Tax equity partnerships take note.

The US Tax Court suggested that partners who do not agree to “deficit restoration obligations” should be allocated income annually to close any deficit capital accounts.

This could affect project developers who enter into tax equity partnerships and keep most of the cash, driving their capital accounts negative.

The US gives partners wide latitude to divide up returns from a partnership as they wish, but with one main constraint. The partnership must keep capital accounts for each partner and use them to distribute what asset value remains when the partnership liquidates. Capital accounts are a metric for tracking what each partner put in and took out of the partnership.

A partner’s capital account increases as the partner suffers a detriment, like contributing more capital to the partnership or having to report a share of the income the partnership earned on the partner’s tax return. It decreases as a partner receives a benefit, like being allocated tax losses or distributed cash.

The partnership cannot allow a partner’s capital account to go negative unless the partner has agreed to contribute more capital, when the partnership liquidates, to close any capital account deficit. This is called a “deficit restoration obligation” or “DRO.” (The IRS may ignore some DROs. For more detail, see “Deficit Restoration Obligations” in the December 2019 NewsWire.)

In cases where a partner does not agree to a DRO, then the partnership cannot continue allocating that partner tax losses once its capital account hits zero. Any remaining losses shift to the other partners.

The partnership agreement must also have a “qualified income offset” provision that says when a partner’s capital account is driven negative by an unexpected adjustment, allocation or distribution, the partner must be allocated income as quickly as possible to eliminate the deficit.

An accounting firm in Redmond, Washington that was organized as a partnership dissolved in 2013 after two of the three partners withdrew to form a competing firm and took clients with them.

The partnership agreement had standard language requiring maintenance of capital accounts for the partners. The partners did not agree to DROs. The agreement had a qualified income offset provision that said if a partnership capital account was driven negative, the partnership would allocate income to the partner as quickly as possible to eliminate the deficit.

The partnership agreement had a two-year non-compete provision for withdrawing partners. It treated any partners who withdrew and whom clients followed as receiving an in-kind distribution of an intangible asset — client goodwill — that belonged to the partnership. The value of the intangible asset reduced the partner’s capital account.

The federal income tax return that the remaining partner filed for the partnership for 2013 showed the two withdrawing partners as having been distributed $742,569 in intangible assets attributable to clients who followed them to their new firm. This pushed their capital accounts negative. Therefore, the tax return allocated 2013 partnership income to close the deficits. The two withdrawing partners ended up being allocated larger shares of the 2013 income than they expected.

Each of them filed a Form 8082 with the IRS to flag that they were not filing their tax returns consistently with the income the partnership told them they had to report.

The IRS audited the partnership’s 2013 return and took the side of the two withdrawing partners, arguing that the remaining partner should have reported a larger share of the 2013 income.

The US Tax Court largely disagreed with the IRS. The court said the qualified income offset provision that required partners who did not agree to DROs to be allocated income to close any capital account deficits was key.

However, it said the partnership should have first allocated among the three partners the amount that the intangible client goodwill had appreciated in value, thus pushing up their capital accounts. The partnership had a zero tax basis it.

Partnerships that dissolve and liquidate usually sell their assets and have income or loss from such sales to allocate that must be allocated to partners. In cases where partnership assets will be distributed to partners in kind, the partnership treats the assets as if sold and allocates the gain or loss inherent in the assets. This pushes up capital accounts before any liquidating distributions. It ensures that the sum of all the partner capital accounts will equal the remaining value inside the partnership.

The US Tax Court said the gain in the intangible client goodwill should have been allocated under the partnership agreement in the same ratio used for other income as if it had been realized before applying the qualified income offset provision to redirect enough income to partners with deficit capital accounts to close the deficits for the year.

It sent the parties back to recalculate the income allocations.

The case is Clark Raymond & Company v. Commissioner. The US Tax Court released the decision in mid-October.