May 20, 2009

Target Capital Account Allocations: The Latest Trend for LLCs

A new term is finding its way into more and more LLC agreements: "target capital accounts." This article discusses why yet another defined term is being introduced and when it might be appropriate. The discussion is directed to LLCs, but is equally applicable to any other entity treated as a partnership for tax purposes.

Profits and Losses Can Be Subject to IRS Reallocation

LLC members are free to negotiate their economic deal, including any system of contributions and distributions. Sometimes members also want to negotiate the tax consequences of that economic deal, i.e., how the LLC's taxable profits and losses each year will be allocated among the members. The problem arises when the agreement with respect to LLC distributions (i.e., who receives the money) conflicts with the agreement with respect to LLC allocations (i.e., who receives the Form K-1 and pays taxes on the profits or deducts the losses).

LLCs treated as partnerships for tax purposes are not taxed. Instead, the LLC members include their allocable share of the LLC's profits or losses on their individual returns.

Section 704 of the Internal Revenue Code—the key provision governing LLC allocations—provides a general rule that partners may provide in their agreement how the partnership's profits and losses will be allocated among the partners. This general rule is tempered by a requirement that the agreed-upon allocations must have "substantial economic effect." If the allocations provided in the agreement lack substantial economic effect, the IRS may reallocate the profits and losses among the partners based on each "partner's "interest in the partnership (determined by taking into account all facts and circumstances)." Because this is such an amorphous standard, most LLCs try to satisfy the substantial economic effect test, thereby precluding the IRS from reallocating the LLC's profits and losses on audit.

Regulations Define Substantial Economic Effect

Because so many LLCs attempt to satisfy the substantial economic effect test, there are extensive Treasury regulations defining exactly what is meant by the term "substantial economic effect." The premise behind these regulations is simple—if a partnership agreement allocates profits or losses to a partner, sooner or later that allocation must have some economic impact on the partner.

Consider the following example: A and B form a 50-50 LLC with each contributing equal amounts of cash. They agree that all distributions from the LLC, both operating and liquidating, will be shared equally. However, the A/B LLC agreement provides that all LLC profits and losses will be allocated to A. Few would suggest that this special allocation of profits and losses should be respected for tax purposes. Even though A and B may have signed an LLC agreement that provides for a disproportionate allocation to A of all profits and losses, the allocation they have described lacks substance. A and B share distributions on a 50-50 basis, and they each should report half of the LLC profits and losses.

The regulations combat this and much more subtle abuses with three key requirements that must be satisfied for agreed-upon allocations to have "substantial economic effect:"

1. Capital accounts must be maintained in accordance with an intricate set of requirements.

2. Liquidating distributions must be based on capital account balances.

3. Partners with a deficit balance at liquidation must be obligated to restore that deficit balance.

Many LLCs Struggle With Requirements

Most LLCs will fail the third requirement—there won't be a deficit restoration obligation. This is where much of the complexity arises. Allocations will still be treated as meeting the third requirement as long as the agreement contains an intricate set of provisions designed primarily to deal with deficit capital account balances. This is what generates terms like "qualified income offsets" and "minimum gain chargebacks." As long as the members are willing to accept the complexity generated when these provisions are included in the agreement, the third requirement can be satisfied without an actual deficit restoration obligation.

But many LLCs struggle with the second requirement, too, i.e., the obligation to liquidate in accordance with capital account balances. While this requirement is central to the IRS goal of having the allocations mean something economically, taxpayers are rightfully concerned about all the tax accounting behind the maintenance of the capital accounts and all the detailed cross references to the regulations with the indecipherable defined terms. If those tax accounting provisions somehow produce the wrong capital account balances, liquidating in accordance with those capital account balances will not reflect the business deal.

Allocation Provisions Drafted to Maintain Business Deal

The historical way of dealing with this tension is to spend a great deal of time drafting allocation provisions in an effort to ensure that in any conceivable combination of profits, losses, distributions, capital account restatements, etc., the allocation provisions always produce the right capital account balances.

Allocation provisions like this are sometimes referred to as "layer cake" allocations because they provide for multiple tiers of allocations, such as "first, to the members to offset all prior loss allocations; second, to the preferred members until their capital accounts equal their unreturned contributions; third, to the preferred members until they receive their preferred return; fourth, to the common members" and on and on.

These days, LLCs are often used for ventures that, it is hoped, will make money rather than lose it. The members aren't particularly concerned about the allocations of profits and losses. If there are tax consequences that go with a particular business deal, so be it. The members are concerned about absolutely maintaining their business deal, and they aren't interested about any possibility, however remote, that the capital account balances might not be in accordance with the business deal.

In response to members in this latter setting, the current trend among tax practitioners is to dispense with the "layer cake" allocations entirely. Instead, the LLC agreement contains a rather simple "target capital account" provision that reads something like this:

LLC profits and losses will be allocated among the members in whatever manner is necessary to cause their respective capital accounts to be equal to the amount the members would receive if the LLC sold all its assets for book value and liquidated.

This arbitrary allocation of profits and losses is intended to force the capital accounts to line up with the agreed business deal.

IRS Silent Thus Far on Target Capital Account Allocations

The regulations are drafted from the perspective that capital accounts will drive the economics. The target capital account allocation approach turns this backwards and instead provides that the economics drive the capital accounts. This makes using target capital accounts challenging. The regulations contain a detailed system for allocating profits and losses that will be respected by the IRS. However, instead of using that system, the practitioner is intentionally doing something very different.

Does it work? Maybe. The IRS hasn't said whether it will treat a target capital account provision like this as meeting the substantial economic effect test.

Given that the provisions are somewhat new, it is difficult to glean much from the IRS silence. Some practitioners argue that the IRS should respect the provision, while others disagree. At this stage of the game, it will be difficult for advisors to give clients comfort that the IRS will respect allocations under a target capital account approach. However, even if the IRS disregards the provision, the Code requires that the allocations be in accordance with the amorphous "interest in the partnership" test.

Proponents of target capital account allocations argue that entitlement to liquidating distributions is certainly strong evidence of what a partner's "interest in the partnership" should be even if the IRS chooses to disregard the drafted allocations.

Even if the IRS ultimately rejects the target capital account approach, the principal downside appears to be that in response to an IRS audit, the LLC might need to construct a more eloquent version of "I may not have done it right, but I still got the right answer."

Target Capital Account Provisions Not Appropriate in Every Situation

Target capital account provisions aren't the optimal solution in every case. Among the situations in which target capital account provisions are not appropriate are the following:

Significant front-end losses. If the LLC anticipates generating losses that will cause negative capital accounts, even a target capital account provision needs to contain a host of complex provisions about how to calculate and allocate the appropriate amounts to the members. This will frustrate the goal of eliminating many of the complex references to the regulations. Moreover, in this setting the members may well be concerned about making sure that the losses that have been allocated to them under the LLC agreement won't be reallocated by the IRS to anyone else.

Simple deals. If the LLC has a very simple contribution/distribution system in which all distributions are shared strictly in proportion to contributed capital, there may be no need to introduce any doubt into the validity of the agreed allocations.

Varying distribution systems. If the LLC has one distribution mechanism for operating distributions and a second distribution mechanism for liquidating distributions, the target capital account allocations will default to the liquidation mechanism, even though liquidation may not occur for some time.

Large LLCs. If the LLC has a large number of members, any challenge to the Form K-1s would present a substantial administrative burden that needs to be avoided.

Tax-exempt members. If the LLC has any tax-exempt members that are concerned about complying with Code Section 514(c)(9)(E), the target capital account approach probably doesn't satisfy the "fractions rule" contained there.

Use of Target Capital Accounts Becoming the Norm

Notwithstanding these limits, in many situations target capital account allocations represent a reasonable alternative to the "layer cake" approach. Particularly in complex economic settings or those in which the business itself is not predictable, target capital account allocations are often preferable to "layer cake" allocations because of the difficulty the practitioner will have in anticipating all possible permutations of the business arrangement.

Target capital accounts have been around for quite awhile, but are now becoming the norm rather than the exception. If an LLC is uncomfortable with the risk that liquidating based on capital account balances might produce the wrong economic result, using target capital accounts in the allocation section of the agreement is often a reasonable alternative.

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