LSI 2010 Real Estate Joint Ventures conference materials.pdf

Brian Todd of Davis Wright Tremaine LLP
Andrew H. Zuccotti of K&L Gates LLP
I. The Basics -- The Substantial Economic Effect Safe Harbor.
Speaker 11: 2
Speaker 12: 2
The Treasury Regulations promulgated under Code Section 704(b) provide that
allocations of items of partnership (or LLC) income, gain, loss and deduction will be
respected if they either (i) satisfy the “substantial economic effect” safe-harbor or (ii) are
consistent with the partners’ interests in the partnership. The latter test involves a facts
and circumstances analysis; the former requires that an allocation must have “economic
effect” and that such economic effect must be “substantial.”
A. Economic Effect, in General. The regulations prescribe three
requirements for an allocation to have economic effect. All three must be provided for in
the partnership or LLC agreement throughout the full term of the LLC or partnership.
The requirements are designed to assure that the organization’s profit and loss allocations
are consistent with the underlying economic arrangement of the members. The
requirements are:
1. That a capital account be maintained for each member in
accordance with the rules set out in the regulations;
2. That liquidating distributions be made in accordance with the
members’ positive capital account balances; and
3. That if a member has a deficit balance in his or her capital account
following the liquidation of his or her interest in the entity, he or she is obligated to
restore the amount of the deficit balance to the LLC or partnership. Treas. Reg. § 1.704-
1(b)(2)(ii)(b).
Each of these requirements is discussed in more detail below.
B. Capital Account Maintenance. Each member’s capital account is
increased by the amount of money and the fair market value of property (net of liabilities
assumed by the LLC or partnership or to which the property is subject) contributed to the
LLC or partnership by the member and by profits allocated to the member. Each
member’s capital account is decreased by the amount of money and the fair market value
of property (net of liabilities assumed by the member or to which the property is subject)
distributed to the member and by allocations of loss to the member. Treas. Reg. § 1.704-
1(b)(2)(iv).
In addition, the regulations permit the capital accounts of the members to be
adjusted to reflect unrealized appreciation or depreciation in the value of the LLC’s or
partnership’s assets upon the occurrence of certain events. These are:
• A contribution to the LLC or partnership by a new or existing member in
exchange for an interest in the LLC or partnership;
• Liquidation of the LLC or partnership or of the member’s interest in the
LLC or partnership;
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Law Seminars International | Real Estate Joint Ventures and Funds | 02/08/10 in Seattle, WA