Many investment fund partnership agreements include income and loss allocation provisions that are driven by distribution rights but do not provide explicit instructions regarding a partner’s share of realized profit or loss. These “targeted allocation” agreements often reference an intent to achieve ending capital account balances commensurate with future distributions, with profit and loss allocations determined accordingly.
From a tax perspective, existing partnership allocation rules provide significant flexibility in determining allocations among partners. However, with this flexibility comes a high degree of uncertainty. Tax law requires allocations that do not have what is known as “substantial economic effect” (SEE) to instead be made in accordance with the “partner’s interest in the partnership” (PIP). Unfortunately, Treasury and the IRS have provided little guidance for determining PIP. On IRS examination, this lack of guidance can lead to significant complexities under the existing partnership audit regulations, including imposition of imputed underpayment obligations, interest charges, and possible penalties.
The Internal Revenue Code provides that an allocation described in a partnership agreement will be respected only if the allocation qualifies as having economic effect, and the economic effect is substantial. Whether an allocation has SEE must be evaluated annually. In the absence of SEE, the partnership must determine each partner’s distributive share of partnership income or loss based on PIP.
Economic effect. An allocation of partnership income or loss will have economic effect if it commensurately affects the partner’s economic position. Treasury regulations set forth three safe harbors intended to give taxpayers certainty that an allocation of partnership income or loss will have economic effect: the general test, the alternate test, and economic effect equivalence. An allocation will satisfy either the general or the alternate test of economic effect only if:
To have economic effect equivalence (the third safe harbor), allocations made to a partner that do not meet the general or alternate test will still be deemed to have economic effect if a liquidation of the partnership at the end of the current year, as well as at the end of any future year, would produce the same economic results to the partners as if either the general or alternate test were satisfied.
Substantiality. The regulations also provide guidance on when economic effect will and will not be considered substantial. In general, the economic effect of an allocation is substantial if there is a reasonable possibility that the allocation “will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.” However, the economic effect of an allocation is not substantial if, as compared to the consequences absent the allocation (and measured on a net present value basis):
In other words, allocations that serve to reduce the partners’ collective tax liability lack substantiality. The regulations focus on two specific situations that may be viewed as lacking substantiality: (i) allocations of items of income or loss that reduce the partners’ collective tax liability without substantially affecting the economic effect among the partners (shifting allocations); and (ii) situations in which one or more allocations will be largely offset by one or more other allocations (transitory allocations).
Although Treasury and the IRS have provided extensive guidance, the rules surrounding SEE remain complex, and many fund agreement allocations will not meet any of the safe harbors for economic effect. First, funds generally do not liquidate in accordance with capital account balances. Second, fund agreements typically provide that no partner shall be unconditionally obligated to restore a negative capital account balance; thus, most fund agreements do not contain a DRO. Third, it is unlikely that the fund’s allocation provisions have economic effect equivalence, which requires assurance that liquidation of the partnership, in any year, will result in partner distributions matching their capital account balances. Such assurance is often impractical and generally may be unreliable.
As previously mentioned, when an allocation in a partnership agreement does not have SEE, the partnership must determine the allocation based on PIP. Despite the importance of defining PIP, the rules and examples found in Treasury regulations provide relatively little guidance for taxpayers. This uncertainty leaves allocations open to potential IRS scrutiny and challenge.
The regulations generally provide that PIP should reflect, based on all relevant facts and circumstances, “the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated.” The regulations further provide the following nonexclusive list of facts that will be considered in determining PIP:
Special rule. The regulations also provide a special rule for determining PIP, according to which a partner’s allocations are generally determined with reference to changes in the partner’s right to capital following a hypothetical sale of the partnership’s assets at book value and a subsequent hypothetical liquidation of the partnership. However, the special rule applies only if (i) the partnership maintains capital accounts in accordance with Section 704(b); (ii) the partnership agreement provides for liquidation of the partnership in accordance with positive capital account balances; and (iii) all or a portion of an allocation of income or loss does not otherwise have economic effect under the general or alternate safe harbor test.
Fundamental challenges in determining PIP. Partnerships — especially investment funds — face complex challenges and uncertainties when determining PIP, which may include the following:
The capital account maintenance rules are fundamental to determining the potential supportability of partnership income or loss allocations. Allocations made by partnerships that do not maintain partners’ capital accounts in accordance with the rules of Section 704(b) cannot have economic effect. In addition, the determination of PIP relies in part on a partner’s economic entitlement to partnership capital.
Treasury regulations provide that proper maintenance of partner capital accounts requires upward and downward adjustments for specific items including contributions by the partner to the partnership; distributions from the partnership to the partner; allocations of items of partnership income, gain, loss, deduction, and certain partnership expenditures; and other adjustments such as required revaluations of partnership property in certain situations.
The determination of PIP is based on facts and circumstances; therefore, each situation needs to be separately addressed. In the absence of additional guidance, the best strategy in preparation for IRS examination may be a detailed, clearly documented assessment of each taxpayer’s particular facts supporting the determination of PIP. For additional analysis, practical insights, and a comprehensive case study, see Jeffrey N. Bilsky, “Investment Fund Allocations: Defining a Partner’s Interest in a Partnership,” Tax Notes Federal, July 8, 2024, p. 195.
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