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Tax News
The AICPA Lends a Helping Hand to the IRS on Targeted Allocations
February 25, 2014
Miscellaneous
A few weeks ago the AICPA came out with a proposed draft targeted allocation ruling with the hope that the IRS will issue much needed guidance regarding whether this type of allocations work for Sec. 704(b) purposes. Targeted allocations are prevalent in private equity deals at the portfolio company level. Basically, instead of adopting a layer cake approach that follows the distribution waterfall, the targeted approach utilizes a targeted capital account that is based on that waterfall and allocates either net, or gross, income or loss of the partnership at the end of the year so that each partner’s capital account is as close as possible to its targeted account.  Many in the community, including myself, think that the approach is suitable in a variety of business deals. Some, like Terry Cuff and William McKee, take the approach with a grain of salt. As it may be, there is no official guidance regarding whether targeted allocations meet the 704(b) rules (either by complying with the economic effect equivalence test, or the PIP test). In the last few years the IRS basically unofficially said that targeted allocations would be OK in some instances but that the IRS' silence on the issue should not be interpreted as a tacit approval. Also, not long ago, Curtis Wilson, IRS associate chief counsel for passthroughs was quoted to say that office of chief counsel will be open to issuing guidance. So where we stand right now, targeted allocations are a standard fare in most deals but without official rule of law that blesses them.

So here comes the AICPA’s suggestion. I think that everybody involved in the industry should read it. Basically the draft ruling goes over 3 scenarios and reasons why each scenario should or should not satisfy the 704(b) regulations. In my mind, the somewhat most controversial part of the ruling would be scenario 3, which posits a priority 5% preferred return (i.e. one partner’s return of capital is subordinated to another partner’s preferred return). Obviously, this creates a situation where one partner’s preferred return could be carried by another partner’s capital contribution and to the extent that the partnership is short on income to cover the preferred return, there is arguably an issue with meeting the economic effect equivalence test. However, the ruling goes on to conclude that even if the partnership earnings are insufficient to support the preferred return, the allocation is still valid.  As I understand the logic, at some point, the AICPA reasons, things will sort themselves out because there will be a capital shift. While practitioners would be pretty happy to get a similar ruling from the IRS, I’d imagine that they will be even happier to get a ruling on this last point. However, I’d venture to say that the IRS may raise an eyebrow on the very last point. When you think about it, from bird's eye view, as long as this is the business deal and there is no abusive foul play at hand, this ought to be the right result, but I am afraid that in their everlasting quest toward preventing abuses, the IRS may not see eye to eye with the business community here.

The ruling can be found here. Also, to those interested, you can find the Lexis ebook I co-authored with Matt that deals with some of these issues here.
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Tags: economic effect equivalence, partner interest in the partnership, section 704(b), targeted allocations