Planning for the Allocation of Cash-basis Items to Partners Whose Partnership Interests Change during the Tax Year

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from PPC Tax Planning Guide—Partnerships, 15th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8241; www.ppcnet.com).

Facts: Able-Baker Co. is a calendar-year partnership with two equal partners, Able and Baker. Able-Baker Co. uses the cash method of accounting. Able and Baker plan to admit Charles to the partnership on July 1, 2002, as an equal partner. The partnership has a liability for $1.2 million, representing a note given on Oct. 1, 2001 for the purchase of real estate. This note bears a simple annual interest rate of 12% (based on a 360-day year). The partners expect to make the first interest payment of $144,000 on Sept. 30, 2002. • Able and Baker have consistently maintained their books using the cash method since the partnership was organized. Accordingly, they have never recognized either accrued income or expenses. They intend to require Charles to make a capital contribution equal to each of the other partners' capital accounts as shown on the partnership books on the date Charles is admitted to the partnership. • The partners seek the advice of their tax adviser as to whether any special tax planning is necessary in connection with Charles' capital contribution and partnership admission. Issue: What tax planning can be done for accrued items in a cash-basis partnership when there is a change in the partners' interests during a tax year?

Analysis

Normally, Able-Baker's partnership income or loss items would be allocated in accordance with the partners' respective partnership interests for 2002 (i.e., for the first six months allocated equally to Able and Baker and for the last six months allocated one-third each to the two original partners and Charles). However, Sec. 706(d)(1) requires certain cash-basis items to be apportioned to the period in which they accrued. In turn, these items must be allocated according to the partners' respective ownership interests during the period the cash-basis expenses accrued. Cash-basis items covered by this provision include interest, taxes, payments for services and rents.

In this case, interest on $1.2 million at 12% accrues at the rate of $400 per day. Accordingly, $36,000 accrues as of Jan. 1, 2002. This amount, which accrued in the prior year, is assigned to the first day of 2002 and allocated among those who were partners during the time the accrual took place and who are still partners as of the first of the year. Able and Baker are each assigned $18,000 of this $36,000.

Exhibit 1 presents the interest accrued up to the payment date (Sept. 30, 2002), which is allocated on a daily basis among the partners as follows:

If there had been a partner during 2001 who was no longer a partner on Jan. 1, 2002, the amount allocable to that person would have been capitalized and allocated to the basis of partnership assets.

Conclusion

The allocation for tax purposes of the $144,000 of interest paid on Sept. 30, 2002 must be made based on each partner's ownership interest during the period that the cash-basis items accrued. The allocation is not based on the partners' sharing percentages on the date the interest is actually paid.

The rules governing the allocation of cash-basis items for tax purposes do not control the economic arrangement among the partners; see Regs. Sec. 1.704-1(b)(1)(iii). While the partners could choose to match their economic allocations and capital accounts to the required tax allocation results, they cannot be compelled to do so. Even though Charles cannot be allocated any of the pre-July interest for tax purposes, there is nothing preventing the partnership from fully charging him for one-third (or for that matter, more) of the interest paid on Sept. 30, 2002. If the partners did allocate the interest expense differently for tax and economic purposes, the different allocations might simply result in a book/tax difference.

This presents interesting, unanswered questions. Do the book/tax difference-balancing rules under the Sec. 704(b) regulations require a subsequent reallocation of cash-basis tax items to reconcile the difference, such that the net effect is merely a timing distortion?

The distortion created by the mismatched book and tax allocations is eliminated if Charles is specially allocated a disproportionate amount (up to 100%) of the interest accruing after his entry for tax purposes; in other words, Able and Baker could allocate the full $36,000 in interest accruing JulySeptember 2002 to Charles. While this would not completely balance the book and tax capital accounts as of September 30, the partners could continue to specially allocate interest and other partnership expenses to Charles until the capital accounts were balanced. While, theoretically perhaps, there is some risk, such allocations have traditionally been allowed under facts similar to these. Thus, through careful planning and compliance with the special allocation rules, partners can usually accomplish most (if not all) of their "retroactive" allocation goals without a retroactive allocation.