Because I started life as a tax shelter lawyer, I’m especially sensitive to how income and losses are allocated within partnerships and limited liability companies (limited liability companies are taxed as partnerships). Agreements in the Crowdfunding space leave something to be desired.
As we all know, partnerships are not themselves taxable entities. The items of income and loss of the partnership “flow through” and are reported on the personal tax returns of the owners. Allocating income and losses is simple when you have one class of partnership interest and everything is pro rata, e.g., you get 70% of everything and I get 30%. It becomes a lot more complicated in the real world.
Say, for example:
- The sponsor of a deal takes a 30% promote in operating cash flow after investors received an 8% annual preferred return.
- On a sale or refinancing, the sponsor takes a 40% promote after the investors receive a 10% internal rate of return.
- In the early years of the deal the project generates ordinary losses, then generates cash flow sheltered by depreciation deductions, then generates section 1231 gain.
The allocation of income and loss in a partnership is governed by section 704(b) of the Internal Revenue Code. Long ago, the IRS issued regulations under section 704(b) that use the concept of “capital accounts” to determine whether a given allocation has “substantial economic effect.” Rules within rules, exceptions within exceptions, definitions within definitions, the section 704(b) regulations are a delight for the kind of person (I admit it) who wasn’t necessarily the coolest in high school.
For years afterward, tax shelter lawyers vied with one another to include as many of the rules and definitions of the regulations as possible in their partnership agreements, verbatim. That lasted until we recognized that (1) no matter how hard we tried, it was impossible to be 100% sure that the allocations would come out right; and (2) there was a better way.
The better way is to give management the right to allocate income on a year-to-year basis, with the mandate that the allocation of income should follow the distribution of cash. To wit:
Company shall seek to allocate its income, gains, losses, deductions, and expenses (“Tax Items”) in a manner so that (i) such allocations have “substantial economic effect” as defined in Section 704(b) of the Code and the regulations issued thereunder (the “Regulations”) and otherwise comply with applicable tax laws; (ii) each Member is allocated income equal to the sum of (A) the losses he or it is allocated, and (B) the cash profits he or it receives; and (iii) after taking into account the allocations for each year as well as such factors as the value of the Company’s assets, the allocations likely to be made to each Member in the future, and the distributions each Member is likely to receive, the balance of each Member’s capital account at the time of the liquidation of the Company will be equal to the amount such Member is entitled to receive pursuant to this Agreement. That is, the allocation of the Company’s Tax Items, should, to the extent reasonably possible, following the actual and anticipated distributions of cash, in the discretion of the Manager. In making allocations the Manager shall use reasonable efforts to comply with applicable tax laws, including without limitation through incorporation of a “qualified income offset,” a “gross income allocation,” and a “minimum gain chargeback,” as such terms or concepts are specified in the Regulations. The Manager shall be conclusively deemed to have used reasonable effort if it has sought and obtained advice from counsel.
Even today, I see partnership agreements that devote pages to the allocation of tax items. The approach in the paragraph above is much simpler and, even more important, much more likely to achieve the right result.
Questions? Let me know.