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Tax Allocations for Securities Partnerships Due to several factors, including the volume of trading, frequency of changes in partners profit and loss (P&L)-sharing percentages and their entering and exiting a partnership, realized gains and losses cannot be allocated for tax purposes based on the partners economic percentages in the period the gain or loss is recognized, without creating some inequity. This type of allocation would lack Sec. 704 substantial economic effect, because the allocation of recognized gains or losses might not be consistent with the actual economic effect reflected in the allocation for book purposes.
Background Securities partnerships are defined as either management companies or investment partnerships that make all of their book allocations in proportion to the nonmanaging partners relative book capital accounts. Partners who provide management or investment advisory services can receive special allocations (such as management and incentive fees). A partnership is a management company if it is registered with the SEC as such under the Investment Company Act of 1940, as amended (15 USC Section 80a). An investment partnership is a partnership that makes revaluations at least annually and on the date of each capital restatement, and 90% of its noncash assets are deemed to be qualified financial assets. A qualified financial asset is any personal property (including stock), actively traded (as defined in Regs. Sec. 1.1092(d)-1) for purposes of the straddle rules.
Allocation Methods
In the example, if realized gains and losses were allocated based on the partners economic percentages for the period in which they were recognized, each partner would be allocated a $100,000 net realized loss; see Exhibit 1. Due to the timing of appreciation of the partnerships investment in X, A and B received all of the economic benefit of the appreciation, but C was allocated $166,667 of realized gain and received the same economic loss. To minimize these disparities, the Code allows securities partnerships to use alternative methods to allocate realized gains and losses. Layering method. When using this method, securities partnerships allocate gains and losses on a partner-by-partner/security-by-security basis. This allocates recognized gains and losses in the same proportion as the underlying unrealized gains and losses were allocated to each partners book capital account. This would require the securities partnership to track the unrealized gains or losses of each lot of stock by each period in which there was a change in partners P&L-sharing percentages due to a contribution, distribution or withdrawal. When a gain or loss is recognized, each layer of the gain or loss is allocated to the partners based on their ownership percentages for each period. In the above example, the $500,000 realized gain on the sale of X would be split into two layersa $1 million gain from January 1March 31 and a $500,000 loss from April 1June 30. Because the investment in D was purchased and sold within the same period, the $800,000 loss would be allocated solely based on the partners P&L-sharing ratios for that period; see Exhibit 2. When applying the layering method to this example, there is no disparity between each partners book and tax capital account. This method offers accuracy, but is time-consuming because of the potentially high number of positions, changing P&L-sharing ratios and turnover; further, the software packages capable of performing these calculations may be cost-prohibitive for some securities partnerships. Aggregate method. Under this method, securities partnerships allocate realized gains and losses based on the unrealized gains or losses allocated to a partner as a whole, rather than on a security-by-security basis. This minimizes the recordkeeping burden found in the layering method, while still minimizing book-versus-tax capital account disparities. The partial-netting and full-netting approaches are the acceptable methods for applying the aggregate method; see Exhibit 3. To allocate gains and losses, the partnership establishes a memorandum account that tracks the difference between each partners book and tax capital account. Under the aggregate method, the partnership allocates gains and losses to each partner to minimize the disparities or the balance in the memorandum account. Partial netting. Under this approach, book gains and losses are netted together for book allocations, but realized gains and losses are aggregated separately before allocation to the partners. Gains are first allocated to the partners whose memorandum account has a positive balance (book capital greater than tax capital), by multiplying the total gains by each partners percent of the total positive memorandum account, but only until the memorandum account equals zero. Any additional gains are allocated to each partner based on his or her sharing ratio. Losses are allocated first to partners with negative balances and then in the same way as gains. Full netting. Under this approach, both book and tax gains are netted together for allocation purposes. If after netting all tax gains, a net gain exists, it would be allocated to partners with positive memorandum accounts first, with any excess then applied to each partner based on his or her sharing ratio.
Conclusion The three different approaches can render both similar and different results. Ultimately, management must pick the method that best fits the partnership. The method must preserve the character and other tax attributes of each item of gain or loss; be determined under a consistently applied approach; and not be determined with a view toward reducing substantially the present value of the partners aggregate tax liability. From Chris Bellamy, CPA, Cohen & Company, Ltd., Cleveland, OH |
