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June 3, 2011

Partnership income allocation complexities are on the rise across the board. The aggregation rules are broken but should they be fixed or scrapped? Is there a practical solution?

Over the past 15 years or so, partnerships have struggled with making allocations of income and loss according to IRC Section 704, which governs a partner’s distributive share of partnership items. As transactions have evolved and increased in sophistication, and as market conditions have changed with an upsurge in volatility, few partnerships are left with straightforward income allocations. Traditional private equity funds, hedge funds, real estate funds and publicly traded partnerships all face significant challenges.

The greatest complexity arises from Section 704(c), which governs the allocation of tax items relating to partnership property with unrealized gains and losses. Under Section 704(c), the allocations of tax items are made in respect both to the assets’ historical record of unrealized gains and losses and to the partners’ economic participation in those gains and losses. As a consequence, the order of complexity of any partnership is largely determined by the product of:

  • The number of assets held by the partnership,
  • The number of partners in the partnership, and
  • The number of allocation periods in which the partners’ economic interests varied.

Large real estate partnerships and master limited partnerships with depreciation, depletion and amortization are affected the most, but the pain is not limited only to these types of ventures.

For example, as investors in traditional single closing private equity and real estate investment funds default on commitments, the resulting dilutions create Section 704(c) complications for partnerships that were previously unaffected. Furthermore, the application of Section 704(c) to securities partnerships continues to confound tax professionals as investment strategies continue to evolve.

Partnership allocations were the topic of a recent New York State Bar Association report addressing the complexity of Section 704(c) and of Sections 743(b) and 734(b), which govern adjustments to basis pursuant to transfers and redemptions of partners’ interests. The Bar concluded that, “just as it is unduly burdensome for many securities partnerships to make reverse 704(c) allocations on a property-by-property basis, it is unduly burdensome for many securities partnerships to make basis adjustments under Section 734 and 743 on an asset-by-asset basis. Accordingly, we believe that the reasons for allowing securities partnerships to use an aggregation method to account for reverse 704(c) allocations also justify allowing these partnerships to use an aggregation method under Sections 743 and 734.” The report goes on to recommend a highly complex, Band-Aid mechanism by which adjustments to aggregated securities could be made and recovered.

While we agree with the assertion that Section 704(c) accounting is burdensome, we believe that the shortcomings of securities aggregation methods are so great that the practical solution is not to change the regulations, but rather to abandon the aggregation methods altogether. The fact of the matter is that the system of aggregation is broken, and we should stop trying to think of ways to patch it.

Faced with a high volume of data and limited to tools such as Microsoft Excel, most partnerships and their accountants make as many reasonable assumptions as possible to simplify the problem down to a human scale. The most common “simplification” used by securities partnerships is to use a Section 704(c) aggregation method, either “partial netting” or “full netting.” These methods allow securities partnerships to allocate all tax items in respect to the partners’ aggregated unrealized gains and losses.

In our experience, simplification is a trap. It leads inevitably to unintended, meaningful economic consequences. We believe that partnership accounting cannot be simplified, and that the only way to address partnership complexity is with sophisticated tools and rigorous processes.

Given the sophisticated software tools and computing horsepower available today versus ten or even five years ago, partnerships should address the issue head on. The problem of volume does not go away, but computers are now exceedingly good at dealing with it.

For example, in 1998, a model designed specifically for a relatively large REIT took over 18 hours to compute partners’ Section 704(c) allocations over one tax year. In 2011, on comparably priced hardware, a more tax-technically sophisticated model can run through 10 years of similar partnership facts in less than 10 seconds. Computing horsepower and data analytics have improved tremendously, so it’s no longer necessary to make compromises in pursuit of manageability.

Lot Layering and Securities Aggregation

Originally, Section 704(c) permitted, but did not require, partnerships to make special allocations that take into account the differences between tax basis and fair market value of partnership property. The 1984 Tax Reform Act made the special allocations mandatory. And in 1993, regulations were finalized generally requiring calculations to be made on a property-by-property basis without aggregation. This method, typically referred to as “lot layering,” requires partnerships to make allocations of realized gains and losses both in respect to the historical market values of individual assets and to the partners’ varied interests in the unrealized gain and loss “layers” of those assets.

While the mathematical and sometimes tax technical complexity of these calculations can be daunting, in the vast majority of cases the results make sense. That is, the partners’ allocations of tax items match their economic gains and losses both in timing and in amount.

Shortly after adopting the 1993 regulations, the IRS offered to certain qualifying partnerships an “aggregate” option intended to simplify the Section 704(c) accounting of actively traded financial assets. Aggregation allows securities partnerships to bypass the property-by-property requirement of lot layering, and instead track partners’ unrealized gains and losses in aggregated, portfolio-level accounts. The regulations offer two specific methods: “partial netting” and “full netting.”

At a glance, these appear to offer results similar to lot layering but with significantly less technical difficulty. Using these methods, however, is not without hidden challenges. While the aggregate methods’ calculations and information-tracking requirements are appealingly straightforward, their simplifying assumptions often create unanticipated distortions in partners’ taxable income allocations. These distortions are exacerbated in times of market volatility such as we have seen since 2007.

The aggregation rules work well during secular markets when the values of portfolio assets move together and with limited price volatility. In fact, this assumption is baked-in and inseparable from the aggregation methods.The root of the problem lies in aggregation’s inability to effectively reconcile economic gains and losses in individual assets with partners’ simplified, portfolio-level unrealized gain and loss accounts. In volatile markets, unintended results emerge. A common, frustrating occurrence is that partners suffering economic losses are allocated taxable gains from assets in which they enjoyed no economic appreciation.

Example: the Root Problem with Aggregation Rules

Facts:

New Partner makes a cash contribution to partnership PRS for a 10 percent interest.

At the time of New Partner’s contribution, PRS holds an asset, A, with 1,000 of Section 704(c) built-in gain.

Subsequent to New Partner’s contribution, the value of A declines by (600), to an adjusted built-in gain of 400. New Partner’s share of the unrealized loss is (60).

In the meantime, other partnership assets have increased in value by 500. New Partner’s share of the unrealized gain is 50.

Overall, New Partner has suffered an economic loss of (10).

PRS disposes of A at a net taxable gain of 400.

Comparison of Gain and Loss Allocations:

Under partial netting:

Taxable gain allocations are made in respect to partners’ aggregate unrealized gains.

New Partner’s unrealized gain account: 50

Total unrealized gains: 900 = 400 related to A + 500 related to other assets

New Partner’s allocation of taxable gain: 22.2 = 400 * [50 / 900]

Under lot layering with no remedial allocation:

Taxable gain allocations are made in respect to unrealized gains only in asset A.

New Partner’s unrealized loss in A: (60)

New Partner’s allocation of taxable gain: 0

Additional challenges lie in the aggregation rules’ incompatibility with other sections of Subchapter K, including Sections 754, 734 and 743, which address the methods by which a partnership may calculate and recover adjustments to basis resulting from distributions and transfers of interest. These sections continue to require a property-by-property approach and do not permit aggregation. This is particularly troubling in today’s market, given that the American Jobs Creation Act of 2004 makes negative adjustments mandatory in all cases with “substantial built-in losses” in excess of $250,000.

Practical Solutions

We believe that the practical solution in all but the simplest partnerships is not to patch the aggregation rules, but rather to abandon them altogether in favor of sophisticated lot-layering approaches. Partnerships that take lot-layering approaches are assured that their partners’ tax allocations have economic integrity.

The historical concern was that lot-layering approaches required enormously complex and monolithic software systems to accurately track property-by-property information and yield technically correct results. However, leaps in computing power and advances in software design have finally made these approaches practical.

New programming tools — such as Microsoft’s F#, C# and LINQ languages in the .NET 4.0 development platform released in 2010 — have combined the best strengths of the functional and imperative programming paradigms, allowing for the solution of complex algebraic problems that were difficult to describe using only one paradigm or the other. No software is a panacea, but these recent advances have brought the most technically challenging, real-world partnership allocations problems within reach. While a full explanation of these software development languages is beyond the scope of this article, the short version of the story is that they facilitate the development of more user-friendly and client-specific income allocation tools that were basically inconceivable only a few years ago.

In fact, new software applications can be customized to specific partnership agreements and can allow partnerships to take many tax modeling functions in-house. For example, real-time income allocation estimates can be made for transaction planning and quarterly estimation purposes. Clients who prefer to continue to outsource these functions to their tax provider should reap the same benefits of improved timeliness while also receiving more easily verifiable and understandable outputs, thus clarifying one of the remaining “black boxes” in tax.

Alvarez & Marsal Taxand Says:

In real-world applications, the simplifications given by aggregation methods ultimately cause more problems than they solve. An interesting irony is that in order to properly implement aggregation methods, a partnership must collect all the same data points necessary to perform lot layering. Yet, once aggregated, these economically meaningful asset-by-asset details are discarded. Partnerships that make this decision may well trade a near-term housekeeping problem for a potential long-term economic problem.

Author

Tyler Horton
Managing Director, Washington, D.C.
202-688-4218
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The author gratefully acknowledges the assistance of Tom O'Sullivan, who contributed significantly to this article. Tom is the owner of Crimson Tree Software, a company specializing in partnership tax software.

For More Information on this Topic, Contact:

Keith Kechik
Managing Director, Chicago
312-288-4024
Profile

Ernesto Perez
Managing Director, New York
305-704-6720
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Frank Walker
Managing Director, Atlanta
404-260-4086
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McRae Thompson
Senior Director, Atlanta
404-720-5224

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