Understanding the effect a partnership agreement has on allocations

Generally, partnerships have a written partnership agreement that sets out the partners’ duties and the allocation to those partners of the partnership’s tax and economic items. Sec. 704(a) provides that this agreement governs the allocation of taxable income, gain, loss, deduction, and credit among the partners. This may create a trap for the uninitiated because it seems to give the partners greater power to govern the allocation of partnership tax items than they actually have.

In reality, tax allocations cannot be made independently of the corresponding economic results and, in fact, merely follow the related economic allocations made under the partnership agreement. In the event that the partnership agreement’s tax allocations do not have substantial economic effect, or if the agreement is silent concerning tax allocations, then the tax allocations must be in accordance with the partners’ interests in the partnership (PIP) rules (Sec. 704(b)). In the case of a family partnership, rules regarding partnership interests created by gift in Sec. 704(e) must be met as well.

Allocations of economic results

Sec. 704 governs only the allocation of tax items and not the allocation of economic items. The tax laws cannot govern how partners agree to divide the partnership’s economic results. Therefore, the partnership agreement is the final word on the allocation of economic items among the partners.

When reviewing a partnership agreement to determine the economic arrangement between the partners, it is important to look at all sections that impact the actual dollars to be contributed by or distributed to the partners. Special attention should be given to sections of the agreement dealing with:

• Capital contributions;
• Capital calls;
• Distributions of cash, including preferred returns;
• Requirements for funding deficits;
• Responsibility for partnership liabilities; and
• Liquidation provisions.

What constitutes the partnership agreement?

For purposes of the substantial economic effect test, the term “partnership agreement” is broadly defined. In addition to the actual document itself, the regulations provide that the partnership agreement also includes all oral and written agreements among the partners, or between one or more partners and the partnership, concerning the partnership’s affairs. Examples of such documents include loan and credit agreements, assumption agreements, indemnification agreements, subordination agreements, and correspondence with a lender concerning terms of a loan or guarantees. This can be seen in IRS Letter Ruling 9622014, where a withdrawing partner was not released from her personal guaranty by a lender, but the purchasing partner entered into a hold-harmless agreement with the taxpayer. The IRS took this agreement between the two individuals into account in determining if the taxpayer constructively received a cash distribution.

Also, the agreement includes federal, state, and local law governing the partnership’s affairs (Regs. Sec. 1.704-1(b)(2)(ii)(h)). In determining proper tax allocations, this latter point is especially important with regard to legal requirements for partners to make contributions to a partnership to cover partnership losses or the rights of partners to share in partnership profits and distributions.

Oral modifications to partnership agreements

Occasionally, partners decide orally to change the partnership’s method of making allocations. Regs. Sec. 1.704-1(b)(2)(ii)(h) provides that such oral modifications are allowed. However, the modifications must be binding and made in accordance with the terms of the partnership agreement or applicable state law (Kresser, 54 T.C. 1621 (1970)). The IRS will respect the modified method only if proof of the oral modification can be produced and the modification is made according to the provisions of the partnership agreement or state law.

For LLCs formed in some states, an oral modification is impossible because the state LLC act requires an LLC’s operating agreement or amendments to the operating agreement to be in writing. (However, an oral agreement may be equitably enforced by a court in those states or may be enforced as a contract executed by and among the members outside of the operating agreement.) When this is not the case, however, oral modifications may be valid if each member agrees to the modification. (However, the IRS can still argue the modification is invalid since it is not written.)

Where an oral modification has been made during the year, the practitioner should recommend that it be reduced to writing and signed by all partners. Even where the state statute permits an oral modification, the documentation of the partners’ agreement is advisable for both legal and tax purposes. When memorializing an oral agreement, the practitioner should be careful not to backdate any documents.

The proper way to memorialize an oral agreement is to prepare a document that includes (1) the date or approximate date (if the exact date cannot be verified) that the agreement was reached; (2) the effective date of the agreement; (3) the terms of the agreement that was reached; and (4) the date the written agreement was actually signed (in no case should this be backdated to the date the oral agreement was reached). All parties to the oral agreement should sign the written agreement.

Example 1. Oral modification of partnership agreement: B is a CPA engaged by the R Partnership to prepare its current-year tax return. The R Partnership agreement has a boilerplate provision that requires use of the safe-harbor-allocation method to make allocations. The agreement further provides that amendments to the agreement require the written consent of all partners. H, a partner of R, has verbally indicated to B that the partners have agreed for the current year and all subsequent years to make allocations based on the PIP rules.

Since the partnership agreement provides a specific method of allocation, and also contains a procedure requiring written amendments, H’s directive to change this method of allocation is probably not a valid oral modification of the agreement and would be disregarded by the IRS. B should tell H that the modification should be put into writing.

The proposed modification would be binding if all the partners signed an amendment to the agreement changing the method of allocation. However, since the safe-harbor method and the PIP rules do not necessarily produce the same results, B should recommend that the partnership disclose to each partner what impact the modification would have. B should also recommend that the partners reduce their understanding to a written agreement or memorandum.

Making changes to the partnership agreement after year end

Modifications to a partnership agreement that affect a specific partnership year can be made up to the due date (not including extensions) of that year’s partnership tax return (see Sec. 761(c)). In effect, this means the partnership’s tax allocation provisions can be manipulated to conform to the partner’s year-end tax planning needs; however, there cannot be retroactive allocations. To be allowable, the allocations made according to the post-year-end change in the partnership agreement must also comply with the substantial economic effect rules (see Sec. 704(b) and related regulations).

This case study has been adapted from PPC’s Tax Planning Guide — Partnerships, 32d Edition (March 2018), by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, Twila A. Bollinger, William R. Bischoff, and Cheryl McGath, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).