Partnership and LLC Agreement Tax Provisions Clarified

Partnership and LLC Agreement Tax Provisions Clarified

Drafting Partnership and LLC Agreements: Tax Boilerplate, Allocation, and Liquidation Provisions - by Ivan Mitev and Matt Kaden - Boies, Schiller & Flexner, LLP

Crafting agreement language requires attention to partnership and LLC objectives and also to tax hazards and opportunities.  Finally, practitioners will have a concise, straightforward, and reliable treatise to consult as they plan and create partnership and LLC agreements. Drafting Partnership and LLC Agreements: Tax Boilerplate, Allocation, and Liquidation Provisions discusses and explains in great detail the “boilerplate” tax provisions that are found in almost all partnership and LLC agreements, for use by practitioners who draft or review such agreements. This short treatise facilitates best practices in tax planning related to the entity's capital accounts, profit and loss, partner/partnership transactions, distributions, liquidation, and other key elements.

Drafting Partnership and LLC Agreements: Tax Boilerplate, Allocation, and Liquidation Provisions is available in the LexisNexis® Store.

 

An excerpt from the complete work by Ivan Mitev and Matt Kaden:

 

1- Drafting Partnership and LLC Agreements § 1.02

 

Drafting Partnership and LLC Agreements: Tax Boilerplate, Allocation and Liquidation Provisions
 
Copyright 2010, Matthew Bender & Company, Inc., a member of the LexisNexis Group.


Drafting Partnership and LLC Agreements: Tax Boilerplate, Allocation, and Liquidation Provisions


1- Drafting Partnership and LLC Agreements § 1.02

 

(Footnotes Omitted)


§ 1.02 Allocations and Liquidations

[1] The Issue
 
The distribution waterfall represents one of the key elements of the business deal between the parties: how the parties will share in the venture's cash-flow. In fact, often the parties will equate the business deal to the waterfall. After all, to a business person and a corporate tax lawyer the key metrics are the cash invested and the cash received from the investment. Often, the waterfall can be quite complicated and involve various priorities and catch-ups. Above, we discussed various boilerplate provisions that can have some effect on the business deal as manifested in the waterfall. Two sections of the agreement, however, can have a significant impact (potentially a disastrous effect if not properly drafted), and thus, deserve special attention. These are the allocation provisions and the liquidation/dissolution provisions. If the agreement's liquidation provisions state that the liquidating distributions will be made in accordance with the partners' positive capital account balances, the ending balances of these capital accounts become extremely important and should be sufficient to cover the aggregate distributions contemplated by the waterfall. Since the allocation of profit/loss directly increases/decreases the partners' capital accounts, those provisions in turn become extremely important. They need to be drafted skillfully so that the ending balances of the capital accounts at any given time reflect the economics of the business deal...

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[2] Whether to Liquidate in Accordance with Capital Accounts
 
... As basic it may sound, the authors cannot emphasize enough that the draftsman must know what the business deal is before it decides whether to liquidate in accordance with capital accounts...


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[3] Layer-Cake or Target Allocations?
 
Assuming that, after going through the above considerations and closely examining the business deal terms, the lawyer is comfortable with the issues (including the... guaranteed payment issue) and has ultimately decided whether to liquidate in accordance with capital accounts, the second major decision is whether to use layer-cake allocations or target allocations. In fact, making the first choice independently from the second choice is meaningless since it is the two choices operating in tandem that have a bottom line effect on the partners. The lawyer may choose from the following four combinations:

 

[a] Liquidating in Accordance with Capital Accounts Plus Layer-Cake Allocations
 
This is the traditional setup for older partnership agreements. In addition, it appears that it is the approach that the IRS agent expects to see in the agreement and is called upon to look for when auditing the partnership. The significant risk of this setup is that any infirmities in the allocation provisions can upset the business deal because the liquidations are in accordance with capital accounts and the allocations directly affect the ending capital balances. One can envision the dreadful scenario of a partner expecting to receive X dollars upon retirement but having only Y dollars in his or her capital account... 

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[b] Liquidating in Accordance with Capital Accounts Plus Target Allocations
 
Target capital accounts have become a favored allocation method. Perhaps this trend may be explained by the fact that, at first glance, this method seems to eliminate the risks inherent in the first method described above, and also eliminate the need to run numerous economic scenarios through the allocation scheme, which can be time-consuming, tedious and most of all, expensive. In essence, allocations are made at the end of the year so as to put the partners' capital accounts at a level which corresponds to the business deal (i.e., the cash each partner is entitled to at each yearend)... 

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[c] Not Liquidating in Accordance with Capital Accounts Plus Layer-Cake Allocations
 
The problem here is not so much economic uncertainty as tax risk (i.e., that the allocations will not be respected). Since the agreement does not liquidate in accordance with capital accounts, the allocations must meet the economic effect equivalence test (described below) or must produce the correct result under PIP. Otherwise, the IRS has the authority to readjust the allocations in accordance with PIP. It is unclear whether the layer cake approach in conjunction with waterfall liquidations has any advantage over the target allocations approach discussed immediately below in Section 1.02[3][d] (with the possible exception of giving the client and the accountants some clear-cut guidance on how partnership items will be allocated)... 

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[d] Not Liquidating in Accordance with Capital Accounts and Target Allocations
 
This is an approach that has become quite common in recent years, yet has been criticized by several authoritative voices in the field of partnership taxation. Its use generally means that the parties intend to comply with the economic effect equivalence test, i.e., that the partners will receive the same amount they would have received had the agreement provided for liquidating distributions in accordance with capital accounts and the rest of the economic effect safe harbor were met. This approach has been criticized principally because it requires that the partnership meet this so-called "dumb but lucky" test. Nevertheless, if used diligently, this approach could offer one significant advantage over other approaches--simplicity. In recognition of the current popularity of this approach (and the controversy surrounding it), set forth below is a list of the pros and cons, as well as a list of particular issues to be aware of, when using it... 

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[e] Target Allocations and Not Liquidating in Accordance with Capital Accounts--What to Watch for 

If the business deal includes a temporary preference, be careful. The traditional approach (i.e., layer-cake allocations and liquidating in accordance with capital accounts) with a savings subparagraph may be more suitable.
 
The regulations require capital account maintenance and liquidation in accordance with capital accounts, among other requirements, in order to satisfy the nonrecourse deduction safe harbor. Some practitioners take the position that satisfaction of the economic effect equivalence test is sufficient to meet the nonrecourse deduction safe harbor. This position is difficult to understand since the regulations expressly provide that the liquidation-in-accordance-with-capital-accounts prong must be met. Nevertheless, since this issue has not been resolved by the IRS or t he courts, it may be worthwhile to meet the other requirements of the nonrecourse deduction safe harbor, such as providing for minimum gain chargebacks in order to have a tenable argument that the deduction allocations should be respected.
 
Target capital accounts should be reduced by the partner's share of minimum gain and partner nonrecourse debt minimum gain. The reason for this is that partner nonrecourse deduction minimum gain and partnership minimum gain are offset by the corresponding chargebacks under the regulations. Since these items offset under the regulations, target allocations allocating any additional income because of any minimum gain or partner minimum gain would double count that gain, and thus lead to distortions... 

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[4] Conclusion about Allocation and Liquidation Provisions
 
The foregoing discussion sets forth four principal approaches to drafting allocations and liquidation provisions. The quintessential question here is which approach is best. The logical answer seems to be that none of these approaches is correct or better than the others; the expectations of the parties and the economics of the business deal will dictate which approach is most appropriate. Each approach requires very careful thought by the drafter but, as long as the final agreement preserves the business deal and assures that the allocations will be respected, the drafter's job is done. (Of course, to the extent the agreement elevates minimization of economic risk over minimization of tax risk, the client should be informed of the specifics of the potential tax consequences). Conversely, if drafted sloppily or in a manner that does not account for the particularities of the deal, or if the tax consequences are unexpected or inadequately explained to the client, any of these approaches can lead to grief, for which the client will likely blame the drafter.