Many partnerships, particularly investment partnerships, suffer losses on certain investments and make profits on other investments, but usually earn an overall profit throughout the life of the partnership. However, tax law does not allow the parties to wait until the end of the partnership’s life to determine the incidents of taxation regarding purported preferred returns recharacterized as guaranteed payments. Instead, each partner must include guaranteed payments as ordinary income for the tax year within or with which ends the partnership tax year in which the partnership deducted the payments as paid or accrued under its method of accounting. The drafter of the partnership agreement prefers to draft targeted allocations in partnership agreements because it reduces malpractice risk.
If the tax return preparer is not consulted during the drafting phase, the tax return preparer should consult with the drafter(s) of a partnership agreement when necessary to clarify any ambiguities therein, including the issues raised in this article. Even though targeted partnership allocations are the predominant allocation method contained in partnership agreements today and have been for a number of years, no guidance has been issued to date. The IRS should issue guidance on targeted partnership allocations so that taxpayers are not left in the dark about a number of ambiguous issues, including, but not limited to, those raised in this article.
Drafters and return preparers should take care to understand the allocation scheme each partnership uses and which scheme is more appropriate under the particular circumstances. Drafters of partnership agreements should collaborate with each taxpayer’s tax return preparer to ensure that the tax return preparer understands the deal being drafted and agrees with its tax treatment before the partnership agreement is executed. Otherwise, the disagreement might not surface until the tax return preparer is preparing the first partnership tax return some months later.
Where a partnership agreement contains a safe-harbor allocation scheme, this argument holds. However, a targeted allocation scheme requires the partnership to walk through a hypothetical liquidation at the end of each tax year to determine how to allocate the partnership’s items of income, gain, loss, and deduction. To make the cash go where it must when partnership profits are insufficient in any given tax year, a capital shift must occur (at least at that moment in time). Drafters of targeted allocations do not draft allocations to try to cause the partners’ ending capital accounts to achieve an economic deal. Some practitioners, though, believe it is possible for targeted allocations to satisfy the alternate test for economic effect if the targeted allocations are drafted to work in tandem with a qualified income offset.
What is meant by Interperiod tax allocation and why is it necessary?
An intraperiod tax allocation is the allocation of income taxes to different parts of the results appearing in the income statement of a business, so that some line items are stated net of tax. This situation arises in the following cases: Continuing operations (results of) are presented net of tax.
An allocation is not to be confused with a distribution of cash; and allocations and distributions do not necessarily go hand-in-hand. Also, the income or loss that is allocated in a partnership agreement is Sec. 704(b) book income or loss—not taxable income or loss. Most partnership agreements, however, require that taxable income or loss be allocated in the same manner as Sec. 704(b) book income or loss. Today, targeted allocations are the standard in the partnership community. To properly track the partners’ economic interest in the partnership and prepare an accurate partnership tax return, it is crucial to identify the kind of allocation scheme used in the partnership agreement.
What is Comprehensive Tax Allocation
Because targeted allocations do not liquidate in accordance with partners’ positive capital accounts, presumably targeted allocations do not satisfy the basic test for economic effect. The deduction of the guaranteed payment creates a circularity issue in that the $20 guaranteed payment is deductible in computing profits.
While targeted allocations provide the advantage of ensuring the partners’ economic deal is preserved, they introduce tax uncertainty into the partnership arrangement for all but the simplest of economic deals. For this purpose, book value does not mean adjusted tax basis or GAAP book value. This accounting process remains the same if the net profit is in fact a net loss; losses are to be distributed in the same way as profits as determined by the partnership agreement. No matter how the allocations are calculated, the process for clearing the income statement remains the same.
Thus, profits would be reduced by the $20 guaranteed payment, thereby creating another shortfall. Practitioners who encounter agreements containing a distribution waterfall as set forth in Example 2 above should be aware of this issue and ask the agreement’s drafter to clarify the ambiguity in the allocation and distribution provisions of the partnership agreement. Targeted allocations involve a partnership’s liquidating not in accordance with partner capital accounts but, instead, in accordance with a negotiated distribution waterfall.
Temporary Depreciation Differences
Additionally, if taxpayers were allowed to include unrealized appreciation in Sec. 704(b) book income, but were not allowed to include the same amount in taxable income, then almost every partnership agreement must be rewritten, because the common definition of Sec. 704(b) book income begins with the partnership’s taxable income as its starting point. Assuming the answer is “no,” however, as discussed in more detail immediately below, purported preferred returns in accrual-basis partnerships adopting targeted allocations may instead properly be treated as guaranteed payments or taxable capital shifts and not as allocations of partnership profit. The IRS should issue guidance clarifying the proper treatment of a profit shortfall for any given tax year where the partnership agreement contains targeted allocations and a cumulative preferred interest payable before every partner’s capital account balance has been repaid and the partnership adopts the accrual method of accounting. C has not received any cash and under the partnership agreement has no right to the cash until the partnership actually liquidates.
If so, then an allocation to a partner will have economic effect even if the partnership agreement does not contain a deficit restoration obligation (or even if the deficit restoration obligation is limited) so long as two additional requirements are satisfied. If a partnership agreement provides for allocating an item of income, gain, loss, deduction, or credit to a partner, there are three ways in which the allocation can have economic effect under the Code and regulations. 9 First, an allocation will have economic effect if the allocation satisfies three strict requirements discussed below under the basic test for economic effect. Second, an allocation will have economic effect if it satisfies the alternate test for economic effect.
Thus, by drafting targeted allocations the drafter has mitigated the risk of the drafted allocations’ not achieving the client’s economic deal and that the drafted allocations will not be respected for tax purposes. Instead, with targeted allocations, the risk of getting the partnership’s allocations correct is entirely on the person preparing the partnership tax return—not on the drafter of the partnership agreement. Obtaining a set of partnership allocations from the drafter shifts the risk back to the drafter of the partnership agreement to draft a set of allocations that will properly achieve the partners’ desired economic deal. The targeted allocations of partnership items of income, gain, loss, deduction, and credit force partners’ capital accounts to follow the economic deal. When partnership agreements contain both targeted allocations and preferred return provisions, in certain situations, it is unclear whether the purported preferred return should be treated as a guaranteed payment, as a capital shift among the partners, or as an allocation of partnership profits.
What is Intraperiod tax allocation?
An interperiod tax allocation is the temporary difference between the effects of tax policy on the financial reporting of a business and its normal financial reporting as mandated by an accounting framework, such as GAAP or IFRS.
- Assuming the answer is “no,” however, as discussed in more detail immediately below, purported preferred returns in accrual-basis partnerships adopting targeted allocations may instead properly be treated as guaranteed payments or taxable capital shifts and not as allocations of partnership profit.
- The IRS should issue guidance clarifying the proper treatment of a profit shortfall for any given tax year where the partnership agreement contains targeted allocations and a cumulative preferred interest payable before every partner’s capital account balance has been repaid and the partnership adopts the accrual method of accounting.
- Additionally, if taxpayers were allowed to include unrealized appreciation in Sec. 704(b) book income, but were not allowed to include the same amount in taxable income, then almost every partnership agreement must be rewritten, because the common definition of Sec. 704(b) book income begins with the partnership’s taxable income as its starting point.
To assist in the drafting process, careful drafters engage the help of accountants or other professionals who are skilled at modeling partnership allocations, including allocations of debt among the partners and the dreaded Sec. 704(c) allocations, to prepare partnership allocation models (or “what-ifs”). Often, the models are run in several different ways—assuming there are losses in early years followed by profits throughout the life of the partnership; assuming there are losses throughout the life of the partnership; assuming there are losses in early years, followed by years of profits, followed by more years of losses, etc. Sometimes, one or more of these models is attached to, and becomes a part of, the partnership agreement as an example of how the parties understand the economic deal should work under different scenarios.
These special allocations must be recorded specifically and accurately to avoid issues with taxes. A common source of deferred tax liability is the difference in depreciation expense treatment by tax laws and accounting rules. The depreciation expense for long-lived assets for financial statements purposes is typically calculated using a straight-line method, while tax regulations allow companies to use an accelerated depreciation method. Since the straight-line method produces lower depreciation when compared to that of the under accelerated method, a company’s accounting income is temporarily higher than its taxable income.
This is a $4,000 total salary distribution to be taken from their $12,000 net income, which will be allocated to their individual capital accounts, leaving $8,000 of net income to be divided. Within a business run as a partnership, special allocations occur when the profits and losses of the company are distributed among owners differently than they might be based simply on percent of ownership. This happens when partners may want to share ownership 50/50 but, for example, one partner has provided more initial startup capital and has thus been allocated a higher percentage of the profits.
Another reason given for using targeted allocations versus safe-harbor allocations is fear that mistakes in the allocations will distort the desired economic deal. 31 Under this test, so long as partnership allocations are proportionate to partner capital, then targeted allocations generally work fine.
44 As a safeguard, it is also advisable to provide in the partnership agreement of any limited liability entity that no distribution may cause any partner’s capital account to go negative. As mentioned briefly above, partnership agreements containing targeted allocations (as contrasted with safe-harbor allocations) may unintentionally result in purported preferred returns being classified as guaranteed payments or taxable capital shifts. If the drafter of a partnership agreement does not draft partnership allocations designed to cause the partner’s ending capital account to equal what it must to achieve the partners’ economic deal, then the drafter has avoided the risk that those allocations are wrong.
Any mistake in drafting the partnership allocations can distort the economic deal. A partnership “allocation” is simply a division of each item of income, gain, loss, deduction, and credit of the partnership between and among the partners.
However, in order to track correctly, that net income does have to be allocated between partners properly. 41 One of those requirements is that the partnership must liquidate in accordance with the partners’ positive capital accounts.
Interperiod tax allocation
If one or more partnership allocations are not in proportion to partner capital (“special allocations” 32), however, then targeted allocations may not always achieve the desired result. Targeted allocations, which generally do not meet any of the safe-harbor requirements, allocate partnership items so that the partners’ ending capital accounts equal the amount the partners should receive under the partnership agreement’s specific order of distribution in liquidation, commonly called the distribution waterfall. They will be respected if they are in accordance with the partners’ interests in the partnership.
The Sec. 704 regulations provide a set of rules (the PIP rules) for determining how allocations must be divided between or among the partners when the allocations do not comply with the safe harbor. Today, nearly all partnership agreements contain targeted allocations, and very few contain safe-harbor allocations. While this distinction may seem like an exercise in semantics, the consequences of drafting partnership allocations in one manner or the other can be significant to both the drafter and the tax return preparer. 2 Historically, drafters of partnership agreements guaranteed this union by requiring that the partnership maintain a separate capital account for each partner that tracked each partner’s economic rights in the partnership and the partnership liquidate in accordance with those capital accounts. To continue the example, consider a partnership agreement declaring A’s net-income salary allowance as $2,000, B’s as $1,000 and C’s as $1,000.
What are some examples of a deferred tax liability?
Third, an allocation will have economic effect if, taking into account all the facts and circumstances, the allocation reaches the same result as if the three strict requirements were contained in the partnership agreement. These three tests for economic effect are explained in the next three sections. 704(a) and (b), allocations of partnership income, gain, loss, deduction, or credit between or among the partners 6 are generally respected so long as the allocations to each partner are set forth in the partnership agreement and have substantial economic effect. Practitioners often refer to partnership allocations that satisfy these conditions as being “safe-harbor” allocations, because the allocations are drafted to satisfy the safe harbor in the regulations. As stated above, when drafting safe-harbor allocations, the goal is to draft a set of allocations that will cause the partners’ ending capital account balances to achieve a given economic deal and then to liquidate the partnership in accordance with those balances.
How does proration affect asset depreciation?
One consequence of a drafter’s choice to use targeted allocations in a partnership agreement is that the allocations do not necessarily comply with the safe-harbor rules. Because targeted allocations do not comply with the safe harbor, the IRS on audit, or a court during litigation, will look to the partners’ interest in the partnership in determining whether the purported allocations are correct. Because this determination is highly factual, only in the case of relatively straightforward economic deals will taxpayers have comfort that their allocations will be respected. Any agreement containing special allocations of particular items of gross income or deduction generally should not use targeted allocations, because of the uncertainty of applying the facts-and-circumstances test to determine partners’ interest in the partnership.