Hamill: Partnerships are booming but their tax rules are not simple

A partnership is the fastest-growing form of operating a business in America. Partnerships offer much flexibility in tax reporting.

The most significant element of this flexibility is the partners’ ability to agree on how they will share the profit and loss.

Partners must report their share of income or loss each year without regard to any distribution made by the partnership.

But the partners may agree to share the income in ways that are different than their ownership of capital.

We see three types of partnership allocations. In a market like Albuquerque, the most common form is “straight-up” allocations.

This means that if three people each contribute one-third of the capital, they agree to share all items, income, loss, and distributions, one-third each.

Straight-up allocations present no tax issues. The partners’ agreement could be verbal. It could be on an envelope.

The IRS would have no reason to challenge straight-up allocations. Any attempted challenge would not be successful.

We also see “special” allocations. This means that the partners’ percentage shares of capital, income, loss or distributions are not the same.

Since we “allocate” only profit and loss, a special allocation means the shares of income or loss are not proportionate to capital.

Now things are getting tricky. The tax law requires that the tax allocation matches the economics of the partners’ arrangement.

This means that tax income is allocated to the partner(s) who enjoy the economic benefits associated with that income.

Similarly, tax losses are allocated to the partner(s) who suffer the economic detriments associated with those losses.

The tax regulations provide a “safe harbor” that protects the integrity of special tax allocations. It requires specific language in the partnership agreement.

Distribution “waterfalls” create special problems. Waterfalls form as water flows over rocks, and different degrees of erosion create layers of water falling into a pool.

A “distribution waterfall” then means that the distributions to the partners change based on specific factors in the agreement.

Perhaps one partner gets his money back first. Perhaps the distributions follow one percentage until certain success targets are achieved. Things then change.

Some agreements have multiple layers in their waterfall. It is not difficult to write an agreement that spells out the terms of the waterfall.

The problem arises with the special allocation safe harbor. It requires that when a partner leaves the partnership, he gets what is in his capital account.

This capital account has specific rules spelled out in the regulations. It can be tricky to draft an agreement that satisfies the distribution waterfall and the allocation safe harbor.

The waterfall itself is easy to draft. But it cannot stand by itself when the agreement includes the safe harbor requirement that each partner get what is in his capital account.

The distribution waterfall clause matched with the liquidate-by-capital creates a complex “layer cake” allocation clause when the partnership liquidates.

The common way to bring the distribution and allocation clauses in line is with what is called a “target” allocation clause.

First, the distribution clause, with all its waterfall layers, is drafted. Again, not a problem to do.

The allocation clause is written next. It says each year’s allocation will be what is needed to create a capital account matching a “hypothetical” distribution.

Hypothetical? Yes, because the intent is to ultimately match the partners’ capital balances to the distributions that they ultimately receive.

That is, the match occurs when the partnership has concluded its business and actually liquidated. We then “settle up” allocations and distributions.

The problem is that income or loss must be allocated each year. Distributions need not be made each year.

So, each year’s allocation must be made as if the partnership is liquidated at the end of that year. Hence, “hypothetical” distributions match hypothetical capital.

Each year’s actual income or loss is used to match hypothetical capital to hypothetical distributions. In the end, actual distributions match actual capital.

The target allocation clause must result in tax and economics matching each year. There is no protection of a safe harbor.

Do you and your friend want to form a partnership where each contributes the same amount, and you share distributions, income and loss equally?

A cocktail napkin will suffice for your allocation clause. Do you want a distribution waterfall instead? Then buckle up and hire someone who really knows what they are doing.