Attorney's Comments Focus on Partners' Interests in Partnership

I write concerning target allocations and guaranteed payments.

REG-115452-14 published proposed regulations relating to disguised payments for services under Section 707(a)(2)(A). REG-115452-14 requests comments concerning "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, net income."¹

This outlines my letter:

 1. Personal Background

I am an attorney. I am licensed to practice law before the courts of the State of California.

I have practiced tax law since 1977.

My practice is concentrated in the areas of partnership taxation (Subchapter K) and real estate taxation. I have been involved in issues of partnership taxation and real estate taxation since 1977. I have been particularly active in writing and lecturing on issues of drafting partnership allocations of income, gain, loss, and deduction before professional seminars in the tax area.

2. Perspective.

I am just a simple, old, obscure South Pasadena tax lawyer with little influence and no constituency. My personal influence is lighter than a feather.² I cast a small shadow. I write in hope of advancing the state of the tax system.

I submit these comments in the hope that they may help to improve the system of partnership taxation.

If my comments have any weight, they should have weight because my comments may have conceptual merit and not because my comments are endorsed by organizations of high reputation. I hope that Treasury and the Internal Revenue Service will judge the merit of my comments based on their consistency with principles of partnership tax law and not based on their source.

I apologize for any flaws in my discussion or analysis.

3. Conflicts.

I write this letter on my own behalf. I do not write on behalf of my law firm, any client, any other organization, or anyone else. My comments stand alone. Neither my law firm, nor any client, nor any other organization, nor anyone else joins in or has endorsed my comments. I stand alone. I do not represent that anyone else necessarily agrees with or supports my comments. I am not lobbying on behalf of any special interest. My errors and perhaps my naivete are all my own. Blame me for any errors in my comments. Do not blame anyone else.

I have not been offered, I have not received, and I will not receive any compensation in connection with the preparation or submission of my comments -- or with any result that they may produce.

To the best of my knowledge, neither my law firm nor any of my clients has any matter discussed in this letter currently under audit by the Internal Revenue Service. I do not have, and I do not believe that my firm or any of its clients has, an immediate, direct financial interest in the outcome of the matters discussed in this letter, other than the general interest of all taxpayers in improving the tax system.

4. Terminology.

I use this terminology in this letter:

Treasury and the Internal Revenue Service should consider rules concerning target allocations only after Treasury and the Internal Revenue Service have undertaken a comprehensive study of partners' interests in the partnership and accordingly have revised regulations concerning partners' interests in the partnership.

Considerable doubt exists that any target allocations will control for purposes of partners' interests in the partnership -- or under any other accepted test. At best, target allocations serve as a tool for revealing how partners' interests in the partnership may work in a particular situation. Revealing the result under partners' interests in the partnership is fundamentally different from controlling the result under partners' interests in the partnership.

In developing rules concerning partnership allocations of income, gain, loss, and deduction, Treasury and the Internal Revenue Service should particularly stress understandability, consistency of result, administrability, and a strong foundation on principles of partnership tax theory.

6. Target Allocations Can Be Drafted in Different Ways and to Different Effect.

Any guidance from Treasury and the Internal Revenue Service should not provide broad approval of "target allocations," "targeted allocations," "target allocation provisions," "targeted capital account allocations," and similar concepts. Guidance, when issued, should be limited to target allocations with carefully described features.

The tax world has not accepted on a single target allocation provision. Target allocation provisions differ widely. Target allocations provisions commonly are drafted in different ways and produce different tax results. Target allocation provisions differ in the manner in which they deal with:

• Net versus gross item allocations.

• "Book" versus taxable item allocations.

• Special allocations where partnership economics indicate that special allocations are appropriate.

• Nonrecourse Deductions.

• Partner Nonrecourse Deductions.

• Minimum Gain Chargeback.

• Partner Minimum Gain Chargeback.

• Allocation of losses where a partner bears the economic risk of

• Deemed capital contribution obligations.

• Asset "book"-ups.

Treasury and the Internal Revenue Service, in providing guidance concerning target allocations, should consider the potential for taxpayers to use target allocations for abusive purposes. Taxpayers commonly use target allocations for abusive purposes.

The tax world appears naïvely to accept the proposition that target allocations are not abusive. While the theoretical foundation for target allocations may be suspect, some advisors argue that Treasury and the Internal Revenue Service should approve target allocations because target allocations are popular with taxpayers and always reach reasonable results. Treasury and the Internal Revenue Service should examine with skepticism the assertion that target allocations always reach reasonable results. Target allocations often reach inappropriate results.

In issuing guidance concerning target allocations, Treasury and the Internal Revenue Service should consider the potential for taxpayers to use target allocations for abusive purposes. Target allocations, if respected, often create the opportunity for significant tax abuse. Target allocations, if respected, may create tax-shelter-like transactions.

Many target allocations, if respected, often override provisions of the tax law. For example, target allocations, if respected, often override the rules concerning partner nonrecourse deductions. Target allocations, if respected, often override rules governing the minimum gain chargeback, the partner minimum gain chargeback, or the qualified income offset. Target allocations, as commonly drafted, can disregard substantiality concerns and can create arguably abusive allocations. Target allocations, as commonly drafted, can fail to take into account which partner bears the economic risk of loss of partnership liabilities. Target allocations are particularly abusive when used in connection with the redemption of a partner from a partnership.

8. Section 704(b) and Partnership Allocations.

Section 704(a) and (b) provide:

The Section 704(b) regulations are grounded on the assumption that most partnership agreements would satisfy the requirements concerning substantial economic effect. The Section 704(b) regulations have failed in several senses. One is that the requirements of substantial economic effect required partnerships to liquidate in accordance with capital accounts. Many partnerships were unwilling to embrace this requirement. These partnerships instead preferred to specific how the partnership should distribute the proceeds of liquidation by describing tiers of distributions (the "liquidation waterfall") that did not reference partner capital accounts. The current trend is strongly in favor of not liquidating in accordance with partner capital account balances. This trend was encouraged by the Internal Revenue Service informally acquiescing in target allocations. The Section 704(b) regulations failed to provide clear, usable standards for substantiality. Substantiality has almost altogether disappeared as a partnership audit issue because so few understand and can apply substantiality. The Section 704(b) regulations also failed carefully to describe the analysis of partners' interests in the partnership. Many tax advisors understand partners' interests in the partnership to means simply what they want partners' interests in the partnership to mean. The current Internal Revenue Service audit permissiveness encourages a wide variety of sloppy target allocation provisions. This permissiveness has permitted partnership target allocation provisions that accomplish allocations that would not be permitted under the rules of substantial economic effect.

The tax law generally does not permit two taxpayers to trade tax items in order to reduce their collective tax liabilities. The rules of Section 704(b) are carefully circumscribed rules that permit partners to allocate partnership tax items among the partners, but only to the extent that the allocations potentially affect partnership economics. Target allocations, however, have no effect on partnership economics.

In any event, Treasury and the Internal Revenue Service should not approve target allocations in a situation in which allocations constructed under normal rules of substantial economic effect would not be respected. Target allocations should not become an end-run around the limitations of substantial economic effect.

Section 704 is not a model of clarity. Section 704(a) and (b), read together, appear to say that the partnership agreement can define how the partnership allocates a partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) if the allocation has substantial economic effect. Some advisors refer to this as the "Section 704(b) safe harbor," but Section 704 does not use safe harbor language. Section 704(a) and (b) appear merely to provide that the tax law will respect allocations in the partnership agreement if and only if those allocations have substantial economic effect.

The Section 704(b) regulations set forth the fundamental principles of economic effect:

The substantial economic effect rules of the Section 704(b) regulations contain extensive requirement so that allocations of allocations of income, gain, loss, and deduction will not be abusive. Target allocations in partnership agreements to a significant extent have displaced of allocations of income, gain, loss, and deduction that have substantial economic effect. This rush to target allocations has occurred without any guidance from Treasury and the Internal Revenue Service that target allocations will have any effect on partnership allocations. The rush to target allocations in partnership agreements assumes that Treasury and the Internal Revenue Service no long care much about the rules of substantial economic effect and perhaps no longer care about the potential abuse of partnership allocations. The Internal Revenue Service audits only a small percentage of partnerships. Substantial economic effect appears to be a low importance audit issue. If Treasury and the Internal Revenue Service no longer care about substantial economic effect and potential tax abuse through partnership allocations of income, gain, loss, and deduction, Treasury and the Internal Revenue Service perhaps should revoke and replace the current Section 704(b) regulations with regulations that better describe what allocations the Internal Revenue Service will accept.

The Internal Revenue Service needs to consider whether, in all cases, the target allocation satisfies the Section 704(b) regulations. This is a much more difficult test. The Section 704(b) regulations set a high standard in order for the tax law to respect allocations of income, gain, loss, and deduction in a partnership agreement.

Most commenters on target allocations devote little attention to whether target allocations satisfy partners' interests in the partnership.

Allocations in a partnership agreement may not have substantial economic effect. Allocations under a target allocation provision typically do not have substantial economic effect. Then, Section 704(b)(2) says that the partnership will allocate income, gain, loss, deduction, or credit (or item thereof) in accordance with partners' interests in the partnership. Section 704(b)(2) does not say that the allocations in the partnership agreement have the alternative of satisfying partners' interests in the partnership. Instead, Section 704(a) and (b) appear to say that the tax law disregards the allocations of income, gain, loss, and deduction in the partnership agreement unless those allocations satisfy substantial economic effect.

Partners' interests in the partnership may prescribe an economic analysis that is used to allocate income, gain, loss, deduction, or credit (or item thereof) whenever allocations in the partnership fail substantial economic effect. It makes no difference then whether the partnership agreement contains purported allocations or are altogether silent concerning allocations. Partners' interests in the partnership then applies Partners' interests in the partnership takes over and allocates income, gain, loss, deduction, or credit (or item thereof).

Partners' interests in the partnership¹² unfortunately is almost an after-thought in the Section 704(b) regulations. The Section 704(b) regulations do not thoroughly develop principles for determining what allocations of income, gain, loss, and deduction satisfy partners' interests in the partnership. Partners' interests in the partnership rules are not detailed. Partners' interests in the partnership rules are not particularly user-friendly. The rules of partners' interests in the partnership are principally stated as a collection of nonexclusive factors. The partners' interests in the partnership rules in the Section 704(b) regulations are little more than a list of considerations to apply, without guidance telling us how to apply these considerations.

The law of partners' interests in the partnership is confused. The law of partners' interests in the partnership is anything but well defined. The general confusion includes confusion over:

• Whether a partnership agreement can prescribe allocations that will control under partners' interests in the partnership,

• Whether partners' interests in the partnership describes a unique solution for allocations under a particular set of economic facts,

• Whether substantiality concerns apply to partners' interests in the partnership, and

• How target allocations should be drafted (if target allocations ever will control allocations of income, gain, loss, and deduction without satisfying substantial economic effect).

A special rule of substantiality has limited application. This special rule does not apply to partnership agreement with target allocation provisions, since partnerships with target allocation provisions do not distribute the proceeds of liquidation explicitly in accordance with partner capital accounts. This rule requires that the partnership distribute the proceeds of liquidation in accordance with partner capital accounts:

This special case of partners' interests in the partnership does talk about the partnership selling all of its assets and distributing the proceeds to the partner in liquidation. This special case of partners' interests in the partnership at least mentions substantiality. The special case of partners' interests in the partnership does not apply to target allocation provisions. Nevertheless, the target allocation provision is a rough adaptation of the rules of this special case of partners' interests in the partnership.

Any target allocation provision is unlikely to control partnership allocations of income, gain, loss, and deduction unless Treasury and the Internal Revenue Service are willing to adopt an exceedingly relaxed interpretation of partners' interests in the partnership.

Many advisors endorse such a relaxed interpretation of partners' interests in the partnership. Many advisors routinely draft partnership agreements containing target allocation provisions. Many advisors find using target allocation provisions convenient, whether or not the target allocation provisions actually affect partnership allocations.

Many advisors have a vested interest in Treasury and the Internal Revenue Service approving target allocations. These advisors have drafted many partnership and LLC agreements using target allocations. The failure of Treasury and the Internal Revenue Service to approve target allocations could embarrass these advisors.

If Treasury and the Internal Revenue Service did approve any target allocation provision for any purpose, Treasury and the Internal Revenue Service should clarify precisely how the particular target allocation provision works.

The correct tax treatment of target allocations, if approved in Treasury and the Internal Revenue Service guidance, also should depend on the development of a comprehensive theory of what is a capital shift in a partnership and how properly to different examples of tax capital shifts.¹⁶ Target allocations coupled with distribution schemes that do not reference partner capital accounts can produce de facto capital shifts among partners. It is possible that these capital shifts should result in deemed guaranteed payments.

If target allocations control allocations of income, gain, loss, and deduction at all, those target allocations must satisfy partners' interests in the partnership. Treasury and the Internal Revenue Service should publish guidance concerning target allocations, but only based on a foundation of a clear, comprehensive analysis of target allocations under partners' interests in the partnership.

Treasury and the Internal Revenue Service should defer guidance on target allocation provisions until Treasury and the Internal Revenue Service have undertaken a comprehensive review of how partners' interests in the partnership operates and how the rules of substantiality operate. This review should result in revised Section 704(b) regulations concerning partners' interests in the partnership and substantiality,

Sound rules for determining partners' interests in the partnership should constitute a foundation for target allocations, if the tax law permits target allocations to control partnership allocations of income, gain, loss, and deduction. Treasury and the Internal Revenue Service should not approve target allocations before Treasury and the Internal Revenue Service understand how partners' interests in the partnership works. The tax law to date has done little to clarify the fine points of partners' interests in the partnership, particularly where the partnership agreement does not liquidate by partner capital accounts. The current provisions of the Section 704(b) regulations concerning partners' interests in the partnership provide such a gossamer structure as to make the rules practically unusable.

Target allocations often differ from the likely result under partners' interests in the partnership. Target allocations do not address substantiality concerns. Target allocations also may fail to cause adjusted capital accounts to equal target capital accounts. In some situations, target allocations create results that differ from the results required under statutory or regulatory provisions. Specific examples are discussed later in this letter.

Target allocation provisions also can fail to make special allocations in situations in which special allocations may be required by partners' interests in the partnership or otherwise.¹⁷

The term "target allocations" refers to a broad approach to allocating partnership income and loss.¹⁸ Considerable inconsistencies in drafting and in result exist between different target allocation provisions that are in common use. Any guidance approving target allocations should define the precise target allocations to which the guidance applies.

Many advisors have a strong interest in receiving Treasury and the Internal Revenue Service approval of target allocations. Many practitioners draft all of their partnership agreements using target allocations. These advisors and their clients often have a personally vested interest in Treasury and the Internal Revenue Service respecting target allocations. These advisors have drafted partnership agreements -- often hundreds or even thousands of partnership agreements -- with target allocations that may be altogether ineffective if Treasury and the Internal Revenue Service completely disapprove target allocations. That is an inconvenient situation for these advisors if target allocations do not do anything at all, as may well be the case. This situation may expose these advisors to considerable embarrassment, client discontent -- or, at least, client skepticism, -- and the potential for errors and omissions claims. Incidentally, many of these target allocation provisions may be defective even if Treasury and the Internal Revenue Service approve some target allocation provision as controlling partnership allocations.

The term "target allocation" refers to a general approach in drafting partnership allocations. Partnerships agreements using the general approach of target allocations have many different target allocation schemes. These different target allocation schemes can reach different results in the same situation. Target allocations are not well defined. In fact, there are many different target allocation provisions that can produce vastly different results in a particular situation. Commenters supporting target allocations rarely discuss the ambiguity of what "target allocation" means.¹⁹ They simply seek broad approval for any allocations in the large target allocation group.

Target allocations never affect partnership economics. That is an important reason to be skeptical of. target allocations. Target allocations are all about tax and have no economic aspect. Why should target allocations control tax effects when the target allocations have absolutely no tax effect? Allocations that do not affect partnership economics are an open invitation to tax abuse. The Section 704(b) regulations (and Section 704 itself) establish the principle that taxpayers should be able to make a deal on partnership allocations only within carefully circumscribed rules of substantial economic effect. Target allocations do not follow those highly circumscribed rules.

Some tax allocation provisions depend on allocations satisfying substantial economic effect or otherwise controlling for tax purposes. If target allocations fail to control partnership allocations, this may disrupt claims to certain tax benefits.

Some tax advisors have been able to use target allocations for darker plans to adapt partnerships with target allocations to achieve tax benefits not intended by Congress. These tax benefits are often associated with investments commonly known as "tax shelters." Many partnership agreements contain target allocations that may result in abusive tax allocation schemes.

Some advisors will argue that they have never seen an abusive use of target allocations. This statement may better reflect what these advisors may not consider abusive rather than whether abuses exist. Some advisors may be blind to the potential for tax abuse if they themselves drafted the allocation provisions. There apparently exists a wide range of opinion concerning what allocations are abusive. Many nationally prominent law firms and accounting firms in the past have provided strong tax opinions concerning other tax plans and strategies that the courts, Treasury and the Internal Revenue Service later have identified as abusive. These law firms and accounting firms presumably were comfortable with these tax plans and strategies when they issued their tax opinions. Advisors with major law firms and accounting firms in the past have approved Son-of-BOSS, CARDs, and a variety of other transactions that we now consider abusive.

Some advisors will ask Treasury and the Internal Revenue Service to approve all target allocations as satisfying partners' interests in the partnership. I recommend that Treasury and the Internal Revenue Service be careful before generally approving the tax effects of target allocations.

Little doubt exists that some target allocation provisions are consistent with partners' interests in the partnership some of the time. It is doubtful that target allocations, as commonly drafted, will satisfy substantial economic effect.²⁰ The failure of target allocations to satisfy substantial economic effect requires target allocations to satisfy partners' interests in the partnership.

A partnership agreement may allocate taxable income and loss in accordance with a single set of percentages (such as 50% to partner A and 50% to partner B). Allocations in a partnership agreement in accordance with straight percentage interests are often consistent with partners' interests in the partnership. That does not mean that these allocations in the partnership agreement control for tax purposes. The partnership would allocate income and loss in precisely the same manner under partners' interests in the partnership if the partnership agreement contained no allocation at all.

I could go to the zoo. I could tell a large elephant I might encounter at the zoo to turn right and to walk in that direction. The elephant might coincidentally turn right and walk in that direction.

I might pat myself on the back. I might think myself a great elephant communicator.

This incident, however, does not make me an elephant whisperer.

I am not an elephant whisperer. I do not understand the elephant language.

I doubt that the elephant understands English. The elephant might not understand my directions. The elephant might not care about my directions if he understood them.

It is altogether coincidental that the elephant will turn right and walk in a direction consistent with my instructions. The elephant is acting on its own. The elephant is not following my instructions.

Some advisors will ask Treasury and the Internal Revenue Service to offer guidance that target allocations can control partnership tax allocations and can satisfy partners' interests in the partnership. For that conclusion to mean anything, the target allocations must control the allocation. The target allocation must act as a tax whisperer. The target allocation must actually affect how the partnership allocates the items of income and loss under partners' interests in the partnership. The target allocation needs to do more than my instruction to the elephant to turn right and to walk in that direction. The target allocation needs to be more than consistent with partners' interests in the partnership. The target allocation needs to control the allocation of income and loss under partners' interests in the partnership for the allocation to have any practical meaning.

12. Defining Target Allocations.

Guidance should define what it means by "target allocation." We start with a partnership agreement that does not explicitly distribute the proceeds of liquidation of partnership assets in accordance with partner capital accounts. The target allocation, as a general matter, allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts. The description of target allocations in Treasury and the Internal Revenue Service guidance needs to describe target allocations with much finer texture.

One bar association (referring to "target allocations" as "targeted capital account agreements") advises: "targeted capital account agreements generally provide that income and loss is to be allocated among the partners in a manner that causes the partners' capital accounts [or target capital accounts] to equal (to the extent possible) the partners' 'target capital accounts,' i.e., the amounts that would be received by the partners if the partnership sold all of its assets for their book values, repaid its liabilities, and then distributed the remaining proceeds to the partners."²¹ The partnership liquidates in accordance with set tiers that do not reference capital accounts.

That is a simple definition of "target allocation," but not an adequate definition. This definition provides a vague sense of how target allocations work. This definition is not a useful definition of "target allocation" for tax guidance. Tax guidance requires a much more precise definition of "target allocation."

If Treasury and the Internal Revenue Service are to approve certain target allocations, Treasury and the Internal Revenue Service need to be precise in what they approve. "Target allocations" and "targeted capital account agreements" include a broad collection of different allocation techniques. Some may work, although that is questionable. Others do not.

The starting point in building a definition of a target allocation is to define adjusted capital accounts, target capital accounts and income and loss.

As a general manner, target allocations allocate income and loss in such a manner that, after the allocations of income, gain, loss, and deduction for the year, adjusted capital accounts will equal target capital accounts. These partnership agreements provide for the partnership to distribute proceeds of liquidation in accordance with tiers (the "liquidation waterfall") or a formula that does not reference the partners' capital account balances. That is the general concept, at least.

• a partner's "book" capital account,²²increased by

• the partner's share of minimum gain, increased by

• the partner's share of partner minimum gain, and perhaps increased by

• certain capital contribution obligations or deemed capital contribution obligations of the partner (without duplication for minimum gain or partner minimum gain added back above), presumably determined in accordance with the scheme described in Treasury Regulations Section 1.704-1(b)(2)(ii)(b).

In practice, advisors often draft target allocation provisions that --

• use tax capital accounts rather than "book" capital accounts in defining adjusted capital accounts,²³

• fail to adjust adjusted capital accounts and target capital accounts on account of partner capital contribution obligations,²⁴

• fail to adjust adjusted capital accounts by minimum gain and partner minimum gain,²⁵ and

• fail to adjust adjusted capital accounts by other allocations required by the Code outside of the target allocation provision.²⁶

• c. Defining What a Target Allocation Allocates,

Some target allocation provisions in partnership agreements allocate net income and net loss -- regardless of whether the result equalizes adjusted capital accounts and target capital accounts.²⁷ The operation of these provisions is in doubt in situations in which insufficient net income and net loss are available to cause adjusted capital accounts to equal target capital accounts.²⁸ Target allocation provisions can approach this situation in at least three ways:

• Some target allocation provisions merely allocate net income and net loss and accept the result. These target allocation provisions provide for a make-up allocation in subsequent taxable years to cause adjusted capital accounts to equal target capital accounts.

• Some target allocation provisions abandon allocations of net income and net loss and switch to allocating gross income and gross losses when gross item allocations are necessary for equalizing adjusted capital accounts and target capital accounts. Few of these provisions provide much texture in indicating precisely which items of gross income or gross loss the provision allocates to each specific partners. As a practical matter, these provisions usually rely on ad hoc determinations by partnership management or partnership accountants for specific allocations to each partner.

• Some target allocation provisions allocate net income and net losses, but create deemed guaranteed payments and special allocations of the resulting deductions to bridge the gap between adjusted capital accounts and target capital accounts.

• d. Special Allocation Provisions.

• Allocations of nonrecourse deductions, which the partnership allocates under the Nonrecourse Deduction Regulations.

• The minimum gain chargeback, which is set forth in the Nonrecourse Deductions Regulations.

• Allocations of partner nonrecourse deductions, which are required under the Nonrecourse Deduction regulations.

• The partner minimum gain chargeback, which is required under the Nonrecourse Deduction Regulations.

• Allocations required under a qualified income offset, which may be required under the Section 704(b) regulations.

• Allocations of exculpatory deductions.

• Forfeiture allocations related to forfeited restricted partnership interests.

• Special allocations of deductions on account of the issuance of service partnership interests.

• Allocations mandated under the varying interests rule (e.g., prorated cash basis items).

• Allocations that the partnership specially allocates under Section 704(c)(1)(C).

• Special allocations in order properly to reflect partnership economics in accordance with partners' interests in the partnership.

• Other special allocations that may be required under the tax laws.

Guidance from Treasury and the Internal Revenue Service should clarify how the partnership should draft the target allocation provision in order to conform to partners' interests in the partnership.

Guidance from Treasury and the Internal Revenue Service also should clarify whether a properly drafted target allocation provision can have any effect on partnership allocations. Considerable doubt remains. The target allocation provision is functional only if the target allocation provision influences how the partnership allocates income and loss for tax purposes. The conventional wisdom is that, if the target allocation provision influence partnership allocations, the target allocation provision must satisfy partners' interests in the partnership.

13. Target Allocations Violate the Fundamental Principles of Economic Effect.

Partnership agreements using target allocations normally liquidate by tiers that do not refer to capital accounts. Target allocations normally do not have any impact on how the partnership distributes cash. This violates the fundamental principles of economic effect:

Target allocation provisions are material only where the target allocation provisions reach allocations that are not uniquely required by a direct application of partners' interests in the partnership. Allocations under a target allocation provision must control partners' interests in the partnership in order for target allocations to be material. I believe that it is doubtful that target allocations should ever control partnership allocations.

The tax law respects target allocations only if the target allocations satisfy partners' interests in the partnership. Target allocations control partnership allocations only if for a taxable year more than one scheme of allocations satisfies partners' interests in the partnership. I do not believe that any such a situation exists.

An allocation provision in a partnership agreement will control a tax allocation (other than under the limited rule for nonrecourse deductions) under Section 704 only if the allocation in the partnership agreement has substantial economic effect or somehow otherwise controls partners' interests in the partnership. Target allocation provisions may describe partners' interests in the partnership in appropriate circumstances, but target allocation provisions should not control partners' interests in the partnership.

If this line of reasoning is correct, then it does not matter what the target allocation provision says. Partners' interests in the partnership disregards the target allocation provision. Partners' interests in the partnership performs its own economic analysis. Partners' interests in the partnership determines the proper allocations of income, gain, loss, and deduction in accordance with partners' interests in the partnership without reference to the target allocation provision.

In order for a target allocation provision to have any tax effect, it is necessary both to overcome the language of Section 704 and to have a situation in which two or more allocation schemes satisfy partners' interests in the partnership. The target allocation provision makes no difference when the partnership has a straight percentage economic scheme. Partners' interests in the partnership will allocate "book" income and loss in accordance with that straight percentage scheme. We do not need a target allocation provision to tell us how to allocate income and loss in this situation.

Similarly, when the partnership agreement provides for a preferred return and then distributes cash in accordance with straight percentages, partners' interests in the partnership normally behaves in the same manner in which the target allocation provision is drafted. That is the only possibility for allocating "book" items. The target allocation provision at best does nothing other than describe how partners' interests in the partnership works whether or not the target allocation provision is present.

The tax law will respect the target allocation provision, if at all, only under partners' interests in the partnership. A precondition for the target allocation provision to have any tax effect is that two or more allocation schemes satisfy partners' interests in the partnership. We can posit that allocation scheme A allocates income and loss in one manner. Allocation scheme B allocates income and loss in a different manner. The target allocation provision is effective only if the target allocation provision selects one of those allocation schemes (say allocation scheme A) and the tax law respects that selection. If partners' interests in the partnership leads to one allocations scheme for the year (say allocation scheme B) and the target allocation provision would lead to another allocation scheme (allocation scheme A), the tax law will reject allocation scheme A since allocation scheme A fails partners' interests in the partnership.

15. Partners' Interests in the Partnership Necessarily Should Have a Unique Solution.

Partners' interests in the partnership must permit two or more solutions for a partnership on a given collection of income, gain, deduction, and loss items if target allocations are to have a meaningful effect on tax allocations. Otherwise, target allocations, at best, merely provide the single solution required by partners' interests in the partnership. In that event, target allocations merely describe partners' interests in the partnership rather than control partners' interests in the partnership. Partners' interests in the partnership would reach precisely the same result in the absence of the target allocations.

I do not believe that it is possible as a matter of basic tax theory for two allocation schemes to satisfy partners' interests in the partnership at the same time.

We can examine what might happen if two or more allocation schemes simultaneously satisfied partners' interests in the partnership.

Assume that both allocation scheme A and allocation scheme B satisfy partners' interests in the partnership for a particular partnership taxable year. Allocation scheme A and allocation scheme B produce different tax liabilities for the partners. Assume that the partnership agreement does not contain a target allocation provision or any other attempt to allocate tax items among the partners. Section 704 requires that the partnership allocate tax items in accordance with partners' interests in the partnership.

Does the partnership make out its tax return in accordance with allocation scheme A or allocation scheme B? Both schemes satisfy partners' interests in the partnership. Does the partnership have a choice? How does the partnership choose? I do not believe that the tax liability of the partners should be elective. If the partnership return is audited, does the field examiner choose allocation scheme A or allocation scheme B? How does the field examiner choose? Can the field examiner override the partnership's selection of allocation scheme A or allocation scheme B? What happens if the case reaches the Tax Court or the District Court? How does the court determine which allocation is correct if both allocation schemes satisfy substantial economic effect?

Partners' interests in the partnership necessarily prescribes a unique allocation scheme for partners' interests in the partnership for a partnership's taxable year. That allocation scheme for partners' interests in the partnership may or may not be consistent with the allocation scheme prescribed by the target allocation provision. A unique allocation scheme for partners' interests in the partnership is necessary in order for each partner to have a unique tax liability for the taxable year. A unique allocation scheme for partners' interests in the partnership is necessary for the partnership to be able to make out its tax return accurately and consistently. A unique allocation scheme for partners' interests in the partnership is necessary for the Internal Revenue Service to be able to resolve an audit of the partnership. A unique allocation scheme for partners' interests in the partnership is necessary for a court to be able to resolve a tax dispute over partnership allocations. A unique allocation scheme for partners' interests in the partnership is inconsistent with a role for a target allocation provision, except as a descriptive provision.

If the unique allocation scheme that satisfies partners' interests in the partnership is the same as the allocation scheme prescribed by the target allocation provision, then that allocation scheme controls. If the unique allocation scheme that satisfies partners' interests in the partnership is not the same as the allocation scheme prescribed by the target allocation provision, then the allocation scheme satisfying partners' interests in the partnership controls. In any event, the target allocation provision has no tax effect on the allocations of income, gain, loss, and deduction. This does not leave any role for the target allocation provision other than as a descriptive provision.

16. Substantiality and Target Allocations.

Several additional hurdles exist to the application of the target allocation provision. Substantiality is an important consideration for substantial economic effect. The substantiality provisions under the Section 704(b) regulations are an important limitation on substantial economic effect.

It seems. doubtful that partners' interests in the partnership would approve allocations that would fail substantial economic effect for failing substantiality under the Section 704(b) regulations. A partnership using a target allocation provision should not be able to achieve allocations that would violate substantiality if the partnership agreement satisfied the requirements of economic effect. Target allocations often may have substantiality issues. It nevertheless is not clear that substantiality applies under the basis test of partners' interests in the partnership.

The Section 704(b) regulations do not provide clear guidance concerning how the partners' interests in the partnership applies substantiality. Guidance that approves target allocation provisions as satisfying partners' interests in the partnership could provide an end-run for partnerships around substantiality. This could lead to many abusive allocations.

Situations also exist in which partners' interests in the partnership requires that the partnership specially allocate items of income among partners. Target allocation provisions do not work at all in these situations.

A series of examples beginning on page 65 of this letter illustrate some problems with target allocation provisions.

17. Value-Equals-Basis Presumption.

Treasury and the Internal Revenue Service should clarify the application of the value-equals-basis presumption in the context of partners' interests in the partnership and target allocations.

The rules under substantiality concerning transitory allocations contain a value-equals-basis presumption. This value-equals-basis presumption provides:

The value-equals-basis presumption often makes little economic sense. One of these situations in which the presumption fails to make economic sense is where the partnership has sold its principal property in a Section 1031 exchange, holds cash though an accommodator's exchange account, and plans to acquire replacement property. The value-equals-basis presumption also is questionable when the partnership has recently valued its assets in order to determine how much to distribute to a retiring a partner. The value-equals-basis presumption can make little practical sense and can lead to abusive target allocations.

The Section 704(b) regulations limit the value-equals-basis presumption, by its terms, to the transitory allocation rule of substantiality, the other rules of substantiality under Treasury Regulations Section 1.704-1(b)(2)(iii), and the adjustment for distributions under the alternate effect (Treasury Regulations Section 1.704-1(b)(2)(ii)(d)(6)), and the Treasury Regulations Section 1.704-1(b)(3)(iii) rule under partners' interests in the partnership. Perhaps significantly, the value-equals-basis presumption rule does not explicitly apply to the basic rules of partners' interests in the partnership under Treasury Regulations Section 1.704-1(b)(2)(i) and (ii). Whether partners' interests in the partnership imports substantiality concerns by implication is uncertain.

18. Target Allocations and devaluations of Partnership Assets.

Guidance on target allocations should address whether the Section 704(b) regulations permit a partnership using target allocations to revalue partnership assets and to redetermine partnership capital accounts. The Section 704(b) regulations may not permit partnerships using target allocations to revalue assets and to redetermine capital accounts accordingly upon events specified in the Section 704(b) regulations. Alternatively, the Section 704(b) regulations may require partnerships using target allocations sometimes to revalue assets and to redetermine capital accounts accordingly.

The aggregate revenue effect of reverse Section 704(c) allocations to retiring partners has not been determined, but it may be considerable. Partnerships often use reverse Section 704(c) allocations in an abusive manner.

The Section 704(b) regulations are skeptical of partnerships revaluing assets to fair market value and redetermining capital accounts. The implicit philosophy is that evil tax advisors can use revaluations to reset capital accounts at unrealistic values in order to thwart the rules of substantiality. The Section 704(b) regulations consequently limit capital account redeterminations based on asset revaluations to these limited situations:

Particularly in the securities investment field, partnerships using target allocations and securities aggregation revalue assets regularly and redetermine capital accounts (often on a daily basis). These partnerships then apply reverse Section 704(c) allocations by preferentially allocating taxable gain to partners who retire during the taxable year. These preferential allocations provide that the partnership allocate gain from the sale of securities during the year, first to retiring partners as reverse Section 704(c) allocations in order to eliminate the revaluation surplus for the partner. These reverse Section 704(c) allocations depend on the ability of the partnership to redetermine capital accounts on prescribed events (and also on the ability to use securities aggregation). The tax law has not determined whether this "fill-up" application of reverse Section 704(c) allocations in this manner is a correct application of the reverse Section 704(c) rules. In any event, this practice of securities aggregation, regular book-ups, and "fill-up" allocations to retiring partners is a common feature of securities partnerships.

These reverse Section 704(c) allocations (coupled with securities aggregation) are particularly popular, since these allocations typically do not increase the tax liability of the partner receiving the allocation, but these allocations decrease the tax liabilities of continuing partners.

Some authorities would object that reverse Section 704(c) allocations only affect timing of tax effects. One similarly might observe that the difference between life and death is merely a question of timing.³²

Assume that a partner has revaluation surplus of $1 million, a capital account of zero, and a tax basis in its partnership interest of zero. Assume that the partnership's income is long-term capital gain. Assume further that the partner holds its partnership interest as a long-term capital asset. The partnership revalues its securities assets on a daily basis. The partnership allocates $1 million in long-term capital gain to the retiring partner as a reverse Section 704(c) allocation. This allocation results in $1 million in long-term capital gain to the retiring partner. The allocation increases the partner's tax basis in its partnership interest from zero to $1 million. The partnership retires the partner for a $1 million cash distribution. The partner does not recognize any gain under Section 731 on the retirement of its partnership interest. The income of the continuing partners is reduced by the excess of (i) 1 million, over (ii) the proportional share of income that the partnership otherwise would have allocated to the continuing partner.

Assume that the tax did not permit the partnership to revalue its assets and to redetermine capital accounts. The partnership would allocate to the retiring partner only the retiring partner's share of long-term capital gain. The sum of this allocation and the long-term gain that the partner recognizes under Section 731 is $1 million, precisely the same amount that the partner would recognize if there had been a reverse Section 704(c) reverse allocation. The reverse Section 704(c) allocation reduces the partnership income allocable to the other partners by $1 million. Without the reverse Section 704() allocation, the partnership income allocable to the other partners is reduced by the small amount of long-term capital gain normally allocated to the partner under the partnership agreement.³³

Alternatively, partners' interests in the partnership may implicitly require regular revaluation of partnership assets -- or perhaps revaluation of partnership assets on particular events (such as the retirement of a partner). The Section 704(b) regulations contain this significant statement concerning revaluations: "If the capital accounts of the partners are not adjusted to reflect the fair market value of partnership property when an interest in the partnership is acquired from or relinquished to the partnership, paragraphs (b)(1)(iii) and (b)(1)(iv) of this section should be consulted regarding the potential tax consequences that may arise if the principles of section 704(c) are not applied to determine the partners' distributive shares of depreciation, depletion, amortization, and gain or loss as computed for tax purposes, with respect to such property."³⁴ The statement is somewhat cryptic, but it does indicate that the failure to redetermine capital accounts on retirement of a partner creates substantiality concerns. The Internal Revenue Service should skeptically regard the failure of a partnership to redetermine capital accounts on the retirement of a partner: this suggests an opportunity for tax abuse.

The Section 704(b) regulations apply the normal capital account adjustment rules in connection with allocations that have substantial economic effect. The use of capital accounts under partners' interests in the partnership may differ from the use of capital accounts under substantial economic effect. Partners' interests in the partnership might well require revaluation of capital accounts on all permitted adjustment events under the Section 704(b) regulations. Alternatively, partners' interests in the partnership might require annual revaluation of capital accounts regardless of whether a normal revaluation event has occurred. The lack of specificity of the rules concerning partners' interests in the partnership under the Section 704(b) regulations admit the possibility that partners' interests in the partnership requires regular redetermination of capital accounts.

19. Target Allocations and Capital Shifts.

Target allocations potentially can involve capital shifts among partners. The tax law concerning capital shifts between partners is not well developed. The general rule appears to be that a capital shift between partners is (or, at least, sometimes can be) a taxable transfer.³⁵ The capital shift may result in a guaranteed payment to the partner whose interest in capital is increased.³⁶ The tax law could consider the transaction the equivalent of a partner receiving a current cash payment from the partnership equal to the capital account credit, followed by the partner recontributing the cash to the partnership. A general consensus exists that the tax law taxes the service partner on a capital shift resulting from the transfer of a partnership capital interest to a partner as consideration for the performance of services.³⁷

The Section 704(b) regulations permit a partnership to revalue partnership assets and to adjust capital accounts, apparently without creating a taxable event.³⁸ The tax law might recharacterize such a transaction as a capital shift between partners in appropriate circumstances.

The Section 704(b) regulations also approve a situation (apparently without recognition of partner gain) when a partnership distributes to a partner in retirement of the partner's partnership interest an amount other than the amount in the partner's capital account.³⁹ The Section 704(b) regulations require that "the partnership interest of one or more partners is purchased (other than in connection with the liquidation of the partnership) by the partnership or by one or more partners (or one or more persons related, within the meaning of section 267(b) (without modification by section 267(e)(1)) or section 707(b)(1), to a partner) pursuant to an agreement negotiated at arm's length by persons who at the time such agreement is entered into have materially adverse interests and . . . a principal purpose of such purchase and sale is not to avoid the principles of the second sentence of paragraph (b)(2)(ii)(a) of this section."⁴⁰ The tax law might characterize this transaction as an implicit capital shift among partners, although the Section 704(b) regulations do not indicate that the transaction is taxable.

The capital account shift to a partner resulting from a preferred return is similar to the capital account shift resulting from the explicit agreement of the partners. The shift accompanying the explicit agreement of the partners appears to be taxable. Treasury and the Internal Revenue Service should provide a sound explanation why the capital account shift resulting from a preferred return is not also taxable if, in fact, that capital account shift is not taxable.

The tax law does not currently provide comprehensive guidelines concerning what is a capital shift among partners and what capital shifts are taxable to the partners. Some of the issues of capital shifts relate to target allocations when target allocations fail to cause adjusted capital accounts to equal target capital accounts. This problem is discussed later in this letter.

I understand that one prominent bar association has commented that "we do not believe that a guaranteed payment should arise solely because the target capital account of a partner at the end of a taxable year differs from the partner's Section 704(b) capital account at the end of the taxable year."⁴¹ This advice may be correct, but a proper consideration of this conclusion requires a comprehensive examination of partners' interests in the partnership and capital shifts among partners. Proper consideration of the validity of target allocations requires a comprehensive examination of partners' interests in the partnership and substantiality.

Treasury and the Internal Revenue Service have received comments that "a preferred return should never give rise to a guaranteed payment if, as of the time a partnership interest is issued, the holder of the interest will receive more than its invested capital back only if and to the extent the partnership generates cumulative net earnings during the period that the interest is outstanding.⁵⁰ [ ⁵⁰ It should be noted that "income" for this purpose should exclude any built-in gain allocated to other partners under Treas. Reg. § 1.704-1(b)(2)(iv)(f) prior to or in connection with the issuance of the preferred equity interest.] . . . We believe this is true even if, as a result of the Section 704(b) allocation rules, the partnership allocates income away from the holder of an interest with a preferred return in one taxable year but then 'shifts' the right to that income back to the holder in a subsequent taxable year in light of the continued accrual of the preferred return, since the shift would never have arisen if the partnership had not generated the income being shifted back."⁴² These comments may well be correct, but the analysis of these comments requires a comprehensive review of the tax consequences of capital shifts. In appropriate circumstances, preferential distributions to a partner dependent on future partnership income can have the effect of capital shifts where the uncertainty of the future income is low.

I do not argue for a particular guidance result with respect to guaranteed payments and capital shifts. The competing considerations make the resolution of the issues difficult. I merely argue that the tax law should base the treatment of capital shifts in each situation based on reasoned analysis and reasoned distinctions where particular transactions are treated differently.

Significantly, guidance may conclude that the treatment of capital shifts is not at all of question of target allocations and that target allocations never control allocations for federal income tax purposes.

20. Example 1: Target Allocation Provision, Service Partner and Preferential Distribution.

The operation and the potential effectiveness of target allocation provisions is particularly uncertain in many situations involving service partners.

Example 1. Fran and American Insurance are members of American Dream Partners, LLC. Fran receives what he considers to be a profits interest in American Dream Partners in exchange for acting as manager of the LLC.⁴³ American Insurance contributes $800 million to American Dream Partners in cash.

Fran makes no capital contribution to American Dream Partners. Fran does not receive an explicit capital account under the American Dream Partners LLC agreement.

This is the initial balance sheet of American Dream Partners (before considering any possible effects of a capital shift on formation):

 Assets                             Liabilities & Capital

Income of American Dream Partners is long-term capital gain. The target allocation provision will preferentially allocate long-term capital gain to Fran until Fran's capital account represents 10% of partner capital accounts. The target allocation provision will convert service income into long-term capital gain.

The LLC agreement of American Dream Partners contains a target allocation provision that allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

The LLC agreement of American Dream Partners does not contain a capital account deficit restoration obligation.

The Internal Revenue Service can make a good case can be made that this situation creates a capital shift on the formation of American Dream Partners. The conventional wisdom is that this capital shift is a taxable capital shift (or some similar recognition transaction) that produces an $80 million guaranteed payment from American Dream Partners to Fran, with a special allocation of the deduction to American Insurance.

The idea is that Fran economically receives a capital interest in American Dream Partners for services and that this transaction should be taxable under Section 83. Fran is in much the same position as if he had received $80,000,000 in cash as consideration for his services and then had contributed the $80,000,000 to American Dream Partners as a capital contribution.

The capital shift is based on the argument that capital accounts in American Dream Partners should be consistent with how the proceeds of liquidation would be distributed if American Dream Partners sold all of its assets at "book" value, paid off its liabilities, and distributed the remaining proceeds to the partners in liquidation. A shift of capital from one partner to another may be a taxable transaction. The tax law has not adequately explored capital shifts among partners. The taxable capital shift argument is grounded on Lehman v. Commissioner.⁴⁴

The idea that receipt of a capital interest in a partnership as compensation for services is taxable has long been asserted and seems to be generally accepted. The amount of the service partner's income has not been resolved.

Fran's situation in Example 1 can be economically similar to Fran not receiving a capital account for services but rather receiving a profits interest with a preferential allocation of net income or gross income that is highly likely to materialize.

If there is a capital shift to Fran upon formation of American Dream Partners, this is a possible American Dream Partners balance sheet after the capital shift:

 Assets                             Liabilities & Capital

If American Dream Partners liquidated in accordance with capital accounts, Fran would receive 10% of the proceeds and American Insurance would receive 90% of the proceeds.

If Fran's admission to American Dream Partners does not result in a capital shift and is not taxable to Fran, then the target allocation provision should operate to create a large allocation to Fran so that, as a result of the allocation, Fran's capital account is equal to 10% of partners' total capital accounts.

21. Example 2: Treatment of Profits Interest With Preferential Allocation of Profits.

A service partner may receive a make-up allocation under a target allocation provision so that the service partner is treated as if he made a full capital contribution when he did not. The argument is that the service partner does not receive a capital interest in the partnership as consideration for the provision of services to the partnership. This is illustrated in Example 2 below.

Example 2. Sarah and Tin Star Equities are members of Oak Tree Partners, LLC. Sarah receives what she considers to be a profits interest in Oak Tree Partners in exchange for acting as manager of Oak Tree Partners. International Real Estate Developers contributes $500 million in cash to Oak Tree Partners.⁴⁵

The operating agreement of Oak Tree Partners provides that all distributions (whether operating distributions or distributions in liquidation) by Oak Tree Partners will be made:

• First, to Tin Star Equities until Tin Star Equities has received the return of its unrecovered capital contribution.

• Second, to Sarah, until Sarah has received $55,555,556 in cash under this second tier.

• Third, 90% to Tin Star Equities and 10% to Sarah.

The operating agreement contains a target allocation provision that allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

This is the initial balance sheet of Oak Tree Partners, LLC:

 Assets                             Liabilities & Capital

Oak Tree Partners is projected to have no net taxable income or net taxable loss over its first three years. Oak Tree Partners plans to admit a new partner for a cash capital contribution immediately prior to the end of year 3. Oak Tree Partners will revalue its assets at the time of the admission of the new partner. The parties believe that there will be sufficient appreciation in its assets so that Sarah will receive a preferential allocation of nontaxable "book" income associated with the asset book-up under the target allocation provision to cause Sarah's capital account to equal $55,555,556. Sarah will not be taxable on account of the asset revaluation and the allocation of unrealized revaluation gain to her capital account.

Sarah may be taxable upon admission under Section 83 upon her receipt of a profits interest in Oak Tress Partners. The proper characterization of the transaction may be that Sarah should be treated as receiving a capital interest in Oak Tree Partners on account of the preferential allocation under the target allocation provision. Economically, Sarah stands close to the position of a partner who receives an immediate capital interest as consideration for the provision of services to Oak Tree Partners. Sarah also could be compared to the partner who is paid $55,555,556 as consideration for the performance of services and who contributed the proceeds to Oak Tree Partners immediately afterwards.

22. Example 3: Target Allocation Provision and Preferential Distribution.

Preferential distribution provisions and preferential returns under a target allocation provision can pose considerable theoretical difficulties for target allocation provisions. Preferential distribution provisions and preferential returns can create significant challenges for target allocations. In appropriate circumstances, preferential distribution provisions and preferential returns may create taxable capital shifts among partners.

Example 3 illustrates a situation in which one partner receives a preferential distribution that economically could be payable out of capital contributed by the other partner. The preference is not dependent on the existence of partnership profits. Example 3 bellow illustrates some of the problems:

Example 3. Catherine and Bill are partners of Kingdom Partners. Each contributes $1 million to Kingdom Partners. Kingdom Partners provides for the following plan of distributions from operations and in liquidation:

• First, $1.1 million to Bill.

• Second, $1.1 million to Catherine.

• Third, 50% to Bill and 50% to Catherine.

 Assets                             Liabilities & Capital

The partnership agreement does not impose a deficit restoration obligation on partners.

Assume that Kingdom Partners does not have any income or loss in year 1.

If Kingdom Partners were to liquidate immediately after its formation, the cash would be distributed in this manner:

                     Bill                $1,100,000

                     Bill                $1,100,000

The idea that a capital shift occurs is based on the argument that capital accounts should be consistent with how the proceeds of liquidation should be distributed if the partnership sold all of its assets at "book" value, paid off all of its liabilities, and distributed the remaining proceeds to the partners in liquidation. A shift of capital from one partner to another may be a taxable transaction, although the tax law has not to a significant extent explored capital shifts amount partners.

Some might argue that the transaction in Example 3 does not create a capital shift and that the imbalance of capital accounts should later be corrected by allocations under the target allocation provision. Some might argue that the imbalance should wait until the disparity between partnership economics and partnership capital accounts is corrected by net income and net loss allocations. Some might argue that the imbalance should wait until the disparity between partnership economics and partnership capital accounts is corrected by gross income and gross loss allocations. The resolution of this matter currently is uncertain.

Example 3 also challenges the target allocation. The target allocation in Example 3 does not cause adjusted capital accounts to equal target capital accounts at the end of year 1. This challenges whether the target allocation provision is in accordance with partners' interests in the partnership. The tax law may require that the disparity between adjusted capital accounts and target capital accounts be corrected by a guaranteed payment to Bill in the amount of $100,000. This letter has suggested additional arguments under which the target allocation provision may fail to control the result under partners' interests in the partnership.

23. Example 4: Percentage-Based Preferred Return and Target Allocation.

A percentage-based preferred return can create similar issues. This is illustrated in Example 4 below. Example 4 may not result in a taxable capital shift and a resulting guaranteed payment. Example 4 may not result in any capital shift at all. All of this is a matter than should be considered and resolved in a comprehensive study of guaranteed payments.

Example 4. Santini and Lysistrata are the two partners of Estate Partners. Santini and Lysistrata each contribute $1 million to Estate Partners.

Estate Partners provides for the following plan of distributions from operations and in liquidation:

• First, to Santini, an amount necessary to return Bill's capital contribution and then to provide a 10% return to Bill on his unrecovered capital contribution.

• Second, to Lysistrata, an amount equal to the amount distributed to Santini under the first tier.

• Third, 50% to Lysistrata and 50% to Santini.

 Assets                             Liabilities & Capital

Estate Partners allocates income and losses under a target allocation provision. The target allocation provision allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

If Estate Partners were to liquidate at the end of year 1, the cash would be distributed in this manner:

                     Santini             $1,100,000

The capital account treatment of the transaction is uncertain. One might argue that capital accounts should be consistent with how cash would be distributed if the partnership sold all of its assets at book value, paid off its debts, and then distributed the balance in liquidation. Capital accounts should be adjusted to reflect partnership economics if this theory of capital accounts is correct. This matter is not settled. The Section 704(b) regulations are not clear that they require an adjustment to capital accounts to ensure that capital accounts are consistent with partnership economics.

24. Example 5: Target Allocation, Like-Kind Exchange, and Retirement of a Partner.

Target allocation provisions often are used for real estate partnerships in connection with Section 1031 exchanges. Example 5 is an example of a typical situation with a real estate general partnership, a Section 1031 exchange, and the retirement of a partner in connection with the exchange. The target allocation provision can operate to transform the partnership into a tax shelter for continuing partners.

Example 5 illustrates a common target allocation problem in connection with a Section 1031 exchange. A partner retires from the partnership contemporaneously with a Section 1031 exchange. The target allocation provision creates what are commonly referred to as a "fill-up" allocation that makes a large disproportionate income allocation to the retiring partner.

In proper situations, the target allocation provision could result in a target allocation to a retiring partner many times the amount of cash that the retiring partner receives for its partnership interest. The retiring partner may not incur any increase in the tax that it will pay on account of the preferential allocation to the retiring partner. Continuing partners can benefit from a substantial reduction in their current tax liability.

Example 5. Tall Towers is a real estate general partnership. Tall Towers owns Tall Towers Hotel, located in Las Vegas, Nevada. The three partners are Malaysian Insurance Co., Zebra Insurance Co., and Callahan Insurance Co. Each partner is a 1/3^rd partner.

Tall Towers allocates all gains and losses under a well-drafted target allocation provision. The target allocation provision allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

Tall Towers does not have a "book"-tax disparity in its assets. Tall Towers does not rebook assets. The controlling capital accounts for tax purposes are the capital accounts at adjusted tax basis.

This is the balance sheet of Tall Towers at the beginning of the taxable year:

                                 Assets

             Depreciation of Improvements       $6,000,000

In addition to these items, Tall Towers exchanges its property at the end of the taxable year in a transaction that qualifies generally under Section 1031. Tall Towers receives $15,000,000 in cash in the exchange transaction, plus replacement real property. Tall Towers invests in qualifying replacement property in the exchange. Tall Towers recognizes $15,000,000 in gain from the exchange (corresponding to the cash).

This computes the net increase in Tall Tower's cash over the taxable year:

         Cash Expenses from Operations           ($38,000,000)

     Depreciation of Improvements                       $6,000,000

     Cash Expenses from Operations                    ($38,000,000)

                                  Assets

The target allocation provision normally has allocated income and loss 1/3^rd to each partner in the past. The liquidation of Malaysian Insurance Co.'s interest in Tall Towers will create unique challenges under the target allocation provision. These would be the annual allocations of Tall Towers if Tall Towers allocated net income and net loss 1/3^rd to each partner:

               Malaysian Insurance Co.        $8,333,333

Tall Towers does not have any nonrecourse liabilities or partner nonreourse liabilities. We do not have to worry about minimum gain or partner minimum gain in applying the target allocation provision.

These are the adjusted capital accounts of the partners (without considering the cash distribution to Malaysian Insurance Co.) before the allocation of income and loss for the year:

              Malaysian Insurance Co.       ($19,533,333)

These are the target capital accounts of the partners (equal to the amount each partner would receive in a liquidation of Tall Towers at "book" value):

               Malaysian Insurance Co.       $55,000,000

This is the balance sheet of Tall Towers on the last day of its taxable year, immediately before the distribution to Malaysian Insurance Co. and after the operation of the target allocation provision (assuming that the target allocation provision allocates net income and net losses).

                                 Assets

                                         Adjusted       Target

                                  Assets

This suggests the possibility that something sinister is afoot. The target allocation provision has not performed its function: to cause partner capital accounts to equal the amount that the partners would receive on liquidation. Malaysian Insurance Co. will receive $57,266,667 more than the amount in its capital account. This suggests the possibility that the allocation is not in accordance with partners' interests in Tall Towers. The allocation does not cause Malaysian Insurance Co. to have a capital account (at adjusted tax basis) equal to the amount that it would receive in liquidation. An allocation of gross income and gross deduction items could come closer to causing Malaysian Insurance Co.'s capital account to equal the amount that he is distributed in liquidation of his partnership interest.

Tall Towers allocates all net income Malaysian Insurance Co. under the target allocation provision, even though Malaysian Insurance Co. is a 1/3^rd partner. Economics of Tall Towers are still shared 1/3^rd each by the three partners. This suggests the possibility that the allocation is not in accordance with partners' interests in Tall Towers and should not be respected. The allocation under the target allocation provision has no effect on how cash is distributed by Tall Towers.

One way to repair the theoretical damage is to provide for a deemed guaranteed payment of $57,266,667 to Malaysian Insurance Co. ($55,000,000 distribution - netative $2,266,667 [Malaysian Insurance Co.'s capital account after the net income allocation] = $57,266,667). This guaranteed payment could be explained by the implicit capital shift among partners that the situation produces. Another way to repair the theoretical damage is to require that Tall Towers make an allocation of net income rather than gross income. A further possibility is simply to live with the results of the net income allocation and to decide that the net income allocation under the target allocation provision satisfies partners' interests in Tall Towers. A final possibility is to require that Tall Tower allocate net income 1/3^rd to each partner, so that the net income allocation for the year is consistent with the three partners' equal interests in Tall Towers.

Of the possibilities, allocating net income 1/3^rd to each partner ($4,466,667 each) seems to be the one most consistent with partners' interests in the partnership. Incidentally, if partners' interests in the partnership has a unique solution, then an allocation 1/3d to each partner in this situation is inconsistent with partners' interests in the partnership if the target allocation provision correctly shows how partners' interests in the partnership works.

The size of the income allocation to Malaysian Insurance Co. is unlikely to have any appreciable tax effect on Malaysian Insurance Co. Income that Tall Towers allocates to Malaysian Insurance Co. will reduce Malaysian Insurance Co.'s gain under Section 731 on the cash distribution. The only effect of a large allocation of gain to Malaysian Insurance Co. would be to reduce the immediate tax liability of the remaining two partners for the year. A large income allocation to Malaysian Insurance Co. on the redemption thus can create tax shelter for Zebra Insurance Co. and Callahan Insurance Co. at no additional cost to Malaysian Insurance Co. This situation can satisfy the deepest aspirations of abusive tax advisors.

Some authorities would argue that Tall Towers must disaggregate its income and loss items and make allocations of gross income and gross losses in order so that Malaysian Insurance Co.'s closing capital account will equal the amount that Malaysian Insurance Co. receives in liquidation. This tax issue has not yet been resolved. Many target allocation provisions are drafted to create gross income and gross loss allocations when necessary to cause adjusted capital accounts to equal target capital accounts.

This is the balance sheet of Tall Towers immediately before the end of the taxable year and before the retirement distribution to Malaysian Insurance Co. This balance sheet shows disaggregated income and loss items for the year.

                                  Assets

This is the balance sheet of Tall Towers after income and loss allocations and before the distribution of cash to Malaysian Insurance Co.:

                               Assets

Some target allocation provisions provide for allocations of gross income and gross deductions when allocations of net income and net losses do not cause adjusted capital account to equal target capital accounts. Very few of these target allocation provisions tell us which items of gross income and gross loss to allocate to each partner. These target allocation provisions are incomplete. The choice typically is left to Tall Towers accountants, a managing partner, a manager, or partnership management. Tall Towers accountants, a managing partner, a manager, or partnership management may be left to select the most abusive allocations, considering the tax circumstances of the individual partners. These target allocation provisions only partially allocate gross income and gross losses.

In the current example, if Tall Towers applies the target allocation provision using allocations of gross income and gross losses, Tall Towers can allocate all of the gross income ($63,000,000) to Capital Malaysian Insurance Co. and the loss items ($49,600,000) one half each to Capital Zebra Insurance Co. and Capital Callahan Insurance Co.

This target allocation provision will result in these allocations for Tall Towers:

                       Gross Income

The correct tax treatment of allocations under a target allocation provision in Example 5 is uncertain. Of course, there is considerable doubt that the tax law will respect the target allocation provision under partners' interests in the partnership whatever the target allocation provision says. A reasonable case could be made that the proper allocation under partners' interests in the partnership would be 1/3^rd to each partner. This is consistent with how the partners share economics under the partnership agreement.

25. "Example 6: Target Allocations and Normal Retirement of a Partner.

Target allocations can produce anomalous effects whenever the partnership retires a partner for a cash payment or for relief of liabilities where the partnership does not revalue assets and redetermine capital accounts on the retirement of a partner. The target allocation provision creates a "fill-up" allocation that may not result in an increase in the tax paid by the retiring partner but that renders retirement payments economically deductible to the partnership. This situation is illustrated in Example 6:

Example 6, Wayward Partners is a mature investment partnership. Each of five partners of Wayward Partners (Chris, Doreen, Fred, Dick, and Margaret) has a 20% economic interest in Wayward Partners. Wayward Partners makes all operating distributions and all distributions in liquidation 20% to each partner.

Wayward Partners has a target allocation provision for allocating income and losses among partners. The target allocation provision allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

This is the balance sheet of Wayward Partners at the beginning of the year:

 Assets                       AB    Liabilities & Capital                  AB

This is the balance sheet of Wayward Partners at the end of the year (before allocations for the year and before accounting for the retirement distribution to Margaret):

                                  Assets

                     Adjusted Capital Account

                     Target Capital Account

                  Adjusted            Target

The target allocation provision may require gross item allocations. This chart shows a possible allocation of gross income and gross losses under the target allocation provision if the target allocation provision requires a gross item allocation:

                  Adjusted            Target

Margaret's adjusted capital account also will equal her target capital account after this allocation:

                  Adjusted           Target

The target allocation provision typically does not provide a clue to which specific allocation of gross income and loss items the target allocation provision requires. It is not clear what allocation partners' interests in Wayward Partners requires. Target allocation provisions involving gross item allocations typically specify final capital account results. These target allocation provisions typically fail to specify the specific allocations required to reach those results. The gross income and gross loss target allocation provision does not specify a specific allocation, but merely describes a generalized method to reach a final allocation. The target allocation provision is not precisely an allocation provision. It is an outline for a target allocation provision. Wayward Partners typically is left to its own devices to reach the specific combination of gross income and loss item allocations to reach that result.

One might object that the specific combination of long-term capital gain and long-term capital loss allocations likely makes little difference in most situations. The combination of different tax items may make an appreciable difference in other situations. It may be significant that the target allocation provision normally does not tell us what specific gross items to allocate to a partner.

One also might object that it is not at all clear that the target allocation provision reaches the correct capital account results in Example 6. Wayward Partners typically has allocated all items 20% to each partner in prior years. Each partner has a 20% economic interest in Wayward Partners. Partners' interests in Wayward Partners may require that the partnership allocate all tax items for the year-of-redemption 20% to each partner. The result produced by the target allocation provision may not satisfy partners' interests in the partnership and may not be respected for tax purposes.

26. Example 7: Target Allocations and Substantiality.

One of the problems with target allocations is that no one knows whether substantiality applies to target allocations. No one is sure how substantiality applies to target allocations if substantiality does apply to target allocations. Target allocations can be used as an end-run around substantiality rules. At the least, target allocations can result in troubling allocations of losses that might not be respected if the partnership sought to qualify allocations under the rules of substantial economic effect.

Example 7. Boston Investment Partners is an equipment leasing partnership. The partners of Boston Investment Partners are Charlie Corp. and Jim. Charlie Corp. has an expiring net operating loss. Jim is in a high tax bracket. Each of Charlie Corp. and Jim make a $10 million capital contribution to Boston Investment Partners.

This is the initial balance sheet of Boston Investment Partners (at adjusted tax basis, which also is "book" value):

 Assets                             Liabilities & Capital

The partnership agreement of Boston Investment Partners distributes proceeds of liquidation in this order if the liquidation occurs in the first two years of operations:

• First, to Jim, in the amount of $10 million.

• Second, to Charlie Corp, in the amount of $10 million.

• Finally, 50% to Jim and 50% to Charlie Corp.

The partnership agreement contains a target allocation provision that allocates items of gross income and gross deduction as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

Boston Investment Partners receives permission to use the cash receipts and disbursements method of accounting.

Boston Investment Partners can liquidate only with the joint consent of both of the partners.

Boston Investment Partners acquires $19,700,000 of equipment, which it leases in the ordinary course of its business. This is the balance sheet of Boston Investment Partners (at adjusted tax basis, which also is "book" value) immediately after this acquisition:

 Assets                             Liabilities & Capital

This is the balance sheet of Boston Investment Partners after depreciation but before allocation of depreciation to the partners:

 Assets                             Liabilities & Capital

                Charlie Corp.       $6,060,000

                Charlie Corp.      $10,000,000

                Beginning     Adjusted      Target                      Closing

 Assets                             Liabilities & Capital

The allocation to Charlie Corp. may fail substantiality. The allocation arguably is inconsistent with the true economics of the partnership. The allocation is particularly suspect. The special allocation will be overridden if the partnership does not liquidate in year 1 or year 2. Charlie Corp. effectively can veto a liquidation of the partnership in those two years.

Partners' interests in the partnership nevertheless may not be subject to substantiality concerns. The allocation perhaps cannot be challenged on substantiality concerns.

If the allocation is subject to substantiality concerns, then it is not clear how substantiality is applied to partners' interests in the partnership. The allocation under partners' interests in the partnership is the baseline allocation against which other allocations are compared in judging substantiality.

Of course, the target allocation provision in the partnership agreement in Example 7 may not control for purposes of partners' interests in the partnership. It is uncertain that a target allocation provision can prescribe partnership allocations in the absence of satisfying the requirements of substantial economic effect.

27. Example 8: Schedular Partnership.

Circumstances may exist under partners' interests in the partnership in which special allocations of one or more partnership items is appropriate. The typical target allocation provision does not take these special allocations into account.

Example 8. High Flying Partners is an investment partnership with schedular economic allocations. Each of its partners contributes cash to High Flying Partners.

Initially, the partners of High Flying Partners were offered the opportunity to subscribe to a business investment. Each of the partners of High Flying Partners was offered the opportunity to subscribe to the initial investment of High Flying Partners, which was denominated the Class A Investment. The Class A Investment is directly held by High Flying Partners. All cash distributions from the Class A Investment (including operating distributions and distributions from liquidations of the investment) are made to the partners in accordance with the Class A Percentage Interests of the partners of High Flying Partners. Class A Percentage Interests are proportional to the Class A Capital Contributions of the partners.

Later, the partners of High Flying Partners were offered the opportunity to subscribe to a second business investment made by High Flying Partners. Each of the partners of High Flying Partners was offered the opportunity to subscribe to the second investment of High Flying Partners, which was denominated the Class B Investment. The Class B Investment is directly held by High Flying Partners. All cash distributions from the Class B Investment (including operating distributions and distributions from liquidations of the investment) are made to the partners in accordance with the Class B Percentage Interests of the partners of High Flying Partners. Class B Percentage Interests are proportional to the Class B Capital Contributions of the partners. Class B Percentage Interests and Class B Capital Contributions can differ materially from Class A Percentage Interests and Class A Capital Contributions of the partners of High Flying Partners.

High Flying Partners has subsequently made Class C, Class D, Class D, Class F, and Class G investments. Capital contributions and class percentage interests were established in the same manner as the technique used for Class A Investments and Class B Investments.

Distributions with respect to each class of investment are made in accordance with the corresponding class percentage interest. Each year, High Flying Partners assesses each investment with a small assessment to meet common partnership expenses. These assessments are withheld from distributions to the class. Assessments are made on the basis of ratio of invested capital.

Some investment classes produce nontaxable income. Some investment classes are heavily loaded with ordinary income. Some investment classes produce principally long-term capital gain.

High Flying Partners has a target allocation provision in its partnership agreement. The target allocation provision is drafted on the basis of a single adjusted capital account and a single target capital account for each partner. That adjusted capital account and target capital account crosses all classes of investment interest in High Flying Partners held by the partner. The target allocation provision allocates net income and net losses as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

The target allocation provision may fail properly to express partners' interests in the partnership under the facts of Example 8. In some cases, the "sharing arrangement [for partnership allocations under partners' interests in the partnership] may or may not correspond to the overall economic arrangement of the partners. Thus, a partner who has a 50 percent overall interest in the partnership may have a 90 percent interest in a particular item of income or deduction."⁴⁸ Example 8 might be an example of a situation in which the partnership should allocate tax items to partners in accordance with class interests rather than under a target allocation provision. The target allocation provision may fail to satisfy partners' interests in the partnership. Partners' interests in the partnership may require special allocations by class of investment.

28. Example 9: Target Allocations and Recourse Debt.

Example 9 illustrates the effects of a partner having personal liability for partnership debt on target allocations. Depending on how the target allocation provision is drafted, the target allocation provision may not properly take into account the partner bearing the economic risk of loss of the partnership debt.⁴⁹

Example 9. McKay and Harry are the two partners of McCovey Partners, a general partnership. All distributions (both operating and in liquidation) are made by McCovey Partners:

                   McKay                         50%

McKay owns his interest in McCovey Partners directly.

Both Harry and McKay own substantial assets independent of their interests in McCovey Partners.

McCovey Partners is approved to use the cash receipts and disbursements method of accounting. The partnership agreement of McCovey Partners contains a well-drafted target allocation provision to allocate income and loss. The target allocation provision allocates net income and net loss as necessary to cause (i) adjusted capital accounts to equal (ii) target capital accounts.

This is the starting balance sheet of McCovey Partners:

                AB                                                      AB

McCovey Partners expends $600,000 on tax-deductible expenses in year 1. McCovey Partners does not have any taxable income in year 1.

At the end of year 1, McCovey Partners has $2,000,000 in accounts receivable from business operations during year 1. McCovey Partners' partnership does not recognize these receivables at the end of year 1 for purposes of recognizing taxable income. As the accounts receivable have not been recognized, McCovey Partners reflects the accounts receivable on its adjusted basis balance sheet at zero.

McCovey Partners does not rebook capital accounts.

This is the balance sheet of McCovey Partners (at adjusted tax basis (which, in this case, controls under Section 704(b)) and fair market value) at the end of year 1 before allocation of the $600,000 in deductions for the year:

             AB          PMV                                  AB          PMV

                Charlie Corp.      $10,000,000

The matter of adjusted capital accounts is more a matter of speculation. McCovey Partners would be insolvent at the end of year 1 based on "book" value (in this case, adjusted tax basis). The single member LLC would block Harry's liability on the debt. McKay would be expected to make a $600,000 capital contribution to McCovey Partners on a liquidation of McCovey partners and its assets at "book" value. This suggests that these are the adjusted capital accounts of the partners:

                McKay              $550,000

                                    Loss

This table shows this loss allocation (adjusting adjusted capital accounts for deemed contribution on account of liability on recourse debt):

                                     Pre-

A better-drafted target allocation provision would adjust adjusted capital accounts because of the $500,000 of the liability that McKay would be expected to bear based on a liquidation at "book" value.

In either event, even the better-drafted target allocation provision, while it describes the correct results, would not control the correct results. Partners' interests in the partnership should operate to produce the same result regardless of the presence of the target allocation provision. The target allocation should be surplus in this situation.

However Treasury and the Internal Revenue Service resolve the issues discussed in this letter, they should resolve these issues in a manner consistent with the broad structure of Subchapter K and particularly the broad structure of the Section 704(b) regulations. Solutions should be principled solutions based on reasonable interpretations of the Code, the Section 704(b) regulations, and case law. The solutions should reflect the principle that Section 704 is fundamentally an anti-abuse provision that governs an area with a long history of tax abuse. Treasury and the Internal Revenue Service should base solutions on understandability, consistency of result, administrability, and a strong foundation on principles of partnership tax theory. Treasury and the Internal Revenue Service should not adopt ad hoc solutions of immediate convenience that may be popular with many practitioners, but that ultimately provide vast opportunities for future tax abuse.

I shall respond to any inquiries. I shall provide supplementary comments on request. I also am available by telephone at 626.441.5404.

Very truly yours,

² My comments do not reflect the vast experience or expertise of a large professional organization or law or accounting firm. My comments are not endorsed or supported by anyone other than me. Large professional organizations have submitted comments that differ considerably from my comments. My comments doubtless would benefit from the much vaster experience and expertise of those organizations. Perhaps my views are more independent of interest than the views of those organizations.

I have prepared comments reflecting a different perspective. I have done the best that I can as a single practitioner to submit comments based on my own experience and without input from others. I do not have a vested economic interest in the approval or rejection of target allocations.

I understand that I do not endorse the popular view. I personally find that the popular view -- even the view popular with large bar and accounting organizations -- is often not the theoretically sound view. I have endeavored to embrace the view most consistent with the overall scheme of the Section 704(b) regulations.

³ Treas. Reg. § 1.704-1(b)(3) ("(3) Partner's interest in the partnership, (i) In general. References in section 704(b) and this paragraph to a partner's interest in the partnership, or to the partners' interests in the partnership, signify the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated. Except with respect to partnership items that cannot have economic effect (such as nonrecourse deductions of the partnership), this sharing arrangement may or may not correspond to the overall economic arrangement of the partners. Thus, a partner who has a 50 percent overall interest in the partnership may have a 90 percent interest in a particular item of income or deduction. (For example, in the case of an unexpected downward adjustment to the capital account of a partner who does not have a deficit make-up obligation that causes such partner to have a negative capital account, it may be necessary to allocate a disproportionate amount of gross income of the partnership to such partner for such year so as to bring that partner's capital account back up to zero.) The determination of a partner's interest in a partnership shall be made by taking into account all facts and circumstances relating to the economic arrangement of the partners, (ii) Factors considered. In determining a partner's interest in the partnership, the following factors are among those that will be considered: (a) The partners' relative contributions to the partnership, (b) The interests of the partners in economic profits and losses (if different than that in taxable income or loss), (c) The interests of the partners in cash flow and other non-liquidating distributions, and (d) The rights of the partners to distributions of capital upon liquidation. The provisions of this subparagraph (b)(3) are illustrated by examples (1)(i) and (ii), (4)(i), (5)(i) and (ii), (6), (7), (8), (10)(ii), (16)(i), and (19)(iii) of paragraph (b)(5) of this section. See paragraph (b)(4)(i) of this section concerning rules for determining the partners' interests in the partnership with respect to certain tax items, (iii) Certain determinations. If (a) Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, and (b) All or a portion of an allocation of income, gain, loss, or deduction made to a partner for a partnership taxable year does not have economic effect under paragraph (b)(2)(ii) of this section, the partners' interests in the partnership with respect to the portion of the allocation that lacks economic effect will be determined by comparing the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the taxable year to which the allocation relates with the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the prior taxable year, and Adjusting the result for the items described in (4), (5), and (6) of paragraph (b)(2)(ii)(d) of this section. A determination made under this paragraph (b)(3)(iii) will have no force if the economic effect of valid allocations made in the same manner is insubstantial under paragraph (b)(2)(iii) of this section. See examples (1)(iv), (v), and (vi), and (15)(ii) and (iii) of paragraph (b)(5) of this section.").

⁴ Treas. Reg. § 1.704-1(b)(2)(iii) ("(iii) Substantiality, (a) General rules. Except as otherwise provided in this paragraph (b)(2)(iii), the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Notwithstanding the preceding sentence, the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement. In determining the after-tax economic benefit or detriment to a partner, tax consequences that result from the interaction of the allocation with such partner's tax attributes that arc unrelated to the partnership will be taken into account. See examples (5) and (9) of paragraph (b)(5) of this section. The economic effect of an allocation is not substantial in the two situations described in paragraphs (b)(2)(ii)(b) and (c) of this section. However, even if an allocation is not described therein, its economic effect may be insubstantial under the general rules stated in this paragraph (b)(2)(iii)(a). References in this paragraph (b)(2)(iii) to allocations include capital account adjustments made pursuant to paragraph (b)(2)(iv)(k) of this section. References in this paragraph (b)(2)(iii) to a comparison to consequences arising if an allocation (or allocations) were not contained in the partnership agreement mean that the allocation (or allocations) is determined in accordance with the partners' interests in the partnership (within the meaning of paragraph (b)(3) of this section), disregarding the allocation (or allocations) being tested under this paragraph (b)(2)(iii).").

⁵ Treas. Reg. § 1.704-1(b)(2)(ii)(d) ("(d) Alternate test for economic effect. If (1) Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, and (2) The partner to whom an allocation is made is not obligated to restore the deficit balance in his capital account to the partnership (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of this section), or is obligated to restore only a limited dollar amount of such deficit balance, and (3) The partnership agreement contains a 'qualified income offset,' such allocation will be considered to have economic effect under this paragraph (b)(2)(ii)(d) to the extent such allocation does not cause or increase a deficit balance in such partner's capital account (in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore) as of the end of the partnership taxable year to which such allocation relates. In determining the extent to which the previous sentence is satisfied, such partner's capital account also shall be reduced for (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 1.751-1, 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 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).").

⁶ Treas. Reg. § 1.704-1(b)(4)(i) ("(i) Allocations to reflect revaluations. If partnership property is, under paragraphs (b)(2)(iv)(d) or (b)(2)(iv)(f) of this section, properly reflected in the capital accounts of the partners and on the books of the partnership at a book value that differs from the adjusted tax basis of such property, then depreciation, depletion, amortization, and gain or loss, as computed for book purposes, with respect to such property will be greater or less than the depreciation, depletion, amortization, and gain or loss, as computed for tax purposes, with respect to such property. In these cases the capital accounts of the partners are required to be adjusted solely for allocations of the book items to such partners (see paragraph (b)(2)(iv)(g) of this section), and the partners' shares of the corresponding tax items are not independently reflected by further adjustments to the partners' capital accounts. Thus, separate allocations of these tax items cannot have economic effect under paragraph (b)(2)(ii)(b)(1) of this section, and the partners' distributive shares of such tax items must (unless governed by section 704(c)) be determined in accordance with the partners' interests in the partnership. These tax items must be shared among the partners in a manner that takes account of the variation between the adjusted tax basis of such property and its book value in the same manner as variations between the adjusted tax basis and fair market value of property contributed to the partnership are taken into account in determining the partners' shares of tax items under section 704(c). See examples (14) and (18) of paragraph (b)(5) of this section."). Cf. Treas. Reg. § 1.704-3.

⁷ This letter will not address those partnership agreements that use a target allocation approach but that liquidate explicitly in accordance with partner capital accounts.

⁸Cf. Treas. Reg. § 1.704-1(b)(3)(iii) ("(iii) Certain determinations. If (a) Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, and (1)) All or a portion of an allocation of income, gain, loss, or deduction made to a partner for a partnership taxable year does not have economic effect under paragraph (b)(2)(ii) of this section, the partners' interests in the partnership with respect to the portion of the allocation that lacks economic effect will be determined by comparing the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the taxable year to which the allocation relates with the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the prior taxable year, and adjusting the result for the items described in (4), (5), and (6) of paragraph (b)(2)(ii)(d) of this section. A determination made under this paragraph (b)(3)(iii) will have no force if the economic effect of valid allocations made in the same manner is insubstantial under paragraph (b)(2)(iii) of this section. . . .").

⁹ See note 8.

¹⁰ Sec note 3.

¹¹ Treas. Reg. § 1.704-1(b)(2)(ii)(a).

¹² Treas. Reg. § 1.704-1(b)(3).

¹³ Treas. Reg. § 1.704-1(b)(3)(i).

¹⁴ Treas. Reg. § 1.704-1(b)(3)(ii).

¹⁵ Treas. Reg. § 1.704-1(b)(3)(iii).

¹⁶ That comprehensive theory of capital shifts should include addressing service partners and partnership options.

¹⁷ These situations can include required forfeitures allocations, required special item allocations properly to reflect partnership economics under partners' interests in the partnership, special allocations required under the varying interests rule, special allocations required for contributed cash method payables, and special allocations required for partner nonrecourse deductions.

¹⁸ The New York Bar Association, Tax Section, provides this description of target allocations:

¹⁹ Commenters favoring target allocations typically discuss examples in which no partner has a negative capital account and in which no partner is retiring in the current year. Target allocation provision tend not to do well in these situations. Target allocation provisions also typically do badly when a partnership has different economic deals on different categories of assets or different categories of income.

²⁰ Substantial economic effect requires that partnerships liquidate in accordance with partner capital accounts.

²¹ New York State Bar Association, Tax Section, Report on Guaranteed Payments and Preferred Returns (November 14, 2016).

²² The concept of "book" capital accounts refers to capital accounts maintained in accordance with the accounting principles set forth in Treas. Reg. § 1.704-1(b)(2)(iv).

²³ This practice does not work well if partnership assets have a "book"-tax difference.

²⁴ This practice does not work well if partners are obligated to make capital contributions, partners guarantee partnership debt, or partners otherwise are liable on partnership debt.

²⁵ This practice does not work well if the partnership generates nonrecourse deductions or partner nonrecourse deductions.

²⁶ These allocations can include forfeiture allocations, allocations of cash basis items required under the varying interests rules, and allocations of deductions attributable to cash method receivables. These allocations also can include certain special allocations of partnership items that may be required under partners' interests in the partnership in order properly to reflect partnership economics.

²⁷ Partnership agreements using target allocation provisions rarely provide adequate guidance concerning allocations to specific partners when the target allocation provisions fail to equalize adjusted capital accounts and target capital accounts.

²⁸ These agreement should separate from net income and net losses income and losses allocated under the minimum gain chargeback, partner minimum gain chargeback, etc. Many target allocation provisions, however, fail to make this adjustment.

²⁹ Treas. Reg. § 1.704-1(b)(2)(ii)(a).

³⁰ Treas. Reg. § 1.704-1(b)(2)(iii)(c).

³¹ Treas. Reg § 1.704-1(b)(2)(iv)(f).

³² Some authorities will object that the "fill-up" allocations serve as a substitute for the operation of Section 734. These partnerships, however, often are unable to make Section 754 elections. Also, the "fill-up" allocations typically advance the tax benefit over the operation of Section 734.

³³ The partnership without the reverse Section 704(c) allocations might be able to make a Section 754 election and to enable basis adjustments to retained partnership assets under Section 734. Many partnerships are unable or unwilling to make Section 754 elections. The effects of the basis adjustments resulting from Section 734 adjustments normally is deferred to subsequent taxable years when the adjusted assets are sold.

³⁴ Treas. Reg. § 1.704-1(b)(2)(iv)(f).

³⁵Lehman v. Commissioner, 19 T.C. 659 (1953). The court summarized the facts: "Petitioners, husband and wife, were partners with others in a limited partnership of which the husband was the only general partner. The agreement provided that when the other partners would earn or receive profits from the business in the total sum of $50,000, each of petitioners should be entitled to receive as a credit on the partnership books the sum of $5,000 to be deducted from the capital contribution of the other partners. Petitioners were on a calendar year basis, the partnership on a fiscal year basis ending March 31. As of March 31, 1948, petitioners became entitled to their total credit in the sum of $10,000. The book entries making the debits and credits were made on November 1, 1948." The court set forth this argument:

³⁷ See Preamble to REG-105346-03 (May 24, 2005) ("Section 83 generally applies to a transfer of property by one person to another in connection with the performance of services. The courts have held that a partnership capital interest is property for this purpose. See Schulman v. Commissioner, 93 T.C. 623 (1989) (section 83 governs the issuance of an option to acquire a partnership interest as compensation for services provided as an employee); Kenroy, Inc. v. Commissioner, T.C. Memo 1984-232. Therefore, the proposed regulations provide that a partnership interest is property within the meaning of section 83, and that the transfer of a partnership interest in connection with the performance of services is subject to section 83. ¶ The proposed regulations apply section 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests. Although the application of section 83 to partnership profits interests has been the subject of controversy, see, e.g., Campbell v. Commissioner, T.C. Memo 1990-162, aff'd in part and rev'd in part, 943 F.2d 815 (8th Cir. 1991), n.7; St. John v. U.S., 84-1 USTC 9158 (CD. 111. 1983), the Treasury Department and the IRS do not believe that there is a substantial basis for distinguishing among partnership interests for purposes of section 83. All partnership interests constitute personal property under state law and give the holder the right to share in future earnings from partnership capital and labor. Moreover, some commentators have suggested that the same tax rules should apply to both partnership profits interests and partnership capital interests. These commentators have suggested that taxpayers may exploit any differences in the tax treatment of partnership profits interests and partnership capital interests. The Treasury Department and the IRS agree with these comments. Therefore, all of the rules in these proposed regulations and the accompanying proposed revenue procedure (described below) apply equally to partnership capital interests and partnership profits interests. . . .").

³⁸ See Treas. Reg. § 1.704-1(b)(2)(iv)(f) ("(f) Revaluations of property. A partnership agreement may, upon the occurrence of certain events, increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership's books. Capital accounts so adjusted will not be considered to be determined and maintained in accordance with the rules of this paragraph (b)(2)(iv) unless (1) The adjustments are based on the fair market value of partnership property (taking section 7701(g) into account) on the date of adjustment, as determined under paragraph (b)(2)(iv)(h) of this section. See Example 33 of paragraph (b)(5) of this section. (2) The adjustments reflect the manner in which the unrealized income, gain, loss, or deduction inherent in such property (that has not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for such fair market value on that date, and (3) The partnership agreement requires that the partners' capital accounts be adjusted in accordance with paragraph (b)(2)(iv)(g) of this section for allocations to them of depreciation, depletion, amortization, and gain or loss, as computed for book purposes, with respect to such property, and (4) The partnership agreement requires that the partners' distributive shares of depreciation, depletion, amortization, and gain or loss, as computed for tax purposes, with respect to such property be determined so as to take account of the variation between the adjusted tax basis and book value of such property in the same manner as under section 704(c) (see paragraph (b)(4)(i) of this section), and (5) The adjustments are made principally tor a substantial non-tax business purpose (i) In connection with a contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership, or (ii) In connection with the liquidation of the partnership or a distribution of money or other property (other than a de minimis amount) by the partnership to a retiring or continuing partner as consideration for an interest in the partnership, or (iii) In connection with the grant of an interest in the partnership (other than a de minimis interest) on or after May 6, 2004 as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner, or (iv) In connection with the issuance by the partnership of a noncompensatory option (other than an option for a de minimis partnership interest), or (v) Under generally accepted industry accounting practices, provided substantially all of the partnership's property (excluding money), consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market.").

³⁹ See Treas. Reg. § 1.704-1(b)(2)(ii)(b).

⁴⁰Id.

⁴¹ Sec New York State Bar Association, Tax Section, Report on Guaranteed Payments and Preferred Returns (November 14, 2016). This report uses the terminology "targeted allocations."

⁴² See New York State Bar Association, Tax Section, Report on Guaranteed Payments and Preferred Returns (November 14, 2016).

⁴³ See REG-105346-03, 70 Fed Reg. 29675-29683 (May 24, 2005) ("1. Application of Section 83 to Partnership Interests ¶Section 83 generally applies to a transfer of property by one person to another in connection with the performance of services. The courts have held that a partnership capital interest is property for this purpose. See Schulman v. Commissioner, 93 T.C. 623 (1989) (section 83 governs the issuance of an option to acquire a partnership interest as compensation for services provided as an employee); Kenroy, Inc. v. Commissioner, T.C. Memo 1984-232. Therefore, the proposed regulations provide that a partnership interest is property within the meaning of section 83, and that the transfer of a partnership interest in connection with the performance of services is subject to section 83. ¶ The proposed regulations apply section 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests. Although the application of section 83 to partnership profits interests has been the subject of controversy, see, e.g., Campbell v. Commissioner, T.C Memo 1990-162, affd in part and rev'd in part, 943 F.2d 815 (8th Cir. 1991), n.7; St. John v. U.S., 84-1 USTC 9158 (C.D. 111. 1983), the Treasury Department and the IRS do not believe that there is a substantial basis for distinguishing among partnership interests for purposes of section 83. All partnership interests constitute personal property under state law and give the holder the right to share in future earnings from partnership capital and labor. Moreover, some commentators have suggested that the same tax rules should apply to both partnership profits interests and partnership capital interests. These commentators have suggested that taxpayers may exploit any differences in the tax treatment of partnership profits interests and partnership capital interests. The Treasury Department and the IRS agree with these comments. Therefore, all of the rules in these proposed regulations and the accompanying proposed revenue procedure (described below) apply equally to partnership capital interests and partnership profits interests. However, a right to receive allocations and distributions from a partnership that is described in section 707(a)(2)(A) is not a partnership interest. In section 707(a)(2)(A), Congress directed that such an arrangement should be characterized according to its substance, that is, as a disguised payment of compensation to the service provider. See S. Rep. No. 98-169, 98 Cong. 2d Sess., at 226(1984).").

⁴⁴Lehman v. Commissioner, 19 T.C.. 659 (1953), discussed in note 35.

⁴⁵Cf. REG-115452-14, 80 Fed Reg. 43653-43661 (July 23, 2016) ("I. General Rules Regarding Disguised Payments for Services ¶ A. Scope ¶ Consistent with the language of section 707(a)(2)(A), § 1.707-2(b) of the proposed regulations provides that an arrangement will be treated as a disguised payment for services if (i) a person (service provider), either in a partner capacity or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership; (ii) there is a related direct or indirect allocation and distribution to the service provider; and (iii) the performance of the services and the allocation and distribution when viewed together, arc properly characterized as a transaction occurring between the partnership and a person acting other than in that person's capacity as a partner. ¶ The proposed regulations provide a mechanism for determining whether or not an arrangement is treated as a disguised payment for services under section 707(a)(2)(A). An arrangement that is treated as a disguised payment for services under these proposed regulations will be treated as a payment for services for all purposes of the Code. Thus, the partnership must treat the payments as payments to a non-partner in determining the remaining partners' shares of taxable income or loss. Where appropriate, the partnership must capitalize the payments or otherwise treat them in a manner consistent with the recharacterization. ¶ The consequence of characterizing an arrangement as a payment for services is otherwise beyond the scope of these regulations. For example, the proposed regulations do not address the timing of inclusion by the service provider or the timing of a deduction by the partnership other than to provide that each is taken into account as provided for under applicable law by applying all relevant sections of the Code and all relevant judicial doctrines. Further, if an arrangement is subject to section 707(a), taxpayers should look to relevant authorities to determine the status of the service provider as an independent contractor or employee. See, generally, Rev. Rul. 69-184, 1969-1 C.B. 256. The Treasury Department and the IRS believe that section 707(a)(2)(A) generally should not apply to arrangements that the partnership has reasonably characterized as a guaranteed payment under section 707(c). ¶ Allocations pursuant to an arrangement between a partnership and a service provider to which sections 707(a) and 707(c) do not apply will be treated as a distributive share under section 704(b). Rev. Proc. 93-27 and Rev. Proc. 2001-43 may apply to such an arrangement if the specific requirements of those Revenue Procedures are also satisfied. The Treasury Department and the IRS intend to modify the exceptions set forth in those revenue procedures to include an additional exception for profits interests issued in conjunction with a partner forgoing payment of a substantially fixed amount. This exception is discussed in part IV of the Explanation of Provisions section of this preamble.").

⁴⁶Lehman v. Commissioner, 19 T.C. 659 (1953), discussed in note 35.

⁴⁷Lehman v. Commissioner, 19 T.C. 659 (1953). discussed in note 35.

⁴⁸ See Treas. Reg. § 1.704-1(b)(3)(i) ("(3) Partner's interest in the partnership (i) In general. References in section 704(b) and this paragraph to a partner's interest in the partnership, or to the partners' interests in the partnership, signify the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated. Except with respect to partnership items that cannot have economic effect (such as nonrecourse deductions of the partnership), this sharing arrangement may or may not correspond to the overall economic arrangement of the partners. Thus, a partner who has a 50 percent overall interest in the partnership may have a 90 percent interest in a particular item of income or deduction. (For example, in the case of an unexpected downward adjustment to the capital account of a partner who does not have a deficit make-up obligation that causes such partner to have a negative capital Account, it may be necessary to allocate a disproportionate amount of gross income of the partnership to such partner for such year so as to bring that partner's capital account back up to zero.) The determination of a partner's interest in a partnership shall be made by taking into account all facts and circumstances delating to the economic arrangement of the partners, (ii) Factors considered. In determining a partner's interest in the partnership, the following factors are among those that will be considered: (a) The partners' relative contributions to the partnership, (b) The interests of the partners in economic profits and losses (if different than that in taxable income or loss), (c) The interests of the partners in cash flow and other non-liquidating distributions, and (d) The rights of the partners to distributions of capital upon liquidation. The provisions of this subparagraph (b)(3) are illustrated by examples (1)(i) and (ii), (4)(i), (5)(i) and (ii), (6), (7), (8), (10)(ii), (16)(i), and (19)(iii) of paragraph (b)(5) of this section. See paragraph (b)(4)(i) of this section concerning rules for determining the partners' interests in the partnership with respect to certain tax items.").

⁴⁹ This example illustrates problems with many, but not all, target allocation provisions in common use. The problems are not endemic to target allocation provisions if they are drafted properly.