Target Capital Allocations: Up to Code?

By Amy L. Rosenthal, CPA, New York City

Editor: Howard Wagner, CPA

Partners & Partnerships

Target capital allocations are fast becoming the allocation method du jour of tax attorneys, though they do not necessarily meet the requirements of Sec. 704(b). Partners are free to negotiate an economic deal among themselves. Since cash is king, target allocations attempt to have the allocations of profit and loss follow the cash. They accomplish this by attempting to make partner capital accounts equal, as closely as possible, to what the partner would receive if the partnership actually liquidated at the end of the year.

Sec. 704(b): The Substantial-Economic-Effect Test

Generally, book allocations are governed by the regulations under Sec. 704(b). For tax allocations to be respected, the regulations require that they have "substantial economic effect," and a two-part analysis must be made each year (Regs. Sec. 1.704-1(b)(2)). Under the first test, the allocations must have economic effect. The second test is to make sure the economic effect is substantial, meaning it must substantially affect the dollar amounts to be received by the partners from the partnership. The economic-effect test is more mechanical. For tax allocations to be valid, the partnership agreement must provide for all of the following:

  1. Partners' capital accounts are maintained under the rules of Sec. 704(b);
  2. Upon liquidation of the partnership, liquidating distributions are made in accordance with the partners' positive capital accounts; and
  3. Partners are required to restore any deficit in their capital accounts.

Very few partners want to have unlimited liability. Luckily, the IRS added an alternative test as a safe harbor. An allocation will still be considered to have economic effect if, instead of the deficit restoration requirement, the partnership provides for a qualified income offset (QIO). Note that both safe harbors require positive capital accounts to drive liquidating distributions for the allocations to be respected.

A third test can be used if the partnership does not satisfy the main provisions or the safe harbor. Under the economic-equivalence test, if an allocation does not otherwise meet the economic-effect test, it will be deemed to have economic effect if the allocations upon liquidation would have the same results as if the three primary requirements of the economic-effect test are met.

The substantial-economic-effect test requires that loss allocations go to the partners who actually bear the risk of the loss and profit allocations. Following the allocation provisions assures a Sec. 704(b) correct capital account. But what if the capital account balance does not represent the business deal? That is where target allocations come in. Target tax allocations follow the business deal.

What Is a Targeted Capital Allocation?

A typical targeted capital allocation provision looks something like this:

After giving effect to the special allocations set forth in Section ____, profits and losses for any allocation year will be allocated among the members in a manner that will result in the capital account balance for each member (which may be positive or negative), after adjusting the capital account for all capital contributions and distributions and any special allocations required pursuant to this agreement for the current and all prior allocation years, being (as nearly as possible) equal to (x) the amount that would be distributed to the member if the company were to sell all of its assets at their current gross asset value, pay all liabilities of the company (limited, with respect to any nonrecourse liabilities, to the value reflected in the members' capital accounts for the assets securing such nonrecourse liabilities), and distribute the proceeds thereof in accordance with Section ____, minus (y) the member's share of company minimum gain and member nonrecourse debt minimum gain. (Whitmire, Nelson, McKee, Kuller, Hallmark, and Garcia, Structuring and Drafting Partnership Agreements: Including LLC Agreements, 45 (Thomson Reuters/Tax & Accounting 2014).)

The tax allocation provision also might provide that the allocations for federal and state tax purposes must reflect, as nearly as possible, the allocation set forth in the book allocation section of the agreement.

In addition, instead of saying that liquidation cash will be paid to partners in accordance with their positive book capital accounts, the liquidation provision of the partnership agreement often will list a specific order in which the payments should be made, with several layers of allocations (a so-called distribution waterfall) and a provision for either a preferential rate of return to one or more partners or an accelerated return of investment for some partners.

Since liquidation cash is not distributed based on positive capital accounts, will the IRS accept the targeted allocations?

Computing the Allocations

Computing target allocations requires two separate calculations. The difference between the two drives the book allocations. The first step is to compute each partner's book capital account before income allocations. The calculation starts by taking the prior year's ending book capital account, adding the fair market value of all contributions for the year, deducting any distributions, and booking any capital account revaluations for the year. The result is the partially adjusted capital account (PACA).

The second step is to compute the targeted capital account. The targeted capital calculation follows the fiction that the partnership will liquidate at the end of the year. All assets will sell for their Sec. 704(b) book values, all liabilities will be paid, and the remaining cash will be distributed in accordance with the liquidation provisions of the partnership agreement. The calculation starts by taking the liquidation value of the partnership, which is the net book equity (from a Sec. 704(b) basis balance sheet) at the end of the year. That liquidation value is then allocated to the partners based on the liquidating distribution provisions in the partnership agreement.

Example:The AB partnership has two partners, A and B. Cash remaining upon liquidation is distributed as follows: Partner B receives a preferred return of 8% per year and his unreturned capital. Partner A receives her unreturned capital, and the remaining cash then is split evenly between the two. Book income for the year is $450,000. On Jan. 1 of the tax year, both partners contribute assets with a book value of $500,000. The beginning capital accounts are shown in Exhibit 1. The balance sheet presented in ­Exhibit 2 is on a book basis at the end of the year. The PACA is computed as shown in Exhibit 3. In step 2, the liquidation value is allocated using the distribution waterfall, ­arriving at a liquidation value after book income of $1,450,000. In step 3, the amount is computed to get PACA as close to the targeted capital as possible.

The fact pattern in step 3 arrives at an income allocation of $205,000 to Partner A and $245,000 to Partner B. All items on the Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., are allocated between the partners pro rata: 45.5%/54.5%. If the agreement were ignored and the amounts were allocated based on positive capital, each partner would have been allocated $225,000.

Note that the Sec. 704(c) rules related to property contributed with a value/basis difference still are in play and control the tax allocations between the partners related to that property. It is important to model the allocation provisions before finalizing the partnership agreement. Using targeted allocations, a partnership could get unexpected results based on the wording of the allocation provision and the results of the income of the partnership.

Using the partnership allocations from the earlier example, consider Exhibit 4 and Exhibit 5, which illustrate the strange results that can occur when allocations are not properly executed. In Exhibit 4, for Partner B, the partner with the preferred return, to be allocated $40,000 of income, Partner A must be allocated $20,000 of loss. In essence, Partner A's capital is funding Partner B's preference.

In this case, Partner B is allocated $40,000 in income even though there is an overall loss in the partnership. This outcome could be a big surprise to Partner B.

The last two exhibits illustrate areas where the wording of the allocation section is very important. If the agreement calls for allocations of net income or net loss, the entire net taxable loss in the last example, shown in Exhibit 5, will be allocated to Partner A. However, if the partnership agreement allows for the allocation of gross items, then gross income and gross expenses can be properly allocated among the partners, assuming there are enough gross items to allocate, causing phantom income to Partner B.


Targeted capital allocations are intended to allocate income in a way that reflects the economic agreements among the partners. A properly worded targeted allocation provision could achieve these results. The allocations are easier for partners to understand and allow them to derive tax items based on the economics of the partnership.

Tax issues are also caused by these allocations, including that the allocations probably don't meet the economic-effect test because they do not require liquidating distributions to follow positive capital. However, because these allocations generally are in line with the partners' interests in the partnership, they may satisfy the economic-equivalency test. The wording of the provision must be reviewed and tested using many scenarios, and close attention should be paid to requiring net vs. gross allocations and testing all liquidation options.

The IRS hasn't ruled on whether it will respect the targeted allocations, so it is unknown whether these allocations will stand up under audit. As more partnerships use these allocations, the hope is that the IRS will consider them industry standard and not challenge them. Ultimately, taxpayers hope the IRS will remove any uncertainty and issue rulings approving the method.


Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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