Partnerships (and LLCs) offer the greatest flexibility to real estate owners in designing highly complicated economic deals between the owners. Today, many real estate deals may provide preferred returns for “investor” partners or promoted interests for the developer or general partner. These economic arrangements may frequently provide a priority return on invested capital or a special allocation of income or gain to another class of partner.
The tax laws require that any allocation of income, deduction, gain or loss must have “substantial economic effect” to be respected by the IRS. In general, this means that partner capital accounts must be maintained under the rules of Section 704(b), and that upon liquidation, distributions must be made in accordance with positive capital account balances.
There are two different approaches in drafting partnership agreements. Historically, partnership agreements would focus on allocating income or loss to the partners based upon the economic arrangement and then making distributions based upon the resulting partner capital account balances. This approach, often referred to as the “safe harbor allocations”, often leads to difficulties in determining how taxable income or loss is to be allocated to the partners. This is especially true where taxable income and book income differ.
A growing trend among tax attorneys is to structure the partnership agreement under a second approach that provides for “Targeted Allocations.” Rather than focusing on how income or loss is allocated under the agreement, Targeted Allocations focus on the amount a partner would receive under the partnership agreement’s specific order of distributions in liquidation, commonly referred to as the distribution waterfall.
The partnership allocations are then drafted to force income or loss over the life of the partnership to be allocated in accordance with the waterfall distribution. This forced income or loss allocation causes the partners’ capital account balances to equal the distribution to be received under the partnership agreement as if all of the partnership assets were sold for their book value.
Several reasons exist for the shift in approach in drafting partnership agreements. First, the Targeted Allocation approach is generally easier, as it is drafted in language that describes the economic deal in a manner understood by the client. Second, the Targeted Allocations frequently reduce the risk of mistakes in the allocations that could ultimately distort the desired economic deal. In any event, it is important to be working with a drafter of the agreement and tax return preparer that understands the economic deal, the tax laws and how to apply the partnership allocation provisions.