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Correcting Capital Account Mistakes
and Errors on Partnership Returns A Comprehensive Guide to Corrections, Allocations and "True-Ups" of Capital Accounts
TUESDAY, NOVEMBER 24, 2015, 1:00-2:50 pm Eastern
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FOR LIVE EVENT ONLY
Nov. 24, 2015
Correcting Capital Account Mistakes and Errors on Partnership Returns
Joseph C. Mandarino, Partner
Smith Gambrell & Russell
Steve R. Johnson, Professor
Florida State University
Berlin (Jay) Robbins, III, CPA, CFP, Member
Warren Averett
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
November 24, 2015
Joseph C. Mandarino Smith, Gambrell & Russell, LLP
Promenade II, Suite 3100
1230 Peachtree Street Atlanta, Georgia 30309
www.sgrlaw.com
Correcting Capital Account Mistakes Interpretation of Partnership Agreements
Overview
• Background and Stakes
• Contractual Interpretation Issues
• Interpretation of §704(b) Capital Account Maintenance Rules
• Interpretation of Other Tax Provisions
• Examples – Disputes and Resolutions
6
Terminology
• For brevity and because of the relative popularity of limited liability companies, these slides will often refer to LLCs, but such term should be understood to include general partnerships, limited partnerships, LLPs, LLLPs, and other entities that are taxed as partnerships for federal income tax purposes.
• Similarly, references to operating agreements also include partnership agreements, and references to members also include partners.
7
Capital Account Mistakes and Interpretation of Partnership Agreements
8
Background
• Most operating agreements provide for capital accounts.
• A capital account is to a member what a stock certificate is to a shareholder – arguably the most important representation of the member’s ownership.
• Operating agreements that provide for capital accounts also generally provide rules for calculating the starting balance of these accounts and adjustments based on the profits, losses, contributions, distributions, and other events.
• In some instances, these rules repeat or cross reference the capital account maintenance regulations under §704(b).
9
Stakes – Targeted Allocations
• In some cases, members will agree on distributions and then provided for “targeted” allocations that result in capital account balances that are in accordance with the agreed shares of the partnership’s assets.
• If mistakes creep into the calculation of those balances, a member may receive allocations of income and loss that are incorrect.
10
Stakes – Tax Distributions
• In many cases, the operating agreement will provide for “tax distributions” – cash distributions to members to pay estimated and actual taxes.
• Often, these distributions are a function of income and loss allocations for the current or prior year.
• If mistakes are made in the calculations of income and loss allocations, then the tax distribution amounts may be erroneous as well.
11
Stakes – Regular Distributions
• In some cases, the members will agree on allocations and then provide for distributions that are a function of, or are triggered by, some metric involving these allocations.
• For example, a junior tranche of members may not be untitled to distributions until a senior level of member receives allocations that reach a specified dollar amount or IRR.
• If there are mistakes in allocations, they will cascade through to these calculations as well.
12
Stakes – Proceeds on Liquidation
• In many cases, a member’s right to share in a liquidation of the LLC is a function of the member’s capital account balance.
• If mistakes have crept into the calculation of that balance, a member may be over- or under-paid.
• Even if the operating agreement does not provide for liquidation in accordance with capital account balances, the tax code may require it – errors will have tax complications as well.
13
Contractual Interpretation Issues
• One of the most common sets of capital account mistakes are errors that arise from interpretations of the operating agreement.
• For simplicity, we refer to these as contractual interpretation issues.
• In practice, there are three major areas of contractual interpretation issues:
• yield/preferred return/IRR calculations
• flip events
• hypercomplexity
14
Yield/Preferred Return/IRR
• Many operating agreements provide for different classes of members who are entitled to different economic rights. For example, a senior member may be entitled to a preferred return on his/her investment.
• Often, the description of that return is lacking. Problems can arise if the parties have different views of how the calculation should be interpreted.
• “Class A members shall be entitled to a 10% preferred return on their capital contributions.”
• Is this a compounding return or a simple return?
• What is the basis for the return? The original investment? The member’s capital account balance, as adjusted?
• What happens if there are insufficient funds to pay distributions?
15
Yield/Preferred Return/IRR
• There are ways to avoid these problems:
• better descriptions (could refer to Excel calc functions, etc.)
• numerical examples included as exhibits
• circulating the calculation ahead of time
• requiring the LLC to include calculations to the members so that disagreements can be flushed out ASAP.
• If problems do arise, alternative dispute resolution (“ADR”) provisions can shield the LLC and its members from litigation sink holes:
• Interpretation differences can be resolved by arbitration, a panel of experts, etc.
• Some agreements grant the LLC full discretion to interpret the operating agreement.
16
Flip Events • Some operating agreements will have shifting
allocations/distributions based on certain events.
• Some of these events may be the attainment of certain yield/preferred return/IRR goal posts, but some may be dependent on the attainment of certain profit or revenue targets, zoning or licensing results, financing events, or calendar dates.
• Problems could be avoided by the use of better descriptions.
• An additional approach is to provide regular notices of the existence of flip events and how “close” they are.
• As above, ADR clauses will not foreclose a dispute over the timing or existence of a flip event, but can minimize the pain of such disputes.
17
Hypercomplexity • Particularly with large projects that involve a number of investors
with different economics, the operation of allocations and distributions can involve many different tiers or waterfalls, numerous flip events, and/or a significant number of conditional or contingent allocations and distributions.
• While any one of these provisions may be administrable, the weight and complexity of multiple provisions can make an operating agreement difficult to interpret.
• Particularly if there were several waves of investment, and different deals were struck each time, the parties may not agree on the interaction of different provisions and disputes may arise.
18
Hypercomplexity • There may be no way to avoid hypercomplexity, especially when
there are different groups of investors who came in at different stages and have different economic deals.
• Ways to avoid disputes in this area include better descriptions and the inclusion of numerical examples as exhibits.
• If problems do arise, ADR provisions can temper the time and expense of disputes.
19
Interpretation of §704(b) Capital Account Maintenance Rules
• In most operating agreements, there is a lengthy set of rules, many of which are culled from, or refer to, the tax regulations issued under IRC 704(b) (the capital account maintenance rules).
• These provisions are often adopted whole scale, even if there is no tax attorney or expert advising the LLC or its members.
• As a result, disputes can arise because the members did not have a good understanding of how these rules and regulations operate.
20
Capital Account Maintenance Rules • Some common issues that come up in practice are:
• differences between GAAP and tax capital accounts
• contributions of non-negotiable notes by members
• distributions of LLC notes to members
• contributions of property subject to nonrecourse debt
• revaluations of capital accounts
• IRC §704(c) allocations
• successor capital accounts
• oil & gas depletion and related issues
21
Capital Account Maintenance Rules • How can these issues be avoided?
• With proper drafting, disputes involving the interpretation of the capital account maintenance rules can be minimized. If compliance with these rules is mandated in the operating agreement, there may be are few areas of interpretational differences.
• Instead, disputes really boil does to the fact that members often didn’t understand how these rules would operate.
• That is a different complain and one for which there may be no remedy at law.
• Some solutions to “I-didn’t-understand-what-I-was-signing” are to document that members were advised that the tax aspects of an investment in an LLC are complicated and to obtain their own tax advice.
• ADR clauses can also be helpful. 22
Interpretation of Other Tax Provisions • The remaining category of items that can give rise to
interpretational differences is a catch all.
• Many of these items do not directly drive capital account adjustments, but can have secondary effects on income/loss and distributions that may affect capital account balances.
• Common items are:
• operation of the minimum gain chargeback rules
• allocation of partnership liabilities
• elective and mandatory basis adjustments
23
Other Tax Provisions • It is difficult to forestall disputes over these types of provisions.
• As with the capital account rules, in many cases the substance of the complaint is that a member did not understand how a specific tax provision might affect the economics of his/her investment.
• Thus, disclaimers and ADR clauses can help to tamp this down.
24
Contractual Interpretation Example • The balance of this section considers two examples that involve a
dispute over a preferred return clause.
• We hope to examine the consequences of the dispute and how the parties could proceed, including settlement options.
25
Example – Base Facts • Newco has three members, A, B and C.
• A invests $1 million and is entitled to a preferred return of 10% on that amount. Once A receives her $1 million plus the preferred return, A is entitled to a 40% interest in profits and losses.
• B invests $200,000 and is entitled to a 40% interest in profits and losses, subject to A’s preferred return.
• C invests no money but is given a profits interest of 20%.
• Newco invests the total of $1.2 million in a single investment asset.
• For the first three years, Newco has losses.
• At the start of Year 4, Newco sells the investment asset for $3 million.
26
Example – Base Facts • The allocations made by Newco for the four-year period are as
follows:
Year total
income/loss A B C totals
1 -100,000 100,000 -133,000 -67,000 -100,000
2 -100,000 100,000 -133,000 -67,000 -100,000
3 -100,000 100,000 -133,000 -67,000 -100,000
4 2,300,000 920,000 920,000 460,000 2,300,000
2,000,000 1,220,000 521,000 259,000 2,000,000
1,000,000 purchase price
-300,000 depreciation
700,000 tax basis
3,000,000 amount received
-700,000 tax basis
2,300,000 gain
27
Example – Base Facts • A argues that she is entitled to $331,000 in preferred returns (i.e.,
10% compounded annually for three years) before the 40% share kicks in.
• B and C argue that A is only entitled to $300,000 (i.e., a 10% simple return) before A’s 40% share kicks in.
28
Example – Base Facts • Under A’s interpretation, the allocations for the four-year period
should have been as follows:
Year total
income/loss A B C totals
1 -100,000 100,000 -133,000 -67,000 -100,000
2 -110,000 110,000 -140,000 -70,000 -100,000
3 -121,000 121,000 -147,333 -73,667 -100,000
4 2,300,000 920,000 920,000 460,000 2,300,000
2,000,000 1,251,000 499,333 249,667 2,000,000
1,000,000 purchase price
-300,000 depreciation
700,000 tax basis
3,000,000 amount received
-700,000 tax basis
2,300,000 gain
29
Example 1 • If there are dispute resolutions provisions in the operating
agreement, this may be resolved quickly.
• If she is not bound by such provisions, A could sue to enforce her view of the agreement.
• Litigation would be time consuming. Even ADR could take so long that, in the interim, Newco would have to file tax returns and issue K-1s.
• If Newco stuck to its position, the dispute over how to interpret A’s preferred return would transmit to the capital accounts maintained for the members.
30
Example 1 • If A were ultimately successful in ADR or litigation, Newco and
the other members might have to make up the preferred return shortfall.
• But this could be years after Newco sells its investment asset.
• Normally, A would be required to include the K-1 information on her personal return.
• However, there is a procedure under which A could take an inconsistent position, disclose it to the IRS and then (potentially) avoid penalties.
• IRS Form 8082 (Notice of Inconsistent Treatment) is used for this purpose. [This is discussed more in the next segment of this webinar.]
31
Example 1 • Conversely, A could report the K-1 as prepared by Newco and
proceed with ADR or litigation.
• If A were ultimately successful, A would then have two options:
• File amended returns to correct the capital account mistakes and other disputed items.
• Treat the litigation outcome as a separate taxable event.
• The former is more complicated and the other participants might not go along.
• The latter can sometimes be simpler. One important qualification is to ensure that the parties characterize the settlement consistent with the dispute from which it arises.
32
Example 1 • For example, if A prevailed in ADR or litigation and it was
determined that A should have received a preferred return of $331,000 instead of $300,000, then A would be entitled to $31,000 in damages plus (in many cases) interest, and (in rarer cases) attorney fees.
• The preferred return income is likely to be characterized as ordinary income.
• Under the Arrowsmith case, A may be required to report these damages as ordinary.
• Characterization of judicial interest?
• Characterization of attorney fees?
33
Example 2 • Same facts as Example 1, but when A brings up her claim, B and C
agree with her.
• The parties then have to fix the problem.
• After three years of errors, if A should have been allocated more income (and, therefore, B and C allocated more loss), there are at least two options to the parties:
• fix the capital accounts by filing amended returns, or
• fix the capital accounts with catch up allocation in the current period.
34
Example 2 • Filing amended returns can raise several issues.
• cost of new return prep
• closed tax years
• interest and penalties for retroactive allocations
• Catch-up allocations (net allocations that eliminate the difference between the erroneous capital account balances and what the parties agree should be the true balances) are much simpler.
• But can the parties make catch up allocations?
35
Example 2 • The allure of a catch up allocation is that amended returns are
unnecessary. Instead, the correct balances are determined and the LLC determines the plug allocation that will result in those balances.
• Under IRC §761(c), retroactive allocations that go back a single year are allowed under certain circumstances:
For purposes of this subchapter, a partnership agreement includes any modifications of the partnership agreement made prior to, or at, the time prescribed by law for the filing of the partnership return for the taxable year (not including extensions) which are agreed to by all the partners, or which are adopted in such other manner as may be provided by the partnership agreement.
36
Example 2 • Some would read this to mean that filing amended returns
cannot be done if the “new” interpretation is in substance a retroactive amendment of the operating agreement. Under this view, only a catch up allocation (or possible a one-year-back allocation) could be done.
• Conversely, if the parties agree that the new interpretation is the correct interpretation and should have been applied in prior years (but was not), then the filing of amended returns does not involve the amendment of the operating agreement but the application of the original intent of that agreement. Accordingly, IRC §761(c) should pose no barrier to the filing of amended returns.
37
Example 2 • If IRC §761(c) does not prevent the parties from filing amended
returns or utilizing a catch-up allocation, are there policy concerns that are implicated.
• In this example, A should have been allocated more income and B and C should have been allocated more loss in the three prior years.
• For B and C, the filing of amended returns that report more loss is unlikely to cause negative ramifications. However, if A underreported its income, the filing of amended returns may result in penalties and interest.
• A would generally prefer a catch up allocation under these facts.
38
Example 2 • Could the IRS treat a catch up allocation as a “shifting allocation”
and thereby ignore it?
• Under Treas. Reg. §1.704-1(b)(2)(iii)(b)(1), a shifting allocation can be disregarded if, among other things,
The total tax liability of the partners (for their respective taxable years in which the allocations will be taken into account) will be less than if the allocations were not contained in the partnership agreement (taking into account tax consequences that result from the interaction of the allocation (or allocations) with partner tax attributes that are unrelated to the partnership).
39
Example 2 • Under our facts, A is arguing that it should have been allocated
more income in prior years. As a result, it will recognize less gain in the year that Newco disposes of its sole asset, and B and C would recognize more gain.
• If B and C were in lower tax brackets than A, the IRS could argue that at the time the catch up allocation was made there was “a strong likelihood” that the overall tax liability would be reduced as a result of the allocation.
• This would create a presumption that the allocation was an impermissible “shifting allocation.” The burden would fall on the taxpayers to overcome this presumption “by a showing of facts and circumstances that prove otherwise.”
40
Example 2 • A similar analysis would apply under the test for impermissible
“transitory allocations.”
• However, it would appear from these facts that a catch up allocation would not meet the definition of a transitory allocation. A transitory allocation occurs is present if
a partnership agreement provides for the possibility that one or more allocations (the “original allocation(s)”) will be largely offset by one or more other allocations (the “offsetting allocation(s)”) . . . .
Treas. Reg. 1.704-1(b)(2)(iii)(c).
• Note that a catch up allocation does not flip back but, instead, charts a new course of allocations that are intended to be different from the original allocations.
• But under different facts, this could be an issue.
41
Example 2 • If the IRS raises the argument that a catch up allocation is an
impermissible shifting allocation, could the parties rebut the presumption?
• If the interpretational dispute was sufficient clear, it is possible that the parties could rebut the presumption.
• However, even if they could not rebut the presumption, and the IRS prevailed, the effect of disregarding the catch up allocation would only have an effect for tax purposes.
• That is, A would be entitled to the additional $31,000 in preferred return, but arguably would not pay tax on it (B and C would). Conversely, A would recognize an additional $31,000 in capital gain for taxes purposes.
42
Example 2 • The IRS is likely to worry that a faux contractual dispute could be
used to make an opportunistic change in tax allocations.
• If the parties were motivated for tax and not economic reasons, then the IRS might reasonably fear that the claimed dispute was really a sham.
• But under our facts, the settlement of the dispute would result in A actually receiving an additional $31,000, while B and C would receive $31,000 less. That is a settlement that has real economics and would seem to suggest that there was an actual dispute. It is not logical that B and C would agree to forego $31,000 in cash proceeds simply to obtain $31,000 of tax losses.
• Key – does the settlement result in a real change in economics?
43
Summary • There are a number of provisions that can give rise to disputes
that affect capital account balances.
• Tighter drafting, disclaimers, and ADR clauses can help minimize this.
• If the parties resolve matters on their own or one party prevails in ADR or court, capital account balances can be fixed by amending returns or a catch up allocation.
• While catch up allocations are attractive, the parties must be aware that the IRS could disregard the allocations.
• Documenting a clear dispute, and showing that the catch up allocations result in a real economic change will help protect the parties.
44
Partnership Allocations and Disclosures
Jay Robbins
Berlin (Jay) Robbins
Why Allocations are Important
• Honor the agreement of the partners
• According to Sec. 704, all allocations must have substantial economic effect
– Allocations must either
• meet a safe harbor rule regarding the maintenance of capital accounts or
• Must be in accordance with the partner’s interest in the partnership
46
Substantial Economic Effect Safe Harbor
• The agreement must provide:
– The determination and maintenance of capital accounts in accordance with prescribed mechanical rules
– Distributions in liquidation of the partnership (or of a partner’s interest) to be made in accordance with positive capital account balances
– A partner with a deficit capital account balance must restore it upon liquidation.
• Alternative – Qualified Income Offset – Most commonly used
47
Capital Account Maintenance/Allocations
• To meet safe harbor – all is done on 704 basis (NOT TAX BASIS)
• Main Difference between 704 and tax
– Book/Tax difference on contributed assets
– Depreciation differences due to contribution of appreciated assets
48
Allocation Methodologies
• Layer Cake/Waterfall
• Target/Forced Allocations
49
Layer Cake/Waterfall
• This methodology generally provides an ordering for allocating profits and losses
• Most Common Type Seen:
– Profits are allocated: • 1) Restore Losses
• 2) To the partners receiving a preferred return to the extent of the preferred return
• 3) Pro Rata to all partners
• Normally - Liquidate according to Capital Accounts
• Can have different allocations for operations and capital transactions
• Most Common in PE Transactions
50
Sample Waterfall Profit Allocation
51
Sample Waterfall Loss Allocation
52
Waterfall Income Allocation Example
• AB Partnership has two partners – A and B which are 50/50 partners
• At 12/31, A has a capital account of $1,500 and B has a capital account of $2,000
• A has taken $2,000 of losses and B has taken $1,500 of losses.
• Per operating agreement, you restore losses first and then allocate pro rata
• Current year income is $10,000
53
Waterfall Example (cont’d)
A B Total
Restore Prior Year Losses
$2,000 $1,500 $3,500
Remaining Pro Rata $3,250 $3,250 $6,500
Total Current Year Income
$5,250 $4,750 $10,000
54
Targeted Allocations
• Partnership uses the distribution provisions to create the profit and loss allocations – i.e. “Income follows the cash”
• Newer documents have this
• You do a capital rollforward and determine what the target capital for each partner should be. You then allocate income or loss to get each partner as close from their true capital to “target” capital
• Most common with complex distribution rules
55
Sample Targeted Allocations
56
Targeted Income Allocation Example
• AB Partnership has two partners – A and B which are 50/50 partners
• At 12/31, A has a capital account of $1,500 and B has a capital account of $2,000
• A has taken $2,000 of losses and B has taken $1,500 of losses.
• Upon Liquidation, all cash is split 50/50
• Current year income is $10,000
57
Targeted Example
• First you need to determine what the target capital accounts are
12/31 Capital (Before Allocations)
$3,500
Current Year Income $10,000
Ending Capital $13,500
58
Targeted Example
• Upon Liquidation, cash will be split 50/50
• Targeted capital will be 50/50
A B
Targeted Capital $6,750 $6,750
59
Targeted Example
• Next you compare Targeted Capital to Actual Capital
A B Total
Actual Capital $1,500 $2,000 $3,500
Targeted Capital
$6,750 $6,750 $13,500
Difference $5,250 $4,750 $10,000
Current Year Income Allocation
$5,250 $4,750 $10,000
60
Targeted Allocations
• Trader and Investment Partnerships use a form of Targeted Allocations
• There are several methods of allocating taxable income after the book-up to FMV.
– Reverse 704c allocation
• Full or Partial Aggregation of trading gains are allocated based on a revaluation account
– Goal is to allocate taxable income to those with a book-tax disparity and ultimately close the difference.
61
Regulatory Provisions
62
Non-recourse Deductions
63
Non-recourse Deductions
• No partner bears any economic risk of loss
• No guaranty on debt
64
Minimum Gain
• Allocations of nonrecourse deductions cannot have substantial economic effect because the creditor alone bears any economic loss attributable to those deductions.
• Nonrecourse deductions must be allocated in accordance with the members’ interests in the LLC.
• The agreement must have a minimum gain chargeback provision
• Reg. 1.704-2
65
Minimum Gain Chargeback
• Minimum Gain = amount of gain that would be realized if partnership disposed of property subject to nonrecourse debt in satisfaction of the debt only. Gain = Nonrecourse liability > book basis of property
• Nonrecourse deductions are allowed every year to the extent of the net increase in a partner’s share of minimum gain.
• If the partner’s share of minimum gain decreases in a year, the minimum gain chargeback hits – items of
income or gain must be allocated to that partner to cover the net decrease
66
Why do we have Minimum Gain Chargeback?
• The theory is from the argument that, although partners are not personally liable for nonrecourse liabilities, a partner who receives an allocation of a nonrecourse deduction will ultimately be required to recognize a corresponding amount of gain
• Minimum gain increases as the adjusted basis of the property decreases.
• Minimum gain decreases as the amount of debt decreases
• MGC rules won’t apply if net decrease in MG is due to: (1) refinancing to become recourse debt or (2) capital contributions made by partner to reduce the loan
67
Minimum Gain
68
Minimum Gain Example • A and B form the AB partnership with each contributing
$10,000. The partnership uses the $20,000 plus $100,000 nonrecourse debt to purchase equipment worth $120,000
• The partnership takes a depreciation deduction of $24,000 in year 1 which is allocated equally to A and B. This gives both partners a deficit capital account of $2,000. There is not a deficit restoration obligation
• If the equipment is sold for the amount of the debt, there would be a $4,000 gain ($100,000 less 96,000 adjusted basis). Since there is a $4,000 minimum gain, the deductions are allowed
69
Minimum Gain Example
• In year 2, the partnership pays $2,000 of the debt principal. The minimum gain would decrease and each partner would recognize $1,000 minimum gain chargeback
70
Member Nonrecourse Deductions
71
Member Nonrecourse Deductions
• Member loans money to the entity – nonrecourse to all other members
• Entity purchases equipment
• Depreciation deductions are allocated to the member who made the loan to the entity
72
Member Minimum Gain Chargeback
• If a member is responsible for a nonrecourse liability that creates minimum gain, if the minimum gain decreases, the member has an allocation of income
73
Member Minimum Gain Chargeback
• E and B form the EB partnership. E then loans $120,000 to the partnership to purchase equipment.
• The partnership takes a depreciation deduction of $24,000 in year 1 which is allocated to E since E bears the risk on the loan. This gives E a negative capital account of $24,000. There is not a deficit restoration obligation
• If the equipment sold for the amount of the debt, there would be a $24,000 gain ($120,000 less 96,000 adjusted basis). Since there is a $24,000 minimum gain, the deductions are allowed
74
Member Minimum Gain Chargeback
• EB Partnership pays E back $5,000 in principal on the note. E’s member minimum gain has decreased which will trigger a $5,000 allocation of income to E
75
Member Minimum Gain Chargeback
76
Debt Restoration Obligation
• Not included in the regulatory provisions, but very important.
• Typically in capital account maintenance section of operating agreement.
• Rarely seen anymore – QIO has made DRO less relevant
• If there is one – it will say the partners are responsible for any negative capital balance in their capital account
77
Qualified Income Offset (QIO)
78
QIO Example
• XY form XY Partnership. X contributes property worth $10,000 and Y contributes $30,000 cash.
• The partnership has decided to distribute cash 50/50
• The partnership distributes $40,000
• X will have a negative $10,000 capital account after the distribution.
• The QIO will require a $10,000 allocation of income to X to cover the negative capital account
79
Gross Income Allocation
• If a member has a negative capital account greater than any allocated minimum gain or nonrecourse debt, income is specially allocated to restore the negative capital account as quickly as possible
80
Gross Income Allocation
81
Section 754 Adjustments
• There is generally basic language in the agreement that will allow you to treat a 754 adjustment as a gain or loss to the partner for capital account purposes
82
Other Items in Partnership Agreements
83
Definitions
• The definitions are as important as the allocations
• Always look for a capitalized term in the definitions
84
Definition Examples
85
Definition Examples
86
Definition Examples
87
704(c) Allocations
• 3 Methods – Traditional, Curative, Remedial
• Is the method established in the operating agreement?
• If the method is not established, who gets to pick it?
88
What Happens when Partner Interests Change?
• What transfers are permitted?
• How do you allocate income when a transfer happens?
– Interim closing of the books
– By Day
– By Month
89
Contributions and Distributions
• What happens if a partner defaults on a capital contribution? Does it affect the ownership in the entity?
• How will distributions be calculated?
• Is there a different distribution for ordinary income and capital events?
90
Administrative Provisions
• When do the tax returns need to be delivered?
• When do the financials need to be delivered?
• Who is the TMP (Tax Matters Partner)?
• Who can authorize a 754 election?
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Separately Stated Items
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Benefits
• IRS requires that certain items related to partners are separately stated
• Health Insurance, HSA contributions, employer match of 401K or other retirement plan contributions, Life and Disability.
• Partners do not receive Section 125 benefits (Fringe Benefits)
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Where to report • If the cost of the Fringe Benefits are paid by the
firm, the amount should be included (grossed up) in the guaranteed payment
• The item (if deductible) is reported on your personal income tax return
• Ie: Health Insurance, retirement plans, and HSA Contributions are reported on Page 1 of your 1040
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Where to report (cont) • Health Insurance is limited to the amount of S/E
income reported on Schedule K-1
– Excess amount is reported as itemized deduction on Sch A
• Retirement Plans contributions consist of both Company Paid (Match) and the elective deferral amount
– Company responsible for discrimination testing
– Company should also be aware of UPE that reduces S/E income
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Disclosures
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Inconsistent Treatment – Partner Level
• IRS requires that taxpayers report the distributive items exactly as they are reported on K-1
• If Taxpayer takes position that is contrary to the K-1, they should disclose differences on Form 8082 – Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR)
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Amended Returns • Returns filed BEFORE December 2017 – New
TEFRA Rules (Discussed in other section)
• Should take careful consideration before amending returns since it impacts all underlying partners
• Generally, amended returns are filed on From 1065X
• Currently, all amended returns fall under TEFRA, unless it is a small partnership
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Amended Returns – 1065X • Many issues to consider with amended returns
• Should it be on 1065X or just 1065 with the Amended box checked?
– Do not use 1065X to file amended returns or AAR for a TEFRA partnership if the return is required to be filed electronically
• NonTEFRA partnerships that file electronically should use Form 1065 and mark the “Amended’ Box
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Amended Returns • Should determine if you should file as an
Administrative Adjustment Request (AAR), and if so, should it be treated as a substitute return
• If amended return reflects net income increase, substitute return should be considered.
– This allows the IRS to assess the tax to each partner without an IRS audit
• If net decrease, should use AAR. The IRS will likely not act if a substituted return is filed
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Amended Returns • Form 1065X requires initial determination
concerning whether filer is a TEFRA or NonTEFRA partnership.
• Prior to 1065X, a TEFRA partnership would file Form 8082 to start an AAR adjustment. This would be signed by the TMP
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Amended Returns • Partners who receive an amended Schedule K-1 from a
TEFRA partnership should file Form 8082 as an attachment to their original or amended individual tax return, and file a copy of Form 8082 with the IRS Center where the partnership filed its Form 1065 or Form 1065X.
• If the partnership filed Form 1065X as an AAR that reflects a net decrease to taxable income, the IRS will either start an examination, approve Form 1065X as filed, or take no action.
• If the IRS taxes no action, the TMP can petition the Tax Court.
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Amended Returns • The consolidated audit procedures are very
complex
• Partners can choose to “opt out” at any time during the consolidated examination. This is generally considered a disadvantage
• Filing an amended return should be avoided whenever possible
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Correcting Capital Account Mistakes
and Errors on Partnership Returns
Steve R. Johnson
SOME HISTORY
IRC § 704(a)
IRC § 704(b) (before 1976)
IRC § 704(b) (current version)
§ 704(b) regulations
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SPECIAL ALLOCATIONS:
§ 704(b) REGULATIONS
1. Fundamental principle: To be valid, an allocation must
be consistent with the partners’ economic arrangement.
Partners receiving an allocation must also have the
corresponding economic benefits and burdens.
2. Four ways to satisfy the fundamental principle:
a) substantial economic effect
b) alternative economic effect
c) accord with partner’s interest in the partnership
d) special rules
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SPECIAL ALLOCATIONS:
WAY ONE: ECONOMIC EFFECT
The allocation has economic effect if all of the three
requirements are met:
1. Partnership maintains capital accounts in conformity to
capital account rules specified in the regulation.
2. Liquidating distributions will be made in accordance
with positive capital account balances.
3. Partners with negative capital accounts at liquidation
will have to pay in to the partnership enough to bring
their capital accounts back up to zero, such pay-in being
used to pay creditors of the partnership or fund
distributions to partners with positive capital accounts.
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SPECIAL ALLOCATIONS:
WAY ONE: SUBSTANTIALITY
1. Affirmative test: an allocation is substantial if there is a
reasonable possibility that it will affect the amount of
money the partners will receive independently of tax
effects.
2. Negative tests:
a) shifting allocations
b) transitory allocations
c) “some help, no hurt” allocations
3. The allocation may be insubstantial if capital accounts
are left unchanged within a year or over a period of
years.
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SPECIAL ALLOCATIONS:
WAYS TWO, THREE, AND FOUR
Way 2: Same as Way One as to the first and second requirements. The third requirement can be met, in lieu of a pay-in, by a “qualified income offset.”
Way 3: The allocation accords with the partner’s interest in the partnership, determined by all facts and circumstances.
Way 4: The special rules are set out in Reg. §§ 1.704-1(b)(4) and 1.704-2. They cover a number of special situations, including allocations to reflect revaluations, allocations to reflect amendments to the partnership agreement, and allocations attributable to nonrecourse liabilities.
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BEYOND SPECIAL ALLOCATIONS:
OTHER SIGNIFICANT CONTEXTS
1. Determining the nature and value of contributed
property for § 704(c) purposes
2. Determining partner’s share of recourse liabilities
3. Determining partner’s share of nonrecourse liabilities
4. Ascertaining whether a distribution is a disguised sale
5. Guaranteed payments and target allocations
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WHAT THE IRS WILL WANT TO REVIEW
1. Book capital accounts and tax capital accounts going
back as much as seven years, with supporting work
papers
2. Schedule M-2 adjustments
3. Ending capital accounts per Schedule M-1
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KINDS OF CAPITAL ACCOUNTS
1. Tax capital accounts
2. § 704(b) book capital accounts
3. Book capital accounts
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CAPITAL ACCOUNT ERRORS THAT WILL BE
PROBLEMATIC ON AUDIT
1. Confusion among types of capital accounts
2. Unclear provisions
3. Mindlessly borrowed provisions
4. Improperly maintained accounts
5. “Muffed hand-offs,” i.e., the creator of the system not
interacting with the ongoing operators of the system
(the absent lawyer and the present accountant)
6. Incomplete tracking of the regulatory requirements as
to how to maintain capital accounts
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PREVENTING OR CORRECTING
PROBLEMATIC CAPITAL ACCOUNT ERRORS
1. Avoiding special allocations
2. Using goal-oriented, not rule-oriented, provisions
3. Eschewing substantial economic effect safe harbors
(Way One and Way Two) to rely instead on the general
“partners’ interest in the partnership” test (Way Three)
4. Making curative allocations
5. Requesting the IRS to approve a change of accounting
method?
6. Reviewing provisions of the partnership agreement
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NEW PARTNERSHIP AUDIT REGIME:
SOME KEY FEATURES
1. TEFRA and electing large partnership regimes abolished.
2. Audit at entity level through partnership representative
without individual partner participation.
3. In general, liability for adjustments imposed on the
partnership, not the partners, and for the year in which the
adjustment is made, not the year of the return adjusted.
4. Generally effective for tax years starting after 2018, but
partnership may elect in as early as the 2016 return.
5. Some partnerships may elect out of the new regime (those
with 100 or fewer partners, none of which are partnerships
or trusts). If partnership elects out, IRS audits the partners,
not the partnership.
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NEW PARTNERSHIP AUDIT REGIME:
SOME KEY CHOICES
1. Whether to elect into the new regime before 2018
2. Whether to elect out of the new regime in 2019 if
partnership eligible to elect out
3. Whether to elect to make the push-up election, causing
liability for payment to fall on partners, not the
partnership
4. How much authority to confer on the partnership
representative
5. What default provisions to craft if partners cannot
agree on key decisions
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