Making Sense of Special Tax Allocations
by John Eliason
Nothing causes a non-tax lawyer’s eyes to glaze over like the special tax allocation provisions included in most limited partnership (and limited liability company) agreements. However, because these special provisions may alter the bargained-for economic agreement of the partners, transactional attorneys should acquire a basic understanding of the purpose and impact of these provisions as opposed to dismissing them as “boilerplate.”
Special allocation provisions exist to satisfy certain requirements of the partnership regulations promulgated under the Internal Revenue Code. Specifically, while the Code provides flexibility in allowing partners to divide income and loss in any manner they choose, the IRS will not respect an allocation if it does not have “substantial economic effect.” This means that such allocations must be made to the partners who enjoy the benefit of the income or bear the economic burden associated with the loss.
If the IRS determines that an allocation does not have substantial economic effect, it will reallocate such income or loss to reflect what the IRS believes is appropriate considering the partner’s interest in the partnership. The uncertainty as to how the IRS will make this reallocation underscores the importance of satisfying this condition.
For businesses structured as limited partnerships (or limited liability companies), limited partners generally will not have any personal liability for the partnership’s obligations. While attractive to limited partners, limited liability results in some allocations possibly not having substantial economic effect. However, rather than disregarding the allocation provisions in limited partnership agreements altogether, the partnership regulations provide a safe harbor that is satisfied if the partnership agreement includes the following special allocation provisions:
Distribution-Triggered Special Allocations: These provisions ensure that a partner does not receive distributions in excess of the partner’s economic interest in the partnership by allocating income and gain to such partner to offset any excess distribution:
· Qualified Income Offset (QIO): A QIO ensures that certain unexpected allocations or distributions that cause a partner’s “capital account” (a measure of the partner’s economic interest in the partnership) to be reduced to a level in excess of the amount the partner is required to restore (i.e., causing a deficit balance) will not cause the allocation to lack substantial economic effect. The QIO accomplishes this by requiring a special allocation of income and gain to the partner in an amount sufficient to eliminate that deficit balance as quickly as possible.
· Gross Income Allocation (GIA): Similar to a QIO, a GIA deals with expected and unexpected distributions not covered by the QIO. The GIA requires a special allocation of income and gain to a partner with a deficit capital account balance at the end of the year to eliminate such deficit balance as quickly as possible.
Non-Recourse Debt Allocations: These provisions ensure that allocations of deductions and other losses associated with non-recourse debt-financed property have substantial economic effect:
· Minimum Gain Chargeback (MGC): For partners that are allocated deductions or receive distributions associated with non-recourse debt-financed property, a MGC requires a special allocation of income and gain to such partners equal to the increase in “minimum gain” associated with such property. “Minimum gain” is the amount by which the non-recourse debt at issue exceeds the sum of the partnership’s adjusted basis in the property plus distributions that are made from non-recourse debt proceeds.
· Partner Non-Recourse Loss Allocations: If a partnership has non-recourse liabilities with respect to which a partner or a related person bears the ultimate economic risk of loss–for example, because the person is the creditor or guarantor with respect to such liability–this provision requires losses or other deductions attributable to such liabilities to be allocated to the partner(s) that bears such economic risk of loss.
· Partner Minimum Gain Chargeback (PMGC):Similar to a MGC, a PMGC deals only with non-recourse liabilities in which a partner or a related person bears the economic risk of loss. A PMGC requires any minimum gain associated with such liability to be specially allocated to those partners that had been previously allocated deductions or losses attributable to such liabilities.
While partnership agreements may include additional special allocation provisions to deal with particular tax situations (for example, if a partner has contributed appreciated property to the partnership), the provisions described above are the most common and arguably the most important ones encountered in a partnership agreement. As such, by gaining a basic understanding of these provisions, non-tax lawyers can better understand and explain the purpose of these tax provisions to their clients.
John Eliason, a partner in Gardere Wynne Sewell LLP, specializes in partnership structuring and tax matters. He can be reached at firstname.lastname@example.org.