The IRS released a Chief Counsel Advice memorandum (CCA 201741018) on Oct. 13, 2017, that addressed the allocation of partnership losses where certain partners had negative capital account balances. The IRS determined that a joint venture's allocation of certain losses failed to meet the substantial economic effect test under Sec. 704(b) and that those losses must instead be allocated in accordance with the partners' interests in the partnership. The IRS also considered whether the laws of a foreign jurisdiction effectively imposed a deficit restoration obligation on some of the partners. The IRS concluded that the foreign jurisdiction's requirement that certain partners contribute additional capital to the joint venture to avoid its liquidation was insufficient to cause those partners to bear the economic risk of losses in excess of their positive capital accounts.
An allocation of income, gain, loss, or deduction set forth in a partnership agreement will be respected if the allocation has substantial economic effect. If the allocation does not have substantial economic effect, a partner's distributive share is determined based on the partner's interest in the partnership, taking into account all the facts and circumstances.
Regs. Sec. 1.704-1(b)(2) provides a two-part analysis to determine whether an allocation has substantial economic effect: (1) The allocation must have economic effect, and (2) the economic effect must be substantial. In the CCA, the IRS primarily focused on whether the joint venture's allocation of losses had economic effect. Regs. Sec. 1.704-1(b)(2)(ii)(b) sets forth three requirements that must be present in a partnership agreement for an allocation to meet the economic effect test: (1) The partnership must maintain capital accounts in accordance with the rules set forth in Regs. Sec. 1.704-1(b)(2)(iv); (2) liquidating distributions must be made in accordance with the partners' positive capital account balances; and (3) the partners must be unconditionally obligated to restore a deficit balance in their capital accounts upon the liquidation of the partnership.
In the CCA, the IRS described a U.S. parent corporation (US Parent) and a foreign parent corporation (Foreign Parent) that agreed to jointly develop resources in a foreign country. To carry out the joint venture, US Parent and Foreign Parent formed a limited liability company under the foreign country's local law and filed an election to treat the joint venture (considered an eligible entity under Regs. Sec. 301.7701-2) as a partnership for U.S. federal income tax purposes. Two other corporations (Country 1 Partner and Country 2 Partner), owned by the parent companies, contributed cash to the joint venture and were treated as the joint venture's only two partners under local law.
Foreign Parent and a U.S. subsidiary of US Parent (US Partner) provided additional funds to the joint venture. US Partner and Foreign Parent were hybrid partners in the joint venture because their contributions were treated as loans under the foreign country's local law but treated as equity for U.S. federal tax purposes. Accordingly, the joint venture had four partners for U.S. federal income tax purposes. Under separate individual agreements, the two hybrid partners (i.e.,Foreign Parent and US Partner) were entitled to fixed minimum payments with respect to their contributions, along with potential additional payments dependent on the net positive cash flow of the joint venture. US Parent treated the fixed payments made to the hybrid partners as guaranteed payments for the use of capital under Sec. 707(c) for U.S. federal income tax purposes.
The joint venture generated losses over its lifetime, due in part to deductions claimed under Sec. 162 for the guaranteed payments made to the hybrid partners. US Partner and Foreign Parent contributed additional amounts to the joint venture to fund its operations. The joint venture, however, allocated the loss deductions to Country 2 Partner and Country 1 Partner, and not to US Partner and Foreign Parent.
The joint venture's operating agreement did not specify how losses would be allocated and did not meet any of the requirements under the economic effect test because the operating agreement did not (1) require the joint venture to maintain capital accounts; (2) distribute liquidation proceeds in accordance with positive capital accounts; or (3) contain a deficit restoration obligation. Because the allocations lacked substantial economic effect, the joint venture's losses were required to be allocated based on the partners' interests in the partnership, reflecting the manner in which the partners agreed to share the economic burden from the loss.
The IRS considered how the joint venture's assets would be distributed upon liquidation. US Partner and Foreign Parent would have first claim on the joint venture's assets, according to both the joint venture's operating agreement and the foreign country's local law, which treated US Partner and Foreign Parent as creditors. Accordingly, the Country 1 Partner and Country 2 Partner bore the burden of the joint venture's losses to the extent of their positive capital accounts. However, the taxpayer disagreed about who bore the burden of losses in excess of the positive capital accounts of Country 1 Partner and Country 2 Partner.
The taxpayer argued that Country 1 Partner and Country 2 Partner bore the economic burden of all of the joint venture's losses because the local law imposed the equivalent of a deficit restoration obligation on them. Under the local law, to maintain its status as an LLC, the joint venture was required to maintain net assets in excess of a certain threshold. If the joint venture's net assets fell below that threshold and its owners did not contribute additional capital, then the government could force the joint venture to liquidate. The taxpayer believed that the additional capital contribution requirement created a deficit restoration obligation with respect to Country 1 Partner and Country 2 Partner.
The IRS disagreed and stated that while Country 1 Partner and Country 2 Partner might choose to contribute additional capital should the joint venture face a shortfall, any such contribution was a business decision and not a legal obligation. Nothing would prevent Country 1 Partner and Country 2 Partner from simply allowing the joint venture to liquidate rather than continue to contribute additional capital. Once the joint venture's losses reduced Country 1 Partner's and Country 2 Partner's positive capital accounts to zero, US Partner and Foreign Parent bore the risk that their capital contributions might not be repaid, as the joint venture would not have sufficient assets for the repayment. Accordingly, to the extent the joint venture's losses exceeded Country 1 Partner's and Country 2 Partner's positive capital accounts, the IRS reasoned that the excess losses must be allocated to US Partner and Foreign Parent in accordance with their interests in the partnership.
CCA 201741018 indicates that the IRS may only consider legally binding obligations in determining whether a partner has an obligation to restore a deficit to its capital account. As demonstrated in the memorandum, it is not enough to show that it would be an economically rational decision to restore such a deficit. The CCA also seems to indicate that the allocation of losses among the partners might have been respected if the joint venture's operating agreement had met the test for economic effect by including the provisions required by Regs. Sec. 1.704-1(b)(2)(ii). If that were the case, Country 1 Partner and Country 2 Partner might have been well-served to consider whether to explicitly include a deficit restoration obligation in the operating agreement.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.