Taxation

When business owners form a partnership (or a multi-member LLC treated as a partnership for tax purposes), the partnership agreement becomes the controlling legal document governing the rights, duties and financial expectations of the partners. In drafting and revising partnership agreements, it is critical to align the legal terms with the tax realities — because in a partnership, the entity itself is generally not subject to income tax; instead the partners are taxed on their allocable share of income, gain, loss, deduction and credit from the partnership.

In this article we explain key concepts such as allocations vs. distributions, capital accounts and basis, waterfalls in distributions, and certain regulatory “safety-net” rules (minimum gain chargeback, qualified income offset, § 754 elections). We then review the deduction for qualified business income (QBI) for partners and highlight how the recently enacted One Big Beautiful Bill Act (the “Act”) affects partnership taxation. Our aim is to equip business owners and advisors with both the legal-framework and tax-planning considerations when negotiating a partnership agreement.

As noted above, a partnership (or an LLC treated as a partnership) is a pass-through entity: it generally does not pay federal income tax itself. Instead, the partnership computes its taxable income (or loss) and allocates those items to its partners under § 701 of the Internal Revenue Code and associated regulations. The partners then report their share on their individual returns.
From a legal perspective this means the partnership agreement must clearly define how income, gain, loss and deduction are allocated among the partners—and those allocations must have “substantial economic effect” or otherwise satisfy the alternative rules under Treas. Reg. § 1.704-1(b) through (h).

One frequent source of confusion is the difference between an allocation and a distribution.

• Allocation: This is the assignment of items of income, deduction, credit, gain or loss to a partner for tax-reporting purposes. For example, the partnership may allocate $100,000 of taxable income to Partner A and $50,000 to Partner B, even if no cash has yet been distributed.

• Distribution: This is the actual transfer of money or other property from the partnership to a partner (or return of capital) pursuant to the partnership agreement. A distribution reduces a partner’s capital account (subject to certain liabilities and basis rules) and may trigger certain tax consequences (for example, if the distribution exceeds the partner’s basis).

In drafting a partnership agreement it is essential to provide (a) the method of allocations, and (b) the method of distributions (timing, priority, seniority, water-marks, etc.). These two concepts are distinct: you can be allocated taxable income now but not actually receive a cash distribution until later; likewise you might receive a distribution without an immediate allocation (though the tax basis ramifications must be tracked).

A common feature in more complex partnership agreements (especially private equity and real-estate ventures) is the waterfall distribution regime. In simple terms, a waterfall defines how, when and in what priority the partnership returns cash or other property to the partners after satisfying certain hurdles (return of capital, preferred returns, catch-up, carried interest, etc.).

For example, a typical waterfall might proceed as follows:

1. Return contributed capital to each partner in proportion to their contributions.

2. Pay a preferred return (e.g., 8%) to each partner until the preferred return is met.

3. Distribute additional profits: first to the investor partners up to a certain X multiple or IRR, then split remaining profits 20% carried to the general partner and 80% to the limited partners.

4. On liquidation, residual cash goes to partners according to remaining capital accounts or agreed splits.

From a tax and legal drafting standpoint, each layer of the waterfall should align with the allocation regime and the partners’ expectations. Mismatch between the economic distribution waterfall and the taxable allocations can lead to § 704 regulatory issues or unintended tax consequences. See, for example, the discussion of “target or waterfall” allocation approaches.

Two related but distinct concepts that are fundamental: the partner’s capital account and the partner’s tax basis.

• Capital Account: The partnership agreement should specify how each partner’s capital account is maintained (often according to Treas. Reg. § 1.704-1(b)(2)(iv)). A typical rule: each partner begins with their contribution, increases by allocations of income or gain and additional contributions, decreases by allocations of loss or deduction and by distributions. The capital account tracks book economic interest.

• Tax Basis (Partner’s outside basis): This is the partner’s tax basis in the partnership interest (outside basis). The basis starts at cost or adjusted contribution, increases by taxable income allocated to the partner, increases by partner contributions, increases by the partner’s share of partnership liabilities (to the extent recourse or certain non-recourse rules apply), and is decreased by distributions and allocated losses. The partner cannot deduct partnership losses in excess of basis (and at risk/other limitations) and cannot have a negative basis without immediate gain recognition (in some cases).

How can a partner increase his/her capital account or basis?

• Capital account: By making additional capital contributions to the partnership; by agreeing to allocations of income/gain to that partner; by being credited with preferred returns or special allocations that increase book income.

• Tax basis: By making additional contributions; by being allocated taxable income or gain; by assuming share of partnership liabilities (subject to recourse/nonrecourse rules).

In the partnership agreement, it is prudent to define capital-account rules (including what items will be added or subtracted and what treatment of unrealized receivables or inventory may apply). The basis side is primarily tax-driven but the economic and legal agreement should support proper basis tracking.

The Treasury Regulations under § 704(b) and § 704(c) impose certain “anti-abuse” allocations that must be included in the partnership agreement if the partners wish to have special allocations respected for tax purposes. Two of those are the minimum gain chargeback and the qualified income offset.

• Minimum Gain Chargeback: Under Treas. Reg. § 1.704-2(f) (for non-recourse debt) and § 1.704-2(i) (for recourse debt), the partnership agreement must provide that a partner who receives a deduction or loss allocation attributable to minimum gain must be specially allocated income or gain later to “chargeback” that minimum gain until it is restored. The “minimum gain” concept arises when partnership nonrecourse liabilities exceed the tax basis of the property – the excess is treated as “minimum gain.” The chargeback ensures that the partner who economically benefits from the offset (via deductions) ultimately shares the income when the property is disposed of or gain is realized. See Treas. Reg. § 1.704-2. Legal Information Institute+1

• Qualified Income Offset (QIO): Under Treas. Reg. § 1.704-1(b)(2)(ii)(d), a partnership agreement must contain a qualified income offset if it wants to allocate losses or deductions that could unexpectedly cause a partner’s capital account to go negative. The QIO provision provides that in the event a partner has a deficit capital account that is required to be restored, the partner will be allocated income or gain as quickly as possible to eliminate the deficit. Legal Information Institute+2Fynk+2

In practice, these provisions are boilerplate but essential if the partners want to maintain tax allocations that deviate from simple pro-rata rules and ensure that the allocations have “substantial economic effect” (or the partner alternative test).

The Treasury Regulations under § 704(b) and § 704(c) impose certain “anti-abuse” allocations that must be included in the partnership agreement if the partners wish to have special allocations respected for tax purposes. Two of those are the minimum gain chargeback and the qualified income offset.

• Minimum Gain Chargeback: Under Treas. Reg. § 1.704-2(f) (for non-recourse debt) and § 1.704-2(i) (for recourse debt), the partnership agreement must provide that a partner who receives a deduction or loss allocation attributable to minimum gain must be specially allocated income or gain later to “chargeback” that minimum gain until it is restored. The “minimum gain” concept arises when partnership nonrecourse liabilities exceed the tax basis of the property – the excess is treated as “minimum gain.” The chargeback ensures that the partner who economically benefits from the offset (via deductions) ultimately shares the income when the property is disposed of or gain is realized. See Treas. Reg. § 1.704-2. Legal Information Institute+1

• Qualified Income Offset (QIO): Under Treas. Reg. § 1.704-1(b)(2)(ii)(d), a partnership agreement must contain a qualified income offset if it wants to allocate losses or deductions that could unexpectedly cause a partner’s capital account to go negative. The QIO provision provides that in the event a partner has a deficit capital account that is required to be restored, the partner will be allocated income or gain as quickly as possible to eliminate the deficit. Legal Information Institute+2Fynk+2

In practice, these provisions are boilerplate but essential if the partners want to maintain tax allocations that deviate from simple pro-rata rules and ensure that the allocations have “substantial economic effect” (or the partner alternative test).

Under § 199A of the Code, non-corporate taxpayers (including partners) may be eligible for a deduction equal to up to 20 % of their “qualified business income” (QBI) from a qualified trade or business carried on through a partnership, S-corporation or sole proprietorship. The deduction is subject to wage and capital-based limitations and phase-outs, particularly for specified service trades or businesses (SSTBs).

Recent legislative changes via the One Big Beautiful Bill Act have important implications for partnerships:

• The Act permanently extends the § 199A deduction for pass-through entities. WilmerHale+2Baker Botts+2

• The phase-in ranges for the deduction’s limitation have been increased (for example from $50,000 to $75,000 for non-joint returns and from $100,000 to $175,000 for joint returns) under the Act. BIPC+1

• A new minimum deduction is introduced: taxpayers with at least $1,000 of QBI from active trades or businesses (material participation) will be eligible for a minimum deduction of $400. BIPC+1

For partnerships, this means the structure of income allocations, W-2 wages of the partnership, unadjusted basis immediately after acquisition (UBIA) of qualified property, and whether the partnership is conducting a Specified Service Trade or Business all matter significantly to maximize the partner’s § 199A benefit.

Here are some key take-aways from the Act relevant to partnerships and partnership agreements:

• The § 199A deduction for qualified business income is now permanent, which means partners can plan with longer-term certainty.

• The Act increases thresholds/phase-in ranges for the QBI deduction’s limitations, making it somewhat easier for partners in certain service-business or lower-income-level contexts to access the full deduction.

• Because the deduction is now more reliably available, partnership agreements should explicitly consider how allocations of income, loss, cash distributions and capital contributions will affect each partner’s QBI eligibility.

• While many provisions of the Act relate to corporate or international tax, the permanent nature of bonus depreciation and first-year expensing (as part of the Act) still impact partnerships that hold qualifying property — which can affect partnership allocations, book-tax differences, and ultimately partner basis and QBI.

1. Align economic and tax allocations: Ensure that the waterfall distribution regime and the taxable allocations (profits, losses, special allocations) align so that partners’ expectations match tax reality.

2. Define capital account and basis rules clearly: The agreement should specify how capital accounts are maintained, how additional contributions or distributions are treated, and how liabilities are allocated for basis purposes.

3. Include minimum gain chargeback and qualified income offset provisions: Even if the partnership expects pro-rata allocations, including these clauses ensures compliance with the § 704 safe-harbor rules.

4. Consider a § 754 election: If the partnership will have transfers of interests (sales or death) or if step-up in basis is desirable, the agreement should provide for decision-making around the § 754 election and how cost will be allocated.

5. Evaluate § 199A eligibility: Since the QBI deduction is now permanent, structure allocations, wages and property basis to maximize partners’ deduction. Review whether the trade or business is an SSTB, whether W-2 wages or UBIA of qualified property will limit the deduction, and whether the partner’s aggregated income is within phase-out thresholds.

6. Periodically revisit and amend: Because tax rules evolve (as evidenced by the Act), the partnership agreement should contain amendment processes (with partner consent) to address changed tax law or shifts in partner expectations or contributions.

7. Coordinate legal and tax advisors: The partnership agreement should be drafted in consultation with tax counsel and the partnership’s accountant so that the legal terms support desired tax outcomes and avoid unintended tax traps.

At Vanguard Legal PLLC, our business-law and tax-savvy attorneys work in tandem with your tax accountant and financial advisors to draft, review and negotiate partnership agreements that are both legally sound and tax-efficient.