Targeted Capital Accounts: The New Standard in Partnership Operating Agreements– July 13, 2016 by Kim Palmer

Targeted capital allocations are becoming standard in new LLC or partnership operating agreements. Historically, operating agreements typically provided for income/loss allocations to the partners based on the safe harbor provided under IRC Regulation 1.704-1(b)(2). This was more of a “cash follows tax” approach, in which the operating agreement provided a calculation for the allocation of taxable income/loss and distributions were then made based on the balance of the each partner’s capital account. The Regulation provides a safe harbor for economic effect if:

1. Capital accounts of the partners are maintained under 704(b);

2. Upon liquidation of the partnership, liquidating distributions are to be made in accordance with positive capital account balances; and

3. If such partner has a deficit balance in his/her capital account following the liquidation of his/her interest in the partnership, he/she is unconditionally obligated to restore the amount of such deficit balance or the agreement provides for a “qualified income offset.”

Conversely, the targeted capital allocation language we are seeing more frequently in partnership agreements is more of a “tax follows cash” approach. With this method, the partnership makes distributions based up on the liquidation provisions of the operating agreement (usually referred to as the “waterfall”). Taxable income/loss is allocated so that, after the income/loss allocation has been made, the balance in each partner’s capital account shall, to the extent that is possible, be equal to an amount that would be distributed to the partner based on a hypothetical liquidation of the partnership. Distributions are made based on the waterfall calculation.

Note that the term “capital account” referred to in the operating agreement means the capital accounts under IRC Section 704(b) and are referred to as the “book” capital accounts. This is a fair market value concept and should not be confused with the books as maintained by the business that may or may not be on a GAAP basis. Tax capital accounts can be different than “book” capital accounts. The intention of the targeted capital allocations is that each partner’s book capital account reflects the amount that partner would receive upon liquidation of the partnership. The book capital account often does not reflect this though, because income/loss does not always reflect the appreciation/depreciation of the entity’s value.

There can also be an ongoing difference between book and tax capital accounts. These differences can be caused by a difference in the basis of the assets that were contributed to the partnership. For book purposes, assets are accounted for and depreciated based on the fair market value on the contribution date; for tax purposes, assets are based on a carryover basis concept. Or it could be that the assets of the partnership were booked up or down as a result of a revaluation event, e.g., a new partner was admitted to the partnership. There are many reasons that book and tax income/loss amounts and book and tax capital accounts may differ. Because of these differences, the allocations of both book and taxable income need to be reviewed annually, and a standard formula will not work under the targeted capital allocations approach.

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The intent of targeted capital allocations is to allocate income/loss that reflects the economic arrangements among the partners. What does this really mean for a partnership? How do taxable income and losses get allocated? It depends on a multitude of factors, including:

  • The waterfall distribution calculation, i.e., is it pro rata? Are there preferred returns to preferred members? How is capital returned and in which order?;
  • Whether the taxable loss is reflective of an economic loss;
  • Whether the taxable income is reflective of an economic gain;
  • The historic allocations of income and loss;
  • Whether there are any special allocations required under IRC Section 704(c); and
  • Whether “book” and tax both reflect a loss or income, i.e., there is “book” income but a tax loss.

We often find in working with LLCs and partnerships that the economic arrangement or value of the entity is different than the taxable income/loss calculation. For example, the entity may reflect a taxable loss for the year, possibly as a result of depreciation expense and/or interest expense, but the value of the entity is actually increasing — which can be supported by a cash flow analysis or an event that books up the capital accounts, such as admission of new units that determines value. When this happens, it is important to note that the targeted capital allocations can produce a counterintuitive allocation, so should be reviewed carefully each year.

There is no template or formula that can be applied in each and every case, so keeping your tax team involved from day one is truly critical.

Contact Kim Palmer at or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.