Several Thoughts on Drafting Target Allocation Provisions

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Several Thoughts on Drafting Target

Allocation Provisions

Terence Floyd Cuff Loeb & Loeb LLP Los Angeles, California

The task of drafting partnership agreements3_{– and particularly target allocations – is} to be as clear and understandable as the delightful text of Moo, Baa, La La La! Partnership agreements – particularly allocations in partnership agreements – much too often lack the clarity of a young children’s book. The result too often is that advisors must puzzle over what the partnership agreement or partnership allocations mean. This too often results in matters going awry. The situation sometimes resembles the results of a children’s rhyme about a Mr. Humpty Dumpty.

Many lawyers find drafting partnership allocations unappealing. The task can be complicated and time consuming. Opportunity abounds for making costly errors. Clients do not appreciate the delicacy of the drafting process. Clients do not understand why the work should be so expensive. Many lawyers look for ways to simplify the drafting. Shortcuts too often have inconvenient results.

Several competing models of drafting partnership allocations of income, gain, loss, and deduction have evolved.

One model of drafting partnership allocations of income, gain, loss, and deduction specifies allocations of income and loss items. This model of allocations credits these items to or debits these items fro m partners’ capital accounts. This model distributes the cash proceeds of the liquidation of the partnership in accordance with capital accounts so determined.

Another model of drafting partnership allocations of income, gain, loss, and deduction specifies how cash will be distributed from operations and in liquidation of the partnership. This model then allocates income and loss items to partners’ capital accounts so that these capital accounts will conform to the cash distribution scheme in liquidation.

1_{Sandra Boynton, Moo, Baa, La La La! (Little Simon 1982).} 2_Id.

3_{This article arbitrarily will mix the terms “partnership”, “limited liability company”, and}

“LLC”. It also will mix the terms “partner” and “member.” A limited liability company normally is taxed as a partnership unless the entity elects to be taxed as a corporation.

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A third model of drafting partnership allocations of income, gain, loss, and deduction might allocate income and loss items in accordance with percentages and similarly distributes cash from operations and cash from liquidation in accordance with the same percentages.

A fourth model of partnership allocations of income, gain, loss, and deduction simply allocates income and loss items in accordance with partners’ interests in the partnership.

A fifth model might specify how cash is distributed from partnership operations and in liquidation of the partnership and say absolutely nothing about how tax items of income, gain, loss, and deduction are allocated.

This Article concerns the second model of partnership allocations of income, gain, loss, and deduction. This model is commonly is referred to as “target allocations.” This model of allocations of income, gain, loss, and deduction is not necessarily superior to or inferior to the other models. Target allocations currently are the rage with many draftsmen. Target allocations are the rage with draftsmen whether they much understand how their target allocation provisions work or not.

Key characteristics of “target allocations” are:

• the partnership does not explicitly liquidate in accordance with capital accounts but rather liquidates in accordance with stated percentages, explicit tiers, etc., that do not depend explicitly on capital account balances, and • allocations of income and loss items are made in such a manner that capital accounts are adjusted to be consistent with the plan for liquidating distributions of cash.

A target allocation provision might –

• first, determine how the partnership would distribute cash on a hypothetical liquidation and

• then, allocate income, gain, loss, and deduction (based on a hypothetical sale of all assets at “book” value) to adjust capital accounts so that they equal the amount of cash that the partnership would distribute to a partner on a hypothetical liquidation.

This Article seeks to explore issues in drafting target allocation provisions by examining a variety of target allocation provisions. These target allocation provisions do not reflect an approved form. No format for partnership allocations of income, gain, loss, and deduction is “best” or “proper” or “right.”4

4_{The tax laws will not respect some ways to draft partnership allocations of income, gain,}

loss, and deduction. The tax laws will not respect allocations of income, gain, loss, and deduction if the allocations fail to have substantial economic effect, do not satisfy the alternate test of economic effect, do not satisfy the economic effect equivalence test, and are not in accordance with partners’ interests in the partnership.

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This Article will not provide advisors with the perfect target allocation provision. No single target allocation provision is “perfect” or appropriate for all circumstances. Every advisor using a target allocation provision should use a target allocation provision that he himself has drafted, that he understands, and that he judges appropriate for the circumstances of a particular partnership agreement. Also, advisors should recognize that the state of knowledge of drafting target allocation provisions is dynamic as advisors are increasingly informed by experience. These clauses are net yet perfect. These clauses will improve as the tax law matures.

This Article is not a template for paper dolls to enable the reader to cut and paste from its examples of target allocation provisions. Examples in this Article are designed to help to guide the reader better to understand target allocation provisions, to refine them, to improve them, and ultimately to forge a target allocation provision much better than anything in this Article. This is a participatory exercise.

Do not cut and paste form language from this Article – or from any other Article – without fully understanding the language and judging that the language is appropriate to your circumstances.

There is peril in cutting and pasting language that comes across your desk from other firms’ partnership agreements. Target allocation provisions in many partnership agreements – even agreements drafted by large, prestigious law firms with offices high up in tall buildings – often are deficient. Target allocation provisions are complex and difficult to draft. Target allocation provisions also are provisional on current knowledge. That are not static. They improve with further thought and greater knowledge and experience.

The function of this Article is to help advisors better to understand some of the considerations in drafting a target allocation provision. Equipped with that understanding, advisors should be able to draft a better target allocation provision themselves.

Treasury and the Internal Revenue Service drafted Treasury Regulations concerning partnership allocations5_{(“Allocation Regulations”) and regulations concerning allocations} of deductions attributable to nonrecourse debt6_{(“Nonrecourse Deduction Regulations”)} prior to prevalence of target allocation provisions. This time was prior to prevalence of limited liability companies. Neither the Allocation Regulations nor the Nonrecourse Deduction Regulations expressly address target allocation provisions.

The failure of the Allocation Regulations and Nonrecourse Deduction Regulations expressly to consider the tax effects of limited liability companies leaves considerable doubt concerning the status of target allocation provisions under these two regulations. Nonrecourse deductions create special issues (discussed below) when a partnership uses a target allocation provision. A special allocation of nonrecourse deductions outside of the target allocation provision may not qualify under the Nonrecourse Deduction Regulations.

5_{Treas. Reg. § 1.704-1.} 6_{Treas. Reg. § 1.704-2.}

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An allocation of nonrecourse deductions under the target allocation provision may not qualify under the Nonrecourse Deduction Regulations.

The prevalence of target allocation provisions and their tax uncertainty suggests that the Internal Revenue Service should make advice on target allocation provisions a high priority. A good case can be made that target allocation provisions generally should be approved for tax purposes, provided that anyone can decide how properly to draft target allocation provisions.

1. Simplicity.

The perceived simplicity of the target allocation provision is considerably overstated. Target allocation provisions can be complex when one considers the complexity of all of the relevant definitions. Drafting a compliant target allocation provision can be every bit as difficult as drafting “layer” cake allocations.

Draftsmen often do not understand the target allocation provisions that they use in their partnership agreements. This can lead to inconvenient results.

The target allocation provision can ask demanding theoretical questions of tax law that are not currently properly resolved.

A draftsman of a partnership agreement can elect to say nothing about partnership allocations of income, gain, loss, and deduction. No law says that the partnership agreement must specify how to allocate items of income, gain, loss, and deduction. The tax laws will allocate items of income, gain, loss, and deduction in accordance with partners’ interests in the partnership if the partnership agreement does not allocate these items in accordance with the Allocation Regulations.

A draftsman perhaps may do as good a job in drafting a partnership agreement by merely describing the cash distribution scheme and accepting the standard of “in accordance with partners’ interests in the partnership” as he would by drafting a target allocation provision. A simple allocation provision might read:

Clause 1. The partnership shall allocate all items of income, gain, loss, and deduction for federal, state, and local income tax purposes in accordance with partners’ interests in the partnership.

Consider using the somewhat amorphous general standard of “in accordance with partners’ interests in the partnership” rather than a form target allocation provision that may not work well and that you do not understand. This scheme is superior to using a complex target allocation provision that you do not understand. The draftsman who uses a target allocation provision that he does not understand invites danger.

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Clause 2. The partnership shall allocate all items of income, gain, loss, and deduction for federal, state, and local income tax purposes 50 percent to partner A and 50% to partner B.

Allocation provisions that liquidate by capital account in appropriate circumstances can be shorter, simpler, and more understandable than target allocation provisions (particularly when one includes the cumbersome definitions that accompany some target allocation provisions). Allocation provisions that liquidate by capital account sometimes can reflect the economic deal more accurately than badly drafted provisions that explicitly state the liquidation scheme without reference to partners’ capital accounts. These allocation provisions do risk getting allocations wrong, with the result that the liquidating distribution scheme may not accord with the partners’ deal. This can produce some embarrassment.

Perhaps the majority of draftsmen of partnership and LLC agreements perceive that the best approach is to use target allocation provisions in drafting allocations of income, gain, loss, and deduction in a broad range of situations. This Article addresses drafting those target allocation provisions.

The tax field has not produced a commonly accepted standard model for drafting target allocation provisions. Some reader of this Article perhaps will draft the new standard target allocation provision. Draftsmen should consider principles discussed in this Article in drafting their target allocation provisions. The perfect target allocation provision is a work in progress. Do not imagine that any provision presented in this Article is the “perfect” target allocation provision. That “perfect” target allocation provision still is to be drafted. The reader may correct that deficiency.

2. Considerations for Target Allocation Provisions.

These are useful issues to consider in drafting a target allocation provision for a partnership agreement:

• Take into account the difference between allocations of “book” items and allocations of tax items. (“Book” items are items of income, gain, loss, and deduction that directly adjust capital accounts computed under the principles of Section 1.704-1(b)(2)(iv).)

• Take into account latent effects of future allocations under the minimum gain chargeback and partner minimum gain chargeback.

• Have a separate minimum gain chargeback, partner minimum gain chargeback, and perhaps a qualified income offset.

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• Carve out partner nonrecourse deductions and do not allocate them under the target allocation provision.7

• Possibly carve out nonrecourse deductions and do not allocate them under the target allocation provision.

• Possibly carve out exculpatory deductions and do not allocate them under the target allocation provision.8

• Exclude specially allocated items from the definitions of “Net Profits” and “Net Losses” if the target allocation provision allocates Net Profits and Net Losses.9

• Consider allocating items of gross income and items of gross loss under the target allocation provision rather than items of net income and items of net loss.

• Make the target allocation provision flexible enough to address “book”-up adjustments.

• Consider situations in which there are not sufficient income items so that the target allocation provision can equalize hypothetical capital accounts and target capital accounts.

7_{The draftsman perhaps also should carve out and specially allocate income that reverses}

exculpatory deductions and specially allocate these items.

8_{See T.D. 8385, 56 Fed. Reg. 66978-66995 (December 27, 1991) (“A partnership may have}

a liability that is not secured by any specific property and that is recourse to the partnership as an entity, but explicitly not recourse to any partner (exculpatory liability). Section 1.704-2(b)(3) of the final regulations defines nonrecourse liability by referring to the definition of nonrecourse liability in the regulations under section 752. Under that definition, an exculpatory liability is a nonrecourse liability. The application of the nonrecourse debt rules of section 1.704-2 – more specifically, the calculation of minimum gain – may be difficult in the case of an exculpatory liability, however, because the liability is not secured by specific property and the bases of partnership properties that can be reached to the lender in the case of an exculpatory liability may fluctuate greatly. Section 1.704-2 does not prescribe precise rules addressing the allocation of income and loss attributable to exculpatory liabilities. Taxpayers, therefore, are left to treat allocations attributable to these liabilities in a manner that reasonably reflects the principles of section 704(b). Commentators have requested that the treatment of allocations attributable to exculpatory liabilities under the nonrecourse debt rules be clarified. The Service and the Treasury solicit further suggestions on the appropriate treatment of allocations attributable to these liabilities. Suggestions should take into account the practical concerns of partnerships as well as the Service’s concerns about the proper allocation of loss and gain items attributable to these liabilities.”).

9_{If the draftsman carves out and specially allocates exculpatory deductions and income that}

reverses exculpatory deductions, these items should be excluded from the definition of Net Profits and Net Losses and should not be allocated under the target allocation provision.

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• Consider the effects of minimum gain and partner minimum gain on the target capital account.

• Consider the effects of obligations of partners to make future capital contributions to the partnership on the target allocation provision.

3. Drafting the Target Allocation Provision.

Consider this example.

Example 1. Ephriam, Balthasar, and Mordechia form Gilgamesh Investments, LLC, a real estate investment limited liability company. Each has a 1/3rd_{interest in profits and}

losses. This is the initial balance sheet of Gilgamesh (entries at “AB” are at adjusted tax basis):

AB Assets

Cash $3,000,000 Total Assets $3,000,000

Liabilities & Capital

Nonrecourse Liabilities $0 Capital Ephriam $1,000,000 Capital Balthasar $1,000,000 Capital Mordechia $1,000,000 Total Liabilities & Capital $3,000,000

The task is to draft allocations in the Gilgamesh limited liability company agreement. The limited liability company agreement could say something like Clause 3:

Clause 3. All items of income, gain, loss, and deduction for tax purposes are

allocated 1/3rd_{to each member.}

Clause 3 might be a satisfactory scheme of allocations of income, gain, loss, and deduction. This is an article about target allocation provisions. This formulation will not do at all for our current purposes.

Another approach would be to draft:

Clause 4. All items of income, gain, loss, and deduction for tax purposes are allocated among the members in accordance with partners’ interests in the partnership.

Clause 4 is technically accurate. The partnership accountants may be disappointed that Clause 4 provides them with little guidance concerning how to complete the partnership’s tax return. Whatever the case, Clause 4 is not a target allocation provision.

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An impatient reader can use Clause 4 in drafting partnership and LLC agreements. He can be absolutely legally correct. He can read this Article no further. He perhaps use can his time more productively reading Moo, Baa, La La La!10_{or Goodnight Moon}11_{or Make Way} for Ducklings12_{or perhaps Where the Wild Things Are}13_{to his children.}

Consider: what am I allocating under the target allocation provision? This is a nontrivial question. A range of possibilities exists.

Target allocation provisions often allocate net taxable income or net taxable loss of the partnership. A draftsman might draft a simple target allocation provision like this:

Clause 5. The Company shall allocate all of its net taxable income or net taxable loss (as the case may be) in such a manner that (after these allocations have been made) each Member’s Capital Account shall be equal to (to the extent possible) the hypothetical amount that the Company would distribute to this Member if the Company sold all of its assets for their adjusted tax bases (or, for the amount of nonrecourse liabilities secured by these assets, if nonrecourse liabilities exceed adjusted tax basis), first applied the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company’s method of accounting), and then distributed the remaining net proceeds of this sale in accordance with Section y.y [the liquidating distribution provision].

Clause 5 does not handle partner nonrecourse deductions satisfactorily. Clause 5

will fail if the partnership has partner nonrecourse deductions. The partnership agreement should allocate partner nonrecourse deductions to the partner who bears the economic risk of loss of these deductions. The clause needs to be modified on account of latent minimum gain and partner minimum gain. Clause 5 also should account for the possibility that a partner has an unconditional obligation to make capital contributions to the partnership.

Clause 5 does not perform well when the partnership has nontaxable income, such as tax-exempt interest. Clause 5 may not perform satisfactorily when the partnership prefers profit distributions to one partner to return-of-capital distributions to another partner. Clause 5

does not define “nonrecourse liabilities.” The term “nonrecourse liabilities” requires definition. “Nonrecourse liabilities” means different things in different contexts. The Nonrecourse Deduction Regulations allocate partner nonrecourse deductions to the partner who bears the economic risk of loss.

10_{Sandra Boynton, Moo, Baa, La La La! (Little Simon 1982).}

11_{Margaret Wise Brown & Clement Hurd, Goodnight Moon (Harper 1947).} 12_{Robert McCloskey, Make Way for Ducklings (Viking 1941).}

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The partnership computes net taxable income or net taxable loss for the year. The partnership looks at tax capital accounts at the end of the year but before income or loss allocations at the end of each year.

Assume that the partnership has $50,000 in net taxable income for the year. Assume that the partnership has this balance sheet at the beginning of the year:

AB at Beginning of Year Assets Cash $3,000,000 Total Assets $3,000,000

Nonrecourse Liabilities $0

Capital Ephriam $1,000,000

Capital Balthasar $1,000,000 Capital Mordechia $1,000,000

Total Capital $3,000,000

This spreadsheet shows the allocation of the $50,000 in net taxable income under

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11 LA1861863.1 913040-00004 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Target Capital Account – Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Assets Cash $3,000,000 $50,000 $3,050,000 $3,050,000 Total Assets $3,000,000 $3,050,000 $3,050,000

Nonrecourse Liabilities $0 $0 $0

Capital Ephriam $1,000,000 $1,000,000 $1,016,667 $16,667 $1,016,667

Capital Balthasar $1,000,000 $1,000,000 $1,016,667 $16,667 $1,016,667

Capital Mordechia $1,000,000 $1,000,000 $1,016,667 $16,667 $1,016,667

Total Capital $3,000,000 $3,000,000 $3,050,000 $3,050,000

Total Liabilities & Capital $3,000,000 $3,000,000 $3,050,000

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The partnership looks at hypothetical capital accounts at the end of the year immediately before the allocation of net taxable income under the target allocation provision. The partnership has $50,000 in net taxable income to allocate. The partnership has $3,050,000 in net assets based on a sale of assets at “book” value. The partnership looks to the partnership agreement and determines how the partnership would distribute cash on a constructive liquidation. The partnership agreement allocates net taxable income to the partners in such a way that those hypothetical capital accounts (after the allocation under the target allocation provision) will equal the cash distributions that the partners would have received on liquidation (target capital accounts).

The partnership might have had a net taxable loss rather than net taxable income. Assume that the same partnership suffered a $30,000 net taxable loss rather than earned $50,000 in net taxable income. The partnership has the same beginning of the year balance sheet.

This spreadsheet shows the allocation of the $30,000 in net taxable loss under Clause 5:

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13 LA1861863.1 913040-00004 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Target Capital Account – Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Assets Cash $3,000,000 ($30,000) $2,970,000 $2,970,000 Total Assets $3,000,000 $2,970,000 $2,970,000

Liabilities & Capital

Nonrecourse Liabilities $0 $0 $0

Capital Ephriam $1,000,000 $1,000,000 $990,000 ($10,000) $990,000

Capital Balthasar $1,000,000 $1,000,000 $990,000 ($10,000) $990,000

Capital Mordechia $1,000,000 $1,000,000 $990,000 ($10,000) $990,000

Total Capital $3,000,000 $3,000,000 $2,970,000 $2,970,000

Total Liabilities & Capital $3,000,000 $3,000,000 $2,970,000 $2,970,000

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The partnership looks at hypothetical capital accounts at the end of the year immediately before the allocation of net taxable loss. The partnership has $30,000 in net taxable loss to allocate. The partnership has $2,970,000 in net assets based on a sale of assets at “book” value. The partnership looks to the partnership agreement. The partnership determines how the partnership would distribute the $2,970,000 in cash on a constructive liquidation. Net taxable loss is allocated to the partners in order that hypothetical capital accounts after the allocation under the target allocation provision will equal the distributions that the partners would have received on liquidation.

The partnership might have nonrecourse liabilities in excess of adjusted tax basis. The partnership might have this balance sheet (with the nonrecourse liability secured by the real estate) at the beginning of the year:

AB at Beginning of Year Assets Cash $600,000 Equipment $1,200,000 Real Estate $4,500,000 Total Assets $6,300,000

Nonrecourse Liabilities $6,200,000

Capital Ephriam $33,333

Capital Balthasar $33,333

Capital Mordechia $33,333

Total Capital $100,000

Total Liabilities & Capital $6,300,000

The partnership has $327,000 in net taxable income to allocate for the fiscal year. This spreadsheet shows the allocation of the income for the fiscal year:

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15 LA1861863.1 913040-00004 AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Hypothetical Adjustment to Capital Accounts from Nonrecourse Liabilities Over Basis (Minimum Gain) Capital Accounts After Nonrecourse over Basis (Minimum Gain) Adjustment But Before Income Allocation Target Capital Account – Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Assets Cash $600,000 $327,000 $927,000 $2,127,000 Equipment $1,200,000 $1,200,000 Real Estate $4,500,000 $4,500,000 Total Assets $6,300,000 $6,627,000 $2,127,000

Nonrecourse Liabilities $6,200,000 $6,200,000 $0 Capital Ephriam $33,333 $33,333 $566,667 $600,000 $709,000 $109,000 $709,000 Capital Balthasar $33,333 $33,333 $566,667 $600,000 $709,000 $109,000 $709,000 Capital Mordechia $33,333 $33,333 $566,667 $600,000 $709,000 $109,000 $709,000 Total Capital $100,000 $100,000 $1,800,000 $2,127,000 $327,000 $2,127,000 Total Liabilities & Capital $6,300,000 $6,300,000 $1,800,000 $2,127,000

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AB at Beginning of Year Net Taxable Income Earned During Year Cash Earned During Year AB at End of Year Before Any Allocations Hypothetical Adjustment to Capital Accounts from Nonrecourse Liabilities Over Basis (Minimum Gain) Capital Accounts After Nonrecourse over Basis (Minimum Gain) Adjustment But Before Income Allocation Target Capital Account – Amount Partner Would Receive on Liquidation Income (Loss) Allocation to Partner Hypothetical Capital Account After Income (Loss) Allocation Total Unallocated Income $327,000 $327,000 Total Cash Earnings $327,000 Nonrecourse Liabilities Over Tax Basis $1,700,000

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The first column of numbers shows the starting balance sheet.

The second and third columns of numbers, respectively, show net taxable income for the year and increases in cash holdings for the year. (The schedule and partnership operations have been simplified.) The partnership earned $327,000 in income and increased its cash holdings by $327,000.

The fourth column of numbers shows the closing balance sheet prior to allocation of the $327,000 in net taxable income.

The fifth column of numbers hypothetically allocates the latent gain from nonrecourse liabilities over tax basis to the partners (which is the only gain that the partnership would recognize if the partnership disposed of all assets in the hypothec sale at adjusted tax basis) to closing hypothetical capital accounts (pre-operating income allocation).

The sixth column of numbers hypothetically increases the partners’ hypothetical capital accounts on account of the latent gain from nonrecourse liabilities over tax basis.

The seventh column of numbers shows the target capital accounts (the amount that each partner would receive on the hypothetical sale and liquidation).

The eighth column of numbers shows the allocation of net taxable income among the partners so that the income allocation would increase hypothetical capital accounts (adjusted by nonrecourse liabilities over adjusted tax basis [or minimum gain]) to equal the amount that each partner would receive on the hypothetical sale and liquidation.

The ninth column of numbers shows the partners’ hypothetically determined hypothetical capital accounts after the allocation under the target allocation provision of net taxable income for the year.

Target allocation provisions sometimes allocate net “book” items of the partnership. “Book” items are items that adjust capital accounts under the Allocation Regulations.14_A simple target allocation provision might be drafted like this:

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Clause 6. The Company shall allocate all of its Net Income or Net Loss (as the case may be).

This allocation shall be made in such a manner that (after these allocations have been made) each Member’s Capital Account shall be equal to (to the extent possible) the hypothetical amount that the Company would distribute to this Member if –

(a) the Company sold all of its assets for their “book” values (or, for the amount of nonrecourse liabilities or partner nonrecourse liabilities secured by these assets, if nonrecourse liabilities or partner nonrecourse liabilities exceed “book” values)

(b) first applied the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company’s method of accounting), and then

(c) distributed the remaining net proceeds of this sale in accordance with Section y.y [the liquidating distribution provision].

For this purpose:

(d) “Book value” means “book value” as used in Treasury Regulations Section 1.704-1(b)(2)(iv).

(e) “Net Income” means the positive net amount of all “book” items (other than Contributions and liabilities) that increase or decrease capital accounts under Treasury Regulations Section 1.704-1(b)(2)(iv) if that net amount produces a net increase to capital accounts, and Net Loss means the negative net amount of all “book” items (other than Distributions and liabilities) that increase or decrease capital accounts under Treasury Regulations Section 1.704-1(b)(2)(iv) if that net amount produces a decrease to capital accounts.

We might redraft the target allocation provision more carefully as provided in Clause 7:

Clause 7. The Company shall allocate all of its items of “book” income and “book” loss.

This allocation shall be made in such a manner that (after these allocations have been made) each Member’s Capital Account shall be equal to (to the extent possible) the hypothetical amount that the Company would distribute to this Member on a Hypothetical Sale and Liquidation.

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For this purpose,

(a) “Hypothetical Sale and Liquidation” means a hypothetical transaction in which the Company –

(i) sells all of its assets for their “book” values (or, for the amount of

nonrecourse liabilities or partner nonrecourse liabilities secured by these assets, if nonrecourse liabilities or partner nonrecourse liabilities exceed “book” values),

(ii) first applies the proceeds to discharge Company liabilities at face amount (including repayment of interest that has accrued and has been deducted under the Company’s method of accounting), and then

(iii) distributes the remaining net proceeds of this sale in accordance with Section y.y [the liquidating distribution provision].

(b) “Book value” with respect to any asset means the asset’s “book” value for purposes of Treasury Regulations Section 1.704-1(b)(2)(iv).

(c) Items of “book” income mean all items (other than Contributions and liabilities) that increase capital accounts under Treasury Regulations Section 1.704-1(b)(2)(iv).

(d) Items of “book” loss mean all items (other than Distributions and liabilities) that decrease capital accounts under Treasury Regulations Section 1.704-1(b)(2)(iv).

(e) Items of “book” income and “book” loss shall be computed by excluding items allocated under the minimum gain chargeback, or under the partner minimum gain chargeback, and also by excluding items allocated as nonrecourse deductions, partner nonrecourse deductions, or exculpatory deductions.

(f ) Each Member’s share of items of “book” income and “book” loss shall

be comprised of a ratable share of the items that are components of “book” income and “book” loss to the extent consistent with the other terms of this Section x.x and except to the extent that the Code requires otherwise.

( g) Capital Accounts shall be determined for this purpose –

(i) after adjustments for any specially allocated items, contributions,

or distributions and

(ii) as if any net “book” income or net “book” loss that the Company would have recognized on this hypothetical sale (such as under the minimum gain chargeback or partner minimum gain chargeback) has been recognized and (other than items allocated under this Section y.y) credited to or debited from (as the case may be) the Members’ Capital Accounts, and

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(iii) by increasing the Capital Account of each Member on account of the amount that the Member would be required to pay or to contribute on account of the Members’ obligations to make payments or contributions to the Company that would fall due on account of the liquidation of the Company or that would be treated as obligations to restore the Member’s deficit Capital Account under Treasury Regulations 1.704-1(b)(2)(ii)(b)(3) (net of the amount of these payments or contributions that the Company would return to the Member on the Hypothetical Sale and Liquidation) (but not including a deemed deficit restoration obligation on account of minimum gain or partner minimum gain [which is already treated as fully recognized for this purpose under paragraph (e)(ii)]).

(h) Nonrecourse liabilities and partner nonrecourse liabilities shall be determined under Treasury Regulations Section 1.1001-2(a)(4)(i).

The partnership agreement then should contain a separate minimum gain chargeback, partner minimum gain chargeback, qualified income offset, and allocation of partner nonrecourse deductions. These provisions might be drafted simply:

Clause 8. This Agreement incorporates by reference, as if fully set forth in this Agreement, the minimum gain chargeback set forth in Treasury Regulations Section 1.704-2(f ), the partner minimum gain chargeback as set forth in Treasury Regulations Section 1.704-2(i), and the qualified income offset set forth in Treasury Regulations Section 1.704-1(b)(2)(ii)(d) as if those provisions were explicitly set forth in this Agreement.

Clause 9. All partner nonrecourse deductions shall be allocated to the Member that bears the economic risk of loss for the liability in accordance with Treasury Regulations Section 1.704-2(i)(1).

Clause 10. All nonrecourse deductions shall be allocated x% to Ephriam, y% to Balthasar, and z% to Mordechia.

Clause 11. All exculpatory deductions shall be allocated x% to Ephriam, y% to Balthasar, and z% to Mordechia, except as otherwise may be required by Section 704.

Clause 7 contemplates separate allocation of nonrecourse deductions, partner

nonrecourse deductions, and exculpatory deductions. The partnership agreement should have a provision allocating tax items of income, gain, loss, and deduction in accordance with Section 704(c)(1)(A) and its principles.

Clause 7 attempts to replicate what would happen on an actual sale and liquidation:

• Clause 7 applies both to traditional income and loss items and to “book”-up

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• Clause 7 is based on allocations of items of gross income and gross deduction rather than net income and net loss.

• Clause 7 addresses situations in which the partnership may not have sufficient net income or net losses in order to cause hypothetical capital accounts to equal target capital accounts.

• Gross item allocations may be required under partners’ interests in the partnership where net item allocations do not cause hypothetical capital accounts to equal target capital accounts.

• This is the target: the hypothetical amount that the Company would distribute to the member if –

o the Company sold all of its assets for their “book” values (or, for the

amount of nonrecourse liabilities or partner nonrecourse liabilities secured by these assets, if nonrecourse liabilities or partner nonrecourse liabilities exceed “book” values),

o first applied the proceeds to discharge Company liabilities at face

amount (including repayment of interest that has accrued and has been deducted under the Company’s method of accounting), and then

o distributed the remaining net proceeds of this sale in accordance with

the liquidating distribution provision.

• Clause 7 does not simply use “nonrecourse liabilities” without defining the

term. The parenthetical where liabilities exceed “book” value refers to both nonrecourse liabilities and partner nonrecourse liabilities. These liabilities are defined by cross-reference to the Treasury Regulations Section 1.1001-2(a)(4)(i). These items are allocated outside of Clause 7 and necessarily will be recognized and adjust capital accounts on a liquidating sale.

• Clause 7 defines “book value” unambiguously by reference to the

Allocation Regulations.

• Clause 7 defines items of “book” income and items of “book” loss by

reference to items that adjust capital accounts maintained in accordance with the Allocation Regulations.

• Clause 7 excludes “book” items allocated under the minimum gain

chargeback and the partner minimum gain chargeback, and nonrecourse deductions, partner nonrecourse deductions, and exculpatory deductions. These items are allocated elsewhere in the partnership agreement.

• Clause 7 hypothetically credits to Capital Accounts the amounts

hypothetically recognized under the minimum gain chargeback and partner minimum gain chargeback on the Hypothetical Sale and Liquidation.

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• Shares of “book” income and “book” loss are comprised of a ratable share of “book” income and “book” loss to the extent reasonably possible.

• Clause 7 determines Capital Accounts after –

o recognition of any specially allocated items. o contributions and distributions for the year.

o recognition of items under minimum gain chargeback and partner

minimum gain chargeback.

o after the net capital contribution that the partner would be expected to

make on liquidation of the partnership, considering qualifying deficit restoration obligations (but not considering deemed deficit restoration obligations on account of minimum gain or partner minimum gain in order to avoid double counting).

The adjustment for restoration obligations may be in error. The law on this question is not altogether. The standard for deficit restoration provisions and capital contribution provisions perhaps should just refer to the rules of partners’ interests in the partnership. This is a matter for the future to resolve.

The alternative test of economic effect provides for these adjustments to capital accounts in determining what losses we can allocate to a partner:

(4) Adjustments that, as of the end of such year, reasonably are expected to be made to such partner’s capital account under paragraph (b)(2 )(iv)(k) of this section for depletion allowances with respect to oil and gas properties of the partnership, and

(5 ) Allocations of loss and deduction that, as of the end of such year, reasonably are expected to be made to such partner pursuant to section 704(e)(2 ), section 706(d ), and paragraph (b)(2 )(ii) of section 751-1, and

(6 ) Distributions that, as of the end of such year, reasonably are expected to be made to such partner to the extent they exceed offsetting increases to such partner’s capital account that reasonably are expected to occur during (or prior to) the partnership taxable years in which such distributions reasonably are expected to be made "(other than increases pursuant to a minimum gain chargeback under paragraph (b)(4)(iv)(e) of this section or under section 1.704-2( f ); however, increases to a partner’s capital account pursuant to a minimum gain chargeback requirement are taken into account as an offset to distributions of nonrecourse liability

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proceeds that are reasonably expected to be made and that are allocable to an

increase in partnership minimum gain)" under section 1.704-2( f ).15

It seems quite plausible that these adjustments should be made in determining capital accounts for purposes of computing target allocations. This question is left to the future to explore. Regulations to date do not provide guidance.

Too many target allocation provisions use the term “nonrecourse liabilities” in the target allocation provision without defining “nonrecourse liabilities.” This leaves the term ambiguous. A well-drafted target allocation provision carefully defines what it means by “nonrecourse liabilities” and “partner nonrecourse liabilities” by reference to Nonrecourse Deduction Regulations or the Section 1001 regulations.16

4. Nonrecourse Liabilities.

The target allocation provision may satisfy the nonrecourse deduction safe harbor if allocations under the target allocation provision are deemed to have economic effect on account of economic effect equivalence. Explicit allocations of nonrecourse deductions then should be respected. Whether this argument works is a matter of conjecture.

The target allocation provision is unlikely to satisfy the nonrecourse deduction safe harbor if allocations under the target allocation provision do not satisfy the economic effect equivalence test. Failure to satisfy economic effect equivalence will create substantial doubt that explicit special allocations of nonrecourse deductions will be respected. Nonrecourse deductions then should be allocated in accordance with partners’ interests in the partnership. What that means often is in doubt. Failure to satisfy the nonrecourse deduction safe harbor calls into question whether allocation of nonrecourse deductions under the target allocation provision – or outside of the target allocation provision – will be respected.

15_{Treas. Reg. § 1.704-1(b)(2)(d}₎₍₄_{), (}₅_{), (}₆_).

16_{Clause 7 defines “nonrecourse liabilities” in terms of Treasury Regulations Section}

1.1001-2. These regulations determine whether a liability is nonrecourse for purposes of determining an amount realized. Liabilities that are nonrecourse for purposes of Section 1001 are not necessarily precisely the same liabilities that are nonrecourse for purposes of Section 704 and Section 752. There is no statutory or regulatory definition of “nonrecourse liabilities” under Section 1001. A nonrecourse liability is a liability that creates an amount realized on sale or exchange equal to the full amount of the liability, even where the liability exceeds the fair market value of the security.

Adjusting target capital accounts in accordance with the principles of the Allocation Regulations is a sensible approach. Nonrecourse deductions produce minimum gain. This minimum gain is based on Section 704 principles for nonrecourse liabilities. Partnership nonrecourse deductions produce partner nonrecourse debt minimum gain,. This partner nonrecourse debt minimum gain is based on Section 704 principles for partner nonrecourse liabilities. Both minimum gain and partner minimum gain create deemed capital account deficit restoration obligations. These deficit restoration obligations should be a factor in drafting the target allocation provision.

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Many advisors will seek to specially allocate nonrecourse deductions in drafting a target allocation provision, despite the uncertainty over whether those special allocations of nonrecourse deductions will be respected for tax purposes. Doubts about the status of allocations of nonrecourse deductions complicate the use of target allocation provisions. The effectiveness of special allocations of nonrecourse deductions often will be in doubt. Advisors seeking certainty that allocations of nonrecourse deductions will be respected should consider the advisability of using a target allocation provision.

Section 752 regulations define a “nonrecourse liability”:

A partnership liability is a nonrecourse liability to the extent that no partner or related person bears the economic risk of loss for that liability under section 1.752-2.17

By contrast,

A partnership liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under section 1.752-2.18

This constitutes a logical partition. A partnership liability necessarily is either a recourse liability or nonrecourse liability under the Section 752 regulations.

Economic risk of loss is determined under Treasury Regulations Section 1.752-2. Extensive rules are set forth in this regulation. The general standard for measuring economic risk of loss is based on the extent that (if the partnership constructively liquidated) the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner.19

17_{Treas. Reg. § 1.752-1(a)(2).} 18_{Treas. Reg. § 1.752-1(a)(1).}

19_{Treas. Reg. § 1.752-2(b)(1) (“(b) Obligation to make a payment. (1) In general. Except}

as otherwise provided in this section, a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or person that is a related person to another partner. Upon a constructive liquidation, all of the following events are deemed to occur simultaneously: (i) All of the partnership’s liabilities become payable in full; (ii) With the exception of property contributed to secure a partnership liability (see section 1.752-2 (h)(2)), all of the partnership’s assets, including cash, have a value of zero; (iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor’s right to repayment is limited solely to one or more assets of the partnership); (iv) All items of income, gain, loss, or deduction are allocated among the partners; and (v) The partnership liquidates.”).

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An obligation to make a payment is measured based on a facts and circumstances test. The analysis is based on all statutory and contractual obligations relating to the partnership liability.20

Special rules apply where a partner or related person is a lender. Regulations provide generally that: “A partner bears the economic risk of loss for a partnership liability to the extent that the partner or a related person makes (or acquires an interest in) a nonrecourse loan to the partnership and the economic risk of loss for the liability is not borne by another partner.”21

A special rule can apply when a partner is a lender. The general rule that treats the lending partner as bearing the economic risk of loss of a nonrecourse loan that the partner lends to the partnership does not apply if –

• a partner or related person whose interest (directly or indirectly through one or more partnerships including the interest of any related person) in each item of partnership income, gain, loss, deduction, or credit for every taxable year that the partner is a partner in the partnership is 10 percent or less,

20_{Treas. Reg. § 1.752-2(b)(3), (4), (5) (“(3) Obligations recognized. The determination of}

the extent to which a partner or related person has an obligation to make a payment under paragraph (b)(1) of this section is based on the facts and circumstances at the time of the determination. All statutory and contractual obligations relating to the partnership liability are taken into account for purposes of applying this section, including: (i) Contractual obligations outside the partnership agreement such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or to other partners, or to the partnership; (ii) Obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership; and (iii) Payment obligations (whether in the form of direct remittances to another partner or a contribution to the partnership) imposed by state law, including the governing state partnership statute. To the extent that the obligation of a partner to make a payment with respect to a partnership liability is not recognized under this paragraph (b)(3), paragraph (b) of this section is applied as if the obligation did not exist. (4) Contingent obligations. A payment obligation is disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs. (5) Reimbursement rights. A partner’s or related person’s obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or a person who is a related person to another partner. (6) Deemed satisfaction of obligation. For purposes of determining the extent to which a partner or related person has a payment obligation and the economic risk of loss, it is assumed that all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation.”).

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• makes a loan to the partnership which constitutes qualified nonrecourse financing within the meaning of Section 465(b)(6) (determined without regard to the type of activity financed).22

A parallel rule applies when a partner is a guarantor of partnership debt. The general rule concerning economic risk of loss does not apply if –

• a partner or related person whose interest (directly or indirectly through one or more partnerships including the interest of any related person) in each item of partnership income, gain, loss, deduction, or credit for every taxable year that the partner is a partner in the partnership is 10 percent or less, guarantees a loan that would otherwise be a nonrecourse loan of the partnership and

22_{Treas. Reg. § 1.752-2(d)(1). See I.R.C. § 465(b)(6) (“Qualified nonrecourse financing}

treated as amount at risk. For purposes of this section – (A) In general. Notwithstanding any other provision of this subsection, in the case of an activity of holding real property, a taxpayer shall be considered at risk with respect to the taxpayer’s share of any qualified nonrecourse financing which is secured by real property used in such activity. (B) Qualified nonrecourse financing. For purposes of this paragraph, the term ‘qualified nonrecourse financing’ means any financing – (i) which is borrowed by the taxpayer with respect to the activity of holding real property, (ii) which is borrowed by the taxpayer from a qualified person or represents a loan from any Federal, State, or local government or instrumentality thereof, or is guaranteed by any Federal, State, or local government, (iii) except to the extent provided in regulations, with respect to which no person is personally liable for repayment, and (iv) which is not convertible debt. (C) Special rule for partnerships. In the case of a partnership, a partner’s share of any qualified nonrecourse financing of such partnership shall be determined on the basis of the partner’s share of liabilities of such partnership incurred in connection with such financing (within the meaning of section 752). (D) Qualified person defined. For purposes of this paragraph – (i) In general. The term ‘qualified person’ has the meaning given such term by section 49(a)(1)(D)(iv). (ii) Certain commercially reasonable financing from related persons For purposes of clause (i), section 49(a)(1)(D)(iv) shall be applied without regard to subclause (I) thereof (relating to financing from related persons) if the financing from the related person is commercially reasonable and on substantially the same terms as loans involving unrelated persons. (E) Activity of holding real property For purposes of this paragraph – (i) Incidental personal property and services The activity of holding real property includes the holding of personal property and the providing of services which are incidental to making real property available as living accommodations. (ii) Mineral property The activity of holding real property shall not include the holding of mineral property.”). See I.R.C. § 49(a)(1)(D)(iv) (“(iv) Qualified persons For purposes of this paragraph, the term ‘qualified person’ means any person which is actively and regularly engaged in the business of lending money and which is not – (I) a related person with respect to the taxpayer, (II) a person from which the taxpayer acquired the property (or a related person to such person), or (III) a person who receives a fee with respect to the taxpayer’s investment in the property (or a related person to such person).”).

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• which would constitute qualified nonrecourse financing within the meaning of Section 465(b)(6) (without regard to the type of activity financed) if the guarantor had made the loan to the partnership.23

The Nonrecourse Deduction Regulations contain complex special rules for determining economic risk of loss with respect to a nonrecourse liability with interest guaranteed by a partner.24

23_{Treas. Reg. § 1.752-2(d)(2).}

24_{Treas. Reg. § 1.752-2(e) (“(e) Special rule for nonrecourse liability with interest}

guaranteed by a partner. (1) In general. For purposes of this section, if one or more partners or related persons have guaranteed the payment of more than 25 percent of the total interest that will accrue on a partnership nonrecourse liability over its remaining term, and it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if the partnership fails to do so, then the liability is treated as two separate partnership liabilities. If this rule applies, the partner or related person that has guaranteed the payment of interest is treated as bearing the economic risk of loss for the partnership liability to the extent of the present value of the guaranteed future interest payments. The remainder of the stated principal amount of the partnership liability constitutes a nonrecourse liability. Generally, in applying this rule, it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if, upon a default in payment by the partnership, the lender can enforce the interest guaranty without foreclosing on the property and thereby extinguishing the underlying debt. The guarantee of interest rule continues to apply even after the point at which the amount of guaranteed interest that will accrue is less than 25 percent of the total interest that will accrue on the liability. (2) Computation of present value. The present value of the guaranteed future interest payments is computed using a discount rate equal to either the interest rate stated in the loan documents, or if interest is imputed under either section 483 or section 1274, the applicable federal rate, compounded semi-annually. The computation takes into account any payment of interest that the partner or related person may be required to make only to the extent that the interest will accrue economically (determined in accordance with section 446 and the regulations thereunder) after the date of the interest guarantee. If the loan document contains a variable rate of interest that is an interest rate based on current values of an objective interest index, the present value is computed on the assumption that the interest determined under the objective interest index on the date of the computation will remain constant over the term of the loan. The term ‘objective interest index’ has the meaning given to it in section 1275 and the regulations thereunder (relating to variable rate debt instruments). Examples of an objective interest index include the prime rate of a designated financial institution, LIBOR [London Interbank Offered Rate], and the applicable federal rate under section 1274(d). (3) Safe harbor. The general rule contained in paragraph (e)(1) of this section does not apply to a partnership nonrecourse liability if the guarantee of interest by the partner or related person is for a period not in excess of the lesser of five years or one-third of the term of the liability. (4) De minimis exception. The general rule contained in paragraph (e)(1) of this section does not apply if a partner or related person whose interest (directly or indirectly through one or more partnerships including the interest of any related person) in each item of partnership income, gain, loss, deduction, or credit far every taxable year that the partner is a partner in the partnership is 10 percent or less, guarantees the interest on a loan to that partnership which constitutes qualified nonrecourse financing within the meaning of section 465(b)(6) (determined

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Contingent obligations to make payments are generally disregarded under the Section 752 regulations in determining economic risk of loss. 25

Reimbursement rights can cause a reallocation of economic risk of loss under Section 752. 26

One of the controversial aspects of the Section 752 economic risk of loss rules is an unlimited presumption of solvency of the partner. A partner is deemed able to satisfy any obligation to make a payment to satisfy an obligation to a partnership, regardless of the partner’s actual assets.27

The Allocation Regulations contain two relevant definitions that operate for purposes of Section 704:

(3) Definition of nonrecourse liability. “Nonrecourse liability” means a nonrecourse liability as defined in section 1.752-1(a)(2) or a § 1.752-7

liability (as defined in § 1.752-7(b)(3)(i))28_{assumed by the partnership from}

a partner on or after June 24, 2003.

without regard to the type of activity financed). An allocation of interest to the extent paid by the guarantor is not treated as a partnership item of deduction or loss subject to the 10 percent or less rule.”).

25_{Treas. Reg. § 1.752-2(d)(4)(“(4) Contingent obligations. A payment obligation is}

disregarded if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged. If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs.”). This may seem like an overly technical rule. This rule can affect how items are allocated under a sophisticated target allocation provision. Sophisticated target allocation provisions often provide for adjustments for capital contribution obligations and deemed capital contribution obligations.

26_{Treas. Reg. § 1.752-2(d)(5)(“(5) Reimbursement rights. A partner’s or related person’s}

obligation to make a payment with respect to a partnership liability is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or a person who is a related person to another partner.”).

27_{Treas. Reg. § 1.752-2(d)(6). (“Deemed satisfaction of obligation. For purposes of}

determining the extent to which a partner or related person has a payment obligation and the economic risk of loss, it is assumed that all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation. See paragraphs (j) and (k) of this section.”).

28_{See Treas. Reg. § 1.752-1(a)(4) (“(4) Liability defined. (i) In general. An obligation}

is a liability for purposes of section 752 and the regulations thereunder (§ 1.752-1 liability), only if, when, and to the extent that incurring the obligation–(A) Creates or increases the basis of any of the obligor’s assets (including cash); (B) Gives rise to an immediate deduction to the obligor; or (C) Gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. (ii) Obligation. For purposes of this paragraph and § 1.752-7, an obligation is any fixed or contingent obligation to make payment without regard to whether the

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(4) Definition of partner nonrecourse debt. “Partner nonrecourse debt” or “partner nonrecourse liability” means any partnership liability to the extent the liability is nonrecourse for purposes of section 1.1001-2, and a partner or related person (within the meaning of section 1.752-4(b)) bears the economic risk of loss under section 1.752-2 because, for example, the partner

or related person is the creditor or a guarantor.29

There is an interesting lack of parallelism between the definition of “nonrecourse liability” under the Section 704 and the definition of “partner nonrecourse liability” under Section 704. The definition of “partner nonrecourse liability” depends on the liability being

obligation is otherwise taken into account for purposes of the Internal Revenue Code. Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps.”). See Treas. Reg. § 1.752-7(b)(3)(i)(“(3) § 1.752-7 liability. (i) In general. A § 1.752-7 liability is an obligation described in § 1.752-1(a)(4)(ii) to the extent that either – (A) The obligation is not described in § 1.752-1(a)(4)(i); or (B) The amount of the obligation (under paragraph (b)(3)(ii) of this section) exceeds the amount taken into account under § 1(a)(4)(i). (ii) Amount and share of § 1.752-7 liability. The amount of a § 1.1.752-752-1.752-7 liability (or, for purposes of paragraph (b)(3)(i) of this section, the amount of an obligation) is the amount of cash that a willing assignor would pay to a willing assignee to assume the § 1.752-7 liability in an arm’s-length transaction. If the obligation arose under a contract in exchange for rights granted to the obligor under that contract, and those contractual rights are contributed to the partnership in connection with the partnership’s assumption of the contractual obligation, then the amount of the § 1.752-7 liability or obligation is the amount of cash, if any, that a willing assignor would pay to a willing assignee to assume the entire contract. A partner’s share of a partnership’s § 1.752-7 liability is the amount of deduction that would be allocated to the partner with respect to the § 1.752-7 liability if the partnership disposed of all of its assets, satisfied all of its liabilities (other than § 1.752-7 liabilities), and paid an unrelated person to assume all of its § 1.752-7 liabilities in a fully taxable arm’s-length transaction (assuming such payment would give rise to an immediate deduction to the partnership). (iii) Example. In 2005, A, B, and C form partnership PRS. A contributes $10,000,000 in exchange for a 25 % interest in PRS and PRS’s assumption of a debt obligation. The debt obligation was issued for cash and the issue price was equal to the stated redemption price at maturity ($5,000,000). The debt obligation bears interest, payable quarterly, at a fixed rate of interest, which was a market rate of interest when the debt obligation was issued. At the time of the assumption, all accrued interest has been paid. Prior to the partnership assuming the obligation, interest rates decrease, resulting in the debt obligation bearing an above-market interest rate. Assume that, as a result of the decline in interest rates, A would have had to pay a willing assignee $6,000,000 to assume the debt obligation. The assumption of the debt obligation by PRS from A is treated as an assumption of a § 1.752-1(a)(4)(i) liability in the amount of $5,000,000 (the portion of the total amount of the debt obligation that has created basis in A’s assets, that is, the $5,000,000 that was issued in exchange for the debt obligation ) and an assumption of a § 1.752-7 liability in the amount of $1,000,000 (the difference between the total obligation, $6,000,000, and the § 1.752-1(a)(4)(i) liability, $5,000,000).”).

Several Thoughts on Drafting Target Allocation Provisions

Several Thoughts on Drafting Target

Allocation Provisions

Table of Contents

1.

Simplicity.

2.

Considerations for Target Allocation Provisions.

3.

Drafting the Target Allocation Provision.

4.

Nonrecourse Liabilities.