Following or Ignoring Capital Accounts Maintenance Rules For Partnerships: In General, Be a Follower.
Tax practitioners, and particularly tax lawyers drafting, reviewing and/or negotiating partnership or limited liability company agreements for clients engaged in a business or investment joint venture, know the importance of meeting the substantial economic effect test under the regulations to §704(b), which is a form of safe harbor contained in federal income tax regulations. But capital accounts, as determined for book purposes as compared to for tax purposes, are critically important in understanding the economics of the particular business venture or “deal” as many are prone to say. Clients may think percentage of ownership in the deal or cash flow preferences are critical to set forth in the document. Of course they are. But added to the mix is the idea that for liquidations or other asset bailout strategies, the joint venturers, be it as partners in a partnership, or as members in a limited liability company, must understand capital accounts and the requirement under the regulations that liquidating distributions must be made in accordance with positive capital account balances. Where a partner has a deficit capital account on liquidation, strict capital account rules require that the partner must be obligated to restore its deficit balance, etc., to meet the safe harbor test.
The safe harbor “substantial economic effect” test, set forth in substantial detail in the regulations, permits the partners to allocate tax items among the participants so that the allocations have a corresponding substantial economic effect. Otherwise, allocations of tax items which do not meet the requirements of the safe harbor are respected only if in accordance with the partner’s interest in the partnership. Treas. Reg. §1.704-1(b)(1)(i) . Where the applicable standards are left unsatisfied, i.e., where the partners are reluctant to put in deficit capital account restoration provision, the Service may reallocate tax items to reflect each partner’s economic interest in the partnership. Treas. Reg. §1.704-1(b)(3)(i). This analysis generally has the Service (or a court in review) looking at how would the sales proceeds be divided among the members if all of the partnership’s assets were sold and the partnership liquidated. While both tests essentially are evaluating the allocation of tax items within the context of their economic interests, the partner’s interest in the partnership method for testing allocations is certainly unpredictable.
The lack of client understanding or acceptance of the role of maintaining and distribution out assets (in liquidation) in accordance with capital accounts has, in certain instances, given thought to more creative methods for determining a partner’s interest in the venture. The thought is that the percentage of ownership in the venture, by analogy to corporate law concepts, should be paramount. Indeed, there may be various instances where clients sign a partnership type agreement and really do not understand the capital account concept and its impact on the rights and interests of the partners. Some have, in response to the criticisms leveled at the complex capital account maintenance rules, permit distributions of cash and other assets to lead the allocation of income and loss. If the draftsmen is not sufficiently sophisticated in drafting legal agreements of this type, it would be best to avoid using this architecture. Those who prefer such other formulas, including corporate type proportionate ownership formulas, run the risk that the Service will have a great degree of flexibility in reallocating tax items among the parties in the event of an audit which predictably would require a fair degree of involvement by tax counsel for the partnership and perhaps counsel for the partners in avoiding an adverse impact for their clients.
The overriding point to be made here is that lawyers drafting partnership and LLC agreements must clearly understand the terms of the deal, whether there are distributional preferences for net cash flow from operations, refinancings, sales and liquidating distributions and how income or loss allocations will be made and to what extent such allocations will effect the partners’ rights in the deal. In many instances a business lawyer may trust the language used in a form from another deal with differing economic formulas and allocations, and assume it will work in the current deal she or he is involved with as well as pass IRS muster. The suggestion here, go over the cash flow, allocation of tax items and distribution provisions, including liquidating distributions, so that clients understand the economics and sign off on the deal. It helps for the client to recognize that normal corporate share ownership norms can frequently vary from capital account rules and principles. Clients and their legal counsel must carefully evaluate whether or not to apply strict capital account based principals in entering into partnership and LLC agreements.
