Editor: Mark Heroux, J.D.
The purpose of this item is very simple: To provide tax practitioners with a step-by- step guide they can use and replicate in their practice to successfully deal with the inherent complexities they encounter when working with partnership allocations under a target capital structured operating agreement. Although this item does not break any new ground per se, it provides something many tax practitioners struggle with: a consistent process for ensuring correct income/ loss allocations. In the age of centralized partnership audit regime exam implications and exit transaction due-diligence examinations, tax practitioners need more than ever to implement procedures that avoid allocation process errors.
During the past decade, the target capital allocation structure has clearly become the most prominent structure used in the process of drafting a partnership operating agreement. This structure allows attorneys to more easily draft the agreement and enhances limited liability company (LLC) owners’ certainty in their understanding of the ultimate cash flow expectations and the economics of the underlying business deal. Unfortunately, however, the tax practitioner who needs to correctly allocate LLC income and loss pursuant to the terms of an operating agreement that might be somewhat less than clear and straightforward is left alone to deal with the complexities the target capital allocation structure creates. Gone are the days of simply multiplying an LLC owner’s percentage share of units by the separately stated items of income/loss/deduction, etc. for the purpose of populating the individual Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc.
Despite the fact that every LLC and its related operating agreement is unique, a process for creating profit and loss allocations can be applied to every partnership with a target capital allocation structure. Not only will the use of a consistent process improve a practitioner’s overall quality, it also will enhance efforts to efficiently train young staff on the process of creating LLC allocations in a manner that assures a quality product is produced and the risk of incorrect allocations is minimized.
Outlined below are 11 clearly delineated steps that must be followed when creating tax allocations for a target capital allocation structured partnership. It is important to note that these steps assume that proper Sec. 704(b) capital account maintenance rules are undertaken and followed. This is consistent with the vast majority of agreements that require capital account maintenance and limitations on deficit capital account balances and that also include a qualified income offset provision. If proper capital account maintenance is not being implemented (as required in the agreement), any allocations made under a target capital allocation structure are problematic and cannot be assured of any level of accuracy. This leaves both the client/ taxpayer and the return preparer subject to the risks associated with not following the dictates of the agreement and/or the applicable tax regulations. The 11 steps are as follows:
Complete the federal taxable income determination for the entity; i.e., finalize the tax provision.
Adjust the federal taxable income from Step 1 to create what would be referred to as Sec. 704(b) income. This represents profit/loss as defined in the agreement and must be used for making allocations consistent with the terms outlined in the operating agreement. Differences between income in Steps 1 and 2 typically involve assets that have a gross asset value for Sec. 704(b) purposes that differs from tax basis, often referred to as Sec. 704(c) differences. If such differences exist, it is imperative that Step 2 be clearly and separately completed because it will drive the remainder of the process.
Update beginning-of-the-year Sec. 704(b) capital accounts for any contributions, distributions, or ownership change activity that occurred during the year. This step creates a “preliminary capital” amount for each member as well as for the total entity.
Using the Sec. 704(b) income from Step 2, identify total end-of-year capital for the full entity, not by individual member, by adding the income to the updated total capital for the entity from Step 3.
Determine end-of-year cash waterfall distribution priority under the terms of the agreement (the distributions that must be made when there are tiered partnerships in the entity structure), assuming a liquidation would occur at the end of the year.
Using the cash waterfall priority (Step 5), allocate total entity capital (Step 4) among the partners to determine the end-of-year target capital for each member. This step allocates among the partners the total end-of-year capital they would be entitled to receive under the terms of the cash distribution provisions.
Compare the target capital for each member from Step 6 to each member’s preliminary capital from Step 3 to determine the correct allocation of income/loss needed to achieve the desired capital account targets and create the necessary allocations for each member.
After the completion of Step 7, if any capital accounts have a deficit, analyze and/or calculate the correct application of minimum gain principles to determine whether any such deficit capital accounts are proper. If not, the income/loss allocations may need to be adjusted.
Make any Sec. 704(c) adjustments if needed to arrive at final tax allocations.
Determine the proportions of total (i.e., bottom-line) income allocations to allocate all separately stated items. Finalize Schedule K-1 details.
Complete the year-end tax basis and capital roll for each member based on the final allocations.
There are a few key components to this process. First, the entire allocation process is driven by the determination and allocation of Sec. 704(b) income. Sec. 704(c) allocations are driven by the Sec. 704(b) allocations and cannot be properly determined without first determining Sec. 704(b) income. Second, it is important to first determine a preliminary capital account for each member and the LLC before the final targets can be determined. Attempting to shortcut any of these steps will lead to problems for any allocations that have any level of complexity.
Finally, it is worth discussing Step 7. This is the step in which the allocations to each member will first be determined. The agreement will need to be carefully analyzed to determine whether allocations will be made of bottom-line net income/loss, or whether the agreement provides for the use of gross revenue or expense items for the purpose of bringing the capital accounts fully into sync with the hypothetical year-end distribution. A good deal of uncertainty surrounds this particular topic that is well beyond the scope of this discussion. It is within this Step 7 that a practitioner would need to make judgments regarding the manner in which these rules will be applied.
Following these 11 steps in the order presented — and avoiding shortcuts in the process — is a sound strategy for managing this aspect of your tax practice.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at email@example.com.