Drafting Partnership Agreements: How to Get the Benefits You Want

PIP (Partners’ Interest in the Partnership) distributions are very commonly used in partnership agreements.¹ For this reason, investors and managers should understand the basic principles of PIP allocations and determine whether and when they should be used before entering into a partnership agreement.

In this alert we cover the following topics:

What are PIP benefits?
How do PIP benefits work?
Choice in the application of PIP allowances
When are they useful?
When are they least useful?
When do they conflict with other allocations?
Do PIP benefits avoid the need for special benefits such as non-recourse deductions, minimum earnings, qualified income offset and curative benefits?

Background

First, some general information about partnership allowances.

A partnership is taxed under the partnership tax rules. These rules require the partnership to create and maintain a capital account for each partner. The capital account rules are accounting rules. These rules can be complex and inflexible. A mistake, or failure to anticipate and address an economic cost or decline in profits, can result in a mismatch between the capital accounts and the business agreement. Unless the partnership uses PIP allowances correctly. Properly used PIP allowances force the capital account balances to align as closely as possible with the business agreement. The following outlines factors to consider when drafting and using PIP allowances correctly.

PIP Assignments

After taking into account special allowances (see below), a partnership using PIP allowances uses a five-step process:

Step 1: Determine the cash available for a liquidating distribution if the assets were sold at book value and all debts/liabilities were discharged²
Step 2: Determine how net cash would be distributed to partners
Step 3: Determine the balance of each partner’s pre-allocation capital account³
Step 4: Adjust each partner’s capital account balance for minimum gain shares (as described below)
Step 5: Distribute the income items so that each partner’s adjusted capital account after distribution is equal to the money the partner would receive in Step 2

As discussed in Step 4, the capital accounts must be adjusted for minimum gain shares. The adjustment for minimum gain shares takes into account the gain that will ultimately be allocated to the partners under the minimum gain chargeback rules. If this adjustment were not made, the PIP allocations would result in a mismatch between the capital accounts and the partners’ shares of the liquidation proceeds under Step 2.

Technically, PIP allocations are not permitted under the partnership tax rules except in limited situations. Most practitioners, however, are convinced that PIP allocations are consistent with the policy of the partnership tax rules and should be respected, if properly implemented, in most situations. The Treasury Department and the IRS seem to agree, to some extent anyway. They know that PIP allocations are widely used. They have also asked tax practitioners to provide input on the rules that would govern PIP allocations. However, you should be aware that there is no express authority to use PIP allocations in the manner in which they are most commonly used.

Items to be allocated under the PIP

PIP distributions are often drafted to allocate net income or net loss (i.e., profits and losses), which are net amounts. To determine net income (and net loss), the partnership offsets all items of income and deductions (after taking into account special distributions). This approach can result in a difference between the capital accounts and the shares of the liquidation proceeds. Such an imbalance can occur when, for example, a partner’s capital account is greater than that partner’s share of the proceeds, but the partnership distributes net income. For this reason, when distributing net income and net loss under the PIP, it is necessary at some point to correct the imbalances in the capital accounts by distributing individual items of income instead of net income or net loss. Often, this correction occurs when the partnership is liquidated.

PIP allocations are sometimes drafted to allocate individual items of income, deduction, gain and loss (income items). This approach allows the partnership more flexibility to achieve correct capital account balances each year. Thus, unlike the allocation of net income or net loss, the allocation of income items generally does not require special allocations of individual items upon liquidation. However, when allocating income items, it is important to instruct the partnership to allocate pro rata shares of each income item as much as possible. So, for example, this approach would prevent one partner from receiving ordinary income while another partner receives an equal amount of long-term capital gain.

While you can allocate your PIP income using net profits or losses, or income items, for a number of reasons primarily related to timing, the choice between these two methods can have a significant impact on the partners’ after-tax return. Partners should determine which approach works best for each transaction.

When PIP benefits are useful

PIP allocations are particularly useful for complex waterfalls. PIP allocations work well if the waterfall contains obstacles or thresholds. PIP allocations are also useful when the ownership interests of the partners are distributed between/among classes, particularly if one class has a preference⁴ on others.

When PIP benefits aren’t so useful

PIP allocations are not as useful when partners contribute capital and share liquidity based on unit ownership or interest percentages. In these simple, straightforward partnerships, it is wise to consider using other “safe harbor” type allocations.

When PIP benefits conflict with other tax rules

Certain partnerships should generally not use PIP allowances:

Any partnership that generates low-income housing tax credits, historic rehabilitation tax credits, or renewable energy tax credits allocates these credits under special rules. However, these rules will not apply if the partnership uses PIP allowances. For this reason, these partnerships typically use safe harbor allowances.
Any partnership that applies the fraction rule cannot use PIP allocations. The fraction rule is an allocation method that may apply to certain partners of tax-exempt entities. If the rule is properly applied, tax-exempt partners should not realize unrelated business taxable income as debt-financed income.
Any partnership that issues non-compensatory partnership options, including interests of one class that are convertible into another class of interest (e.g., preferred into common stock). The regulations regarding these options apply only if protective allowances are used. Drafters should carefully consider how to account for the conversion feature if the partnership uses PIP allowances.
The tax regulations provide a safe harbor for the allocation of non-recourse deductions. This safe harbor does not apply if the partnership uses PIP allowances. In practice, however, partnerships that use PIP allowances also allocate non-recourse deductions under this safe harbor. Practitioners are generally reassured by the fact that the safe harbor is designed so that the non-recourse deduction is allocated based on the partners’ interests in the partnership.

Special allocation provisions

Most partnership agreements provide special allocations for qualifying income offset rules, non-recourse deductions and minimum gain chargebacks. There are two reasons to retain these allocations, although they are arguably unnecessary (particularly qualifying income offset). First, the non-recourse deduction and minimum gain chargeback rules tell the partnership managers how to allocate these items according to accepted rules, and these allocations will most likely be consistent with the interests of the partners in the partnership. Second, many practitioners (opposing counsel) will want these provisions included in the partnership agreement.

Curative allowances

Curative allowances are intended to reverse the effect of other special allowances to the extent that those other allowances result in capital accounts that are inconsistent with the commercial agreement. In other words, they have the same objective as PIP allowances. However, they may also interfere with the objective of PIP allowances, which is to ensure that each partner’s capital account is as close as possible to that partner’s share of the liquidation proceeds. For this reason, you should consider whether curative allowances should be included if PIP allowances are used.

¹The term partnership means herein a partnership for United States federal income tax purposes, including a limited liability company (LLC) with two or more members that have not elected to be taxed as a corporation. partnership agreement includes an LLC operating agreement or limited liability company agreement.

² Also take into account any outstanding capital contribution obligations of partners, if any.

³Adjust the balance of contributions and distributions made during the given tax year.

⁴ If a preferred interest has a conversion feature, determine whether and (if so) how PIP allocations may operate with that conversion feature.