Targeted Partnership Allocations
Targeted partnership allocations may be the subject of future IRS guidance.
The AICPA, the trade group for the US accounting industry, sent the IRS and Treasury in February a draft revenue ruling that it would like the IRS to issue about targeted allocations.
IRS regulations require partnerships to keep a capital account for each partner that tracks what the partner contributed and what he got out of the partnership. When the partnership liquidates, the capital accounts are supposed to be used by partners to divide up what remains.
With targeted allocations, the partnership simply divides up what remains according to a business deal. It tries during the life of the partnership to share economic returns in a manner that causes the capital accounts to remain in the ratio the business deal requires any assets remaining at liquidation to be shared, but there is no guarantee the capital accounts will be in this ratio.
The AICPA said that there is a widespread misconception that the IRS approves of targeted allocations because it has not challenged partnerships that use them.
The ruling the AICPA wants the IRS to issue would say that targeted allocations work as long as they are economically equivalent to using capital accounts to distribute assets at liquidation. This would have to be true not only for the particular tax year in which the allocations are tested but also for all future years.
The allocations lead to the same result as using capital accounts to distribute assets at liquidation in the first two of three examples the AICPA asked the IRS to address.
In the examples, a 50-50 partnership is formed between partners A and B. A contributes $100 in cash and B contributes assets worth $100 in which B has a basis of $100. The business deal is that A and B are distributed cash in a 50-50 ratio until each gets its $100 back, then A gets cash to give it a 5% return on its $100 in invested capital and remaining cash is distributed 50-50. The partnership allocates net income and loss so as to try to keep the capital accounts in a ratio that matches the business deal.
In example 1, the partnership has net income. The AICPA says that A and B will receive the same amount at liquidation as if the partnership kept proper capital accounts and used them to distribute remaining assets.
In example 2, the partnership as no net income. Each partner will get back $100 at liquidation.
In example 3, the business deal is different. A gets its capital and return first, then B gets its capital back and then everything else is shared 50-50. The AICPA says targeted allocations using this formula do not work because these allocations will leave B with less than B would receive if proper capital accounts were used at liquidation unless the partnership will have enough net income each year to give A its preferred return. There is no guarantee the partnership will have enough net income in future years.
It is unclear whether the AICPA believes that the IRS should allow the targeted allocations in the third example on audit as long as the partnership had enough net income in fact through the tax year being audited to cover the A preferred return.