The Targeted Allocations Approach: A Basic Primer

Editor: Alan Wong, CPA

Partners & Partnerships

This item discusses a growing trend in the allocation provisions of partnership agreements in which limited partnerships have been adopting a targeted allocation approach through which “tax follows cash.” Under the targeted allocation model, the distribution provisions of the partnership agreement effectively govern all distributions made by the partnership. The allocation provisions of the partnership agreement require the partnership to imagine a hypothetical liquidation of the partnership at year end and therefore require the allocation of income or loss to reflect the “true” economics of the partnership. However, one notable trouble spot regarding the targeted allocations approach appears when the actual cashflow of the partnership does not match the respective allocations of taxable income to the partners—specifically the general partner.

Background

The allocation provisions of many partnership agreements have historically relied on the Sec. 704(b) safe-harbor economic effect regulations and provided that income or loss would first be allocated to the partners’ capital accounts and then, after such allocations, cash or other property would be distributed in proportion to each respective partner’s capital accounts. In other words, under this traditional allocation approach, “cash follows tax.” Partnership agreements are drafted focusing first on the cashflows. Second, income and loss allocations follow the cashflows. Third, final distributions are made in accordance with the capital accounts.

When the partnership has a simple economic arrangement, the traditional allocation approach is a fairly straightforward exercise. However, when the economic arrangements become more complicated, the allocation and distribution provisions of the partnership agreement also become much more complicated. In such a case, the distribution provisions must reflect the economic arrangements reached between the limited partners and the general partner. The allocation provisions must also reach such economic arrangements, but because of the complexities involved in partnership book and tax accounting, the allocation provisions may not be aligned with the distribution provisions.

It appears that the targeted allocations approach (also referred to as the targeted capital, target allocations, or forced allocations approach) grew as a response to the traditional allocations approach, which often gave rise to unanticipated economic results that the partners may not have necessarily agreed to. Proponents of the targeted allocations approach claim that under it, the partners can at least be assured that the income allocation provisions of the partnership agreement will reflect the distribution provisions so that the true economic deal will be respected.

Targeted Allocations at Work

Under the typical targeted allocations approach, the starting point is a partner’s partially adjusted capital account, which is usually defined as the partner’s capital account adjusted to reflect distributions to or contributions by the partner during the tax year.

In order to see the targeted allocation approach at work, consider the following example.

Example 1: Partnership Z is formed with A as the limited partner and B as the general partner. A contributes $1,000 of cash to the partnership. B does not contribute cash to the partnership but will contribute services. The partnership agreement provides that a limited partner is first entitled to a return of its capital, and then the general partner is entitled to share in 20% of gains. In year 1, the partnership sells an asset for $300 that it purchased for $200, recognizing gain of $100. Under the partnership agreement, the partnership distributes $300 to the limited partner.

In this example, A’s partially adjusted capital account would be $700 ($1,000 of the capital contribution minus the $300 distributed to A). As the general partner, B neither contributes capital into the partnership nor receives a distribution. As a result, B’s partially adjusted capital account will be $0.

The second step in a typical targeted allocations approach is to determine the partner’s target capital account. This step is the crux of the approach. Essentially, the tax practitioner assumes that at the end of each tax year the partnership has undergone a hypothetical liquidation, calculates the amount that each partner would receive if the partnership sold all its assets for their respective tax bases (without taking into account any unrealized gain or loss), and then distributes all the proceeds in accordance with the distribution provisions of the partnership agreement.

Example 2: Partnership Z sells its remaining $800 of assets at cost. The partnership thus has $800 available to distribute to the partners. Under the distribution provisions of the partnership agreement, A receives $700 as a return of its capital. The remaining $100 is distributed as follows: A receives a distribution of $80, and B receives a distribution of $20. As a result, A’s target capital account is $780, and B’s target capital account is $20.

The third step in a simple targeted allocation approach is to allocate the $100 of gain that Z recognizes upon the sale of the asset for $300 that it had purchased for $200. Under the targeted allocation approach, the $100 of gain is allocated to reduce the relative differences between the partners’ target capital accounts and their partially adjusted capital accounts. In this example, $80 would be allocated to A (the difference between $780 and $700), and $20 would be allocated to B (the difference between $20 and $0).

Special Concerns

The previous example did not take into account the complexities of a preferred return, but it outlines the basic mechanics of the targeted allocations approach. However, it also illustrates a special concern and trouble spot regarding this approach: In certain instances, taxable income may not match actual cashflow. Specifically, in Example 2, B, the general partner, is allocated gain of $20 even though the partnership distributes the $300 cash to A as a return of A’s capital contribution. Simply put, B, the general partner, is allocated income without receiving an actual cash distribution (phantom income). While the targeted allocations approach may reflect the appropriate economic arrangement between the limited partner and the general partner at the time the partnership was formed, allocating phantom income to the general partner may not be in line with the economic and business expectations of both parties.

One potential cure for the allocation of phantom income to the general partner is to include a tax distributions provision in the partnership agreement, which would allow the general partner to receive tax distributions (e.g., on a quarterly basis) to cover the tax liability that it would incur on any income allocated to it under the targeted allocations approach. A typical partnership agreement generally defines “tax distributions” as an amount equal to taxes imposed, or anticipated to be imposed, with respect to taxable income allocated to the general partner for a period with respect to the carried interest distributions made to the general partner. It is also common to see language stating that for purposes of calculating anticipated taxes for tax distributions, one must assume that each member of the general partner is subject to the highest applicable marginal U.S. federal, state, and local income tax rates. Also important to note is that a tax distribution is generally treated as an advance distribution of amounts otherwise distributable to the general partner, and as a result this reduces the general partner’s tax capital account.

If the limited partners and the general partner agree to include a tax distribution provision in the partnership agreement, the tax practitioner should be prepared to use the targeted allocations approach on a regular basis in order to calculate an estimate of the amount of tax distributions to be made to the general partner by the partnership and the amount of cash to be set aside by the partnership to fulfill that obligation.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.