No Job Name · covers a lot of unpleasant surprises and other sins, 1Section references are to the Internal Revenue Code unless the context indicates otherwise. The term ‘‘partnerships’’

Targeted AllocationsHit the SpotBy William G. Cavanagh

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 90A. Cash-Follows-Tax Is Wrong for Clients . . . 90B. How Did We Get to Cash-Follows-Tax? . . 90C. Where’s the Beef? . . . . . . . . . . . . . . . . . 90D. Scope and Coverage of Report . . . . . . . . 91E. Recommendations . . . . . . . . . . . . . . . . . 91

II. Section 704(b) Economic Effect Tests . . . . . . 91A. Safe Harbor Economic Effect Test . . . . . . 92B. Alternate Test for Economic Effect . . . . . . 94C. Economic Effect Equivalence . . . . . . . . . 95D. Partner’s Interest in the Partnership . . . . . 96E. Nonrecourse Deductions . . . . . . . . . . . . . 97

III. What Does the Tax Boilerplate Mean? . . . . 98A. The Boilerplate . . . . . . . . . . . . . . . . . . . 98B. What Does It Mean? . . . . . . . . . . . . . . . . 98

IV. Targeted Allocations . . . . . . . . . . . . . . . . . 102A. Targeted vs. Traditional Allocations . . . . 102

B. Drafting Targeted Allocation Provisions . 103C. Economic Certainty: Burden on

Preparer . . . . . . . . . . . . . . . . . . . . . . . 104D. Tax Certainty (or Lack Thereof) . . . . . . 104E. Preferred Return and Targeted

Allocations . . . . . . . . . . . . . . . . . . . . . . 105F. Potential Drafting Issues . . . . . . . . . . . . 106

V. Tracking Allocations . . . . . . . . . . . . . . . . . 106VI. Allocations Based on Taxable Income . . . . 107VII. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 108Appendix A: Testing Partnership Allocations . . . 108Appendix B: Sample Tax Boilerplate . . . . . . . . . 108Appendix C: Sample Targeted AllocationProvision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

William G. Cavanagh is a tax partner in the NewYork office of Chadbourne & Parke LLP and can bereached at [email protected]. A previousversion of this report was delivered to the Tax Forumin New York City in March 2009.

Cavanagh analyzes the economic effect prong ofthe substantial economic effect test applicable topartnership allocations and discusses traditional al-locations as well as targeted and tracking allocations.He describes the function of some of the standard taxboilerplate provisions and suggests that those provi-sions be included as an appendix to partnershipagreements rather than incorporated into the text ofagreements. (A sample appendix is included.)

The author compares the traditional ‘‘liquidate inaccordance with capital accounts’’ allocation provi-sions with targeted and tracking allocation provi-sions that, although not explicitly sanctioned by theregulations, are nonetheless favored by many taxpractitioners. He argues that the targeted/trackingallocation ‘‘tax follows cash’’ model is far superior to

the traditional allocation ‘‘cash follows tax’’ model,and he recommends that the IRS provide guidance(regulations or rulings) indicating that targeted andtracking allocations will satisfy the economic effector alternative economic effect tests.

Cavanagh also recommends that the IRS modifyapplicable rules to help tax practitioners avoid mis-takes in drafting partnership tax allocation provi-sions, including confirming that the equivalenteconomic effect test applies to partnerships withqualified income offset provisions; permitting tax-payers to rely on the value-equals-basis rule indetermining a partner’s interest in the partnership;providing in the regulations that qualified incomeoffset, minimum gain charge-back, and partner non-recourse debt minimum gain charge-back provisionsare automatically incorporated into partnershipagreements; and providing in the regulations thatminimum gain charge-backs automatically carve outany gain that duplicates profits already allocated tothe partner.

Copyright 2010 William G. Cavanagh.All rights reserved.

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This report is a clarion call for action. The section704(b)1 substantial economic effect regulations ap-plicable to partnerships desperately need a rewrite.The IRS and tax practitioner groups should make ita high priority to devote significant resources to thisproject since so many of today’s businesses arepartnerships.2 This report focuses on the economiceffect prong of the regulations. The substantialityrules also present several issues that merit reconsid-eration, but we leave them for another day.3

I. Introduction

A. Cash-Follows-Tax Is Wrong for ClientsHere’s the problem. For 20-plus years now, so-

phisticated tax practitioners have been dutifullyfollowing the McKee treatise tax allocation model,memorialized in the section 704(b) safe harboreconomic effect regulations. These regulations blesstax allocations when the partnership maintainsproper capital accounts reflecting the allocationsand agrees to liquidate in accordance with capitalaccounts. The intellectual and economic underpin-ning for these rules makes sense. The allocation oftax items has economic significance only if it ismatched dollar for dollar in the economics of thedeal. The approach is ill-conceived, however.

The safe harbor economic effect regulations arebuilt on the notion that cash follows tax (moreappropriately, cash follows book, but we will post-pone that discussion), which means that cash isdistributed in liquidation the way that taxable prof-its have been allocated to capital accounts. Thisrequires partners to agree upfront to accept cashfrom the partnership in liquidation of their interestbased on their capital account balances.

Somehow tax practitioners have convinced busi-ness folks that they should trust the complicated tax

allocation provisions to produce the correct capitalaccounts and thus the cash they expected. Thesebusiness folks would be very surprised (and prob-ably horrified) to learn that the standard impen-etrable tax boilerplate provisions, which taxadvisers do not (and perhaps cannot) explain, actu-ally bear on the economic results they will enjoy.Anyone explained ‘‘qualified income offset’’ to cli-ents recently?

B. How Did We Get to Cash-Follows-Tax?How did we get here? Recall that the section

704(b) substantial economic effect regulations weredeveloped when partnerships were being used pri-marily for tax shelter transactions. The great taxshelter debate at the time for tax practitioners andthe IRS alike focused on the tax allocation provi-sions of tax shelter partnerships. The IRS wanted todevelop rules that linked tax and economics. Taxpractitioners wanted as much tax certainty as pos-sible.

In this context it is easy to understand why weended up with a cash-follows-tax capital accountliquidation analysis. The regulations were designedto maximize certainty for the tax results, not theeconomic results. In retrospect, this approach doesnot seem to serve client interests very well. Whyshould some arcane section 704(b) capital accountrule that no one truly understands determine howmuch cash the partner is entitled to receive?

C. Where’s the Beef?Well, why haven’t there been more problems?

One might rightly ask whether this is a solution insearch of a problem, since there has not been a hugeoutcry of disgruntled clients whose economic ex-pectations have been dashed in capital accounts.

How have tax lawyers been so successful inconvincing their clients that the traditional ‘‘liqui-date in accordance with capital accounts’’ theoryworks, and why have there apparently been so fewsurprises? There are several fairly obvious answers.First, who can tell? It can be difficult for business-people to determine whether their economic resultsare the product of capital accounts gone astray orthe bona fides of the business deal. Not many taxpractitioners step up to blame lousy tax allocationprovision drafting for poor economic results. Sec-ond, businesspeople are not worried about theliquidation scenario because partnerships typicallygo on forever, and when they liquidate early, it isprobably because the economics fell short of expec-tations anyway. Third, tax return preparers oftenignore the complicated tax allocation provisionsand try to come up with the right economic result.Fourth, during the life of the partnership, the part-nership’s distribution of cash to pay taxes probablycovers a lot of unpleasant surprises and other sins,

1Section references are to the Internal Revenue Code unlessthe context indicates otherwise. The term ‘‘partnerships’’ asused in this report refers to all entities classified as partnershipsfor federal income tax purposes.

2It was a welcome development at the July 10, 2010, NewYork State Bar Association (NYSBA) Tax Section’s summermeeting to receive some reassurance about the efficacy oftargeted allocations from Curtis Wilson, IRS associate chiefcounsel (passthroughs and special industries). Amy S. Elliott,‘‘IRS to Address Problems Caused by LLC Guidance,’’ Tax Notes,July 19, 2010, p. 258, Doc 2010-15509, 2010 TNT 134-3. See alsorecently released NYSBA Report on Partnership Target Alloca-tions, Sept. 23, 2010, Doc 2010-20877, 2010 TNT 185-18.

3For insightful discussion of substantiality, see the recentlyreleased NYSBA Report on Partnership Target Allocations,September 23, 2010, Doc 2010-20877, 2010 TNT 185-18. See alsoRichard M. Leder, ‘‘Tax-Driven Partnership Allocations WithEconomic Effect: The Overall After-Tax Present Value Test forSubstantiality and Other Considerations,’’ 54 Tax Law. 753(2001).

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which provides a cushion for tax practitioners.Fifth, there is some fairly uniform tax boilerplatethat protects against most tax traps for the unwary,even for unsophisticated tax advisers, unless the taxboilerplate is unwittingly tinkered with for ‘‘simpli-fication’’ purposes. And sixth, buyers and sellersrarely consider capital accounts when pricing part-nership interests.

D. Scope and Coverage of ReportThe preceding section underplays the problems

and overstates the acceptance of capital accountliquidation partnerships. In fact, many sophisti-cated tax practitioners now use tax allocations thatdo not drive liquidations. Many less sophisticatedtax practitioners use traditional capital account al-location provisions but miss some of the nuancesand fall short of the mark. And many even lesssophisticated practitioners draft simple tax alloca-tion provisions that do not even try to hit the mark.No matter how well conceived the section 704(b)economic effect regulations may have been, they areno longer carrying the day. It is time for a thought-ful reexamination.

This report is divided into the following sections:Part II provides an overview of the existing eco-nomic effect regulatory scheme. This section coverslittle new ground and can be skipped by partner-ship tax mavens. Part III serves two functions. Itdescribes selected aspects of this regulatory schemeto explain briefly to our corporate colleagues thefunction of some of the tax boilerplate and convo-luted provisions they always want to edit, paredown, or remove. As part of this exercise, wesuggest specific steps the IRS can consider taking toeliminate some of the unnecessary traps for theunwary in the section 704(b) economic effect rules.Part IV discusses targeted allocations, Part V dis-cusses tracking allocations, and Part VI discussestaxable income allocations.

E. RecommendationsThis report proposes a partial fresh start.First, the existing economic offset regulations

should be retained because they are based on a solideconomic premise. The regulations should be up-dated and refined.

Second, the regulations should expand the tax-oriented provisions that are deemed to be includedin partnership agreements. The code and regula-tions mandate section 704(c) and reverse section704(c) allocations, section 754 adjustments (in somecases), minimum gain chargebacks, and some capi-tal account adjustments. The list can be expanded toinclude qualified income offsets, gross income allo-cations, and so on, so that the mere failure toinclude one of those provisions is not automaticallyfatal.

Third, the regulations should explicitly sanctiontax allocation methods that do not drive liquida-tions of capital accounts but achieve similar eco-nomic symmetry between cash and tax. Two suchmethods are targeted allocations and tracking allo-cations.

Fourth, consideration should be given to devel-oping an alternative tax allocation scheme that hasas its starting point allocating taxable profits andlosses (rather than book profits and losses). Thiswould be a useful exercise, since many partnershipagreements are drafted from this perspective andoften do not contain much more tax plumbing.

II. Section 704(b) Economic Effect TestsUnder section 704(b), a partnership’s allocation

of income, gain, loss, deduction, or credit (or itemthereof) must have ‘‘substantial economic effect.’’ Ifnot, the allocation is determined — taking intoaccount all the facts and circumstances — in accor-dance with the ‘‘partner’s interest in the partner-ship.’’ There are two components to the substantialeconomic effect test: The allocation must have eco-nomic effect, and the economic effect must besubstantial.4 Allocations are generally tested itemby item, but the tests are equally applicable to themore typical allocation of bottom-line income orloss.5 In layman’s parlance, the tax allocation pro-vision must be consistent with the allocation of risksand opportunities in determining each partner’seconomic reward from the partnership.

The regulations provide that the tax allocationprovision in a partnership agreement is valid if itsatisfies one of three tests:

• the allocation has substantial economic effect;• the allocation is in accordance with the part-

ner’s interest in the partnership; or• the allocation is deemed to be in accordance

with the partner’s interest in the partnership.6

The varied versions of these tests are summa-rized in Appendix A.

The first two types of tests, substantial economiceffect and the ‘‘partner’s interest in the partnership’’test, look to who bears the economic benefit orsuffers the economic burden of items of income andloss, respectively. Generally, the results should bethe same under both tests.

The third type of test, ‘‘the deemed interest in thepartnership’’ test, provides rules for allocating taxitems that have no economic counterpart (for ex-ample, nonrecourse deductions).

4Reg. section 1.704-1(b)(2)(i).5Reg. section 1.704-1(b)(1)(vii).6Reg. section 1.704-1(b)(1)(i).



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A. Safe Harbor Economic Effect Test1. Mechanical test. The safe harbor economic effecttest is mechanical and requires the partnershipagreement to contain specific boilerplate provisionsdesigned so that the tax allocation provisions, posi-tive and negative, have a dollar-for-dollar effect onthe aggregate amount of money each partner re-ceives over the life of the partnership. The regula-tions establish three requirements for the safeharbor economic effect test:

Capital accounts: Capital accounts must bemaintained as provided in the regulations.Liquidating distributions: Liquidating distri-butions must be made in accordance withpositive capital account balances of the part-ners.Deficit restoration makeup: Partners withnegative capital account balances must be ob-ligated unconditionally to restore the amountof a deficit balance in the partner’s capitalaccount if his interest is liquidated.

2. Capital account maintenance.a. In general. The first prong of the economic

effect safe harbor is the requirement that the part-nership maintain capital accounts in accordancewith complex rules set forth in the regulations.These rules legitimize and indeed mandate theproverbial second and third set of books. One setmust be kept on an income tax basis, a second setmust be kept on a tax-book basis, and when appli-cable, a third set must be kept on a generallyaccepted accounting principles basis.

The tax regulations detail what it takes to prop-erly maintain capital accounts. Positive adjustmentsare generally made for:

• contributions of money;• contributions of property (based on fair market

value net of liabilities as defined in section752);

• tax-exempt income; and• allocations of income and gain.Negative adjustments are generally made for:• distributions of money;• property distributions to the partner (based on

FMV net of liabilities as defined in section 752);• nondeductible expenditures; and• allocations of loss or deductions.b. Capital account revaluation. The regulations

permit capital accounts to be revalued and adjustedin the event of partner contributions and partner-ship distributions.7 This is effected by allocating theunrealized gain to the existing partners.8 This book

up or book down is designed so that tax resultscorrespond with economic results.

c. Capital accounts and transfers of partnershipinterests. No adjustments are made to partnercapital accounts in the event of a transfer of apartnership interest even if the transfer results in atechnical tax termination of the partnership. Exist-ing partners continue with their existing capitalaccounts. The new transferee partners inherit thecapital accounts of their transferor.9 This is truewhether or not a section 754 election is in effect.(The section 754 election effectively provides thenew partner with a tax basis step-up in its share ofthe underlying assets.)

This no-capital-account-adjustment result fortransfers is a function of the economic role playedby capital accounts under the regulations. Capitalaccounts determine the amount of money the part-ner is ultimately entitled to receive from the part-nership. The rights of partners in partnershipliquidation proceeds cannot be altered merely be-cause one partner takes ownership of a formerpartner’s interest. As a corollary, this also puts greatpressure on capital account computations becausethe new partner needs to know the amount of thecapital account.

Observation: Query how many of us havebeen involved in partnership-sale transactionsin which the transferee partner did not evenask about the amount of the capital account,much less deeply delve into the computations.And even when transferee partners ask, thecapital account computations are often notmaintained with great care and precision, andin any event are woefully out of date, becausethe tax returns for the previous year have notbeen filed. Does this raise any questions aboutthe real-world economic significance of capitalaccounts?

3. Liquidating in accordance with capital accounts.

a. In general. The second prong of the economicoffset safe harbor is the requirement that the part-nership liquidate in accordance with positive capi-tal account balances.10 Under the regulations,capital account balances are determined after takinginto account all capital account adjustments for theyear. The regulations require that liquidating distri-butions be made to the partner by the end of the taxyear of that liquidation (or, if later, within 90 daysafter the date of the liquidation). The partnership ispermitted to book up capital accounts at the time of

7Reg. section 1.704-1(b)(2)(iv)(f) and (g).8Reg. section 1.704-1(b)(2)(iv)(f)(2).

9Reg. section 1.704-1(b)(2)(iv)(l).10Reg. section 1.704-1(b)(ii)(b)(2).



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liquidation, giving the retiring partner the benefit ofany appreciation in partnership assets.

This requirement backstops — or more properly,gives purpose and economic substance to — therequirement that the partnership maintain propercapital accounts. If capital accounts are disregardedfor purposes of determining cash distributions inliquidation or otherwise and do not affect theeconomics, capital account maintenance does notitself have any economic substance.

b. Purchase instead of liquidation. The regula-tions permit the partnership or the partners to buyout a partner (other than in a complete liquidation)under an arm’s-length agreement between personswho at the time of the agreement have ‘‘materiallyadverse interests,’’ provided that a principal pur-pose of the purchase and sale is not to avoid theprinciples of liquidating a partner’s interest in ac-cordance with capital accounts.11

The scope of this provision is unclear. It mayapply, for example, to sanction a formula pricebuyout of a partner when the partners want toavoid the need to determine FMV on the buyoutdate. Similarly, the provision may sanction abargained-for redemption price, eliminating therisk that the IRS could argue that the purchase pricedid not reflect FMV and therefore the partnersnever intended to liquidate in accordance withcapital accounts.

Observation: Query whether the provisionwould sanction the use of a formula price,embedded in the partnership agreement, fordetermining the value of various classes ofpartnership interests in the event the partner-ship was sold. Some partnership agreementsprovide that classes of interests with the sameeconomic rights during the life of the partner-ship are to receive the same amount of salesproceeds even when capital accounts differ.The rationale is that the likelihood of liquida-tion is so low on a present value/actuarialbasis that the two classes of interests haveequivalent value. This is a sound economicjudgment, but it underscores a flaw in thecapital account liquidation construct.

c. Liquidation includes section 708 liquidation.The term ‘‘liquidation’’ includes a section708(b)(1)(B) constructive liquidation (sale or ex-change of a 50 percent or greater interest in profitsand capital). The regulations indicate that partners

are not required to restore deficits in the event thepartnership termination is caused by a sale orexchange.12

d. Liquidation: Not a state law test. The regula-tions eschew reliance on state law and provide auniform rule, applicable to all partnerships, that apartnership liquidation occurs on the earlier of atechnical tax termination under section 708(b)(1)(b)or the date on which the partnership ceases to be agoing concern (even though it may continue forpurpose of winding up its affairs, liquidating itsdebts, and distributing remaining amounts to credi-tors). While a person continues to be a partnerunder reg. section 1.761-1(d) as long as she is owedmoney by the partnership and is entitled to liqui-dating distributions, the regulations provide that ifa liquidation is artificially delayed for a principalpurpose of deferring the partner’s obligation torestore a deficit, the deficit make-up provision isdeemed violated.4. Deficit makeup. The third prong of the safeharbor economic effect test requires partners with adeficit in their capital account to ‘‘unconditionallyrestore’’ the amount of the deficit before the end ofthe year of liquidation (or within 90 days), with theamount being paid either to creditors or to otherpartners with positive capital account balances.Most partners balk at signing up for unlimitedliability, so the regulations have an alternative test,discussed below, which effectively permits partnersto claim deductions up to the amount of theircapital account balances and then some,13 providedthe partnership agreement contains a ‘‘qualifiedincome offset’’ provision.5. Is there economic reality to the economic effectsafe harbor? The economic substance of the capitalaccount liquidation requirement is undercut by atleast five features. First, there is no requirement thatthe partnership make nonliquidating distributionsin accordance with capital accounts. The effect isthat the provision at the heart of the economic effectanalysis rarely comes into play.

Second, it is unclear under the regulations — andoften unclear under the partnership agreement —what distributions should be treated as liquidatingdistributions or regular distributions. Partnershipagreements often draw a different business linebetween operating cash flow versus cash flow fromcapital events (that is, sales and leveraged financ-ings).

Third, partnerships rarely liquidate. Business-people might argue hard and long about how cashfrom a capital event should be distributed. They

11Reg. section 1.704-1(b)(2)(ii)(b).

12Reg. section 1.704-1(b)(2)(iv)(b).13Reg. section 1.704-1(b)(2)(ii)(D).



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rarely get as worked up about how cash on liqui-dation should be distributed, other than as a subsetof the business terms for distributions generally orcapital events generally.

Fourth, as discussed, partners often buy and sellpartnership interests without paying much atten-tion to capital account balances.

And fifth, the economic effect tests do not takeinto account time value of money principles, whichare really the heart of economics.

Observation: The safe harbor economic effecttest takes a somewhat simplistic snapshot ofpartnership economics to determine whether apartnership allocation has economic effect.This rough justice was necessary for the rulesto be administrable. But since the rules repre-sent only rough justice, perhaps it is appropri-ate to consider whether there should bealternative approaches.

B. Alternate Test for Economic Effect1. In general. Most partnerships do not contain adeficit restoration obligation and therefore seek tosatisfy the so-called alternate test for economiceffect.14 The alternate economic effect safe harborrequires the same capital account maintenance andcapital liquidation as under the basic economiceffect safe harbor, but it does not require deficitrestoration. The trade-off for eliminating deficitrestoration is that partners without a deficit resto-ration obligation are permitted loss allocations onlyup to the amount of their capital accounts. For thispurpose, a partner’s capital account is adjusted toinclude the partner’s share of minimum gain (orpartner minimum gain), which is treated as adeemed deficit restoration obligation. (Minimumgain is discussed in Part II.E below.) Also, capitalaccounts are adjusted for some anticipatory items.See II.B.2 below.

The alternate test for economic effect does notaffect loss allocations of nonrecourse deductionsand partner nonrecourse deductions. (Nonrecoursedeductions are discussed in Part II.E below.) Thosedeductions have their own allocation rules indepen-dent of the substantial economic effect test.

As a technical matter, for partnerships meetingthe alternate safe harbor test, the partnership allo-cation is deemed to have economic effect to theextent the allocation does not cause or increase adeficit balance in the partner’s capital account inexcess of the deemed deficit restoration obligationamount (via minimum gain and partner minimumgain chargeback) plus any actual deficit restorationobligation.

2. Anticipatory downward capital account adjust-ments. Under this alternate economic effect test,some downward adjustments are made to a part-ner’s capital account that reduce the partner’s abil-ity to absorb losses under section 704(b). Theseadjustments provide for hypothetical reductions inthe capital account of a partner for specified adjust-ments, allocations, or distributions that are reason-ably expected to be made as of the end of the yearin which the allocation is to be made. These adjust-ments include reasonably expected depletion allow-ances, reasonably expected loss and deductionallowances, and reasonably expected distributionsin excess of corresponding increases in capital ac-count.15

Depletion: The capital account must be re-duced for all reasonably expected (whateverthat means) depletion allowances for oil andgas properties. Although this provision seemsodd, it is needed because depletion is deduct-ible at the partner level as opposed to thepartnership level.

Reasonably expected future deductions:Capital accounts must be reduced for futureallocations of loss or deductions that are rea-sonably expected to be made under section704(e)(2) (family partnerships), section 706(d)(changes in interests during the year), and reg.section 1.751-1(b)(2)(ii) (‘‘hot’’ assets).

Distributions: The capital account must bereduced for distributions that are reasonablyexpected to be made after year-end to theextent those distributions exceed any reason-ably expected offsetting capital account in-creases attributable to profits for the year.

For determining whether reasonably expecteddistributions will be matched by reasonably ex-pected profit allocations, the presumed value ofproperty is tax basis (book value), not FMV. Theeffect is that if the partnership has cash that itreasonably expects to distribute next year, profitsfrom a sale it also reasonably expects to makecannot be taken into account under the ‘‘valueequals basis rule’’ to eliminate the need for thecapital account adjustment. By contrast, no adjust-ment is required if the cash reasonably expected tobe distributed arises from the sale itself, because thevalue-equals-basis presumption applies to both theavailability of the cash and the amount of profitsreasonably projected.3. Qualified income offset. As discussed, reg. sec-tion 1.704-1(b)(2)(ii) requires capital accounts to be

14Reg. section 1.704-1(b)(2)(ii)(D). 15Reg. section 1.704-1(b)(2)(ii)(d)(4) through (d)(6).



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reduced by specified reasonably expected adjust-ments, allocations, or distributions. The qualifiedincome offset requirement backstops this rule byrequiring a chargeback for partners who unexpect-edly receive such an adjustment, allocation, ordistribution.

The qualified income offset technically allocatesitems of gross book income when there is a dispar-ity between taxable income and book income. Thisallocation consists of a pro rata portion of each itemof partnership income and gain for the year. Taxableincome and gain are allocated under section 704(c)principles in cases of a book-tax disparity.4. Practical aspects of alternate economic effecttest. These rules effectively sanction allocatinglosses and deductions to a partner to bring itscapital account to zero. As a backstop, these rulesrequire the partnership to look forward to deter-mine whether there are reasonably predictable fu-ture events that would bring that partner to a deficitin a subsequent year. If there are such future events,the regulations require that those amounts be takeninto account in determining the amount of loss ordeduction that can be allocated currently. If futureevents that were not reasonably expected bring thepartner into a capital account deficit position, thequalified income offset provision allows specialallocations of income (including gross income) tocure the partner’s capital account deficit.

Observation: Query how often the anticipa-tory downward adjustment and the qualifiedincome offset come into play. It is probably therare partnership that concludes it cannot allo-cate deductions to a partner in year 3 thatwould bring her capital account to zero be-cause a distribution to the partner is reason-ably expected in the following year or two orthree that will exceed the partner’s share ofincome in the next year. In most cases taxreturn preparers will not even think about thenext year. If they give next year so much as afleeting thought, they will probably concludethat (1) there is enough uncertainty surround-ing the cash distributions that they are notreasonably expected, or (2) even if cash distri-butions are reasonably expected, it is uncertainenough that there will not be offsetting incomeallocations to ignore the rule.Observation: Perhaps the only circumstancein which these rules (anticipatory adjustmentsand qualified income offsets) may come intoplay as a practical matter is when the partner-ship has cash available at year-end to distrib-ute. In that case, it may be inappropriate toallocate losses to the partner to take her capitalaccount down to zero when cash out of thatyear’s earnings will be distributed. For the

typical partnership, which does not file a taxreturn before the summer at earliest, thesefacts should be ascertainable.

C. Economic Effect EquivalenceThere is a third test, the economic equivalence

test, that treats some tax allocations that do nototherwise satisfy the safe harbor economic effecttests as deemed to have economic effect.16 This rule,which the IRS calls the ‘‘dumb but lucky’’ rule,17 canapply to partnership agreements devoid of the threeprovisions needed to satisfy the economic effect test(capital accounts, liquidating per capital accounts,and unlimited deficit restoration). Tax allocationsare deemed to have economic effect if a liquidationof the partnership at the end of that year or anyfuture year would produce the same results thatwould occur if the three requirements of the pri-mary economic effect tests had been met.

There are two noteworthy points about this test.First, it sanctions tax allocations missing the magicwords that as an economic matter would otherwisepass muster under the safe harbor economic effecttest (which requires deficit restoration), but notthose that would otherwise pass muster under thealternate economic effect test (which substitutes aqualified income offset for deficit restoration).While at first blush that appears to be a curiousomission, it probably never occurred to the IRSregulation writers that the drafter of a dumb-but-lucky tax allocation provision would have had theforesight to include a qualified income offset provi-sion. This becomes relevant for targeted allocations.

Second, the test requires uniformity of result‘‘regardless of the economic performance of thepartnership.’’ The scope of this requirement is un-clear. Query whether it requires the tax allocationprovisions to be tested under facts that do not yetexist (for example, the partnership has nonrecoursedebt; partners have deficit capital accounts, etc.).

At least one notable author has concluded thatthe equivalent economic effect test may have noapplication unless the partner has a deficit capitalaccount restoration provision.18 That author con-tends that the result should be the same even whenthe partnership agreement prohibits loss allocationsin excess of capital accounts and contains a quali-fied income offset provision. (This is the case withtargeted allocations discussed in Part III below.)This would render the equivalent economic effecttest a virtual dead letter because most partnerships

16Reg. section 1.704-1(b)(2)(ii)(i).17See IRS, ‘‘MSSP Audit Technique Guide on Partnerships,’’

at 6-8 (Dec. 1, 2002), Doc 2003-26024, 2003 TNT 241-26.18See Terence Floyd Cuff, ‘‘Several Thoughts on Drafting

Target Allocation Provisions,’’ 87 Taxes 171, 188 (2009).



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these days take the form of limited liability compa-nies (because no one wants unlimited liability) andstate law partnerships rarely contain deficit restora-tion obligation. Presumably the commentator’s re-sponse would be that the provision was written in asimpler time when there were general partners andgeneral partnerships and that its scope was inten-tionally limited.

This narrow reading of the regulation is incon-sistent with the clear intent of the regulation toprovide a safety net for unsophisticated taxpayersand their advisers when the tax allocations andeconomic results match through no fault of theirown.19 It would serve no one’s interest to limit thisregulation so narrowly, forcing partners into thebriar patch of ‘‘partner’s interest in the partnership’’described below where, unlike here, the valueequals tax basis (book value) presumption is un-available. That would not be a wise use of IRSresources.

Still, since there is contrary commentary, IRSguidance on this point would be helpful.

Recommendation 1: The IRS should issue anotice or revenue ruling (1) confirming thatthe equivalent economic effect test applies to apartnership with a qualified income offset, and(2) describing the circumstances in which itapplies to a partnership without a deficit res-toration provision when the partners do not orcannot have a capital account deficit.

D. Partner’s Interest in the Partnership1. Facts and circumstances test. Partnerships thatdo not satisfy the economic effect safe harbors arerequired to make tax allocations based on thepartner’s interest in the partnership.20 The ‘‘part-ner’s interest in the partnership’’ test is based on theeconomics and, in most cases, looks to the effects ofthe allocation on partner’s capital accounts and howcash would be distributed on a hypothetical liqui-dation of the partnership. The test asks how incomeand loss items would be allocated so that, if thepartnership is liquidated under the liquidation pro-visions of the partnership agreement, distributionswould be made in accordance with capital accounts.

The regulations provide little guidance on how todetermine a partner’s interest in the partnership,perhaps reflecting the drafters’ desire to encouragereliance on the safe harbor economic effect andalternate economic effect tests (or their conclusionthat the rules were so well formulated that every-

one would comply). Perhaps too the drafters hadrun out of steam (and time) on the project.

The regulations state the general rule that apartner’s interest in the partnership is based on ‘‘themanner in which the partners have agreed to sharethe economic benefit or burden (if any)’’ of partner-ship items. The regulations indicate that the part-ner’s share should be determined item by item if thepartner’s economic interest in an item differs fromthe bottom-line sharing.

The regulations identify four facts and circum-stances to be weighed, including:

• the partners’ relative contribution to the part-nership;

• the partners’ interests in the economic profitsand losses if different from those in taxableincome and loss;

• the partners’ interests in cash flow and othernonliquidating distributions; and

• the partners’ rights to distributions in liquida-tion.21

Observation: Initially, this facts and circum-stances test appears to call for a much morenuanced analysis than the economic effect safeharbor, which focuses almost exclusively onthe economic results in liquidation. However,the first three factors (contributions, profitsand losses, and cash flow distributions) mayall be subsumed in the fourth factor (liquidat-ing distributions). Still, the regulation does notgive much guidance on how the liquidatingdistributions factor should be applied. Theregulations do not incorporate the value-equals-tax basis (book value), which maymean the analysis should be based on FMV.Also, it is conceivable that when the sale ofproperty triggering minimum gain or a liqui-dation is unlikely or distant, the partnershipshould match tax allocations and cash distri-butions on a more current basis rather thanwait for the fix-up allocations.

The unavailability of the value-equals-tax basis(book value) presumption could work for or againsttaxpayers. For example, the effect of tax allocationson the relative economics among the partners mightbe very different depending on the value of thepartnership’s assets. This is examined further in thetargeted allocation discussion below.

As a practical matter, it will usually be difficultfor IRS agents and taxpayers to cope with all thepermutations that would be triggered by thesevaluation and timing uncertainties. It would be

19For what it’s worth, the IRS market segment specializationpaper on partnerships, supra note 17, does not suggest at all thatthe provision should be construed so narrowly.

20Reg. section 1.704-1(b)(3). 21Reg. section 1.704-1(b)(3)(ii).



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helpful for the IRS to issue additional guidance onthe partner’s interest in the partnership test.

Recommendation 2: The IRS should considerwhether it would be appropriate to give tax-payers the option to rely on the value-equals-tax basis (book value) rule in determining apartner’s interest in the partnership. (It wouldbe inappropriate to make the value-equals-basis rule mandatory, because the partner’sinterest in the partnership test turns on theeconomics.) The IRS should also consider ad-ditional simplifying conventions (for example,assume year-end liquidation).

2. Special rule for partnerships that maintaincapital accounts but lack deficit restoration orqualified income offset. The partner’s interest inthe partnership regulations contain a special rulethat gives the partnership allocations more certaintywhen the partnership maintains proper capital ac-counts and liquidates in accordance with positivecapital accounts.22 Allocations are then made bydetermining how distributions and contributionswould be made if the partnership were liquidatedat year-end.

This special rule applies when the partnershipfails the economic effect test solely because of thelack of either a deficit restoration makeup obliga-tion or a qualified income offset. The partner’sinterests in the partnership are determined by com-paring the hypothetical results of a current-yearliquidation with a final-year liquidation. The resultis adjusted for items set forth in the alternate test foreconomic effect (for example, reasonably expectedfuture distributions in excess of offsetting capitalaccount adjustments). For taxpayers maintainingproper capital accounts and liquidating in accor-dance with capital accounts, this rule providessome certainty, because it incorporates the simpli-fying and administrable value-equals-tax basis(book value) presumption.

E. Nonrecourse DeductionsThe substantial economic effect rules apply prin-

cipally to so-called recourse deductions — deduc-tions funded by capital contributions or partnershipliabilities when a partner has personal liability,including nonrecourse liabilities guaranteed by apartner.

There are special classes of allocations that arenot subject to the substantial economic effect rules:

• nonrecourse deductions;• partner nonrecourse deductions;• minimum gain chargeback allocations;

• partner minimum gain chargeback allocations;and

• qualified income offset allocations.The tax regulations23 recognize that deductions

attributable to nonrecourse debt (for example, de-preciation attributable to nonrecourse purchaseprice financing) can never have economic effect onthe partners because the lender, not the partners,suffers the economic loss associated with a corre-sponding value decline. When property has beenacquired with equity cash and nonrecourse financ-ing, it is only the depreciation deductions in excessof the equity cash that are treated as nonrecoursedeductions, because the partners are at risk for theequity cash.

The regulations24 treat allocations of nonrecoursedeductions as being in accordance with the part-ners’ interests in the partnership if they satisfy thefollowing requirements:

Capital account maintenance: Capital ac-counts are properly maintained, liquidatingdistributions are required to be made in accor-dance with positive capital account balances,and partners agree to a deficit restorationobligation or to a qualified income offset.Nonrecourse deductions: Nonrecourse de-ductions are allocated in a manner that isreasonably consistent with allocations thathave substantial economic effect of some othersignificant partnership item attributable to theproperty securing the nonrecourse liabilities.

Minimum gain chargeback: The partnershipagreement contains a minimum gain charge-back provision.

Otherwise compliant: All other material allo-cations and capital account adjustments arerecognized under reg. section 1.704-1(b).

Minimum gain is the gain that would be realizedby the partnership if the property securing thenonrecourse debt were sold in a taxable transactionfor an amount equal to the nonrecourse liability.Partners are permitted to increase their capitalaccounts by their share of minimum gain in deter-mining whether an allocation of losses would giverise to a deficit capital account. A partner’s capitalaccount adjusted to reflect this increase is called the‘‘adjusted capital account.’’

Under the minimum gain chargeback provision,if there is a decrease in minimum gain, for example,from a sale of property or repayment of debt, thepartnership allocates income or gain at that time to

22Reg. section 1.704-1(b)(3)(iii).

23Reg. section 1.704-2(b)(1).24Reg. section 1.704-2(e).



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the partner who previously enjoyed the economicbenefit of the nonrecourse deductions associatedwith the property.

III. What Does the Tax Boilerplate Mean?Part II above describes in general terms the basic

regulatory scheme for tax allocations that satisfy thesafe harbor economic and alternate economic effecttests.

Part III is intended as a plain English roadmapexplanation of the extensive tax boilerplate thatimplements this regulatory scheme. It describeswhat can go wrong if the boilerplate is not there,and it suggests specific steps the IRS can take toeliminate some of the unnecessary traps for theunwary in the section 704(b) economic effect rules.See Appendix B for a sample tax boilerplate.

A. The BoilerplateThe well-considered partnership agreement

drafted by experienced tax practitioners containstax boilerplate provisions that satisfy the safe har-bor alternate economic effect test. Our corporatecolleagues are often tempted to simplify the provi-sions for a particular deal. Sometimes this is evenappropriate. But to prevent inappropriate tinkering,many firms have moved the tax boilerplate provi-sions to an appendix in their model partnershipagreements.

The traditional partnership agreement seeking tosatisfy the alternate economic effect safe harborcontains the following provisions:

• proper maintenance of capital accounts;• liquidation in accordance with positive capital

account balances;• qualified income offset in lieu of a deficit

restoration obligation;• nonrecourse deductions allocated under one of

the special allocation provisions in accordancewith a permitted sharing ratio;

• minimum gain chargeback;• gross income allocation;• curative allocations; and• tax distributions to cover quarterly taxes.All but the last provision address regulation

requirements. The final item (tax distributions),which is not required by the tax regulations, hasbeen added somewhat jocularly to this list to un-derscore the point that the tax distribution provi-sion can hide or soften the blow of surprises in thetax allocations.

B. What Does It Mean?1. Why do the tax allocation provisions allocatebook profits and losses, which take a full page todefine, rather than taxable income? One of themore baffling aspects of partnership agreements isthat the general tax allocation provisions do not

actually allocate taxable income; they allocate bookincome, with adjustments. The allocation provi-sions allocate book income rather than taxableincome because the section 704(b) economic effectrules apply to allocations of book income, nottaxable income.

The term ‘‘book income’’ in this context is a bit ofa misnomer; it is a partnership tax concept that hasnothing to do with GAAP or accounting income.Book income and taxable income are each deter-mined based on income tax principles. The differ-ence is the starting point. Taxable income uses thetax basis of an asset as the starting point. Bookincome uses the book value of the asset as thestarting point. The initial book value of an asset isgenerally FMV, even if the tax basis of the asset islower (for example, because the asset was contrib-uted to the partnership).

In the simple case in which each partner contrib-utes a pro rata amount of cash to the partnership atthe same time and the partnership uses the cash tobuy property, book income and taxable income arethe same because the tax basis and book value ofeach asset acquired by the partnership is initiallyFMV.

Taxable income and book income differ, however,when:

• partners contribute appreciated or depreciatedproperty to a partnership;

• one or more partners receive a non-pro-ratadistribution of appreciated or depreciatedproperty from the partnership;

• one or more partners receive a carried interestor a profits interest in the partnership; and

• an existing or new partner makes cash contri-butions to the partnership that are not pro ratato the initial cash contributions.

In each case, partnership assets and capital ac-counts must be revalued to FMV for book purposesto prevent an inadvertent shifting of value to orfrom partners. The resulting disparity between thebook value and tax basis of the assets gives rise to adifference between book income and taxable in-come.

Example: A and B contribute $100 each to ABPartnership for a 50 percent interest, and ABbuys Blackacre for $200. When the value ofBlackacre has increased to $300, C contributes$100 for a 25 percent interest. The capitalaccounts of A and B are increased (booked up)to $150 each.If the partnership sells Blackacre the next day for

$300 FMV, A and B but not C should pay tax on the$100 gain because C has not realized any economicbenefit from the appreciation. This is accomplishedby booking up the book value of partnership prop-erty from $200 to $300 when C joins the partnership.



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Taking into account the $100 cash contributed by C,the partnership now has a total $400 book value.Future section 704(b) allocations of partnershipprofits or losses are based on this $400 book value.Thus, when the partnership sells the property for$300, it has zero book gain ($300 sales price less$300 book value). Then special adjustments aremade under section 704(c) for A and B to accountfor the $100 difference between book income andtaxable income.

This book value versus tax basis dichotomy isembodied in partnership agreements in the defini-tion of gross asset value. The initial gross assetvalue of an asset is its FMV on the date assets arecontributed, distributed, or revalued. Assets arerevalued, for example, because of capital contribu-tions to the partnership.

The gross asset value concept manifests itselfthroughout the partnership tax boilerplate:

Profits and losses: Profits and losses are com-puted using gross asset value rather than taxbasis in determining depreciation and gain orloss from the sale of an asset.Capital accounts: Capital accounts are com-puted using gross asset value rather than taxbasis.Special allocation provisions: The special al-location provisions are based on gross assetvalue rather than tax basis.

2. How and when does the partnership agreementreconcile the difference between book income andtaxable income? What’s the significance of thesection 704(c) allocation? As discussed above, thetax allocation provisions allocate book income andnot taxable income. Book income differs from tax-able income when there is a disparity between thebook value of an asset and its tax basis.

Under the section 704(b) regulations, a partner’sshare of book items is governed by section 704(b).Once the appropriate book allocation treatment hasbeen determined, section 704(c) governs the deter-mination of the partner’s share of the tax items (forexample, depreciation or the gain or loss on sale)when tax basis differs from book basis. Section704(c) and the companion provisions of section704(b) are mechanical in eliminating book-tax dif-ferences over time.

The standard tax boilerplate includes a section704(c) special allocation provision that contains therules for allocating items to account for the differ-ence between book income and taxable income(which, as noted above, is attributable to the differ-ence between the tax basis and book value of anasset). The section 704(c) regulations contain severalalternations for making up this difference. The taxboilerplate is modified from deal to deal to reflect

the partner’s agreement to account for this differ-ence using the traditional method, the remedialmethod, the curative method, or some alternative.3. What happens if the partners have made dis-proportionate cash contributions? Partners oftencontribute capital to a partnership in a differentratio than they share profits:

Example: A contributes $90; B contributes $10.A and B agree to a 50/50 sharing after capitalis returned ratably to A and B.

A common mistake in that situation is for thepartnership agreement to allocate profits and lossesconsistent with cash flow. Thus, the first $100 ofprofits would be allocated on a 90/10 basis. Theproblem is that the first $100 of cash flow representsreturn of capital and therefore should effectivelycome back to the partners tax free. This is accom-plished by allocating the first $100 of profits usingthe general 50/50 sharing ratio. Partner B will besurprised to pay tax on $50 of income even thoughA gets $90 of cash and B gets $10. Tax distributionprovisions go a long way in solving this problem.4. Why all the special definitions and specialallocation provisions relating to nonrecourse de-ductions, nonrecourse debt, and minimum gainchargeback? The tax boilerplate typically containsseveral definitions and special allocation provisionsregarding nonrecourse debt. Special rules areneeded for nonrecourse debt because the lenders,not the partners, bear the economic risk of nonre-course debt. For this reason, allocations of nonre-course deductions can never have an economiceffect on the partners.

The regulations need to create a legal fiction topermit nonrecourse deductions to be allocated tothe partners. This legal fiction is manifested in threeways. First, nonrecourse deductions are carved outof the normal profit and loss allocation provisionand are allocated under special allocation rules.Second, the allocation of nonrecourse deductionshas to be substantially consistent with the allocationof another significant item relating to the property(for example, recourse deductions). Third, the taxregulations deem partners to bear the economic lossof a nonrecourse deduction if they are required topick up the income as the debt is paid off or if theproperty is sold for the amount of the nonrecoursedebt. This is the so-called minimum gain. Theamount of nonrecourse deduction that can be allo-cated to a partner cannot exceed that partner’s shareof minimum gain.5. What happens if the partnership agreementdoes not contain all the provisions relating tononrecourse debt and minimum gain chargeback,etc.? The nonrecourse debt and minimum gain rulesare mandatory and apply whether or not these



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provisions are included in the partnership agree-ment. Nevertheless, the regulations providing thesale harbor for nonrecourse deduction allocationsrequire the partnership agreement to include aqualified income offset and minimum gain charge-back provision.25 If these provisions are not in-cluded, partners cannot determine the allocationpercentages among the partners for the nonrecoursedeductions. That’s probably not a major concern,but it is an avoidable trap for the unwary.

Recommendation 3: The IRS should issue anotice declaring that the section 704(b) regula-tions will be amended to mandate a qualifiedincome offset and to permit partners to qualifyfor the safe harbor for nonrecourse deductionseven if the minimum gain chargeback, partnernonrecourse debt minimum gain chargeback,and qualified income offset are not included inthe partnership agreement.Partnerships without this tax boilerplate prob-

ably also run the more serious risk that if an assetsubject to nonrecourse debt is sold, the mandatoryminimum gain chargeback on the sale will dupli-cate the prior chargeback of operating income tothat partner. This can occur when the partnershipagreement contains the following provisions:

• allocate profits first to reverse prior loss allo-cations; or

• allocate income first to reverse negative capitalaccounts (note that it does not cause a problemto allocate income first to reverse negativeadjusted capital accounts because the term‘‘adjusted capital accounts’’ already reflects thehypothetical minimum gain chargeback); or

• allocate income first to partners who receivedprior allocations of losses in accordance withthose losses.

This is probably a common problem, even forpartnership agreements that contain all the requi-site boilerplate. That is because tax return preparersmay not maintain up-to-date minimum gain recon-ciliation charts. This issue arises only if partnershipallocations are subject to varying sharing ratios orpriorities over time. If sharing ratios are constant,no distortion will result.

The fix is easy and is reflected in standard taxboilerplate that excludes nonrecourse deductionsand minimum gain from the definition of net profitsand net losses. Those items are allocated under thespecial allocation provisions.

For partnerships without any of the nonrecoursedebt plumbing, some self-help may be appropriate.It might be fair to read into the typical taxable

income chargeback provision an exception thatwould carve out of that chargeback a taxable in-come chargeback for nonrecourse deductions thatwill otherwise be covered by the minimum gainchargeback. It would be helpful for the IRS to issuea revenue ruling or notice to that effect.

Recommendation 4: The IRS should issue anotice declaring that the section 704(b) regula-tions will be amended to provide that unlessthe partnership agreement explicitly providesto the contrary, profits shall not be chargedback to reverse nonrecourse deductions other-wise covered by the minimum gain charge-back provision.

If the partnership has charged back operatingincome in an earlier year that covers nonrecourselosses, as a general rule the partnership should notbe required to double up with a chargeback ofminimum gain to the same partners. It would behelpful if the IRS could also confirm this pointthrough a notice or ruling. If the IRS thought it wasnecessary, that ruling might narrow the scope of theexception to prevent abuses.

Recommendation 5: The IRS should issue anotice declaring that the section 704(b) regula-tions will be amended to carve out from themandatory minimum gain chargeback anygain that duplicates profits already allocatedto the partner.

The other self-help alternative under the regula-tions is to obtain an IRS waiver of the minimumgain chargeback requirement.26 That provision ishelpful, but probably unwieldy if it requires anadvance ruling. Query whether tax return preparerscan simply assume that the IRS will grant thewaiver in preparing the tax returns.6. What happens if the partnership agreementdoes not contain a qualified income offset provi-sion? As described above, partnership agreementsinclude a so-called qualified income offset provi-sion to satisfy the alternate test for economic effect.The qualified income offset covers some unex-pected adjustments, distributions, and allocationsto a partner. The qualified income offset occurs afterallocation for minimum gain and partner minimumgain chargeback but before other allocations. Theprovision allocates items of gross book income.

Partnerships that liquidate in accordance withcapital accounts but fail to include a qualifiedincome offset provision in the agreement cannotqualify for the nonrecourse deduction safe harboror the alternate economic effect test and must run

25Reg. section 1.704(e)(1) and (e)(3). 26Reg. section 1.704-2(f)(4).



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the gamut of the special ‘‘partner’s interest in thepartnership’’ test discussed in Part I above.

The qualified income offset provision is so ob-scure and so little understood or invoked that itseems inappropriate to exclude partnerships fromqualifying for the nonrecourse deduction safe har-bor or the alternate economic effect test merelybecause the partnership agreement does not containsuch a provision.

Recommendation 6: The IRS should issue anotice declaring that the section 704(b) regula-tions will be amended to require qualifiedincome offsets, except perhaps when the part-nership agreement explicitly disclaims such aprovision. At the election of the partnership,the amendment would be effective on the dateof the notice (consider an even earlier effectivedate).

7. Is all this much ado about nothing, because thecurative allocations provision conforms capitalaccounts to economics? Typical tax boilerplate willgenerally contain a curative allocations section,which would appear to hold great promise. Theprovision says generally that to the extent possible,the special allocations required by the tax regula-tions should be applied to offset other specialallocations so that partners end up with the samecapital account balances they would have ended upwith had no special allocations been made.

To the uninitiated, this obscure language appearsto be a general cure-all that brings straying capitalaccounts into line with the economics. No suchluck!

The curative allocation provision has a much lessambitious role. The provision is needed becausethere is not necessarily offsetting symmetry be-tween the allocation of nonrecourse deductions andthe chargeback of minimum gain under the section704(b) nonrecourse debt regulations.27

For example, a minimum gain chargeback istriggered only if there is a net decrease in minimumgain for all partnership properties rather than on aproperty-by-property basis. Thus, if a partnershipdisposes of one of many properties subject to non-recourse debt, the disposition does not trigger mini-mum gain if overall partnership minimum gainincreases.28 As a corollary, since minimum gain isallocated among the partners proportionately basedon the allocation of all nonrecourse deductions andnonrecourse distributions, the sale of encumberedproperty that produces partnership minimum gain

can trigger minimum gain chargeback to a partnerwho has not been allocated any nonrecourse deduc-tions from the property sold.29 This is a simplifyingrule, because it is easier to monitor overall partner-ship minimum gain rather than property-by-property minimum gain.

Similarly, a distribution of the proceeds of anonrecourse financing can give rise to minimumgain. That minimum gain is equal to the differencebetween the amount of the debt and the tax basis.Under some circumstances that minimum gain canbe charged back to the partners in a manner thatdoes not track to the cash distribution.

In view of this lack of parallelism between theminimum gain chargeback and the event giving riseto the minimum gain (nonrecourse deduction ordistribution of nonrecourse loan proceeds), thecurative allocation provision authorizes offsettingspecial allocations, if possible, to bring each part-ner’s capital accounts in line with the economics.The curative allocation thus attempts to fix a verynarrow problem. It is not a broad fix for capitalaccount deviations.

Everyone still feel comfortable thinking that liq-uidating in accordance with capital accounts pro-duces the right economic result?8. What function does the gross income allocationserve? The tax boilerplate contains a gross incomeallocation, which requires items of gross income tobe allocated to partners who would otherwise havehad a capital account deficit in excess of the part-ner’s share of minimum gain. This provision rarelycomes into play as an operative provision for allo-cating gross income. Instead, it serves to protectagainst capital account reductions.30

This provision is the answer to the reg. section1.704-1(b)(2)(ii)(d)(6) requirement under the alter-nate economic effect safe harbor that capital ac-counts be reduced by distributions reasonablyexpected to be made in subsequent years to theextent they exceed offsetting increases in capitalaccounts that are reasonably expected to occur. Thepartnership may reasonably expect to make distri-butions in the following year because it reasonablyanticipates income. The reasonable expectation ofnet income does not get taken into account forpurposes of determining whether a capital accountreduction is necessary.

By contrast, the prophylactic gross incomechargeback ensures in virtually all situations thatthe partnership can project capital account increasesthat would offset reasonably anticipated decreasesfrom partnership distributions.

27Robert L. Whitmire et al., Structuring and Drafting Partner-ship Agreements, paras. 7-35 (drafting treatise).

28See reg. section 1.704-2(m), Example 2(ii).

29Reg. section 1.704-2(g)(2).30Drafting treatise, supra note 27, at paras. 6-58.



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This provision eliminates the need to adjustcapital accounts in applying the alternate economiceffect safe harbor for reasonably expected distribu-tions. That leaves only the proverbial unwary whoare subject to this adjustment.

Recommendation 7: The IRS should considermandating gross income allocations, absent aspecific partnership agreement disclaimer tothe contrary, to eliminate this trap for theunwary.

9. What happens if the partnership agreementdoes not provide for capital accounts or provides afaulty definition? The section 704(b) regulationsprescribe specific rules for maintaining capital ac-counts. When the partnership agreement is silent orprovides a faulty definition, the regulations will stilltest the allocations based on a properly definedcapital account.

For partnerships that liquidate in accordancewith capital accounts, the liquidation economicsshould as a matter of contract law be based on thepartnership definition of capital accounts, even if itdeparts from the tax law definition. This preservesthe business deal but places the efficacy of the taxallocations at risk. This is the correct result. The IRSregulations should not be changed to provide anon-tax-compliant capital account definition forpurposes of determining how partnership interestsare to be liquidated.

IV. Targeted Allocations

A. Targeted vs. Traditional Allocations

The typical partnership has partners who put upthe cash; partners who contribute appreciated prop-erty, including zero basis intangibles; and partnerswho contribute neither but do the work. The moneypartners often want their money back first; thosecontributing goodwill and the like want to receiveback the value someday but not necessarily upfront;and those contributing services will receive a profitsinterest. In the typical non-tax-driven business deal,the parties will reach agreement on the economicsand perhaps provide for tax distributions, but willleave the tax allocations to the drafters of theagreement.

Under the traditional tax allocation approach, thedrafters will first put together the cash flow priori-ties and will seek to build the profit and lossallocations around the cash flows. Final distribu-tions will be made in accordance with capital ac-counts. Drafters who do not want to liquidate inaccordance with capital accounts but who want

more certainty than the dumb-but-lucky approachmay use so-called targeted allocations.31

The typical partnership agreement containingtargeted allocation provisions provides for detailedcash distribution provisions and says simply thatprofits and losses are allocated so that each part-ner’s capital account will be equal to (or as close aspossible to) the cash he is supposed to receive underthe cash distribution provisions if his partnershipinterest were liquidated at that time. This giveseconomic certainty and maybe tax certainty as wellif the allocations are done properly, but it makes thetax return preparer’s job more difficult.

The classic situation in which a targeted alloca-tion is used is when Partner A puts up the moneyand is entitled to a preferred return on the moneyplus a priority cash distribution of the preferredreturn and his capital.

Example: Partner A contributes $1,000 to thepartnership. Partner B contributes goodwillworth $1,000. A is entitled to cash sufficient toprovide A with a 10 percent preferred returnplus capital; B then receives an amount equalto his $1,000 capital contribution; and then Aand B split 50/50. Assume that in year 1 thepartnership has income of $400.

The targeted allocation provision is a ratherelegant way of providing A with capital back taxfree. Under the targeted allocation approach, A andB’s capital account will be computed taking intoaccount contributions and distributions for the year.Then the partnership will determine how muchcash each partner would receive in liquidation.Based on the facts outlined above, the liquidationvalue (cash plus gross asset value of assets) was$2,400 ($1,000 original cash plus $1,000 goodwillplus $400 earnings); A is entitled to a $100 priorityreturn after year 1 (10 percent preferred return) plus

31This approach has been called ‘‘forced allocations,’’ ‘‘targetallocations,’’ and ‘‘targeted allocations.’’ We will use the term‘‘targeted allocations.’’ This topic has received relatively littleattention in tax writings. Terence Floyd Cuff has been the mostprolific writer on this topic. See Cuff, supra note 18. See alsoTerence Floyd Cuff, ‘‘Target Allocations and the Redemption ofa Member,’’ 37 Real Estate Tax. 60 (2010); Todd D. Golub, ‘‘TargetAllocations: The Swiss Army Knife of Drafting (Good for MostSituations — But Don’t Bet Your Life on It),’’ 87 Taxes 157 (2009);Thomas C. Lenz, ‘‘Using the Targeted Capital Account Ap-proach to Allocate Income and Loss — Is It Better Than theTraditional Layered Approach?’’ 5 J. Passthrough Entities 25(2002); Brian J. O’Connor and Steven R. Schneider, ‘‘CapitalAccount Based Liquidations: Gone With the Wind or Here toStay,’’ 102 J. Tax. 21 (2005); Warren P. Kean, ‘‘A Partner’s Interestin the Partnership for Purposes of Section 704(b),’’ 807 PLI 825(2008). A leading drafting treatise covers the topic tersely andtreats ‘‘forced allocations’’ almost dismissively. Drafting treatise,supra note 27, at paras. 7-159 et seq.



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$1,000 return of capital or $1,100; B is entitled to thenext $1,000; and A and B split the next $300 50/50.That gives A a targeted capital account of $1,250and B a targeted capital account of $1,150 (total$2,400). That means that A receives an incomeallocation of $250 to bring his capital account to$1,250, and B receives an income allocation of $150to bring his capital account to $1,150. In accordancewith the priority distribution, all the $400 cash isdistributed to A.

The results would be the same if the partnershipcontained a traditional capital account liquidationprovision.

B. Drafting Targeted Allocation ProvisionsA somewhat simplified targeted allocation pro-

vision would be as follows:

Net Profits and Net Losses for the year shall beallocated among the partners in a manner suchthat, to the extent possible, the capital accountbalance of each partner at the end of such yearshall be equal to the excess (which may benegative) of:

(1) the amount that would be distributedto such partner if (a) the company were tosell the assets of the company for theirGross Asset Values, (b) all Company li-abilities were settled in cash according totheir terms (limited, with respect to eachnonrecourse liability, to the book valuesof the assets securing such liability), and(c) the net proceeds thereof were distrib-uted in full pursuant to the distributionprovisions, over

(2) the sum of (a) the amount, if any,without duplication, that such Partnerwould be obligated to contribute to thecapital of the Company, (b) such Part-ner’s Share of Partnership MinimumGain determined pursuant to Treas. Reg.section 1.704-2(g) and (c) such Partner’sShare of Partner Nonrecourse Debt Mini-mum Gain determined pursuant to Treas.Reg. section 1.704-2(i)(5), all computed asof the date of the hypothetical sale de-scribed in (1) above.

In practice the targeted allocation provisionworks as follows:

First, each partner’s capital account is adjustedbased on the year’s activity (contributions, distribu-tions, and capital account book-ups and book-downs), as well as special allocations that are nottaken into account in net profits and net losses.

Second, the partnership computes the targetamount needed in the capital account based on theamount of the hypothetical cash distribution to the

partner that would result after a cash sale of part-nership property at book value.

Third, net profits and net loss items are allocatedto the partners to bring each partner’s capital ac-count in line with the distributions she wouldreceive on that year-end date.

In effect the partnership makes a year-end com-putation of what the partner’s capital accountwould have to be so he would receive the correctamount of cash in liquidation of his interest andthen allocates profits and losses so that the capitalaccount reaches that total.

Tax practitioners have not settled on model lan-guage for targeted capital account allocations. Thefollowing are some of the key concepts:

Hypothetical sale at book value: The compu-tations are based on the sale-at-book-valueconcept that forms the heart of the section704(b) regulations. As with the safe harboralternate economic effect test, this legal fictionprobably distorts the true economic situationin many cases when a more realistic assump-tion regarding value might lead to very differ-ent tax allocations. Query whether there can besituations in which it would be appropriate todepart from this fiction and look to real values.Any such rule might be difficult to administer.

Section 704(b) plumbing: The targeted alloca-tion provision retains the section 704(b)plumbing (definitions, capital accounts, spe-cial allocations, etc.) that is found in the tradi-tional tax allocation provisions discussed inPart I above. Net profits and net losses aredefined in terms of book income, not taxableincome. It is particularly important to sepa-rately allocate nonrecourse deductions andminimum gain chargeback so that operatingprofits are not allocated to offset prior lossesthat would otherwise be covered by the mini-mum gain chargeback. The same holds true forpartner nonrecourse deductions and partnerminimum gain. This avoids a double charge-back of income (operating profits under thepartnership agreement and minimum gain re-quired by the regulations) against nonrecoursedeductions and partner nonrecourse deduc-tions. The agreement also contains the quali-fied income offset provision required by thesafe harbor alternate economic effect and thenonrecourse deduction allocation rules.

Allocation of gross versus net income: Practi-tioners vary on whether partnerships shouldallocate items of gross income when a part-ner’s capital would otherwise fall short of thetargeted account. This will be discussed inmore detail below.



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C. Economic Certainty: Burden on PreparerPartnership agreements drafted using targeted

allocations provide partners certainty as to eco-nomic results; their cash flow is not tied to thevagaries of capital accounts. As is evident above,however, those agreements still require complicatedand sophisticated drafting. The tax boilerplate thatso many agreements lack is just as necessary fortargeted tax allocation provisions as for traditionaltax allocation provisions. Some of the recommenda-tions in Part III designed to simplify tax allocationprovision drafting are probably equally appropriatefor targeted allocation agreements.

Targeted allocation provisions are certainly moredifficult for the tax return preparer than the tradi-tional tax allocation provisions. Targeted allocationprovisions skip the step-by-step detail on how to dothe allocations. Even more important, the provi-sions force the tax return preparer to tackle capitalaccounts each year with rigor and accuracy. Inmany cases, this task is never encountered by taxreturn preparers for partnerships that contain tra-ditional allocation provisions.

This places tax return preparers in an unenviableposition. At the same time, however, the partner haseconomic certainty in terms of the cash he wouldreceive under various valuation scenarios.

D. Tax Certainty (or Lack Thereof)1. Targeted allocations and economic effect tests.Partners in partnerships using targeted allocationsare assured of receiving the distributions they bar-gained for. Query whether the tax results are ascertain.

The issue is whether the partnership agreementsatisfies the capital account liquidation requirementof the safe harbor economic effect and alternateeconomic effect tests. The capital account liquida-tion requirement under the regulations is that thepartnership agreement ‘‘provides’’ that ‘‘liquidatingdistributions are required in all cases to be made inaccordance with positive capital account bal-ances.’’32

Those who do not believe in targeted allocationscontend that even though per force the partner-ship’s liquidating distributions will be in accor-dance with capital accounts, the safe harboreconomic effect tests are not satisfied because thepartnership does not explicitly provide for liquida-tions in accordance with capital accounts; it explic-itly provides for liquidation based on distributionpercentages.33 This reading of the regulations maybe too narrow.

Targeted allocation provisions are designed toensure that liquidating distributions will be madein accordance with capital accounts. A partnershipagreement that contains those provisions can besaid to ‘‘provide’’ that liquidating distributions arein accordance with capital accounts. The regulationdoes not require the partnership to ‘‘state’’ thatliquidating distributions will be in accordance withcapital account.34 It uses the term ‘‘provides,’’ whichhas a broader meaning than the ‘‘explicitly states’’reading given by some. In this context, the term‘‘provides’’ has a result-oriented rather than means-oriented connotation. The ‘‘results’’ of targeted al-locations satisfy this results-oriented test.

Under the circumstances, properly drafted tar-geted allocation provisions that include a qualifiedincome offset provision ought to satisfy the section704(b) alternate economic effect test. In view ofseveral partnership agreements that rely on thetargeted allocation approach and the mixed viewsreflected in writings on this issue, it would behelpful for the IRS to issue a revenue ruling ornotice blessing targeted allocations under the sec-tion 704(b) alternate economic effect safe harbor.

Recommendation 8: The IRS should issue anotice or revenue ruling indicating that tar-geted allocation provisions can qualify underthe section 704(b) safe harbor economic effectand alternate economic effect tests. If desired,the IRS can specify appropriate conditions,subject to further guidance in regulations.

2. Targeted allocations and economic equivalencetests. If targeted allocations do not satisfy thealternate economic effect safe harbor, querywhether they can satisfy the dumb-but-lucky eco-nomic equivalence safe harbor.

As discussed earlier, this test validates alloca-tions otherwise flunking the economic effect testwhen the hypothetical liquidation of the partner-ship would produce the same economic result forthe partners in the current year or any future year asthe economic effect test (maintain capital accounts,liquidate in accordance with capital accounts, un-limited deficit restriction) regardless of the eco-nomic performance of the partnership.

As also discussed earlier, some distinguishedcommentators would limit this safe harbor to part-nership agreements with unlimited deficit restora-tion provisions. This is too narrow a reading anddoes not well serve the interests of the IRS or

32Reg. section 1.704-1(b)(2)(ii)(b)(2).33Drafting treatise, supra note 27 at paras. 7-150.

34Compare reg. section 1.704-2(e), which is the nonrecoursededuction safe harbor. This regulation says that the partnershipagreement must ‘‘contain’’ a minimum gain chargeback provi-sion. See also reg. section 1.704-1(b)(2)(ii)(d): ‘‘The partnershipagreement contains a qualified income offset.’’



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taxpayers. Properly drafted targeted allocationsought to pass muster under this regulation.

3. Targeted allocations and partner’s interests inthe partnership. The section 704(b) economic effecttests are safe harbors. Failure to satisfy these testsmeans that the allocation will be tested under the‘‘partner’s interests in the partnership’’ standard. Itis difficult to imagine that the IRS would consideran attack on the use of targeted allocations anefficient use of audit resources. Unfortunately, theIRS executive team’s view of how audit resourcesshould be deployed is no protection against indi-vidual agents seeking to press the point that theallocations do not stand up in a particular case.

Part II above briefly described the relevant in-quiry for determining a partner’s interest in thepartnership. While one would generally expecttargeted allocations to equal ‘‘partner’s interests inthe partnership,’’ there is some softness in thatconclusion because of the absence of the ‘‘tax basisequals fair market value’’ presumption in applyingthe partner’s interest in the partnership method.That proves too much, however. Without that pre-sumption, it may be difficult in many cases todetermine a partner’s interest in the partnership.

4. Targeted allocations and nonrecourse deduc-tions. As described in Part II above, allocations ofnonrecourse deductions can never have economiceffect and must be allocated in accordance with thepartner’s overall economic interest in the partner-ship.35 The regulations go on to provide a specialrule that says nonrecourse deductions will bedeemed to be in accordance with the partner’sinterests in the partnership when (1) liquidatingdistributions are made in accordance with capitalaccounts and (2) the nonrecourse deductions areallocated in a manner that is reasonably consistentwith the allocation of another item that has substan-tial economic effect.36

Some commentators argue that this rule calls intoquestion the ability of partnerships using targetedallocations to specially allocate nonrecourse deduc-tions because the partnership agreement does notsatisfy either prong of the test.37 If correct, thatconclusion would leave the allocation of nonre-course items entirely up in the air. This would notbe a good result because of the whipsaw potentialfor either the IRS or for taxpayers.

Recommendation 9: The IRS should issue anotice or revenue ruling confirming that the

nonrecourse deduction allocation rules can besatisfied by partnerships using targeted allo-cations.

E. Preferred Return and Targeted Allocations

One of the disputes with targeted allocations iswhether a gross income allocation may be manda-tory when one partner is entitled to a preferredreturn that takes priority over another partner’scapital return.

Example: A and B each contributes $100 to thepartnership. A is entitled to receive a com-pounded 12 percent return on her $100 invest-ment plus return of capital before B is entitledto any return of capital. The partnership earns$10 of net profits in year 1.

In this example, net profits for the year fell shortof the preferred return. This issue is not unique totargeted allocations and would also seem to bepresent for traditional liquidate-in-accordance-with-capital-account allocations. The question iswhether the partnership should allocate $12 of grossincome to the partner who is entitled to the priorityreturn, or treat the amount as a $12 guaranteedpayment to that partner, or simply allocate $10 ofnet income and wait for the next year to catch up.

Some commentators argue that the section 704(b)partner’s interest in the partnership rule may re-quire a gross income allocation even if the targetedallocation provision in the agreement only requiredallocations of items of net income and loss.38 Alter-natively, the amount could be treated as an accruedguaranteed payment for A in year 1 or a taxablecapital shift.39

The difficulty with imputing phantom incomeeach year is that it often may not correlate well witheconomic reality and the parties’ business expecta-tions. The parties generally expect the preferredreturn to come out of earnings — anticipated to below in the early years and more significant downthe road. The better view would appear to be toallocate net profit and net loss items only, particu-larly if the partners anticipate early-year low profitsand expect that the preferred return would befunded from expected future profits.

35Reg. section 1.704-2(b)(1).36Reg. section 1.704-2(e).37Cuff, supra note 18, at 29.

38Id. at 54-55. See also Lenz, supra note 31, at 30, who agreesthat a gross income allocation is required. O’Connor andSchneider, supra note 31, at 24-26, conclude that the preferredreturn is a guaranteed payment or a taxable capital shift.

39This assumes an accrual method partnership. The guaran-teed payment construct gets more complicated with a cashmethod partnership since the deduction (and income) is post-poned to the year of payment. Cuff, supra note 18, has arguedthat the apparent deemed capital shift might be a deemedguaranteed payment.



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Under that approach, the extraordinary adjust-ments (gross income allocation or guaranteed pay-ment) would be made only if the partners’ robustexpectations did not materialize and the shortfallremaining at the end of the life of the partnershipwas made up of liquidating proceeds.40 This avoidsextraordinary year-to-year phantom income adjust-ments.

This result would appear to be consistent withthe partner’s interest in the partnership. The normaltax snapshot — tax basis equals value — does notreflect economic reality. It seems inconsistent withthe partner’s interest in the partnership test torequire a gross income allocation or a guaranteedpayment or a taxable capital shift for an earningsshortfall in a particular year when the value of theproperty may have increased dramatically and thefuture looks robust.

F. Potential Drafting IssuesThe drafting treatise41 offers the following check-

list of drafting issues with targeted allocations:

1. Circularity: Drafters sometimes forget toremove ‘‘liquidation in accordance with capi-tal accounts’’ from the distribution provisions.Leaving it in produces a circular definition.

2. Distribution provisions: The targeted allo-cation provision puts more pressure on draft-ing accurate distribution provisions. Also, itmay be more difficult to allocate tiers of lossesto partners. This may need to be accomplishedby specifying the amount the partner is en-titled to receive if liquidation occurs at varioustimes, which may be tricky.

3. Special allocations: The partnership agree-ment still needs to provide for special alloca-tions relating to nonrecourse deductions,qualified income offset, etc., and profits andlosses based on book income. The draftingtreatise adds that the curative allocation pro-vision is not needed because targeted alloca-tions are inherently curative.

4. Priority returns: As with traditional alloca-tion provisions, the drafter of a targeted allo-cation provision still needs to deal withwhether priority returns of capital should bematched (if at all) with profits or items of grossincome. If they are not so matched, the partnerreceives back his capital tax free. If they are so

matched, the partner is simply receiving apriority income allocation rather than a prior-ity return of capital.

5. Disproportionate losses: The drafting trea-tise says the targeted allocation is difficult touse if the business deal calls for a dispropor-tionate allocation of depreciation or losses anda chargeback only out of gains, not profits.

The drafting treatise is somewhat dismissive oftargeted allocations, apparently based on the viewthat the traditional capital account liquidation pro-vision produces the right economic result for thepartners.42 That’s theoretically true.

Theory and practice can be very different, how-ever, as the drafting treatise admits in the nextparagraph on that same page:

In all but the simplest transactions, this needto anticipate and accurately deal with a widerange of unpredictable future events imposes atremendous burden on the drafter and creates avery real risk that some future events will beoverlooked or mishandled. [Emphasis added.]

With such a high risk of mistake, one wonderswhy the drafting treatise does not more readilyembrace targeted allocations. Might it be better toerr on the side of tax mistake rather than economicmistake and use targeted allocations?

V. Tracking AllocationsThe targeted allocation provisions discussed in

the preceding section secure the partner’s casheconomics but provide relatively little guidance forthe tax return preparer. Targeted allocation provi-sions also force tax practitioners to give up thehard-learned craft of drafting complex tax alloca-tion provisions. The somewhat terse ‘‘allocate taxitems to give the right capital account’’ is much lesselegant than a well-drafted tax allocation provision.For these reasons, some drafters simply eschewreliance on capital accounts at all and draft partner-ship agreements with tax allocations that simply‘‘track’’ the distribution provisions, that is, ‘‘track-ing allocations.’’43

The drafting process begins with the distributionprovisions. Once the distribution provisions are set,the drafter develops tax allocation provisions toreflect the cash distribution priorities. This is thesame process used in drafting traditional ‘‘liquidatein accordance with capital account’’ provisions,

40See Lewis R. Steinberg, ‘‘Fun and Games With GuaranteedPayments,’’ 57 Tax Law. 533, 567 (2004). See also Kean, supra note31, at 415-417.

41Drafting treatise, supra note 27, at paras. 7-161 et seq.

42Id. at paras. 7-160.43The term ‘‘tracking allocations’’ captures the concept, al-

though the term may already be claimed by those who issueinterests in a partnership that track specific investments.



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except that here the final distributions are based onformula, not capital accounts.

If the drafter maintains the proper symmetrybetween the tax allocation provisions and the dis-tribution provisions, the tax allocations during thelife of the partnership should be the same as the taxallocations under the traditional capital accountliquidation approach. If the tax allocations are dif-ferent, the partners may suffer a tax detriment, butat least they will end up with the correct cash result.

These partnership agreements typically providefor all the tax allocation and special allocationdefinitions and plumbing reflected in traditionalpartnership agreements. Some of it may appearsuperfluous (for example, capital accounts). How-ever, it is useful and helpful to include the capitalaccount concept because capital accounts serve asthe economic scorecard for judging whether a taxallocation has economic effect. In any event, IRSagents and clients will expect to see this tax boiler-plate even if they do not understand it.

There may be circumstances in which this draft-ing technique may not work well for a particularbusiness deal. For example, if Partner A is entitledto a preferred return that has priority over thereturn of B’s capital, it is unclear whether A shouldbe allocated items of gross income when taxableincome for the year is less than the preferred return.As we have seen, the same issue arises under anytax allocation scheme.

In view of the emerging prevalence of this tech-nique, it would be helpful if the IRS establishedrules for tracking allocations.

Recommendation 10: The IRS should issue anotice or revenue ruling indicating that track-ing allocations will satisfy the economic effector alternate economic effect safe harbors to theextent that liquidation would in fact be inaccordance with capital accounts.

VI. Allocations Based on Taxable Income

We know from experience that many, perhapsmost, partnership agreements do not contain thedetailed boilerplate discussed in Part III and do notrequire liquidation in accordance with capital ac-counts. (We could take a survey of how many lawfirm partnership agreements contain these provi-sions, but we know the proverb about the holes inthe shoes of the cobbler’s children.)

The most basic tax allocation provision, whichour corporate brethren and clients often urge us toadopt, is to provide simply as follows:

Taxable income and losses and distributions,including in liquidation, will be allocated inaccordance with Percentage Interests.

The IRS in its audit guidelines refers to this typeof provision as the dumb-but-lucky approach. Insimple cases, this provision may achieve the desiredbusiness and tax results.

It is fine for the partnership to make allocationsbased on taxable income rather than book incomewhen there is no difference between book incomeand taxable income. This would happen when (1)all partners have made pro rata cash contributionsto the partnership at the same time, (2) no partnerhas contributed property to the partnership, (3) thepartnership has not made property distributions tothe partners, and (4) no partner has received apartnership interest for services. In that case, thebook value of partnership assets should generallyequal their tax basis so there would be no differencebetween book income and taxable income.

Let’s say book income and taxable income aredifferent because one of these enumerated eventsoccurred and the book value and tax basis of anasset differs (for example, because a partner con-tributed an appreciated asset rather than cash). Inthat case section 704(c) would override the taxallocation provisions of the partnership agreementand would require, for example, an allocation ofgain or loss from the sale or depreciation of the assetto be allocated among the partners to account forthe difference between book value and tax basis.

The simple tax allocation provision may passmuster even in that situation, at least when filteredthrough the tax return preparation process, becausethe tax return preparer will fill in some of the gapsleft open by this provision. For example, we couldexpect the tax return preparer to properly apply thesection 704(c) rules to come up with the correct taxreturn reporting. In effect the popular tax boiler-plate regime of using book income rather thantaxable income for allocations may simply be abookkeeping convention. In either case adjustmentsneed to be made under section 704(c) so that taxreturn preparers can arrive at the correct bottom-line tax numbers for taxpayers.

Similarly, if the partnership recognized losses,the tax return preparer may well allocate the lossesamong the partners by applying a surrogate alter-nate economic effect safe harbor.

In effect the tax return preparer would probablyconstrue the partnership agreement to contain thenecessary tax plumbing to reach the right tax resultfrom an economic perspective. As a practical matter,tax traps may not snare the unwary in the partner-ship tax world if one employs the right tax returnpreparer.

Still, because this type of allocation provision isso prevalent in the real world, it would be helpfulfor the IRS to develop rules.



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Recommendation 11: The IRS should developrules to accommodate allocations based ontaxable income.

VII. ConclusionThe IRS and tax practitioners have spent signifi-

cant time and resources of late simplifying thesubchapter C rules and eliminating many long-lived traps for the unwary. This has been a produc-tive and rewarding effort for participants andobservers alike. The ground was familiar to themany of us who decided to become tax practitio-ners as a result of our corporate tax class. But exceptperhaps for spinoffs and intragroup reorganiza-tions, the subchapter C reorganization rules pale inimportance to subchapter K for most tax practitio-ners. Anyone can file a simple certificate and form acorporation. Tax practitioner input is needed fromday one when a partnership is being put in place.

The preceding discussion makes a compellingcase that subchapter K partnership allocation rulesneed to be refined and updated. This is one of manybasic partnership tax matters that deserve concertedhigh-level attention. The IRS and tax practitionergroups should collaborate on this project, devotingthe same level of resources to subchapter K regula-tion modernization that has been devoted to sub-chapter C. This should be a high priority project.

Appendix A:Testing Partnership Allocations

Test 1: Economic effect safe harbor: requirescapital account maintenance, liquidation in accor-dance with capital accounts, and unlimited deficitrestoration obligation. Reg. section 1.704-1(b)(2)(ii)(b).

Test 2: Alternate economic effect safe harbor:requires capital account maintenance, liquidation inaccordance with capital accounts, and qualifiedincome offset in lieu of unlimited deficit restorationobligation; capital accounts determined taking intoaccount anticipatory capital account adjustmentsusing value equals tax basis (book value) presump-tion. Reg. section 1.704-1(b)(2)(ii)(d).

Test 3: Economic effect equivalence (dumb butlucky): tax allocations deemed to have economiceffect if, at the end of each partnership year, aliquidation at year-end or any future year-endwould produce the same economic results to thepartners that would occur if the partnership satis-fied the economic effect safe harbor (proper capitalaccounts, liquidation in accordance with capitalaccounts, unlimited deficit restoration obligation)regardless of economic performance. Reg. section1.704-1(b)(2)(ii)(i).

Test 4: Partner’s interest in the partnership —facts and circumstances: liquidating distributions

may be key, but no value equals tax basis (bookvalue) presumption. Reg. section 1.704-1(b)(3)(i).

Test 5: Special ‘partner’s interest in the partner-ship’ rule: partner’s interest in partnerships thatmaintain capital accounts and liquidate per capitalaccounts determined based on book value liquida-tion analysis in which the partnership flunks safeharbor economic effect tests because of the lack of adeficit restoration provision or qualified incomeoffset; capital accounts determined taking into ac-count anticipatory capital account adjustments us-ing value equals tax basis (book value)presumption. Reg. section 1.704-1(b)(3)(iii).

Test 6: Nonrecourse deductions: tax allocationsfor nonrecourse deductions based on partner’soverall economic interests in the partnership;deemed to be in accordance with partner’s interestif (1) capital account maintenance and liquidation isin accordance with capital accounts and deficitrestoration obligation or qualified income offset; (2)allocation is reasonably consistent with allocationhaving substantial economic offset of another sig-nificant item related to the property; (3) minimumgain chargeback; and (4) all other material alloca-tions recognized. Reg. section 1.704-1(b)(3)(iii).

Test 6: Partner nonrecourse deductions: tax allo-cations for nonrecourse deductions allocated topartner who bears economic risk of loss. Reg.section 1.704-2(i)(1).

Appendix B:Sample Tax Boilerplate

Tax Definitions, Capital Accounts, and SpecialAllocations1. Tax Definitions.

‘Adjusted Capital Account Deficit’ means thedeficit balance (if any) in a Member’s Capital Ac-count as of the end of any taxable year of theCompany, after:

a. crediting to such Capital Account anyamount which such Member is obligated torestore pursuant to this Agreement or isdeemed obligated to restore pursuant to theminimum gain chargeback provisions of Treas.Reg. section 1.704-2(f) and (g), and

b. charging to such Capital Account any ad-justments, allocations or distributions de-scribed in the qualified income offsetprovisions of Treas. Reg. section 1.704-1(b)(2)(ii) which are required to be charged tosuch Capital Account pursuant to this Agree-ment.

‘Company Minimum Gain’ means the amountdetermined in accordance with the principles ofTreas. Reg. section 1.704-2(d) and 1.704-2(g).



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‘Contributed Assets’ has the meaning set forth inSection 4(a) below.

‘Depreciation’ means, for each taxable year ofthe Company or other period, an amount equal tothe depreciation allowable with respect to an assetfor such taxable year or other period; provided,however, that if the Gross Asset Value of an assetdiffers from its adjusted basis for federal income taxpurposes at the beginning of such taxable year orother period, Depreciation shall be an amount thatbears the same ratio to such beginning Gross AssetValue as the federal income tax depreciation withrespect to such asset for such taxable year or otherperiod bears to such beginning adjusted tax basis;and provided further, that if the federal income taxdepreciation for such taxable year or other period iszero, Depreciation shall be determined with refer-ence to such beginning Gross Asset Value using anyreasonable method selected by the Members.

‘Gross Asset Value’ shall be determined as fol-lows:

a. the initial Gross Asset Value of any assetcontributed by a Member to the Companysubsequent to the date hereof shall be the fairmarket value of such asset, as agreed to by theMembers;

b. the Gross Asset Value of all Company assetsshall be adjusted to equal their respective fairmarket values (taking Section 7701(g) of theCode into account) as of the following times:(i) the acquisition of additional Shares by anynew or existing Member in exchange for morethan a de minimis Capital Contribution or inconnection with the performance of services;(ii) the distribution by the Company to aMember of more than a de minimis amount ofCompany assets as consideration for Shares,but only if, in the case of either (i) or (ii), theMembers reasonably determine that such ad-justment is necessary or appropriate to reflectthe relative economic interests of the Membersin the Company; (iii) the liquidation of theCompany; and/or (iv) the forfeiture by a de-faulting Member of its Shares;

c. the Gross Asset Value of any Company assetdistributed to any Member shall be the fairmarket value (taking Section 7701(g) of theCode into account) of such asset on the date ofdistribution;

d. the Gross Asset Values of Company assetsshall be increased (or decreased) to reflect anyadjustments to the adjusted basis of such Com-pany assets pursuant to Section 732(d), Section734(b) or Section 743(b) of the Code, but onlyto the extent that such adjustments are takeninto account in determining Capital Accounts

pursuant to Treas. Reg. section 1.704-l(b)(2)(iv)(m) and 1.704-1(b)(2)(iv)(f); pro-vided, however, that Gross Asset Values shallnot be adjusted pursuant to this subsection (d)to the extent that the Members determine thatan adjustment pursuant to subsection (b) ofthis definition is necessary or appropriate inconnection with a transaction that would oth-erwise result in an adjustment pursuant to thissubsection (d);

e. if the Gross Asset Value of any Companyasset has been determined or adjusted pursu-ant to subsection (a), (b), (c) or (d), such GrossAsset Value shall thereafter be adjusted by theDepreciation that would be taken into accountwith respect to such asset for purposes ofcomputing gains or losses from the dispositionof such asset; and

f. Gross Asset Value of any Company asset thatwas not contributed by a Member means theadjusted basis of such Company asset forfederal income tax purposes.

‘Nonrecourse Deductions’ has the meaning setforth in Treas. Reg. section 1.704-2(b)(1).

‘Profits’ and ‘Losses’ shall mean, for each taxableyear of the Company or other period, an amountequal to the Company’s taxable income or loss, asthe case may be, for such taxable year or period,determined in accordance with Section 703(a) of theCode (for this purpose, all items of income, gain,loss and deduction required to be stated separatelypursuant to Section 703(a)(1) of the Code shall beincluded in taxable income or loss), with the follow-ing adjustments:

a. any income of the Company that is exemptfrom federal income tax and not otherwisetaken into account in computing Profits orLosses pursuant to this subparagraph shall beadded to such taxable income or loss;

b. any expenditures of the Company describedin Section 705(a)(2)(B) of the Code or treated asSection 705(a)(2)(B) of the Code expenditurespursuant to Treas. Reg. section 1.704-l(b)(2)(iv)(i), and not otherwise taken into ac-count in computing Profits or Losses pursuantto this definition shall be subtracted from suchtaxable income or loss;

c. in the event the Gross Asset Value of anyCompany asset is adjusted pursuant to sub-paragraph (b) or (c) of the definition thereof,the amount of such adjustment shall be takeninto account as gain or loss from the disposi-tion of such asset for purposes of computingProfits or Losses;



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d. gain or loss resulting from the disposition ofany Company asset with respect to which gainor loss is recognized for federal income taxpurposes shall be computed by reference tothe Gross Asset Value of the asset disposed of,notwithstanding that the adjusted tax basis ofsuch asset differs from its Gross Asset Value;e. in lieu of the Depreciation taken into ac-count in computing such taxable income orloss, there shall be taken into account Depre-ciation for such taxable year of the Companyor other period, computed in accordance withthe definition thereof;f. to the extent an adjustment to the adjustedtax basis of any Company asset pursuant toSection 734(b) of the Code is required, pursu-ant to Treas. Reg. section 1.704-l(b)(2)(iv)(m)(4), to be taken into account indetermining Capital Accounts as a result of adistribution other than in liquidation of aMember’s Shares, the amount of such adjust-ment shall be treated as an item of gain (if theadjustment increases the basis of the asset) orloss (if the adjustment decreases such basis)from the disposition of such asset and shall betaken into account for purposes of computingProfits or Losses; andg. notwithstanding any other provision of thisdefinition, any items which are specially allo-cated pursuant to Section 3 below shall not betaken into account in computing Profits andLosses.‘Regulations’ shall mean a regulation issued by

the United States Treasury Department and relatingto matters arising under the Code.

‘Regulatory Allocations’ has the meaning setforth in Section 3(h) below.

‘Member Nonrecourse Debt’ has the samemeaning as the term ‘‘partner nonrecourse debt’’ setforth in Treas. Reg. section 1.704-2(b)(4).

‘Member Nonrecourse Debt Minimum Gain’means an amount, with respect to each MemberNonrecourse Debt, equal to the Company Mini-mum Gain that would result if such Member Non-recourse Debt were treated as a NonrecourseLiability, determined in accordance with the provi-sions of Treas. Reg. section 1.704-2(i)(3) relating to‘‘partner nonrecourse debt minimum gain’’.

‘Member Nonrecourse Deductions’ has thesame meaning as the term ‘‘partner nonrecoursedeductions’’ set forth in Treas. Reg. section 1.704-2(i)(1) and 1.704-2(i)(2).2. Capital Accounts.

Each Member’s initial Capital Account shall re-flect the Gross Asset Value of such Member’s initialCapital Contribution. Except as provided in this

Section 2, the Capital Account of each Member shallbe (i) increased by (A) the amount of cash and theGross Asset Value of any property contributed tothe Company by such Member (net of liabilitiessecured by the property or to which the property issubject that the Company is considered to assumeor take subject to pursuant to Section 752 of theCode), and (B) Profits and any other items ofincome and gain allocated to such Member; (ii)decreased by (A) the amount of cash and the GrossAsset Value of any property distributed to suchMember (net of liabilities secured by the property orto which the property is subject that such Member isconsidered to assume or take subject to pursuant toSection 752 of the Code) and (B) the Losses and anyother items of deduction and loss allocated to suchMember; and (iii) otherwise maintained in accor-dance with Treas. Reg. section 1.704-1(b)(2)(iv) inorder for the allocation of Profits and Losses to have‘‘substantial economic effect’’ in accordance withTreas. Reg. section 1.704-1(b)(2).

For purposes of this Section 2, (i) an assumptionof a Member’s unsecured liability by the Companyshall be treated as a distribution of money to thatMember, and (ii) an assumption of the Company’sunsecured liability by a Member shall be treated asa cash contribution to the Company by that Mem-ber.

In the event of a contribution of money or otherproperty to the Company (other than a contributionmade ratably by all existing Members), an issuanceof Shares in connection with the performance ofservices, or the forfeiture by a Member of its Shares,the Capital Accounts for the Members shall beadjusted in respect of the hypothetical ‘‘book’’ gainor loss that would have been realized by the Com-pany if all Company assets had been sold for theirGross Asset Values in a cash sale.

In the event that Company assets other thanmoney are distributed to a Member in liquidation ofthe Company, or in the event that assets of theCompany other than money are distributed to aMember in kind, in order to reflect unrealized gainor loss, Capital Accounts for the Members shall beadjusted in respect of the hypothetical ‘‘book’’ gainor loss that would have been realized by the Com-pany if the distributed assets had been sold for theirGross Asset Values in a cash sale. In the event of theliquidation of a Member’s Shares, in order to reflectunrealized gain or loss, Capital Accounts for theMembers shall be adjusted in respect of the hypo-thetical ‘‘book’’ gain or loss that would have beenrealized by the Company if all Company assets hadbeen sold for their Gross Asset Values in a cash sale.

If Company property is reflected on the books ofthe Company at a book value that differs from theadjusted tax basis of such property, the Members’



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Capital Accounts shall be adjusted in accordancewith Treas. Reg. section 1.704-1(b)(2)(iv)(g) for allo-cations of depreciation, depletion, amortization,and gain or loss, as computed for book purposes,with respect to such property.

Upon any transfer of all or part of an interest inthe Company, as permitted by this Agreement, theCapital Account (or portion thereof) of the transf-eror that is attributable to the transferred interest (orportion thereof) shall carry over to the transferee.

The foregoing provisions of this Section 2 and theother provisions of this Agreement relating to themaintenance of Capital Accounts are intended tocomply with Treas. Reg. section 1.704-1 and 1.704-2and shall be interpreted and applied in a mannerconsistent with such Regulations and any amend-ment or successor provision thereto. The Membersshall cause appropriate modifications to be made ifunanticipated events might otherwise cause thisAgreement not to comply with such Regulations, solong as such modifications do not cause a materialchange in the relative economic benefit of theMembers under this Agreement.3. Special Tax Allocations. The following specialallocations shall be made in the following order:

a. Minimum Gain Chargeback. Subject to theexceptions set forth in Treas. Reg. section1.704-2(f), if there is a net decrease in Com-pany Minimum Gain during a taxable year ofthe Company, each Member shall be speciallyallocated items of income and gain for suchtaxable year (and, if necessary, for subsequentyears) in an amount equal to such Member’sshare of the net decrease in Company Mini-mum Gain during such taxable year (whichshare of such net decrease shall be determinedunder Treas. Reg. section 1.704-2(g)(2)). It isintended that this Section 3(a) shall constitutea ‘‘minimum gain chargeback’’ as provided byTreas. Reg. section 1.704-2(f) and shall be in-terpreted consistently therewith.b. Member Nonrecourse Debt Minimum GainChargeback. Subject to the exceptions containedin Treas. Reg. section 1.704-2(i)(4), if there is anet decrease in Member Nonrecourse DebtMinimum Gain during a taxable year of theCompany, any Member with a share of suchMember Nonrecourse Debt Minimum Gain(determined in accordance with Treas. Reg.section 1.704-2(i)(5)) as of the beginning ofsuch taxable year shall be specially allocateditems of income and gain for such taxable year(and, if necessary, for subsequent years) in anamount equal to such Member’s share of thenet decrease in Member Nonrecourse DebtMinimum Gain (which share of such net de-crease shall be determined under Treas. Reg.

section 1.704-2(i)(4) and 1.704-2(j)(2)). It is in-tended that this Section 3(b) shall constitute a‘‘partner nonrecourse debt minimum gainchargeback’’ as provided by Treas. Reg. section1.704-2(i)(4) and shall be interpreted consis-tently therewith.

c. Qualified Income Offset. In the event anyMember unexpectedly receives any adjust-ments, allocations, or distributions describedin Treas. Reg. section 1.704-l(b)(2)(ii)(d)(4),1.704-l(b)(2)(ii)(d)(5), or 1.704-l(b)(2)(ii)(d)(6)(modified as appropriate, by Treas. Reg. sec-tion 1.704-2(g)(1) and 1.704-2(i)(5)), items ofCompany income and gain for such taxableyear shall be specially allocated to the Memberin an amount and manner sufficient to elimi-nate, to the extent required by the Regulations,any Adjusted Capital Account Deficit of theMember as quickly as possible, provided thatan allocation pursuant to this Section 3(c) shallbe made if and only to the extent that theMember would have an Adjusted Capital Ac-count Deficit after all other allocations havebeen tentatively made as if this Section 3(c)were not in this Schedule 3.01.

d. Gross Income Allocations. To the extent re-quired by the Regulations, in the event aMember has a deficit balance in its CapitalAccount at the end of any taxable year of theCompany in excess of the sum of (A) theamount such Member is required to restorepursuant to the provisions of this Agreement,if any, and (B) the amount such Member isdeemed obligated to restore pursuant to Treas.Reg. section 1.704-2(g) and 1.704-2(i)(5), suchMember shall be specially allocated items ofCompany income and gain in the amount ofsuch excess as quickly as possible, providedthat an allocation pursuant to this Section 3(d)shall be made if and only to the extent thatsuch Member would have an Adjusted CapitalAccount Deficit after all other allocations havebeen tentatively made as if this Section 3(d)were not in this Schedule 3.01.

e. Nonrecourse Deductions. Any NonrecourseDeductions shall be allocated to the Membersin the same manner as Losses are allocatedpursuant to Section 4.01 of this Agreement.

f. Member Nonrecourse Deductions. Any Mem-ber Nonrecourse Deductions shall be allocatedto the Member that bears the economic risk ofloss for the Member Nonrecourse Debt towhich such deductions relate as provided inTreas. Reg. section 1.704-2(i)(1). If more thanone Member bears the economic risk of loss,such deduction shall be allocated between or



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among such Members in accordance with theratios in which such Members share sucheconomic risk of loss.g. Certain Section 754 Adjustments. To the extentany adjustment to the adjusted tax basis of anyCompany asset pursuant to Section 732(d),Section 734(b) or Section 743(b) of the Code isrequired, pursuant to Treas. Reg. section 1.704-1(b)(2)(iv)(m), to be taken into account indetermining Capital Accounts as the result of adistribution to a Member in complete liquida-tion of its interest in the Company, the amountof such adjustment to Capital Accounts shallbe treated as an item of gain (if the adjustmentincreases such basis) and an item of loss (if theadjustment decreases such basis) and suchgain or loss shall be specially allocated to theMembers in accordance with their interests inthe Company as determined under Treas. Reg.section 1.704-1(b)(3) in the event Treas. Reg.section 1.704-1(b)(2)(iv)(m)(2) applies, or to theMember to whom such distribution was madein the event Treas. Reg. section 1.704-l(b)(2)(iv)(m)(4) applies.h. Limit on Loss Allocations. Notwithstandingthe provisions of Section 4.01 of this Agree-ment or any other provision of this Agreementto the contrary, Losses (or items thereof) shallnot be allocated to a Member if such allocationwould cause or increase a Member’s AdjustedCapital Account Deficit and shall be reallo-cated to the other Members in proportion totheir [respective Capital Account balances],subject to the limitations of this Section 3(h).i. Curative Allocations. The allocations underSections 3(a) through (h) above (such alloca-tions, the ‘‘Regulatory Allocations’’) are in-tended to comply with certain requirements ofthe Regulations. It is the intent of the Membersand the Company that, to the extent possible,all Regulatory Allocations shall be offset eitherwith other Regulatory Allocations or with spe-cial allocations of other items of income, gain,loss or deduction pursuant to this Agreement.Therefore, notwithstanding any other provi-sion of this Agreement to the contrary (otherthan the Regulatory Allocations), the Com-pany shall make such offsetting special alloca-tions of income, gain, loss or deduction inwhatever manner the Company determinesappropriate so that, after such offsetting allo-cations are made, each Member’s Capital Ac-count balance is, to the extent possible, equalto the Capital Account balance such Memberwould have had if the Regulatory Allocationswere not part of the Agreement and all itemswere allocated pursuant to Section 4.01 of the

Agreement. For purposes of this Section 3(i),future Regulatory Allocations under Sections3(a) through (h) that are likely to offset otherRegulatory Allocations previously made shallbe taken into account.

4. Tax Allocations: Section 704(c).a. For federal, state and local income taxpurposes only, with respect to any assets con-tributed by a Member to the Company (‘‘Con-tributed Assets’’) which have a Gross AssetValue on the date of their contribution whichdiffers from the Member’s adjusted basistherefore as of the date of contribution, theallocation of Depreciation and gain or losswith respect to such Contributed Assets shallbe determined in accordance with the provi-sions of Section 704(c) of the Code and theRegulations promulgated thereunder usingthe method described under Treas. Reg. sec-tion 1.704-3(b). [This needs to be conformed tothe specific deal]. For purposes of this Agree-ment, an asset shall be deemed a ContributedAsset if it has a basis determined, in whole orin part, by reference to the basis of a Contrib-uted Asset (including an asset previouslydeemed to be a Contributed Asset pursuant tothis sentence).b. In the event the Gross Asset Value of anyCompany asset is adjusted pursuant to sub-paragraph (b) of the definition thereof, subse-quent allocations of income, gain, loss anddeduction with respect to such asset shall takeaccount of any variation between the adjustedbasis of such asset for federal income taxpurposes and its Gross Asset Value in the samemanner as under Section 704(c) of the Codeand Treas. Reg. section 1.704-3(b).c. Allocations pursuant to this Section 4 aresolely for purposes of federal, state, and localtaxes and shall not affect, or in any way betaken into account in computing any Mem-ber’s Capital Account or share of Profits,Losses, other items, or distributions pursuantto any provision of this Agreement.

5. Allocations in the Event of Transfer. If all or anyportion of any Shares are transferred to a substituteMember during any taxable year of the Company,Profits, Losses, each item thereof and all other itemsattributable to such Shares for such period shall bedivided and allocated between the transferor andtransferee by applying an interim closing of theCompany’s books method.6. Profits Interest Safe Harbor. The Tax MattersMember is authorized to amend this Agreement,without the consent of the other Members, to com-ply with any safe harbor finalized by the UnitedStates Department of the Treasury or the Internal



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Revenue Service relating to the tax treatment of atransfer of an interest in the Company for services.For example, this Section 6 shall apply to any safeharbor finalized by Internal Revenue Service noticeor Regulations as successor to the proposed safeharbor described in Internal Revenue Service No-tice 2005-43, 2005-1 C.B. 1221. In the event any suchsafe harbor is finalized and elected by the Com-pany, all Members agree to comply with all therequirements of such safe harbor and any amend-ments to this Agreement that the Tax Matters Mem-ber effects pursuant to this Section 6.

Appendix C:Sample Targeted Allocation Provision

A somewhat simplified targeted allocation pro-vision would be as follows:

Net Profits and Net Losses for the year shall beallocated among the partners in a manner suchthat, to the extent possible, the capital accountbalance of each partner at the end of such yearshall be equal to the excess (which may benegative) of:

(1) the amount that would be distributedto such partner if (a) the company were tosell the assets of the company for theirGross Asset Values, (b) all Company li-abilities were settled in cash according totheir terms (limited, with respect to eachnonrecourse liability, to the book valuesof the assets securing such liability), and(c) the net proceeds thereof were distrib-uted in full pursuant to the distributionprovisions, over(2) the sum of (a) the amount, if any,without duplication, that such Partnerwould be obligated to contribute to thecapital of the Company, (b) such Part-ner’s Share of Partnership MinimumGain determined pursuant to Treas. Reg.section 1.704-2(g) and (c) such Partner’sShare of Partner Nonrecourse Debt Mini-mum Gain determined pursuant to Treas.Reg. section 1.704-2(i)(5), all computed asof the date of the hypothetical sale de-scribed in (1) above.



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Documents

No Job Name · covers a lot of unpleasant surprises and other sins, 1Section references are to the Internal Revenue Code unless the context indicates otherwise. The term ‘‘partnerships’’