LSI 2010 Real Estate Joint Ventures conference materials.pdf

Brian Todd of Davis Wright Tremaine LLP
Andrew H. Zuccotti of K&L Gates LLP
2. Alternate Economic Effect Test. To permit the members of an
LLC (or the limited partners of a limited partnership or the partners of an LLP) to
preserve their limited liability while at the same time matching tax and economic
consequences of profit and loss allocations, the regulations provide an alternative test for
economic effect. This test requires that the first two prongs of the regular economic
effect test (maintenance of capital accounts and liquidating distributions in accordance
with capital account balances) be satisfied. Additionally, instead of requiring members to
have a deficit make up obligation, if the partnership or limited liability company
agreement contains a “qualified income offset provision,” the regulations will deem an
allocation to have economic effect to the extent it does not cause, or increase, a deficit
balance in a partner’s or member’s capital account as of the end of the year in which the
allocation occurs in excess of any limited amount that the partner or member is by
contract obligated to restore.
3. Adjustments for Reasonably Expected Events. In making the
determination whether an allocation will create (or increase) a deficit in a member’s
capital account in excess of any amount the member is obligated to restore, the
regulations require not only that all allocations for the year be taken into account, but, in
addition, that certain allocations or events reasonably anticipated to occur in future years
be taken into account. The most relevant of these events typically relates to future
distributions. This rule requires that the partner’s or member’s capital account be
reduced by any distributions expected to be made in future years, to the extent such
distributions exceed offsetting increases to the member’s capital account that reasonably
are expected to occur during (or prior to) the years in which the distributions are expected
to be made. The purpose of this rule is to prevent a loss allocation from being made to a
partner or member in one year, which drops his capital account balance to (or close to)
zero when it is expected that a distribution will be made in a subsequent year without any
offsetting profit allocation, which distribution would create a deficit in the member’s
capital account. Absent this requirement, since the member has no obligation to make a
contribution to the LLC to restore his capital account deficit, and consequently would not
bear the economic burden associated with the loss earlier allocated to him, the goal of
matching economic and tax consequences would fail.
4. Qualified Income Offset. Notwithstanding that an allocation will
have economic effect under the alternate test only to the extent it does not create (or
increase) a deficit in a partner’s or member’s capital account, after taking into account
reasonably expected distributions to the partner or member, a partner’s or member’s
capital account nonetheless may become negative as a result of unexpected events or
distributions. Since the partner or member has no obligation to restore the deficit, and
cannot in that way bear the economic burden associated with the loss contributing to the
deficit, the regulations employ a gross income allocation mechanism as a substitute for
the deficit restoration obligation. In other words, a partner or member whose capital
account unexpectedly drops below zero is required to bear the economic burden of the
loss creating the deficit by receiving a subsequent allocation of gross income to restore
his or her capital account to zero as quickly as possible. The regulations denominate this
gross income allocation a “qualified income offset,” and require that a partnership or
LLC agreement contain a qualified income offset provision in order to satisfy the
Speaker 11: 4
Speaker 12: 4
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Law Seminars International | Real Estate Joint Ventures and Funds | 02/08/10 in Seattle, WA