Partnership Preferred Returns: Identifying Capital Shifts and Recharacterization Risks

Description

The most critical task for tax counsel drafting partnership agreements is ensuring that the allocations in the operating documents reflect the partners' business intent while complying with IRS regulations. Target allocation provisions, which are increasingly popular in partnership agreements, present many issues. One of these issues is the risk that partnership preferred returns may be recharacterized as guaranteed payments or may require recognition of income without an associated partnership distribution. The guidance from the IRS is unclear as to the character and timing of including preferred returns as taxable income.

In partnership agreements where preferred returns are accrued but unpaid, there can be an implied shift of capital from subordinated partners to the partners entitled to the preferred return. The preferred partners may be required to recognize ordinary income with respect to the implied capital shift, which can generate a costly and often unforeseen current year tax. Because preferred returns are favored in certain types of partnerships, many partnership agreements contain allocations involving preferred returns that can create an unrecognized tax risk. Proper planning and drafting may mitigate the potential dangers of IRS challenges to the intended character and timing of income associated with preferred returns.

Listen as our experienced panel provides a thorough and practical guide to meeting the planning and reporting challenges involved in partnership agreements with preferred returns.