When real estate developers and fund sponsors send a partnership agreement to their attorney for review, the attorney typically reads it as a legal document. The lawyer checks the governance provisions, the buy-sell mechanics, the indemnification language, and the dispute resolution clauses. The lawyer reviews for the things lawyers ordinarily review for in contracts: clarity, enforceability, protection from unanticipated outcomes.
That review misses something important. The partnership agreement is also — and in a real sense, primarily — the tax framework of the deal. Almost every economic outcome the partners care about is determined by tax provisions buried inside the agreement. And those provisions are far more consequential than most lawyers, and most partners, realize at the time of signing.
Allocations Are Not What They Look Like
The first place this becomes apparent is in how the agreement allocates partnership income, loss, deductions, and credits. A partnership agreement may say that profits and losses are allocated in proportion to capital contributions, or follow a tiered waterfall, or shift after a preferred return is paid. What the agreement actually does for federal income tax purposes, however, depends on whether those allocations satisfy the substantial-economic-effect requirements of Treasury Regulation § 1.704-1(b).
Those rules are technical, and the regulations setting them out are among the longest and most arcane in the Code. In summary, an allocation will be respected only if (i) capital accounts are maintained in accordance with the regulations, (ii) liquidating distributions are required to follow positive capital account balances, and (iii) any partner with a deficit capital account is either subject to an unconditional deficit-restoration obligation or is protected by a qualified income offset that, together with a minimum-gain chargeback for nonrecourse deductions, prevents the partner from receiving losses that lack economic effect.
If those features are missing — or, more commonly, present in form but not actually administered in operation — the IRS has authority to reallocate income and loss according to the partners’ interests in the partnership, which may be very different from what the partners thought they negotiated. The dispute that follows is often won or lost on whether the agreement’s capital-account language was followed in practice during the years before the audit.
Debt Allocations Drive Basis, and Basis Drives Loss Deductibility
For real estate partnerships specifically, the rules of § 752 governing how partnership-level debt is allocated among the partners can be the most economically important provisions in the entire agreement. A partner can deduct partnership losses only to the extent of basis in the partnership interest, and basis under § 722 includes the partner’s share of partnership liabilities under § 752.
How the agreement addresses recourse versus nonrecourse debt, partner-level guarantees and bottom-dollar arrangements, qualified nonrecourse financing under § 465(b)(6), and minimum gain under Treasury Regulation § 1.704-2 will determine whether and when each partner can use the losses the project generates. For a project generating substantial early-year losses through cost segregation and bonus depreciation, the difference between getting these allocations right and getting them wrong can run into hundreds of thousands or millions of dollars per partner.
Distributions and the Waterfall
The distribution waterfall is usually the section the partners read most carefully, because it tells them when and how they get paid. What the partners often miss is that the waterfall has tax consequences distinct from its cash-flow consequences. Distributions in excess of basis trigger gain under § 731. The partner’s basis in distributed property carries over (with limitations) under § 732. Distributions of partnership interests to a service partner can be ordinary income under § 83 if the regulations under that section have not been carefully considered.
And in real estate funds in particular, the question of whether the sponsor’s carried interest is a profits interest under Rev. Proc. 93-27, qualifies for the safe harbor of Rev. Proc. 2001-43, and will hold up under the three-year holding-period rule of § 1061 turns on how the agreement is drafted and on what events occur during the partnership’s operation. Drafted thoughtlessly, the carried interest may be taxed as ordinary compensation income at the moment of grant or recharacterized as short-term capital gain on disposition, neither of which is usually what the parties intended.
The Section 754 Election and the Things It Cannot Fix
A § 754 election allows a partnership, on the transfer of a partnership interest or distribution of partnership property, to adjust the basis of its assets to reflect the new economic reality. The election is often described as a routine technical matter. It is not. The election binds the partnership for all future years (subject to revocation procedures), and the basis adjustments under § 743(b) and § 734(b) require careful tracking that is often beyond the capacity of the partnership’s accounting system.
More importantly, a § 754 election can address some basis disparities but not others. A partner who buys an interest in a partnership without a § 754 election in place can end up paying tax on built-in gain that the partnership’s prior partners economically realized. A partner who receives a distribution from a partnership without a § 754 election can end up with a basis in the distributed property that bears no relation to the property’s fair market value. The agreement should address whether the election will be made on transfers or distributions, who decides, and how the cost of the resulting tracking will be allocated.
State Income Tax and the Composite Return Question
For partnerships with operations or property in more than one state, the agreement should also address composite return mechanics, withholding obligations on nonresident partners, and how state-level taxes paid at the partnership level will be credited to or recovered from individual partners. These are mechanical questions, but the answers vary substantially state-to-state, and getting them wrong can produce double taxation or surprise liabilities at the partner level several years after the income year.
Reading the Agreement Before It Is Signed
None of this is to suggest that a partnership agreement should be drafted by a tax lawyer instead of by deal counsel. The drafting, structuring, and negotiating tasks are the proper domain of corporate and real estate practitioners who handle that work every day. But the tax provisions of any sophisticated partnership agreement — the allocation provisions, the capital account maintenance language, the debt allocation language, the distribution waterfall, the § 754 election language, the state tax provisions, and the carried-interest provisions if applicable — should be reviewed by a tax practitioner who reads the document the way the IRS will read it on examination.
The cost of that review is small in comparison to the cost of discovering, three years into the partnership’s operation, that the document does not do what the partners intended. The right time to ask the tax questions is before the agreement is signed.