correcting capital account mistakes and errors on partnership...
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Correcting Capital Account Mistakes
and Errors on Partnership Returns A Comprehensive Guide to Corrections, Allocations and "True-Ups" of Capital Accounts
TUESDAY, NOVEMBER 24, 2015, 1:00-2:50 pm Eastern
STRAFFORD LIVE WEBINAR
“Correcting Capital Account Mistakes and Errors on Partnership Returns”
November 24, 2015
SOME USEFUL SOURCES
Steve R. Johnson
University Professor
Florida State University College of Law
I. State Law
Allan Donn, Robert W. Hillman & Donald J. Weidner, The Revised Uniform Partnership Act
(Thomson West 2014)
II. Accounting
Joe Ben Hoyle, Thomas F. Schaefer & Timothy S. Doupnik, Fundamentals of Advanced
Accounting (McGraw – Hill, 4th
ed. 2010)
III. Tax
A. Treatises and Books
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts ch. 87
(partnership allocations) (Thomson Reuters, updated through 2015)
Laura E. Cunningham & Noel B. Cunningham, The Logic of Subchapter K: A Conceptual Guide
to the Taxation of Partnerships (West, 4th
ed. 2011)
William S. Mckee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships
and Partners (Warren Gorham & Lamont, 2014 with periodic updates)
Joni Larson, Partnership Taxation: An Application Approach (Carolina Academic Press, 2nd
ed.
2013)
Richard Lipton, Paul Carman, Charles Fassler & Walter Schwidetzky, Partnership Taxation
(LexisNexis, 3rd
ed. 2012)
Arthur B. Willis & Philip F. Postlewaite, Partnership Taxation (7th
ed. 2011 with periodic
updates)
B. Articles
Howard E. Abrams, Partnership Book-Ups, 127 Tax Notes 435 (Apr. 26, 2010)
Donald H. Baker, What Does That Operating Agreement Mean? A Primer on LLC Capital
Accounting for the Non-Specialist, Michigan Business Law Journal, Summer 2010, p. 13
Terence F. Cuff, Some Conjectures on Target Allocation Provisions, Real Estate Taxation 127
(2013)
Terence F. Cuff, Some Further Conjectures on Target Allocation Provisions, Real Estate
Taxation (2013)
Craig Gerson, Karen T. Lohnes & John Smalz, Value Equals Basis and Partners’ Distributive
Share: Stuffing, Fill-Ups, and Waterfalls, 105 Journal of Taxation 109 (2006)
Todd D. Golub, How to Hit Your Mark Using Target Allocations in a Real Estate Partnership, 50
Tax Management Memorandum 403 (Sept. 28, 2009)
Andrea Monroe, Too Big to Fail: The Problem of Partnership Allocations, 30 Virginia Tax
Review 465 (2010)
Daniel L. Simmons, Built-in Gain and Built-in Loss Property on Formation of a Partnership: An
Exploration of the Grand Elegance of Partnership Capital Accounts, 9 Florida Tax Review 599
(2009)
Donald J. Weidner, Partnership Allocations and Capital Account Analysis, 42 Ohio St. Law
Journal 467 (1981)
Donald J. Weidner, Capital Accounts in LLCs and in Partnerships: Powerful Default Rules and
Potential Tax Significance, 14 Florida St. University Business Review 1 (2015)
IV. Drafting
Brian J. O’Connor & Steven R. Schneider, Partnership and LLC Agreements: Learning to Read
and Write Again, Tax Notes, Dec. 21, 2009, p. 1323
Joe Garcia, Jr., Mark Kuller, Robert Whitmire, Sandra Hallmark, William McKee & William
Nelson, Structuring and Drafting Partnership Agreements: Including LLC Agreements (Thomson
Reuters 2014)
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STRAFFORD LIVE WEBINAR
“Correcting Capital Account Mistakes and Errors on Partnership Returns”
November 24, 2015
CAPITAL ACCOUNTS FROM THE PERSPECTIVE OF THE IRS
Steve R. Johnson
University Professor
Florida State University College of Law
I. Some History
1. The tax issue one usually thinks of first as to capital accounts are special allocations of
partnership income, loss, and other items.1 As will be seen in Part IV of this outline,
capital accounts can be relevant to other tax issues as well. However, special allocations
did much to shape the approach of federal tax law to capital accounts.
2. Capital accounts began as creatures of financial, not tax, accounting. They proved useful
as a way of measuring and assuring that the economic deal of the co-venturers was being
upheld though the myriad events that take place in the life of a partnership. But federal
tax law eventually realized the utility of capital accounts as anti-abuse mechanisms.
3. Partnerships, and now LLCs, are far more flexible vehicles under state law than are
corporations. As originally designed, Subchapter K of the Internal Revenue Code was
simple and permissive, in order not to interfere with the flexibility of partnerships.
4. But the IRS came to learn that the evil twin of flexibility is potential for abuse. Over
generations, Subchapter K has mutated from short and simple to long and hideously
complicated, as Congress engrafted onto it numerous anti-abuse rules.
5. Section 704(b) is one of these anti-abuse rules. That provision empowers the IRS to
disregard certain partnership allocations and to reallocate them in more appropriate
fashion. See Reg. § 1.704-1(b)(3)(ii) (setting out factors used in determining the extent of
the reallocation).
1 “Partnership” for these purposes includes all entities governed by the rules in Subchapter K of the Internal
Revenue Code as to income tax treatment of partnerships and their owners. The great majority of multi-member
LLCs are within subchapter K.
2
6. In 1976, section 704(b) was changed from a subjective to an objective approach. Under
the old version, the provision attacked partnership allocations having the “principal
purpose of … the avoidance or evasion of any tax.” The new and current version attacks
allocations which lack “substantial economic effect” (SEE).
7. In 1983, Treasury revised the 704(b) regulations to, among other things, officially place
heavy reliance on capital accounts in testing whether allocations have SEE.
This was not revolutionary, however. Many cases under pre-1976 law took the view that
“[t]he validity of an allocation to a partner is discovered by examining the effect of the
allocation upon the capital accounts of the partners at liquidation.” Miller v. Comm’r,
T.C. Memo. 1984-336. In addition to the cases cited by Miller, see Magaziner v.
Comm’r, T.C. Memo. 1978-205. The most widely cited case of this line is Orrisch v.
Comm’r, 55 T.C. 395 (1970); aff’d per curiam, 31 AFTR2d 1069 (9th
Cir. 1973).
II. Capital Accounts and Special Allocations
1. The 704(b) regulations describe four alternative portals to the golden realm of valid
allocations. Way One — the most widely discussed and important portal — centers on
the use of capital accounts.
2. a. The “fundamental principle” of Way One is that “in the event there is an economic
benefit or economic burden that corresponds to an allocation, the [venturer] to whom the
allocation is made must receive such economic benefit or bear such economic burden.”
Reg, § 1.704-1(b)(2)(i)(a).
b. This is accomplished when the allocation has an economic effect and that effect is
substantial. Reg. § 1.704-1(b)(2)(i).
c. Under Reg. § 1.704-1(b)(2)(ii)(b), the allocation has an economic effect when all of
three requirements are satisfied:
i. The partnership agreement provides for use of capital accounts in
accordance with extensive rules set out in Reg. § 1.704-1(b)(2)(iv);
ii. The partnership agreement provides that all liquidating distributions will
be made in accordance with positive capital account balances; and
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iii. The partnership agreement provides that, upon liquidation, partners with
negative capital accounts must pay to the partnership the negative balance,
to be used to pay creditors of the partnership or to make distributions to
other partners in accordance with their positive capital accounts.
d. For the allocation to be respected, the economic effect must be substantial. This
requirement is satisfied “if there is a reasonable possibility that the allocation … will
affect substantially the dollar amounts to be received by the partners from the
partnership, independent of tax consequences.” Reg. § 1.704-1(b)(2)(iii)(a).
The regulations also describe three types of insubstantial allocations: shifting
allocations, transitory allocations, and “some help, no hurt” allocations. Reg. §
1.704-1(b)(2)(iii)(a), (b) & (c). Safe harbors as to transitory allocations involve
riskiness, the five-year rule, and the value-equals-basis rule.
3. Way Two is an alternate test for economic effect. The requirements remain the same as in
Way One except that, instead of an obligation to restore the deficit balance, a partner with
a negative capital account may instead be allocated additional income up to the amount of
the deficit (a “qualified income offset”). Reg. § 1.704-1(b)(2)(ii)(d).
4. Way Three: If the allocation does not satisfy the safe harbors of Way One or Way Two, it
will still be respected if “taking into account all the facts and circumstances, the
allocation [is] in accordance with the partner’s interest in the partnership.” Reg. § 1.704-
1(b)(1)(i). This way is elaborated in Reg. § 1.704-1(b)(3). Illustratively not exhaustively,
the Regulations identity four factors: partners’ relative contributions, their interest in
economic profits and losses, their interests in cash flow or other non-liquidating
distributions, and their rights to distribution of capital upon liquidation. Capital account
analysis may be part of this inquiry, but the exacting capital account rules specified under
Way One need not apply.
5. Way Four: Reg. §§ 1.704-1(b)(4) and 1.704-2 contain numerous special rules as to the
maintenance or capital accounts. Some are requirements, pitfalls for the incautious.
Others are safe harbors or alternatives for partnerships whose agreements may be
problematic under the usual SEE rules. The special rules relate to, among other subjects,
1- allocations to reflect revaluations of partnership property, 2- allocations of tax credits
and credit recapture, 3- allocations of excess percentage depletion, 4- allocations
attributable to nonrecourse liabilities, 5- allocations under § 613A(c)(7)(D) (oil and gas
property), 6- allocations arising as a result of amendments to the partnership agreement,
7- allocations of recapture income or credit, 8- allocations of creditable foreign taxes, 9-
allocations with respect to noncompensatory options, and 10- corrective allocations, that
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is, allocations (consisting of pro rata portions of each item) for tax purposes of gross
income and gain, or gross loss and reduction, that differ from the partnership’s allocation
of the corresponding book item.
III. IRS Examination of Capital Account Issues as to Special Allocations
1. The IRS’s Partnership Audit Techniques Guide (ATG), part of the IRS’s Market Segment
Specialization Program, is nearly 300 pages, consisting of multiple parts. It is available
on the IRS’s website at https://www.irs.gov/Businesses/Parternships-Audit-Techniques-
Guide-(ATG). The original version is available at 2002 WL3270029.
2. The ATG is not law, and taxpayers cannot rely on it as binding on the IRS. See Casa de
La Jolla Park, Inc. v. Comm’r, 94 T.C. 386, 396 (1990). However, the ATG is quite
useful in suggesting how the IRS sees the issues, what issues loom large on the IRS’s
audit “radar screen,” and how Revenue Agents are supposed to develop those issues.
3. The portions of the ATG most relevant to special allocations are Chapter 1 “Basic
Principles,” originally issued as LMSB-04-0208-007, and Chapter 6 “Partnership
Allocations,” originally issued as LSMB-04-1107-76.
a. These chapters summarize the portions of the regulations described above, and —
like the regulations themselves — give many instructive examples.
b. In addition, Chapter 6 instructs Revenue Agents as follows as to the special rules
under Way Four above. “It is important to bear in mind that the SEE test does not
apply to the allocation of recourse deductions or tax credits because they do not have
corresponding economic allocation. Additionally, even though allocation of foreign
tax expenditures decrease the partners’ capital accounts, such allocations are not
analyzed under [SEE]. The partner to whom such expenditure is allocated can take a
dollar for dollar offsetting foreign tax credit.” (p. 3) See Reg. § 1.704-1(b)(4)(viii).
4. Chapter 1 instructs Revenue Agents that “it is important to distinguish” among the three
types of capital accounts: “tax capital accounts, IRC section 704(b) book capital
accounts, and book capital accounts which are based on generally accepted accounting
principles (GAAP).” (p. 2)
a. A key difference between tax capital accounts and book capital accounts relates to
contributed property. For example, assume that Dave and Donna form a partnership,
agreeing to be 50%-50% partners. Dave contributes $100,000 to the partnership, all
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in cash. Donna contributes property whose fair market value is $100,000 in which she
has an adjusted basis of $85,000.
The FMV of the property as of the date of contribution is called its book value. Thus,
Dave and Donna have equal book capital accounts: $100,000 for Dave and $100,000
for Donna.
Tax capital accounts, however, look to adjusted basis, not FMV. Thus, Dave and
Donna do not have equal tax capital account. Since the basis in the U.S. currency
always equals its face amount, Dave’s tax capital account is $100,000 — the same as
his book capital account. However, Donna’s tax capital account is only $85,000 —
which is less than her book capital account. (pp. 2-3 & Ex. 1-1)
b. Chapter 1 also instructs Revenue Agents that “partners’ book capital accounts can
sometimes be increased or decreased with no tax consequences. A revaluation of a
capital account [is] a ‘book-up’ or ‘book-down.’ For example, the partners generally
wish to restate their book capital accounts upon the admission of a new partner. For
business purposes, this permits them to document their ownership in the appreciation
of partnership assets that accrued prior to the new partner’s admission. For tax
purposes, this would permit gain or loss inherent in the property at that point to be
taxed to the partner to whom it is properly allocable, thus upholding the assignment
of income doctrine.” (p. 2)
c. Chapter 1 directs Revenue Agents to Chapter 6 for discussion of IRC section 704(b)
book capital accounts. (p. 2)
d. Capital account is a partner-level account. The various kinds of capital accounts also
should be distinguished from another partner-level attribute: outside basis (the
partner’s basis in his, her, or its partnership interest). Some of the events that cause
capital accounts to increase or decrease also cause outside basis to increase or
decrease.
One important difference is that changes in entity-level debt affect basis but not
capital accounts. Thus, the ATG instructs Revenue Agents: “A partner’s outside basis
is made up of his/her tax capital account and his/her share of the partnership’s
liabilities.” (p. 6)
e. Chapter 1 instructs Revenue Agents that the following should be included in their
examination techniques, information requests, and interview questions. First, agents
should ascertain whether the partnership is “maintaining book capital accounts
according to the safe harbor rules under the [SEE] test in the 704 regulations.”
Second, agents should request the partnership to provide its book capital account
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calculations. Third, agents should ask “Does the partnership maintain book capital
account workpapers? “and “Does the Schedule M-2 reflect the book capital
accounts?” (p. 2)
5. Chapter 6 provides added detail as to capital accounts and partnership allocations.
a. Chapter 6 makes the important observation that “[t]he term ‘partnership agreement’ is
very broad and refers to any agreement which has an impact on the economic sharing
arrangement of the partners …. [It] may be oral or written.” (p. 2) See Reg. § 1.704-
1(b)(2)(ii)(h). Chapter 6 gives as examples loan and credit agreements; assumption,
indemnification, or subordination agreements; correspondence with a lender as to
loan terms; and guarantees.
b. Chapter 6 clarifies that the regulatory rules as to how capital accounts are to be kept
for SEE (Way One) purposes must apply “throughout the full term of the
partnership.” (p. 3)
c. As to the substantiality aspect of SEE, Chapter 6 warns Revenue Agents: “If the
capital accounts are left unchanged, either within a given year, or over a period of
years, them the allocation(s) may be insubstantial. Therefore, a threshold question is
’Are Capital Accounts Affected?’” (p. 6)
d. Capital account analysis is a very useful, but not perfect, tool for detecting potential
abuses as to partnership allocations. For example, “capital account balances reflect
amounts and not character” (p. 6) Thus, capital account analysis does not protect
against abuses based on type of items allocated. “A straightforward example would
be one in which a partner with a large net operating loss carryforward is allocated all
of the partnership’s taxable dividends while a high bracket partner is allocated an
equal amount of the partnership’s tax exempt interest income.” (p. 6)
The above example is a shifting allocation. Capital account analysis also is of limited
utility as to transitory allocations and “some help, no hurt” allocations. The regulations
specifically provide that, with designated exceptions, these three types of allocations fail
the substantiality test. Chapter 6 explains and exemplifies the need for and the limits of
these special rules. (pp. 6-9) See also Rev. Rul. 99-43, 1999-2 C.B. 506 (holding special
allocation of the cancellation of indebtedness income to an insolvent partner who would
be able to exclude that income from taxability to be insubstantial), distinguishing Rev.
Rul. 92-97, 1992-2 C.B. 124.
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e. Similarly, Chapter 6 explains and exemplifies the special rules as to allocations
attributable to non-recourse deductions, including minimum gain chargebacks. (pp. 9-
12) It alerts Revenue Agents that “[a] partnership with non-recourse debts and
negative capital accounts has minimum gain.” (p. 9)
f. Chapter 6 adds to the examination techniques advice given by Chapter 1. Chapter 6
directs Revenue Agents to “[c]ompare the allocations in the partnership agreement
with those actually made on the tax return. If there are differences, ask for an
explanation and supporting documents.” (p. 5) it also directs agents to “[r]eview the
partnership agreement for the three requirements of economic effect in the
[regulations].” (p. 5)
In light of the broad construction given to “partnership agreement,” however, Chapter 6
also directs agents to “[o]btain not only the partnership agreement, but also any other
documents which describe the business deal — letters, loans, guarantees,
indemnification, that is, any collateral arrangement which could affect a partner’s rights
and obligations.” (p. 5) For example, “although the responsibility of the partnership debt
may appear to be shared equally among the partners, it is important to be alert to the
impact of side agreements or guarantees.” (p. 4)
IV. Capital Accounts and Other Partnership Tax Issues
1. Although one thinks of capital accounts most often in connection with special allocations,
they can bear on other partnership tax issues as well, including the following.
2. a. Under IRC § 704(d), a partner may deduct her distributive share of partnership losses
only up to her outside basis.
b. Capital account analysis may lead a Revenue Agent to set up a 704(d) issue.
Specifically, the Overview of the ATG notes: “when inspecting a partner’s Schedule
K-1, it may be disconcerting to see that the partner has a negative capital account; that
is, the partner has deducted losses in excess of their cash investment. This occurs
because the capital account does not include that partner’s share of liabilities. If the
amount of liabilities allocated to the partner (shown on Schedule K-1 just above the
ending capital account) is not greater than the capital account, the partner’s losses
should be limited.” (p. 2)
3. a. IRC § 704(c) sets out rules as to allocation of income, gain, loss, and deduction with
respect to property contributed to the partnership.
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b. Capital accounts analysis is part of 704(c) analysis. Chapter 1 of the ATG directs
Revenue Agents to “[d]etermine if there was IRC section 704(c) property contributed
to the partnership. The book capital accounts and the tax capital accounts should
reflect a different value for the contributed property.” (p. 5)
c. Chapter 3 of the ATG provides details. (p. 3 (Ex. 3-2) & p. 8 (Ex. 3-8)) Chapter 3
directs Revenue Agents: “If the taxpayer keeps both book and tax capital accounts,
compare the book and tax capital accounts going back 7 years and note any
difference.” (p. 11) Chapter 4 adds that “a line by line comparison of these parallel
capital accounts will readily indicate whether the distributed property is IRC section
704(c) built-in gain property.” (p. 24)
d. Chapter 4 also instructs agents to request “workpapers used to calculate the partners’
capital accounts for the current year and prior six years if there is “reason to suspect
that built in gain or loss property was contributed to the partnership” as well as to
request “[a]n outside basis calculation for all the partners. An analysis of the capital
accounts should identify the partner who contributed the built in gain or loss property
and the partner who received the property in a distribution …. [C]omparisoin of the
fair market value of the property on the date of contribution and its basis will provide
the amount of built in gain or loss.” (p. 20)
4. a. IRC § 752 sets out rules as to increases and decreases of a partner’s share of liabilities.
b. As noted above, capital accounts are relevant to determining a partner’s share of
nonrecourse liabilities.
c. Capital accounts also matter in determining a partner’s share of recourse liabilities.
The determination is made through a constructive liquidation exercise to establish the
extent to which the partner would be obligated to make a payment. See Reg. § 1.752-
2. Capital accounts matter to this exercise. The hypothetical sale of assets pursuant to
the constructive liquidation is presumed to result in a loss. Chapter 1 of the ATG
states: “Allocation of the loss to the partners’ capital accounts results in deficit capital
account balances. The relative amount in each partner’s deficit capital account
balance evidences each partner’s obligation to make a payment.” (p. 7)
5. a. IRC § 731 addresses the taxability of distribution to partners, and IRC § 736 addresses
payments to a retiring partner or a decreased partner’s successor. Payments that in form
are distributions may instead involve disguised property sales.
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b. Chapter 4 of the ATG directs Revenue Agents to “[r]eview the ending capital
accounts on the Schedule K-1. If an ending capital account is reduced to zero, then a
partnership interest may have been liquidated.” (p. 10)
c. Chapter 4 also instructs agents to ask the partnership to provide a “[s]chedule of book
and tax capital accounts to determine if there is a history of normal distributions to
partners or is this an unusual transaction.” (p. 16) [sic]
This instruction assumes that such a schedule already exists. Neither an IRS
Information Document Request nor an IRS summons can be used to force a taxpayer
to create documents not already in existence. E.g., United States v. Davey, 543 F.2d
996, 1000 (2nd
Cir. 1976); IRM 25.5.4.2.1(1).
d. Chapter 4 also directs the agent to “[r]eview the ending capital accounts on the
Schedules K-1. If an ending capital account is reduced to zero, then a partnership
interest may have been completely liquidated.” (p. 10) The Overview adds: “Care
must be taken to ensure that any negative capital account is reported in income in the
year of liquidation …. [Partners] frequently forget to [do so] …. [E]ven a gift or
charitable contribution of a partnership interest will result in a gain where the capital
account was negative.” (p. 2)
6. a. On July 23, 2015, Treasury published notice of proposed regulations under IRC §
704(a)(2)(A) as to disguised payments for services. The notice states in part: “Some
taxpayers have expressed uncertainty whether a partnership with a targeted capital
account agreement must allocate income or a guaranteed payment to a partner who has an
increased right to partnership assets determined as if the partnership liquidated at the end
of the year even in the event that the partnership recognizes no, or insufficient, income.”
b. The notice states Treasury’s view that existing rules under Reg. §§ 1.704-1(b)(2)(ii)
and 1.707-1(c) require partner capital accounts to reflect the partner’s distribution
rights as if the partnership liquidated at the send of the tax year. However, the notice
requested “comment on specific issues and examples with respect to which further
guidance would be helpful.”
7. a. IRC § 446(e) requires taxpayers to obtain the permission of the IRS as to change of
accounting method. Is a change in how the partnership keeps capital accounts such a
change? In particular, is it such a change if the partnership discovers it has been keeping
accounts incorrectly and changes to a proper approach?
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b. Reg. §1.446-1(e)(2)(ii)(a) & (b) provides that the rule includes changes to treatment
of material items as well as changes to overall methods. It also provides that such a
change “does not include correction of mathematical or posting errors in the
computation of tax liability [or adjustments not involving] the proper time for
[inclusion or deduction].”
c. However, in subsequent rulings and briefs, the IRS has seemed to go beyond the
regulation. See Michael B. Lang, Elliot Manning & Mona L. Hymel, Federal Tax
Accounting 580-97 (2d ed. 2011).
d. The case law is not conclusive, both because the cases have different facts and
because they seem to take different analytical tacks. Compare Diebold v. United
States, 891 F.2d 1579 (Fed. Cir. 1989) (change of method) to Northern States Power
Co. v. United States, 151 F.3d 876 (8th
Cir. 1998) (no change).