Remember from a tax perspective, partners agree to share the economic benefits and burdens of ownership. This means that not only will they share profits, but they will also share losses and – in a worst case scenario — perhaps contribute additional capital in support of the business. For tax purposes, we need to create and maintain some record of this activity.
Enter the partner’s capital account. This is the most important element of partnership taxation; it is an ongoing record documenting the partner’s economic participation in the partnership. The actual workings of this account are one of the most complex in US taxation and therefore beyond the scope of a few blog posts. However, some initial observations can be made.
Always remember that we we’re keeping a record that shows ongoing participation in the benefits and burdens of partnership ownership.
Under the treasury regulations, partnership allocations must have “substantial economic effect” – a term of art in the partnership tax world. Economic effect, in turn, has three factors, the first of which is this… each partner’s capital account is increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in paragraph (b)(2)(iv)(g) of this section, but excluding income and gain described in paragraph (b)(4)(i) of this section; and is decreased by (4) the amount of money distributed to him by the partnership, (5) the fair market value of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), (6) allocations to him of expenditures of the partnership described in section 705 (a)(2)(B), and (7) allocations of partnership loss and deduction (or item thereof), including loss and deduction described in paragraph (b)(2)(iv)(g) of this section, but excluding items described in (6) above and loss or deduction described in paragraphs (b)(4)(i) or (b)(4)(iii) of this section; and is otherwise adjusted in accordance with the additional rules set forth in this paragraph (b)(2)(iv).
In effect, all we’re doing is increasing the partner’s account when he contributes money or property and when he receives some allocation from the partnership (NOT a distribution) and decreasing his account when the partnership distributes money or cash to the partner, or when the partnership allocates some loss or deduction.
Let’s look at simple example.
1.) Partner X contributes $100 cash to a partnership on formation (he’s a 50/50 partner with partner y). This increases his capital account by $100.
2.) Partnership makes $50 in year 1. As Partner X is a 50% partner, the partnership allocates $25 to Partner X, increasing his partnership account to $125.
3.) In year 1, the partnership distributes $75 cash to Partner X. This decreases partner X’s capital account by $75 to a final total of $50.
Again, always remember the prime purpose of the partnership capital account is to keep an ongoing record of the partner’s actual economic participation and you should be fine.
Next, we’ll look at two more factors the capital accounts must comply with.