Although a partnership is the most flexible vehicle for taxpayers seeking non-pro-rata allocations of profit and loss items, for those allocations to be respected by the IRS they must have “economic effect”. This term has often confused taxpayers and their accountants. However, the IRS provides a safe harbor rule in Treas. Reg. 1.704-1(b)(2)(iv) whereby a partnership maintaining its capital accounts in compliance with Code Section 704(b) will be deemed to have its allocations blessed as having “economic effect”.
A full discussion of the capital account maintenance rules is beyond the scope of this article, but some discussion is warranted.
Partners’ capital accounts are equity accounts kept in the accounting records of a partnership. Capital accounts are adjusted upward or downward each year depending on the transactions that occurred within the partnership. The goal of a capital account is to track a partner’s economic investment in the partnership.
A partner’s capital account initially consists of their initial capital contributions (cash + fair market value (hereafter “FMV”) of property, net of liabilities associated with the property).
Each partner’s capital account is increased by the following:
- Additional cash contributed to the partnership by the partner;
- The FMV of additional property contributed by the partner, net of liabilities associated with the property;
- Allocations of partnership income to the partner (both taxable and tax-exempt income);
- Positive 704(b) revaluations (book-up adjustments);
Each partner’s capital account is decreased by the following:
- Allocations of partnership losses to the partner (both tax-deductible losses and nondeductible expenses);
- The FMV of property distributed to the partner;
- Note: a distribution of property triggers book gain or loss that then increases or decreases the partners’ capital accounts; then the partners’ capital accounts are reduced by their pro-rata share of the FMV of the distributed property
- The amount of any cash distributed to the partner;
- Negative 704(b) revaluations (book-down adjustments);
One of the basic requirements of the Code Section 704(b) capital account maintenance provisions is that partnership assets must be recorded at fair market value (FMV) rather than at cost basis. This can often prove difficult when the partners are contributing assets other than cash or marketable securities to the partnership. The Treasury regulations provide that the FMV of the property contributed to the partnership is determined using an arms-length standard where the parties have adverse interests.
Another basic tenement of this regime is that the partners’ capital accounts determine distribution rights. Upon liquidation, the partnership must make liquidating distributions in accordance with the partners’ positive capital account balances, and a partner is unconditionally obligated to restore a deficit capital account balance following a liquidation of the partner’s partnership interest.
Within the context of maintaining proper capital accounts arises the question of how a partnership’s operating agreement (hereafter referred to as the LLC’s operating agreement) should address the maintenance of the partners’ capital accounts.
The LLC’s operating agreement should provide that partners’ capital accounts will be maintained in compliance with Code Section 704(b). Additionally, the LLC operating agreement, ideally, should also address potential partnership revaluations of property.
For example, an LLC operating agreement may provide that the LLC Manager may, in their sole discretion, adjust the capital accounts of the Members to reflect a revaluation of Company property (including intangible assets such as goodwill) to its fair market value, at the following times:
- In connection with the acquisition of a Member Interest by a new or existing Member for more than a de minimis amount
- In connection with the liquidation of the Company
- In connection with a more than de minimis distribution to a retiring or continuing Member as consideration for his/her Member Interest
It is important to consider who is the true owner of a capital account. It is common nowadays for a partner to own a partnership in more than one way. For example, a partner may own 10% of a partnership in his/her own name and own another percentage of the same partnership in the name of a grantor trust. The treasury regulations provide that a person may only have one capital account however, regardless of how many ways he/she owns a partnership interest.
“a partner who has more than one interest in a partnership shall have a single capital account that reflects all such interests, regardless of the class of interests owned by such partner (e.g., general or limited) and regardless of the time or manner in which such interests were acquired.” 
This is known as the one capital account rule.
Another common issue partnerships encounter is how to treat the capital account of a husband and wife who jointly own a partnership interest.
For example, an LLC operating agreement may provide that where capital is contributed (either initially or as part of an additional capital contribution) by a husband and wife as tenants by the entireties, they should be treated as having a single capital account and for all purposes of the LLC be treated as a single Member. Additionally, the LLC operating agreement should specify that the married couple should let the LLC Manager know, in writing, which spouse will cast votes at meetings of the LLC.
Another critical issue to consider regarding capital accounts is how partners should agree to treat additional capital contributions to the partnership. Some partners may want to contribute additional capital to the LLC while others may not. One way to resolve this issue is to require unanimous consent of all the Members before allowing the LLC to accept new contributions.
For example, an LLC agreement may provide that no Member is required to make additional contributions or payments of any kind with respect to the Company, his/her interest, or either. The agreement may provide that only after a unanimous vote shall Members be required to make any additional capital contributions in proportion to their Membership Percentages. Additionally, where less than all Members will contribute additional capital a unanimous vote may still be required. In the event a Member contributes additional capital, without first obtaining the unanimous consent of all the Members, that Member can be deemed to have made a gift of property to the other Members (equal to those other Members Membership percentages multiplied by the value of that contribution).
The rules governing the proper treatment of partners’ capital accounts are complex, but we hope this discussion has added to your understanding of some of the issues involved therein.