)(iv) and liquidating distributions are required to be made in accordance with positive capital account balances), and requirement (3) of either section (b)(2)(ii)(b) or section (b)(2)(ii)(d) is satisfied (i.e., partners with deficit capital accounts have an unconditional deficit restoration obligation or agree to a qualified income offset); (2) Beginning in the first taxable year of the partnership in which there are nonrecourse deductions and thereafter throughout the full term of the partnership, partnership agreement provides for allocations of nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities; (3) Beginning in the first taxable year of the partnership that it has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain, and thereafter throughout the full term of the partnership, the partnership agreement contains a provision that complies with the minimum gain chargeback requirement of paragraph (f ) of this section; and (4) All other material allocations and capital account adjustments under the partnership agreement are recognized under section (b) (without regard to whether allocations of adjusted tax basis and amount realized under section 613A(c)(7 )(D) are recognized under section (b)(4)(v)). 30 A target allocation provision may not meet the requirements of requirement (1). The heart of the target allocation provision is that distributions are made in accordance with specified tiers that do not reference capital accounts. Distributions are not required to be made in accordance with positive capital account balances. A target allocation provision usually is designed to produce consistency between specified distributions without referencing capital accounts and distributing liquidation proceeds in accordance with capital accounts. Knowledgeable tax advisors will debate whether tax allocations can satisfy requirement (2) consistency with allocations that have substantial economic effect. This poses the question of whether allocations under the target allocation provision can have substantial economic effect or deemed economic effect. 30 Treas. Reg (e). 31

32 5. Exculpatory Liabilities. A category of nonrecourse liability under Section 704 may not produce minimum gain or nonrecourse deductions. This class of liabilities generally is referred to as exculpatory liabilities. 31. This class of liabilities are not secured by any specific property and [are] recourse to the partnership as an entity, but explicitly not recourse to any partner. 32 There is some doubt concerning how deductions attributable to exculpatory liabilities should be handled under a target allocation provision. There is some doubt concerning how deductions attributable to exculpatory liabilities should be handled under any allocation regime. There is reason to believe that there is flexibility in allocating exculpatory deductions. Some agreements will specially allocate exculpatory deductions and not allocate these exculpatory deductions under the target allocation provision. Exculpatory deductions are an area where tax theory currently is immature. Three examples of exculpatory liabilities are: A liability that is a general recourse liability to a limited liability company. An unsecured liability of a limited liability company. An unsecured liability of a general partnership that does not permit recourse against its partners. An unsecured liability of a special purpose limited liability subsidiary of a partnership (at least, this may be an exculpatory liability; this liability may not be recourse to the partnership as an entity). A liability that is full recourse to partnership assets but nonrecourse to the partners very likely is not a nonrecourse liability for purposes of Section The liability apparently does not qualify as a partner nonrecourse liability if the partner is a lender. The liability is recourse for purposes of Section A liability that is nonrecourse for purposes of Section 752 that is not a nonrecourse liability for purposes of Section 1001 is problematic. A liability might be a loan from a nonpartner lender (not affiliated with a partner) which loan is full recourse to all partnership assets. (The loan might be an unsecured partner from a small partner.) This liability is a nonrecourse liability under Section 704. The liability likely is recourse for purposes of Section The partnership may endeavor to compute minimum gain with respect to this liability. Minimum gain determined by first computing for each partnership nonrecourse liability any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability, and then aggregating the separately computed gains. 31 See T.D. 8385, 56 Fed. Reg (December 27, 1991). 32 Id. 32

33 (1) Amount of partnership minimum gain. The amount of partnership minimum gain is determined by first computing for each partnership nonrecourse liability any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability, and then aggregating the separately computed gains. The amount of partnership minimum gain includes minimum gain arising from a conversion, refinancing, or other change to a debt instrument, as described in paragraph (g)(3) of this section, only to the extent a partner is allocated a share of that minimum gain. For any partnership taxable year, the net increase or decrease in partnership minimum gain is determined by comparing the partnership minimum gain on the last day of the immediately preceding taxable year with the partnership minimum gain on the last day of the current taxable year. 33 This amount of minimum gain is computed independently of the fair market value of the property if the liability is a nonrecourse liability for purposes of Section The amount realized on disposition of property to satisfy a liability that is nonrecourse under Section 1001 is equal to the amount of the nonrecourse liability. The amount realized on disposition of property to satisfy a liability that is a recourse liability under Section 1001 is limited to the fair market value of the property. Partnership minimum gain depends on the property being subject to the nonrecourse liability. This language ( subject to ) normally implies that the property is security for the nonrecourse liability. It is not clear that property should be considered subject to a liability that the property does not secure. An interpretational problem arises when we consider the definition of partnership minimum gain. The Nonrecourse Deduction Regulations provide: 33 Treas. Reg (d)(1). 33

34 (2) Definitions of and allocations pursuant to a minimum gain chargeback. To the extent a nonrecourse liability exceeds the adjusted tax basis of the partnership property it encumbers, a disposition of that property will generate gain that at least equals that excess ( partnership minimum gain ). An increase in partnership minimum gain is created by a decrease in the adjusted tax basis of property encumbered by a nonrecourse liability below the amount of that liability and by a partnership nonrecourse borrowing that exceeds the adjusted tax basis of the property encumbered by the borrowing. Partnership minimum gain decreases as reductions occur in the amount by which the nonrecourse liability exceeds the adjusted tax basis of the property encumbered by the liability. Allocations of gain attributable to a decrease in partnership minimum gain (a minimum gain chargeback, as required under paragraph (f ) of this section) cannot have economic effect because the gain merely offsets nonrecourse deductions previously claimed by the partnership. Thus, to avoid impairing the economic effect of other allocations, allocations pursuant to a minimum gain chargeback must be made to the partners that either were allocated nonrecourse deductions or received distributions of proceeds attributable to a nonrecourse borrowing. Paragraph (e) of this section provides a test that, if met, deems allocations of partnership income pursuant to a minimum gain chargeback to be in accordance with the partners interests in the partnership. If property encumbered by a nonrecourse liability is reflected on the partnership s books at a value that differs from its adjusted tax basis, paragraph (d)(3) of this section provides that minimum gain is determined with reference to the property s book basis Minimum gain depends on the principal balance of a nonrecourse liability exceeding the adjusted tax basis (or book value) of partnership property that the nonrecourse liability encumbers. The definitions in the paragraph set forth above repeatedly refer not just to nonrecourse liability but to the property it encumbers. 35 These is uncertainty in the meaning of encumbers in this context. The term encumbers perhaps means burdens. That, however, is not a common legal use for the term encumbers. A more 34 Treas. Reg (b)(2). 35 Compare with Treas. Reg (h)(1) ( (h) Distribution of nonrecourse liability proceeds allocable to an increase in partnership minimum gain. (1) In general. If during its taxable year a partnership makes a distribution to the partners allocable to the proceeds of a nonrecourse liability, the distribution is allocable to an increase in partnership minimum gain among the liabilities in proportion to the amount each liability contributed to the increase in minimum gain to the extent the increase results from encumbering partnership property with aggregate nonrecourse liabilities that exceed the property s adjusted tax basis. See paragraph (m), Example (1)(vi) of this section. If the net increase in partnership minimum gain for a partnership taxable year is allocable to more than one nonrecourse liability, the net increase is allocated among the liabilities in proportion to the amount each liability contributed to the increase in minimum gain. ). 34

35 common use of encumbers as a legal term means that the property has been pledged as security for the liability. A liability perhaps produces minimum gain under this usage only if the liability is secured by a pledge of property as security for the liability. This meaning may be consistent with the concept of nonrecourse liability under Section Limiting minimum gain to nonrecourse liabilities under Section 1001 can be appealing. The root concept of minimum gain is that minimum gain is the minimum amount that the partnership would recognize on a foreclosure or sale of the property. This suggests that minimum gain should be limited to liabilities that are nonrecourse liabilities under Section 1001, even though nonrecourse liabilities are defined under Section 704 and Section 752. Exculpatory liabilities perhaps should generate minimum gain. Nonrecourse liabilities under Section 704 are expressly defined in terms of nonrecourse liabilities under Section 752 rather than Section No particular evidence suggests that, when the Nonrecourse Deduction Regulations were drafted, the draftsmen considered the possible difference between nonrecourse liabilities under Section 1001 and nonrecourse liabilities under Section 704 or Section 752. The discussion of exculpatory liabilities in Treasury Decision 8385 strongly implies that nonrecourse liabilities generate minimum gain: Section (b)(3) of the final regulations defines nonrecourse liability by referring to the definition of nonrecourse liability in the regulations under section 752. Under that definition, an exculpatory liability is a nonrecourse liability. The application of the nonrecourse debt rules of section more specifically, the calculation of minimum gain may be difficult in the case of an exculpatory liability, however, because the liability is not secured by specific property and the bases of partnership properties that can be reached to the lender in the case of an exculpatory liability may fluctuate greatly. 36 This statement may have been based on a misapprehension of the operation of Section The quoted passage fails to recognize that exculpatory liabilities may fail to generate minimum gain at all. Perhaps potential cancellation of indebtedness income will substitute for amount recognized on a sale or foreclosure. Treasury Decision 8385 gives the partnership apparent flexibility in drafting allocations of income and loss attributable to exculpatory liabilities: 36 See T.D. 8385, 56 Fed. Reg (December 27, 1991). 35

36 Section does not prescribe precise rules addressing the allocation of income and loss attributable to exculpatory liabilities. Taxpayers, therefore, are left to treat allocations attributable to these liabilities in a manner that reasonably reflects the principles of section 704(b). Commentators have requested that the treatment of allocations attributable to exculpatory liabilities under the nonrecourse debt rules be clarified. The Service and the Treasury solicit further suggestions on the appropriate treatment of allocations attributable to these liabilities. Suggestions should take into account the practical concerns of partnerships as well as the Service s concerns about the proper allocation of loss and gain items attributable to these liabilities. 37 The flexibility that may be offered by Treasury Decision 8385 is uncertain. Allocations of exculpatory deductions must be made in a manner that reasonably reflects the principles of section 704(b). This may be a significant challenge. A court might interpret this language restrictively. Precisely how exculpatory deductions should be allocated by a partnership that uses target allocation provisions is a matter of conjecture and one that goes beyond the scope of this article. There is doubt uncertainty concerning how a partnership should allocate exculpatory deductions. For example, exculpatory deductions funded by a partner loan presumably should be allocated to the funding partner. Other exculpatory exculpatory deductions should be allocable to all partners. The prevalence of exculpatory deductions suggests that advisors should consider how they should allocate exculpatory deductions. Whether exculpatory deductions produce minimum gain will affect the behavior of target allocation provisions. Minimum gain creates a deemed capital account deficit restoration obligation. The future has much to resolve about exculpatory liabilities and exculpatory deductions. The resolution of many of these questions can affect future drafting of target allocation provisions. Some allocations are mandated by Treasury Regulations. The most prominent of these mandated allocations is the minimum gain chargeback. Another one of these mandatory allocations is the partner minimum gain chargeback that can apply when a partner or partner affiliate has made a nonrecourse loan to the partnership. The minimum gain chargeback will allocate income and gain items based on past allocations of nonrecourse deductions. Allocations under the minimum gain chargeback or partner minimum gain chargeback may or may not conform to how the partnership would allocate these income and gain items under the target allocation provision. The partner minimum gain chargeback will allocate income and gain items based on past allocations of partner nonrecourse deductions. 37 Id. 36

37 Partner nonrecourse deductions are allocated to the partner who bears the economic risk of loss of the partner nonrecourse debt that created the deductions. Partner nonrecourse deductions are not appropriately allocated under the target allocation provision. Partner nonrecourse deductions should be excluded from the operation of the target allocation provision. A partnership may have either partner nonrecourse deductions or partner nonrecourse deductions. Good drafting practice requires excluding items allocated under the minimum gain chargeback or the partner minimum gain chargeback (or the qualified income offset) from items allocated under the target allocation provision. Good drafting practice excludes partner nonrecourse deductions from items allocated under the target allocation provision. The partnership agreement is not permitted arbitrarily to allocate partner nonrecourse deductions. Partner nonrecourse debt or partner nonrecourse liability means any partnership liability to the extent the liability is nonrecourse for purposes of Treasury Regulations Section , and a partner or related person (within the meaning of Treasury Regulations Section (b)) bears the economic risk of loss under Treasury Regulations Section because, for example, the partner or related person is the creditor or a guarantor. 38 The Nonrecourse Deduction Regulations require that partnership losses, deductions, or Section 705(a)(2)(B) expenditures that are attributable to a particular partner nonrecourse liability ( partner nonrecourse deductions ) be allocated to the partner who bears the economic risk of loss for the liability. The Nonrecourse Deduction Regulations further provide that, if more than one partner bears the economic risk of loss for a partner nonrecourse liability, any partner nonrecourse deductions attributable to that liability must be allocated among the partners according to the ratio in which they bear the economic risk of loss Qualified Income Offset. Many advisors believe that the partnership agreement should contain a separate qualified income offset. The qualified income offset, however, is not normally considered to be a mandatory allocation required under the Allocation Regulations. A qualified income offset may not be a necessary accessory to a target allocation provision if the partnership does not seek to qualify the target allocation provision under the alternate test of economic effect. A qualified income offset, however, conceivably could be required in order to satisfy partners interests in the partnership. An auditing Internal Revenue Service agent might expect to see a qualified income offset and might be well be pleased to see one when auditing the partnership. A partnership agreement contains a qualified income offset if, and only if, the partnership agreement provides that 38 Treas. Reg (b)(4). 39 Treas. Reg (i)(1). 37

38 A partner who unexpectedly receives an adjustment, allocation, or distribution described in paragraphs (4), (5), or (6) of the Allocation Regulations (described below), will be allocated items of income and gain (consisting of a pro rata portion of each item of partnership income, including gross income, and gain for such year) in an amount and manner sufficient to eliminate its deficit balance as quickly as possible. These are the adjustments, allocations, and distributions described in paragraphs (4), (5), or (6): Adjustments that, as of the end of the year, reasonably are expected to be made to the partner s capital account under paragraph (b)(2)(iv)(k) of the Allocation Regulations for depletion allowances with respect to oil and gas properties of the partnership, Allocations of loss and deduction that, as of the end of the year, reasonably are expected to be made to the partner pursuant to Section 704(e)(2), 40 Section 706(d), 41 and Treasury Regulations Section 751-1(b)(2)(ii), 42 and 40 See I.R.C. 704(e)(2) ( (2) Distributive share of donee includible in gross income. 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. ). 41 See I.R.C. 706(d) ( (d) Determination of distributive share when partner s interest changes. (1) In general. Except as provided in paragraphs (2) and (3), if during any taxable year of the partnership there is a change in any partner s interest in the partnership, each partner s distributive share of any item of income, gain, loss, deduction, or credit of the partnership for such taxable year shall be determined by the use of any method prescribed by the Secretary by regulations which takes into account the varying interests of the partners in the partnership during such taxable year. (2) Certain cash basis items prorated over period to which attributable (A) In general. If during any taxable year of the partnership there is a change in any partner s interest in the partnership, then (except to the extent provided in regulations) each partner s distributive share of any allocable cash basis item shall be determined (i) by assigning the appropriate portion of such item to each day in the period to which it is attributable, and (ii) by allocating the portion assigned to any such day among the partners in proportion to their interests in the partnership at the close of such day. (B) Allocable cash basis item For purposes of this paragraph, the term allocable cash basis item means any of the following items with respect to which the partnership uses the cash receipts and disbursements method of accounting: (i) Interest. (ii) Taxes. (iii) Payments for (footnote continued on the next page) 38

39 Distributions that, as of the end of the year, reasonably are expected to be made to the partner to the extent they exceed offsetting increases to the partner s capital account that reasonably are expected to occur during (or prior to) the partnership taxable years in which the distributions reasonably are expected to be made (other than increases pursuant to a minimum gain chargeback under Treasury Regulations Section (b)(4)(iv)(e) or under services or for the use of property. (iv) Any other item of a kind specified in regulations prescribed by the Secretary as being an item with respect to which the application of this paragraph is appropriate to avoid significant misstatements of the income of the partners. (C) Items attributable to periods not within taxable year. If any portion of any allocable cash basis item is attributable to (i) any period before the beginning of the taxable year, such portion shall be assigned under subparagraph (A)(i) to the first day of the taxable year, or (ii) any period after the close of the taxable year, such portion shall be assigned under subparagraph (A)(i) to the last day of the taxable year. (D) Treatment of deductible items attributable to prior periods. If any portion of a deductible cash basis item is assigned under subparagraph (C)(i) to the first day of any taxable year (i) such portion shall be allocated among persons who are partners in the partnership during the period to which such portion is attributable in accordance with their varying interests in the partnership during such period, and (ii) any amount allocated under clause (i) to a person who is not a partner in the partnership on such first day shall be capitalized by the partnership and treated in the manner provided for in section 755. (3) Items attributable to interest in lower tier partnership prorated over entire taxable year. If (A) during any taxable year of the partnership there is a change in any partner s interest in the partnership (hereinafter in this paragraph referred to as the upper tier partnership ), and (B) such partnership is a partner in another partnership (hereinafter in this paragraph referred to as the lower tier partnership ), then (except to the extent provided in regulations) each partner s distributive share of any item of the upper tier partnership attributable to the lower tier partnership shall be determined by assigning the appropriate portion (determined by applying principles similar to the principles of subparagraphs (C) and (D) of paragraph (2)) of each such item to the appropriate days during which the upper tier partnership is a partner in the lower tier partnership and by allocating the portion assigned to any such day among the partners in proportion to their interests in the upper tier partnership at the close of such day. (4) Taxable year determined without regard to subsection (c)(2)(a). For purposes of this subsection, the taxable year of a partnership shall be determined without regard to subsection (c)(2)(a). ). 42 See Treas. Reg (b)(2)(i), (ii) ( (2) Distribution of section 751 property (unrealized receivables or substantially appreciated inventory items). (i) To the extent that a partner receives section 751 property in a distribution in exchange for any part of his interest in partnership property (including money) other than section 751 property, the transaction shall be treated as a sale or exchange of such properties between the distributee partner and the partnership (as constituted after the distribution). (ii) At the time of the distribution, the partnership (as constituted after the distribution) realizes ordinary income or loss on the sale or exchange of the section 751 property. The amount of the income or loss to the partnership will be measured by the difference between the adjusted basis to the partnership of the section 751 property considered as sold to or exchanged with the partner, and the fair market value of the distributee partner s interest in other partnership property which he relinquished in the exchange. In computing the partners distributive shares of such ordinary income or loss, the income or loss shall be allocated only to partners other than the distributee and separately taken into account under section 702(a)(8). ). 39

40 Treasury Regulations Section (f ); however, increases to a partner s capital account pursuant to a minimum gain chargeback requirement are taken into account as an offset to distributions of nonrecourse liability proceeds that are reasonably expected to be made and that are allocable to an increase in partnership minimum gain) under Treasury Regulations Section (f ). Many advisors endorse including a separate qualified income offset in addition to a target allocation provision if only to accommodate the predilections of auditing Internal Revenue Service agents. Besides, most advisors already have qualified income offsets in their form files, and a good qualified income offset can give a partnership agreement the aura of robustness even if practically no one understands precisely what the qualified income offset really does. Furthermore, the qualified income offset rarely actually applies for most partnerships. Advisors also should consider whether the three adjustments made to capital accounts under the alternate test of economic effect should be made for purposes of target allocations. To date, no clear authority exists on this question. 7. Economic Effect. Target allocation provisions appear to fail to provide economic effect 43 under the Allocation Regulations to allocations of income, gain, loss, and deduction. 44 Target allocation provisions have substantial risk of not satisfying the alternate test of economic effect 45 ( alternate economic effect ) or the economic effect equivalence test ( economic effect equivalence ). The matter is not resolved especially with respect to economic effect equivalence. 46 The partnership tax laws then would evaluate target allocation provisions under the ambiguous standard of partners interests in the partnership. Target allocations of nonrecourse deductions are uncertain to meet requirements for nonrecourse deduction allocations under the Nonrecourse Deduction Regulations. The matter is not at all resolved. Considerable doubt exists concerning whether target allocation provisions satisfy the fractions rule under Section 514(c)(9)(E). The matter has not been clearly resolved. This makes use of target allocation provisions possibly inappropriate until uncertainties in the law are resolved where a partnership seeks to satisfy the fractions rule. Advisors perhaps should to wait until the tax law has resolved whether target allocations without deficit restoration can satisfy the fractions rule. 43 Treas. Reg (b)(2)(ii). 44 See discussion in Cuff, Some Basic Issues in Drafting Real Estate Partnership and Limited Liability Company Agreements, 65 NYU INSTIT. ON FED. TAX N (2007). 45 Treas. Reg (b)(2)(ii)(d ). Cuff, Some Basic Issues in Drafting Real Estate Partnership and limited liability company agreements, 65 NYU INSTIT. ON FED. TAX N [7] (2007). 46 Treas. Reg (b)(2)(ii)(i ). 40

41 Common practices in drafting partnership agreements may be flawed or those common practices may turn out to be completely fine. Some able practitioners may have been following poor drafting practice or they may have been drafting partnership agreements completely satisfactorily. Allocations under a target allocation provision apparently cannot satisfy the basic tests of economic effect... throughout the full term of the partnership, the partnership agreement provides (1) For the determination and maintenance of the partners capital accounts in accordance with the rules of paragraph (b)(2)(iv) of this section, (2) Upon liquidation of the partnership (or any partner s interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (2) and requirement (3) of this paragraph (b)(2)(ii)(b)), by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), and (3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2) of this paragraph (b)(2)(ii)(b)). 47 The partnership may maintain capital accounts in accordance with or more or less in accordance with the Allocation Regulations. The target allocation provision has an uncertain claim to satisfying requirement (2) of economic effect liquidation in accordance with capital accounts. Advisors, however, may argue that requirement (2) of economic effect is de facto satisfied if the target allocation provision and distribution provisions are crafted properly. The target allocation provision has a particularly poor claim to satisfying requirement (3) of economic effect deficit capital account restoration. 47 Treas. Reg (b)(2)(ii)(b). 41

42 The Allocation Regulations require that partnership allocations of income, gain, loss, and deduction have substantiality in order to have substantial economic effect. 48 The test of substantiality is sufficiently complex, badly thought out, and badly written that few partnership advisors are much concerned with substantiality of allocations any more. 49 This Article will not discuss issues of substantiality in detail. Partnership tax laws test partnership allocations of income, gain, loss, and deduction with the test of substantiality in order for allocations to have substantial economic effect. Failure to satisfy substantiality potentially can result in advisor penalties under Section 6694 and possibly client penalties under Section Alternative Test of Economic Effect. Some advisors assert that the target allocation provision can satisfy the alternate test of economic effect. Other advisors disagree. The debate usually is conducted at a level of sufficient sophistication about partnership tax theory that most advisors will decline to participate. The alternate test of economic effect provides: If (1) Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, and 48 Treas. Reg (b)(2)(i). 49 On substantiality, see Treas. Reg (b)(2)(iii)(a) ( Except as otherwise provided in this paragraph (b)(2)(iii), the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Notwithstanding the preceding sentence, the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. In determining the after-tax economic benefit or detriment to a partner, tax consequences that result from the interaction of the allocation with such partner s tax attributes that are unrelated to the partnership will be taken into account.... ). See, also, Cuff, Some Basic Issues in Drafting Real Estate Partnership and limited liability company agreements, 65 NYU INSTIT. ON FED. TAX N (2007). 42

43 (2) The partner to whom an allocation is made is not obligated to restore the deficit balance in his capital account to the partnership (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section), or is obligated to restore only a limited dollar amount of such deficit balance, and (3) The partnership agreement contains a qualified income offset, such allocation will be considered to have economic effect under this paragraph (b)(2)(ii)(d) to the extent such allocation does not cause or increase a deficit balance in such partner s capital account (in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore) as of the end of the partnership taxable year to which such allocation relates. In determining the extent to which the previous sentence is satisfied, such partner s capital account also shall be reduced for (4) Adjustments that, as of the end of such year, reasonably are expected to be made to such partner s capital account under paragraph (b)(2)(iv)(k) of this section for depletion allowances with respect to oil and gas properties of the partnership, and (5) Allocations of loss and deduction that, as of the end of such year, reasonably are expected to be made to such partner pursuant to section 704(e)(2), section 706(d), and paragraph (b)(2)(ii) of section 751-1, and (6 ) Distributions that, as of the end of such year, reasonably are expected to be made to such partner to the extent they exceed offsetting increases to such partner s capital account that reasonably are expected to occur during (or prior to) the partnership taxable years in which such distributions reasonably are expected to be made (other than increases pursuant to a minimum gain chargeback under paragraph (b)(4)(iv)(e) of this section or under section (f ); however, increases to a partner s capital account pursuant to a minimum gain chargeback requirement are taken into account as an offset to distributions of nonrecourse liability proceeds that are reasonably expected to be made and that are allocable to an increase in partnership minimum gain) under section (f ). 50 A target allocation provision makes an uncertain case for satisfying the alternate test of economic effect. The case for satisfying requirement (1) of the alternate test of economic effect is uncertain. The partnership agreement using target allocation provisions will not explicitly liquidate in accordance with capital accounts, even if the agreement maintains capital accounts in accordance with the Allocation Regulations. The partnership agreement may be able to satisfy requirement (2) of the alternate test of economic effect. 50 Treas. Reg (b)(2)(ii)(d ). 43

44 The partnership agreement can satisfy requirement (3) of the alternate test of economic effect if the partnership agreement contains an explicit qualified income offset. A target allocation provision operating by itself without a separately stated qualified income offset is unlikely to satisfy requirement (3) of the alternate test of economic effect. The target allocation provision by itself is unlikely to constitute a qualified income offset. The target allocation provision, however, may be drafted to work in tandem with a qualified income offset. 9. Economic Effect Equivalence Test. Many advisors are comfortable that target allocation provisions can satisfy the economic effect equivalence test and have deemed economic effect. The economic effect equivalence test is a results-oriented test. The debate divides concerning whether target allocation provisions satisfy the economic effect equivalence test divides some of the ablest tax advisors in the country. One group of advisors appears positive that a well-drafted target allocation provision will satisfy the economic effect equivalence test. Another group of advisors is equally convinced that the typical target allocation provision cannot satisfy the economic effect equivalence test. There presumably is a third group of advisors who are not sure. Advisors in the third group usually are quieter than advisors in the other two groups. The Internal Revenue Service might appropriately weigh in on this debate. A partnership may have considerably greater difficulty satisfying the economic effect equivalence test than is generally supposed. Economic effect equivalence may apply only to a very limited class of partnerships, which may exclude practically all limited liability companies. Economic effect equivalence may be of profoundly limited usefulness for a limited partnership or limited liability company. A partnership agreement may have to have a capital account deficit restoration obligation (or such an obligation may need to be supplied under state law) if allocations are to satisfy economic effect equivalence, but this matter is not unambiguously clear from the Allocation Regulations. The economic effect equivalence test requires: Allocations made to a partner that do not otherwise have economic effect under this paragraph (b)(2)(ii) shall nevertheless be deemed to have economic effect, provided that as of the end of each partnership taxable year a liquidation of the partnership at the end of such year or at the end of any future year would produce the same economic results to the partners as would occur if requirements (1), (2), and (3) of paragraph (b)(2)(ii)(b) of this section had been satisfied, regardless of the economic performance of the partnership Treas. Reg (b)(2)(ii)(i ). 44

45 The economic effect equivalence test ties to the basic test of economic effect but does not appear to tie at all to the alternate test of economic effect. At least, the portion of the Allocation Regulations considering economic effect equivalence does not refer explicitly to the alternate test of economic effect. Economic effect equivalence must be satisfied at the end of the current year and at the end of any future year. The economic effect equivalence test requires that as of the end of each partnership taxable year a liquidation of the partnership at the end of such year or at the end of any future year would produce the same economic results to the partners as would occur if requirements (1), (2 ), and (3) of paragraph (b)(2)(ii)(b) of this section had been satisfied, regardless of the economic performance of the partnership. The meaning of this language is unclear. The partnership must satisfy economic effect equivalence regardless of the economic performance of the partnership. What this means is not clear. A partnership with target allocation provisions will not liquidate explicitly in accordance with capital accounts. Further, a partnership agreement with target allocation provisions typically will not provide for deficit capital account restoration. Whether these elements are required in order for a target allocation provision to produce economic effect equivalence is not entirely resolved. An example in the Allocation Regulations suggests that the regulations do have flexibility, at least with respect to requiring that the partnership liquidate in accordance with capital accounts. Few limited liability company agreements or limited partnership agreements provide for deficit capital account restoration. Depending on the resolution of this issue, many or few partnership agreements will satisfy economic effect equivalence. Economic effect equivalence may be the minnow that swallows the whale if economic effect equivalence is applied as a more practical test that does not require deficit capital account restoration for limited liability companies. Economic effect equivalence might become the most common defense for partnership allocations. Language of economic effect equivalence may require that the partnership satisfy deficit capital account restoration or, at least, produce the same economic results to the partners as would occur if the partnership agreement contained a qualifying capital account deficit restoration obligation. What this means, particularly in the case of a limited liability company, is not altogether clear. Limited liability companies rarely have deficit restoration obligations. These deficit restoration obligations may not be necessary for a limited liability company. Limited liability companies offer members the protection of a liability shield that usually (but not invariably) protects member assets from entity liabilities. Whether a limited liability company can satisfy economic effect equivalence in absence of an explicit capital account deficit restoration obligation unlikely to be found in a partnership agreement designed with target allocation provisions is a matter of conjecture. This matter would greatly benefit from clarification of the current Allocation Regulations. Most limited liability companies may have difficulty satisfying requirement (3) of economic effect deficit restoration. Few limited liability company agreements have capital account deficit restoration obligations. A limited liability company may have difficulty satisfying requirement (3) of economic effect equivalence without a capital account deficit 45

46 restoration obligation either explicitly set forth in the partnership agreement or imposed by state law. Advisors of the limited liability company may suggest that requirement (3) is satisfied automatically the liability shield of the limited liability company will ensure that no member will have a deficit capital account at liquidation and therefore an explicit deficit restoration obligation is meaningless. 52 Treasury and Internal Revenue Service promulgated economic effect equivalence prior to widespread use of limited liability companies. A court perhaps should look at economic effect equivalence more flexibly and in light of current prevalence of limited liability companies. No abuse is apparent in circumstances in which a limited liability company de facto liquidates in accordance with capital accounts but a member does not have a deficit capital account restoration obligation. The implicit purpose of the deficit capital account restoration obligation would seem to be merely to ensure that the partnership truly liquidate in accordance with positive capital account balances. A court perhaps could waive requirement (3) for a limited liability company where the court determines that risk is remote that a partner will have a deficit capital account in excess of the partner s share of minimum gain and partnership minimum gain. Protection afforded by the limited liability company s liability shield usually should protect members from having positive capital accounts when another partner has a negative capital account if allocations work properly. We might be able to suggest economic circumstances in which one partner might be required to return a pro rata distribution and another would not. 53 Circumstances can exist in which distributions to partners can be clawed back by the limited liability company. Circumstances exist in which the shield of limited liability can be pierced by creditors. Many limited liability company advisors might respond that it is nonsense to require a limited liability company to have a deficit restoration provision in its limited liability company agreement in order to meet economic effect equivalence. (Partnership and limited partnership advisors incidentally might make the same argument.) Skeptics might respond that regulations so punctilious as to require a qualified income offset under alternate economic effect should be interpreted to require deficit restoration in order to satisfy economic effect equivalence. The economic effect equivalence test is illustrated by this example from the Allocation Regulations. The example unfortunately does not make economic effect equivalence much clearer. 52 Treas. Reg (b)(2)(ii)(e). 53 For example, the distributions to partners could be set aside as fraudulent conveyances in appropriate circumstances, and a creditor might elect to pursue its remedies against only one partner. 46

47 Example (4). (i) G and H contribute $75,000 and $25,000, respectively, in forming a general partnership. The partnership agreement provides that all income, gain, loss, and deduction will be allocated equally between the partners, that the partners capital accounts will be determined and maintained in accordance with paragraph (b)(2)(iv) of this section, but that all partnership distributions will, regardless of capital account balances, be made 75 percent to G and 25 percent to H. Following the liquidation of the partnership, neither partner is required to restore the deficit balance in his capital account to the partnership for distribution to partners with positive capital account balances. The allocations in the partnership agreement do not have economic effect. Since contributions were made in a 75/25 ratio and the partnership agreement indicates that all economic profits and losses of the partnership are to be shared in a 75/25 ratio, under paragraph (b)(3) of this section, partnership income, gain, loss, and deduction will be reallocated 75 percent to G and 25 percent to H. (ii) Assume the same facts as in (i) except that the partnership maintains no capital accounts and the partnership agreement provides that all income, gain, loss, deduction, and credit will be allocated 75 percent to G and 25 percent to H. G and H are ultimately liable (under a State law right of contribution) for 75 percent and 25 percent, respectively, of any debts of the partnership. Although the allocations do not satisfy the requirements of paragraph (b)(2)(ii)(b) of this section, the allocations have economic effect under the economic effect equivalence test of paragraph (b)(2)(ii)(i) of this section. (iii) Assume the same facts as in (i) except that the partnership agreement provides that any partner with a deficit balance in his capital account must restore that deficit to the partnership (as set forth in paragraph (b)(2)(ii)(b)(2) of this section). Although the allocations do not satisfy the requirements of paragraph (b)(2)(ii)(b) of this section, the allocations have economic effect under the economic effect equivalence test of paragraph (b)(2)(ii)(i) of this section. 54 Several features of this example are interesting. The partnership agreement in the example does not liquidate explicitly in accordance with capital account balances. The partnership agreement in (i) contains allocation of tax items inconsistent with the distribution scheme in liquidation. The partnership agreement has partners making contributions in a 75:25 ratio, it provides that all income, gain, loss, and deduction will be allocated equally between the partners, and all distributions will be mae in a 75:25 ratio. The allocations in the partnership agreement, of course, are nonsense allocations completely at variance with partnership economics. The allocations have no economic effect. 54 Treas. Reg (b)(5), Example (5). 47

48 The partnership agreement in (ii) produces the same results as if the partnership did liquidate in accordance with capital account balances. The example indicates that producing the same results as liquidating in accordance with capital account balances in good enough to satisfy the economic effect equivalence test. The partners in (ii) are ultimately liable under a state law right of contribution for debts of the partnership. This acts as a surrogate deficit capital account restoration obligation. This surrogate deficit restoration obligation apparently satisfies the deficit capital account restoration requirement. The economic effect equivalence test appears to ignore the subtleties of the definition of liquidation under the Allocation Regulations. The example does not discuss the significance of the failure to meet the time periods for deficit restoration in the Allocation Regulations. The Allocation Regulations require restoration within a fixed period not discussed in the example: If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2 ) of this paragraph (b)(2)(ii)(b)). 55 The example fails to note that the concept of liquidation in the Allocation Regulations is broader than the normal state law concept of liquidation. Deficit restoration is required on a constructive tax liquidation of the partnership. That aspect is not present in the example. The example does not capture the many nuances of liquidation in the Allocation Regulations. The Allocation Regulations provide: 55 Treas. Reg (b)(2)(ii)(b)(3). 48

49 For purposes of this paragraph, a liquidation of a partner s interest in the partnership occurs upon the earlier of (1) the date upon which there is a liquidation of the partnership, or (2) the date upon which there is a liquidation of the partner s interest in the partnership under paragraph (d) of section For purposes of this paragraph, the liquidation of a partnership occurs upon the earlier of (3) the date upon which the partnership is terminated under section 708(b)(1), or (4) the date upon which the partnership ceases to be a going concern (even though it may continue in existence for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to its partners). Requirements (2) and (3) of paragraph (b)(2)(ii)(b) of this section will be considered unsatisfied if the liquidation of a partner s interest in the partnership is delayed after its primary business activities have been terminated (for example, by continuing to engage in a relatively minor amount of business activity, if such actions themselves do not cause the partnership to terminate pursuant to section 708(b)(1)) for a principal purpose of deferring any distribution pursuant to requirement (2) of paragraph (b)(2)(ii)(b) of this section or deferring any partner s obligations under requirement (3) of paragraph (b)(2)(ii)(b) of this section. 56 Some advisors believe that a court would approve target allocation provisions under the economic effect equivalence since target allocation provisions are not abusive and should be encouraged. A court could use the economic effect equivalence test to justify approving allocations under a target allocation provision. Thus far, target allocation provisions have not be tested in court in tax litigation. Other advisors believe that economic effect equivalence can be satisfied only if the partnership agreement has an explicit deficit restoration provision or a deficit restoration provision implied under state law. These advisors may believe that the partnership agreement must explicitly liquidate by capital accounts in all events in order to satisfy economic effect equivalence. Some advisors believe that economic effect equivalence requires either an explicit or an implied capital account deficit restoration obligation. This view often is based on the example in the Allocation Regulations. Some advisors argue that economic effect equivalence is a limited exception and that economic effect equivalence was not intended to undermine the extensive, precise tests of economic effect. Broad application of the economic effect equivalence test to limited liability companies would substantially restrict the importance of capital account deficit restoration. Some advisors argue that the precision with which the deficit restoration obligation requirement was drafted suggests that the Allocation Regulations did not intend that this requirement should be easily avoided or circumvented. 56 Treas. Reg (b)(2)(ii)(h). 49

50 Partnerships using target allocations do not expressly allocate in accordance with capital accounts. They normally do not have any provision for deficit capital account restoration at any time. They may compute capital accounts in accordance with the Allocation Regulations or close to in accordance with the Allocation Regulations, but these capital accounts do not affect partnership economics. A partnership agreement using a target allocation provision reads differently from a partnership agreement seeking to satisfy the primary test of economic effect under the Allocation Regulations. Advisors also should remember that, even if a target allocation provision satisfied the economic effect equivalence test, allocations also must satisfy the requirement of substantiality under the Allocation Regulations. The tax law also has not clearly resolved whether satisfaction of the economic effect equivalence test will vest allocations with sufficient deemed economic effect so that allocations under a target allocation provision will satisfy Section 514(c)(9)(E) or the nonrecourse deduction safe harbor under the Nonrecourse Deduction Regulations. Part (iii) of the example is a situation in which the economic effect equivalence test is satisfied by a capital account deficit restoration obligation. This part uses the irregular allocations in part (i), except that economics are conformed to capital accounts by the deficit restoration obligation. The example conclides that the allocations have economic effect under the economic effect equivalence test. A special class of economic cases particularly challenges target allocation provisions. The economic plan of a partnership agreement may return capital to partner A, pay a preferred return to partner A, and then return capital to and then profits to partner B. The subordination of return of capital distributions to partner B to both capital and profit distributions to partner A can create a situation in which capital accounts will not properly account for how the partnership would liquidate unless capital is shifted from one partner to another. Existing tax law on how to approach this situation is perilously thin. Some advisors believe that this situation requires a taxable capital shift between partners. Other advisors do not feel that a capital shift is necessary. The partnership agreement may violate the requirement of economic effect equivalence of equivalence that the partnership liquidate in accordance with capital accounts in these situations. The exercise of options to acquire partnership interests also may create situations in which the partnership may fail to liquidate in accordance with capital accounts, notwithstanding the application of a target allocation provision. This situation also provides challenges for satisfying the economic effect equivalence test with target allocations. This Article will not resolve whether the target allocation provision will satisfy economic effect through the economic effect equivalence test. The resolution of this question is not clear. Advisors are divided in their views. 50

51 10. Partners Interests in the Partnership. The Allocation Regulations provide only general guidance concerning partners interests in the partnership. The Allocation Regulations provide a Readers Digest introduction to partners interests in the partnership. The partners interests in the partnership rules can be easy to apply in easy circumstances. The tax laws often provide uncertain guidance on how to apply partners interests in the partnership rules in more complicated circumstances. The general message of partners interests in the partnership is that partners interests in the partnership signif[ies] the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated. 57 This is correct. This guidance is of limited help. The Allocation Regulations continue: Except with respect to partnership items that cannot have economic effect (such as nonrecourse deductions of the partnership), this sharing arrangement may or may not correspond to the overall economic arrangement of the partners. Thus, a partner who has a 50 percent overall interest in the partnership may have a 90 percent interest in a particular item of income or deduction. 58 This is helpful. It does not provide an unambiguous analytical paradigm for determining partners interests in the partnership. The Allocation Regulations advise in a parenthetical: For example, in the case of an unexpected downward adjustment to the capital account of a partner who does not have a deficit make-up obligation that causes such partner to have a negative capital account, it may be necessary to allocate a disproportionate amount of gross income of the partnership to such partner for such year so as to bring that partner s capital account back up to zero. 59 This is useful. This passage tell us that partners interests in the partnership may require gross income or gross loss allocations to achieve partners interests in the partnership. This language from the Allocation Regulations may provide guidance that target allocation provisions should base allocations on gross items or perhaps this is a false inference. Gross items allocations in target allocation provisions can help to avoid capital shifts between partners. Gross item allocations can be useful in ensuring that a target allocation provision will satisfy partners interests in the partnership. The Allocation Regulations clarify: 57 Treas. Reg (b)(3). 58 Id. 59 Id. 51

52 The determination of a partner s interest in a partnership shall be made by taking into account all facts and circumstances relating to the economic arrangement of the partners. 60 This advice is daunting. We do not have a clear analytical paradigm or a clear analytical objective, and the test is applied by taking into account all facts and circumstances relating to the economic arrangement of the partners. We may be in for a difficult, uncertain analytical expedition. This language may clarify that what the partnership agreement says about allocation is irrelevant in determining partners interests in the partnership. Partners interests in the partnership is based on all facts and circumstances relating to the economic arrangement of the partners. What the partnership agreement says with respect to allocations (by contrary to partnership economics) may have no relevance to the inquiry if the partnership agreement uses a target allocation provision and allocations seek to qualify under partners interests in the partnership. The draftsmen perhaps should not spend too much time seeking to perfect a target allocation provision. That target allocation provision may make little difference to tax allocations at all. The Allocation Regulations determine partners interests in the partnership based on these factors (among others): (a) The partners relative contributions to the partnership, (b) The interests of the partners in economic profits and losses (if different than that in taxable income or loss), (c) The interests of the partners in cash flow and other non-liquidating distributions, and (d) The rights of the partners to distributions of capital upon liquidation. 61 The Allocation Regulations provide special rules where a partnership agreement satisfies the capital account maintenance rules of the Allocation Regulations and the capital account liquidation rules of the Allocation Regulations: If (a) Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, and (b) All or a portion of an allocation of income, gain, loss, or deduction made to a partner for a partnership taxable year does not have economic effect under paragraph (b)(2)(ii) of this section, 60 Id. 61 Treas. Reg (b)(3)(ii). 52

53 the partners interests in the partnership with respect to the portion of the allocation that lacks economic effect will be determined by comparing the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the taxable year to which the allocation relates with the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the prior taxable year, and adjusting the result for the items described in (4), (5), and (6) of paragraph (b)(2)(ii)(d) of this section. A determination made under this paragraph (b)(3)(iii) will have no force if the economic effect of valid allocations made in the same manner is insubstantial under paragraph (b)(2)(iii) of this section This language suggests (under the circumstances in which this rule applies) a capital account analysis in applying partners interests in the partnership. This language also appears to set forth the paradigm for target allocations. Many advisors would like to imagine that partners interests in the partnership involves no more than a capital account analysis. Capital account analysis seems to have been the inspiration of target allocation provisions. A pure capital account analysis, however, is unlikely to apply to target allocation provisions. Target allocation provisions typically do not liquidate expressly by capital account. The hypothetical sale under this test is a hypothetical sale where all partnership property were sold at book value and the partnership were liquidated immediately following the end of the taxable year to which the allocation relates with the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the prior taxable year. 63 This rule assumes a sale of all assets at book value (without a special rule for property encumbered by nonrecourse liabilities) followed by a constructive liquidation. The special rule adjusts the capital account result for the items described in (4), (5 ), and (6 ) of paragraph (b)(2)(ii)(d ) of this section. These are the included adjustments: (4) Adjustments that, as of the end of such year, reasonably are expected to be made to such partner s capital account under paragraph (b)(2)(iv)(k) of this section for depletion allowances with respect to oil and gas properties of the partnership, and (5) Allocations of loss and deduction that, as of the end of such year, reasonably are expected to be made to such partner pursuant to section 704(e)(2), section 706(d), and paragraph (b)(2)(ii) of section 751-1, and 62 Treas. Reg (b)(3)(iii). 63 Treas. Reg (b)(3)(iii). 53

54 (6 ) Distributions that, as of the end of such year, reasonably are expected to be made to such partner to the extent they exceed offsetting increases to such partner s capital account that reasonably are expected to occur during (or prior to) the partnership taxable years in which such distributions reasonably are expected to be made (other than increases pursuant to a minimum gain chargeback under paragraph (b)(4)(iv)(e) of this section or under section (f ); however, increases to a partner s capital account pursuant to a minimum gain chargeback requirement are taken into account as an offset to distributions of nonrecourse liability proceeds that are reasonably expected to be made and that are allocable to an increase in partnership minimum gain) under section (f ). 64 The special rule appears to clarify that considerations of substantiality can apply to partners interests in the partnership. This matter has not been resolved. The special rule does provide: A determination made under this paragraph (b)(3)(iii) will have no force if the economic effect of valid allocations made in the same manner is insubstantial under paragraph (b)(2)(iii) of this section. 65 This may imply that substantiality can provide as a secondary test to partners interests in the partnership wherever partners interests in the partnership applies. The most important message of the Allocation Regulations on partners interests in the partnership is that the analysis is not a purely capital account analysis. This suggests caution concerning the reliability of allocations under a target allocation provision. Those allocations are based purely on satisfying a capital account analysis. 11. Substantiality. Consider the possibility that allocations under a target allocation provision not only need to satisfy an economic-effect-based test but also may need to satisfy rules of substantiality or their equivalent. This Article will not materially discuss substantiality and target allocations. Allocations likely must satisfy economic effect or an equivalent test (such as the economic effect equivalence test or partners interests in the partnership) and satisfy substantiality or an equivalent test. However frustrating this Article may seem to this point, this Article would be infinitely more frustrating if it robustly explored issues of substantiality concerning the target allocation provision. The basic test of substantiality is this: 64 Treas. Reg (b)(2)(ii)(b). 65 Treas. Reg (b)(3)(iii). 54

55 ... the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. 66 This is the true test of substantiality. This test may be applied to a target allocation provision. The Internal Revenue Service might use substantiality to disallow target allocations even though the target allocations satisfy either the economic effect equivalence test of partners interests in the partnership. The Allocation Regulations set forth various negative tests. The most important negative test is this (which does not really tell you when substantiality is satisfied, but does tell you when substantiality is not satisfied): Notwithstanding the preceding sentence, the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. In determining the after-tax economic benefit or detriment to a partner, tax consequences that result from the interaction of the allocation with such partner s tax attributes that are unrelated to the partnership will be taken into account.... References in this paragraph (b)(2)(iii) to a comparison to consequences arising if an allocation (or allocations) were not contained in the partnership agreement mean that the allocation (or allocations) is determined in accordance with the partners interests in the partnership (within the meaning of paragraph (b)(3) of this section), disregarding the allocation (or allocations) being tested under this paragraph (b)(2)(iii). 67 This test is difficult to apply in practice. The baseline to which the Allocation Regulations compare allocations often is uncertain. This baseline is the situation if the allocation (or allocations) were not contained in the partnership agreement. That often involves difficult judgments. We need to know the after-tax economic consequences to at least one partner in present value terms, without knowing the discount rate or the precise discounting formula to apply. 66 Treas. Reg (b)(2)(iii)(a). 67 Id. 55

56 We need to know the present value after-tax consequences if the allocation (or allocations) were not contained in the partnership agreement. This often is speculative and may depend on information not readily available to the partnership. The test speaks in terms of a strong likelihood, but we do not know precisely what that means. How likely is a strong likelihood? The test requires us to know the after-tax economic consequences to all partners in order for us to know that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. This is easier to discuss than to quantify. The partnership typically will not have this information at its disposal. How does the partnership go about getting this information? Can the partnership compel production of this information? Must partners cooperate. The substantiality test clarifies that: In determining the after-tax economic benefit or detriment to a partner, tax consequences that result from the interaction of the allocation with such partner s tax attributes that are unrelated to the partnership will be taken into account. This is fine to discuss, but this information will not be readily available to the partnership. The information often will be speculative. The Allocation Regulations clarify that [r]eferences... to a comparison to consequences arising if an allocation (or allocations) were not contained in the partnership agreement mean that the allocation (or allocations) is determined in accordance with the partners interests in the partnership (within the meaning of paragraph (b)(3) of this section), disregarding the allocation (or allocations) being tested under this paragraph (b)(2)(iii). The partners interests in the partnership allocations often are a matter of speculation. The Allocation Regulations specify other rules for shifting and transitory allocations. 68 Be mindful that these tests of substantiality might be applied to disallow target allocations that otherwise satisfy partners interests in the partnership or the economic effect equivalence test. 12. Net versus Gross Item Allocations. A healthy controversy disputes whether the target allocation provision should allocate net income and net loss or items of gross income and items of gross loss. This argument becomes significant when the partnership does not have enough items of net income or net loss to achieve target capital account values. The partnership may not have enough items of net income or net loss to achieve target capital account values, for example, when the 68 Treas. Reg (b)(2)(iii)(b), (c). 56

57 partnership makes a distribution of profits to one partner in preference to return-of-capital distributions to another partner. A partnership agreement might provide for this scheme of distributions from operations and on liquidation: First, to partner A, in an amount equal to an 8% preferred return to partner A, on his net invested capital in the partnership. Second, to partner A to return to partner A his net invested capital in the partnership. Third, to partner B, in an amount equal to an 8% preferred return to partner B, on his net invested capital in the partnership. Fourth,, to partner B to return to partner B his net invested capital in the partnership. Fifth, 70% to partner A and 30% to partner B. On an liquidation at the end of the year, partner A would have recovered all of his preferred return and his net capital investment before partner A receives any distributions. Partner A might fully recover his preferred return, even though partner B would not receive a full return of capital. The partnership would not have liquidated in accordance with capital accounts, violating a fundamental precept of economic effect. Some advisors believe that an allocation of gross items of income, gain, loss, and deduction is required in this situation because gross item allocations are more likely to cause hypothetical capital accounts under the target allocation provision to equal target capital accounts. Other advisors, however, believe that the partnership should be able to allocate net items under the target allocation provision, even where not enough net items are available to cause hypothetical capital accounts to equal target capital accounts. A net item allocation (net profits or net losses) may not be cause hypothetical capital accounts to equal target capital accounts. This can pose a serious obstacle to allocations satisfying economic effect equivalence. The economic effect equivalence test, for example, depends on the partnership agreement achieving the same results that it would achieve if it satisfied the three basic tests of economic effect. Economic effect equivalence would seem to be violated. Economic effect equivalence requires that: as of the end of each partnership taxable year a liquidation of the partnership at the end of such year or at the end of any future year would produce the same economic results to the partners as would occur if requirements (1), (2 ), and (3) of paragraph (b)(2)(ii)(b) of this section had been satisfied, regardless of the economic performance of the partnership. 69 A target allocation 69 Treas. Reg (b)(2)(ii)(i ). 57

58 provision is particularly problematic when distributions of profits to one partnership are preferred to return-of-capital distributions to another partner. An advisor favoring net item allocations might argue that his target allocation provision should be respected under partners interests in the partnership. The standard of partners interests in the partnership is an uncertain one. It is reasonable to suppose that partners interests in the partnership results in a unique allocation scheme: given a set of economic results for the partnership and a fixed distribution scheme, only one set of tax allocations should satisfy partners interests in the partnership. If partners interests in the partnership does not produce a unique allocation scheme, partners interests in the partnership simultaneously may result in more than one allocation scheme and, as a consequence, partners simultaneously may have two different correct tax liabilities (one under each allocation scheme). This would be anomalous. This reasoning suggests that, given a particular economic situation for a partnership, either a gross item allocation scheme or a net item allocation scheme, but not both, will satisfy partners interests in the partnership where the gross item allocation scheme and the net item allocation scheme do not produce identical results. The gross item allocation scheme seems the more likely to satisfy partners interests in the partnership. This scheme comes closest to the result with a partnership that fully complied with the three basic tests of economic effect under the Allocation Regulations. 13. Capital Shifts. It may not be possible to allocate items in such a manner that hypothetical capital accounts equal target capital accounts even with gross item allocations. Some advisors believe that there will be a shift of capital among partners if there are insufficient items to adjust hypothetical capital accounts to equal target capital accounts. This shift in capital may result in a deemed guaranteed payment to the partner whose capital accounts is increased. No direct authority addresses this subject. This is a matter about which knowledgeable advisors often speak at bar association meetings. A partner receiving a capital account in exchange for the performance of services is treated as receiving a guaranteed payment from the partnership. 70 This suggests that any shift of capital among partners (in the absence of a sale) may result in a guaranteed payment. Readers, however, are cautioned that this is a matter very much in controversy and very far from resolved. Authorities also have not explored the effect of the partnership s 70 See Prop. Treas. Reg (b)(4) ( (4) To the extent that a partnership interest is -- (i) Transferred to a partner in connection with the performance of services rendered to the partnership, it is a guaranteed payment for services under section 707(c); (ii) Transferred in connection with the performance of services rendered to a partner, it is not deductible by the partnership, but is deductible only by such partner to the extent allowable under Chapter 1 of the Code. ) 58

59 accounting method on when this guaranteed payment may occur if, in fact, the transaction is properly characterized as a guaranteed payment. The timing of income recognition may differ between an accrual method partnership and a cash method partnership. 14. Deficit Restoration and Contribution Obligations. The Allocation Regulations prescribe these general rules for a limited obligation to restore a deficit capital account: (c) Obligation to restore deficit. If a partner is not expressly obligated to restore the deficit balance in his capital account, such partner nevertheless will be treated as obligated to restore the deficit balance in his capital account (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section) to the extent of (1) The outstanding principal balance of any promissory note (of which such partner is the maker) contributed to the partnership by such partner (other than a promissory note that is readily tradable on an established securities market), and (2) The amount of any unconditional obligation of such partner (whether imposed by the partnership agreement or by State or local law) to make subsequent contributions to the partnership (other than pursuant to a promissory note of which such partner is the maker), 59

60 provided that such note or obligation is required to be satisfied at a time no later than the end of the partnership taxable year in which such partner s interest is liquidated (or, if later, within 90 days after the date of such liquidation). If a promissory note referred to in the previous sentence is negotiable, a partner will be considered required to satisfy such note within the time period specified in such sentence if the partnership agreement provides that, in lieu of actual satisfaction, the partnership will retain such note and such partner will contribute to the partnership the excess, if any, of the outstanding principal balance of such note over its fair market value at the time of liquidation. See paragraph (b)(2)(iv)(d)(2) of this section. See examples (1)(ix) and (x) of paragraph (b)(5) of this section. A partner in no event will be considered obligated to restore the deficit balance in his capital account to the partnership (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section) to the extent such partner s obligation is not legally enforceable, or the facts and circumstances otherwise indicate a plan to avoid or circumvent such obligation. See paragraphs (b)(2)(ii)(f), (b)(2)(ii)(h), and (b)(4)(vi) of this section for other rules regarding such obligation. For purposes of this paragraph (b)(2), if a partner contributes a promissory note to the partnership during a partnership taxable year beginning after December 29, 1988 and the maker of such note is a person related to such partner (within the meaning of section T(h), but without regard to subdivision (4) of that section), then such promissory note shall be treated as a promissory note of which such partner is the maker. 71 The Allocation Regulations also address the reduction of a partner s obligation to restore a deficit capital account: (f) Reduction of obligation to restore. If requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, a partner s obligation to restore the deficit balance in his capital account (or any limited dollar amount thereof) to the partnership may be eliminated or reduced as of the end of a partnership taxable year without affecting the validity of prior allocations (see paragraph (b)(4)(vi) of this section) to the extent the deficit balance (if any) in such partner s capital account, after reduction for the items described in (4), (5), and (6) of paragraph (b)(2)(ii) (d) of this section, will not exceed the partner s remaining obligation (if any) to restore the deficit balance in his capital account The Nonrecourse Deduction Regulations treat a partner s share of minimum gain in effect as a limited capital account deficit restoration obligation for purposes of the alternate test of economic effect: 71 Treas. Reg (b)(2)(ii)(c). 72 Treas. Reg (b)(2)(ii)( f ). 60

61 For purposes of section (b)(2)(ii)(d), a partner s share of partnership minimum gain is added to the limited dollar amount, if any, of the deficit balance in the partner s capital account that the partner is obligated to restore The Nonrecourse Deduction Regulations treat a partner s share of partner minimum gain in effect as a limited capital account deficit restoration obligation for purposes of the alternate test of economic effect: For purposes of section (b)(2)(ii)(d), a partner s share of partner nonrecourse debt minimum gain is added to the limited dollar amount if any, of the deficit balance in the partner s capital account that the partner is obligated to restore, and the partner is not otherwise considered to have a deficit restoration obligation as a result of bearing the economic risk of loss for any partner nonrecourse debt The Allocation Regulations treat a partner s share of minimum gain and the partner s share of partner minimum gain as an addition to the limited dollar amount of the partner s capital account deficit restoration obligation only for purposes of the alternate test of economic effect. Advisors, however, generally seek to satisfy the economic effect equivalence test or partners interests in the partnership with target allocation provisions. The economic effect equivalence test ties to the basic test of economic effect and not to the alternate test of economic effect. Treating a partner s share of minimum gain and partner minimum gain as reducing the target capital account certainly seems to be a sensible approach in applying a target allocation provision if the formula looks to target capital accounts pre-recognition of minimum gain and partner minimum gain. Advisors, however, should recognize that this goes beyond what the Allocation Regulations and the Nonrecourse Deduction Regulations say explicitly. A partner s share of minimum gain and a partner s share of partner minimum gain in any event constitute an amount that will be recognized on a disposition of all partnership assets. A target allocation provision may determine target capital accounts after adjustments for any specially allocated items, contributions, or distributions for the fiscal year and as if any net book income from the minimum gain chargeback or partner minimum gain chargeback that would have been recognized on this hypothetical sale has been recognized and credited to or debited from (as the case may be) the members capital accounts. Advisors are cautioned to reduce target capital accounts for unrecognized minimum gain and partner minimum gain if their computations are pre-recognition of the minimum gain chargeback and partner minimum gain chargeback. Advisors are cautioned not to reduce target capital accounts for minimum gain and partner minimum gain if their computations 73 Treas. Reg (g). 74 Treas. Reg (i)(5). 61

62 are post-recognition of the minimum gain chargeback and partner minimum gain chargeback. Under the alternate test of economic effect, an allocation will be considered to have economic effect... to the extent such allocation does not cause or increase a deficit balance in such partner s capital account (in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore) as of the end of the partnership taxable year to which such allocation relates. 75 The capital account adjustment on account of expected contributions in Clause 7 requires special consideration. This adjustment is not clearly mandated by the Allocation Regulations, but it is suggested by the Allocation Regulations. The partners relative contributions to the partnership are a factor under partners interests in the partnership. 76 Deficit restoration is an important test of economic effect. 77 Obligations to make contributions to restore a deficit capital account balance qualify under that test only is contributions are required to be made within time periods specified in the Allocation Regulations and also are required on tax terminations of the partnership. Clause 7 imports that standard. The portion of the Allocation Regulations devoted to obligations to restore deficits similarly requires that the obligation is required to be satisfied at a time no later than the end of the partnership taxable year in which such partner s interest is liquidated (or, if later, within 90 days after the date of such liquidation). 78 This standard also is embraced in the alternate test of economic effect Treas. Reg (b)(2)(ii)(d ). 76 Treas. Reg (b)(3)(ii)(a). 77 Treas. Reg (b)(2)(ii)(b)(3) ( (3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2 ) of this paragraph (b)(2)(ii)(b)). ). 78 Treas. Reg (b)(2)(ii)(c) ( (c) Obligation to restore deficit. If a partner is not expressly obligated to restore the deficit balance in his capital account, such partner nevertheless will be treated as obligated to restore the deficit balance in his capital account (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section) to the extent of (1) The outstanding principal balance of any promissory note (of which such partner is the maker) contributed to the partnership by such partner (other than a promissory note that is readily tradable on an established securities market), and (2 ) The amount of any unconditional obligation of such partner (whether imposed by the partnership agreement or by State or local law) to make subsequent contributions to the partnership (other than pursuant to a promissory note of which such partner is the maker), provided that such note or obligation is required to be satisfied at a time no later than the end of the partnership taxable year in which such partner s interest is liquidated (or, if later, within 90 days (footnote continued on the next page) 62

63 The adjustment to capital accounts on account of obligations to contribute to capital as set forth in Clause 7 may be incorrect. A capital contribution obligation perhaps should adjust capital accounts even though the obligation does not meet the requirements of the basic test of economic effect under the Allocation Regulations. Such a contribution obligation might be an obligation that is payable at a set time, but that is not payable as required at the times required under the basic test of economic effect under the Allocation Regulations. The adjustment for the obligation to contribute in the future perhaps should be discounted to present value if the obligation does not accelerate on the liquidation of the partnership. The adjustment for the obligation to contribute in the future perhaps should be discounted only if the obligation does not accelerate on the liquidation of the partnership and the obligation does not bear adequate interest. The adjustment for the obligation to contribute in the future perhaps should be equal to the fair market value of the obligation if the obligation does not accelerate on the liquidation of the partnership. The Allocation Regulations unfortunately do not provide any clear guidance. 15. Conclusion This Article has resolved nothing. It has neither made the case in favor of target allocations nor made the case against them. Target allocation provisions can be sensible if used in proper circumstances when the draftsman understands the resulting allocations. The draftsman must discern when target allocation provisions are appropriate after the date of such liquidation). If a promissory note referred to in the previous sentence is negotiable, a partner will be considered required to satisfy such note within the time period specified in such sentence if the partnership agreement provides that, in lieu of actual satisfaction, the partnership will retain such note and such partner will contribute to the partnership the excess, if any, of the outstanding principal balance of such note over its fair market value at the time of liquidation. See paragraph (b)(2)(iv)(d )(2 ) of this section. See examples (1)(ix) and (x) of paragraph (b)(5) of this section. A partner in no event will be considered obligated to restore the deficit balance in his capital account to the partnership (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section) to the extent such partner s obligation is not legally enforceable, or the facts and circumstances otherwise indicate a plan to avoid or circumvent such obligation. See paragraphs (b)(2)(ii)( f ), (b)(2)(ii)(h), and (b)(4)(vi) of this section for other rules regarding such obligation. For purposes of this paragraph (b)(2), if a partner contributes a promissory note to the partnership during a partnership taxable year beginning after December 29, 1988 and the maker of such note is a person related to such partner (within the meaning of section T(h), but without regard to subdivision (4) of that section), then such promissory note shall be treated as a promissory note of which such partner is the maker. ). 79 Treas. Reg (b)(2)(d ) ( (d ) Alternate test for economic effect. If (1) Requirements (1) and (2 ) of paragraph (b)(2)(ii)(b) of this section are satisfied, and (2 ) The partner to whom an allocation is made is not obligated to restore the deficit balance in his capital account to the partnership (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section), or is obligated to restore only a limited dollar amount of such deficit balance, and (3) The partnership agreement contains a qualified income offset,. ). 63

64 and when they are not. Target allocation provisions are not a solution for all situations and for all partnership agreements. This Article has not provided you with the perfect target allocation provision. This Article, however, has endeavored to illuminate issues that you would consider in drafting your own target allocation provision. This Article has endeavored to frame some interesting questions. One reader may resolve these questions. 64

65 If you have made it this far, take some time off and read Moo, Baa, La La La! 80 or Goodnight Moon 81 or Make Way for Ducklings 82 or perhaps Where the Wild Things Are 83 with your kids. They deserve your time. These are great books. It s quiet now. What do you say?! Sandra Boynton, Moo, Baa, La La La! (Little Simon 1982). 81 Margaret Wise Brown & Clement Hurd, Goodnight Moon (Harper 1947). 82 Robert McCloskey, Make Way for Ducklings (Viking 1941). 83 Maurice Sendak, Where the Wild Things Are (Harper & Row 1963). 84 Sandra Boynton, Moo, Baa, La La La! (Little Simon 1982). 65