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Partnership Agreements

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Jack and Sawyer start a business in the US state "Random island that has the ability to disappear and move and probably isn't even in our dimension" wrote a partnership agreement that in part has the following clauses: 1) We will keep track of the capital account of our partnership interests in accordance with the regulations; 2) When one of our interests is liquidated, that partner must be paid any positive balance in his capital account; 3) If one of us owes money to the capital accounts after the partnership has been liquidated by any means then that partner will pay the partnership the amount owed at the time of liquidation; 4) Jack and Sawyer agree that Jack will receive 80% of the partnership's tax-exempt income and Sawyer will receive the remaining 20% and all of the ordinary income.

You know that Jack is a doctor and in the 50% tax bracket (yes, these are made up future tax brackets), and that Sawyer is not making much money because he is in therapy recovering from years of fraud and deceit and is therefore in the 10% tax bracket. The partnership receives 100k in tax-exempt interest and 100k in ordinary income in Year 1.

You wonder why Jack and Sawyer think it is a good idea to enter in a business together, and with all that they have going on, why tax minimization is on their mind.
Are the provisions in the partnership agreement enforceable?

PLEASE cite the source law (codes, regulations, relevant cases etc.) do not make jumps in logic, show all steps! Do not stop analysis because one element fails, if applicable test requires elements.

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The partnership agreements are provided.

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Some of the provisions are enforceable while some of them are not enforceable. Federal tax law gives owners' of entities permission to agree how income within the entity will be allocated if in a partnership. The caveat is that the allocation must reflect the economic reality of the owners' business arrangement as tested under regulations and rules that are some of the most complicated within the tax code. In accordance with the Tax Court decision of Orrisch v. Commissioner in 1970, the business is subjected to substantial economic effect tests wherein capital accounts represent the crux of special allocation.

Therefore, under the regulations set forth by Orrisch v. Commissioner, the precedent was set that found if a partnership didn't address liquidation rights to capital and how a partner with a negative capital account balance would be treated, the business would fail to have capital accounts that fall under special allocation. The regulations establish that for an allocation to be considered substantial, any partner's after-tax position in regard to present value terms may be improved by the allocation and a strong likelihood must exist that none of the partner's after-tax economic position will be substantially worse as a result of the allocation. Therefore, if the U.S. Treasury is the only loser as a result of the allocation in regard to tax revenue, it will fail to pass the present value test.

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Solution provided by:
Raushaun Rigsby, MSc
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  • Bachelor of Science , Sam Houston State University
  • Masters of Science, Kaplan University
  • Masters of Science , Kaplan University
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