Today, I want to continue looking at the partnership capital account. But before I get into the details, let’s review a few basic points. First, from a tax perspective, partners share the economic benefits and burdens of ownership. That means if a partnership makes money, the partners do too. But if the partnership needs more money to continue as a going concern, the partners will have to contribute additional funds. In addition, the allocations of a partner’s capital account must have “substantial economic effect.” This is a term of art in the tax world. In order to have economic effect, the computations for the partner’s capital account must comply with three requirements. I covered the first last week (Part I). This week, we’ll look at the remaining two.
(2) Upon liquidation of the partnership (or any partner’s interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (2) and requirement (3) of this paragraph (b)(2)(ii)(b)), by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), and
(3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2) of this paragraph (b)(2)(ii)(b)).
Before you get confused by the excess verbiage, remember that partners have to share the benefits and burdens of being partners. So, under number (2) above, we see that partners share the benefits of being partners; if a partnership is liquidated and there are excess funds available after paying off creditors, the partners get to share in the profits in direct proportion to the ownership in the partnership.
In contrast, if there is a deficit in each or any partner’s account, they have to make an additional contribution to the partnership.
Here’s a simple example to illustrate both points. Partners A and B each have $50 in their capital account after the partnership has wound up its business and paid off all creditors. They will each receive $50 of the remaining available funds. Let’s reverse the process and say that each partner has ($50) – a $50 deficit account after the partnership has paid off all its debts. That means the partnership was an economic failure and each partner gets to contribute an additional $50 to pay off the partnership’s creditors.
As an FYI, the above examples are deliberately very simple to illustrate the underlying policy of these regulations. As I mentioned in last week’s post, partnership accounts are one of the most complex areas of tax law with many nuances that go far beyond these posts. However, the above illustrations should give you a good general overview of the basic concepts involved.
Next I’ll look at some of the requirements for “substantial.”