Revaluations Revisited: Partnership Allocations and the Demise of the Ceiling Rule | The Tax Lawyer
Updated: 5 days ago
This article was originally published in Vol. 54, No. 2 (Winter 2001) edition of The Tax Lawyer. The full pdf is linked below, and you can find it in JSTOR.
The idea for this article began with a challenge from a client. He was setting up a hedge fund, where allocations of gains and losses would be made twice a year based on changes in net asset value. Accordingly, unrealized as well as realized gains and losses were to be reflected in these allocations. Also, on those allocation dates, investors would acquire or redeem interests in the fund. The percentage interest in the fund that would be issued or redeemed would be based on the net asset value at that time.
I explained that under arrangements of these types, any unrealized gains and losses that were reflected in net asset value would have to be allocated for tax purposes, when realized, in accordance with the percentage interests of the investors at the times when those gains and losses accrued, although if an asset had both gains and losses in different accrual periods, something called the “ceiling rule” could affect those allocations. I dutifully drafted language for the partnership agreement requiring these tax allocations to be made in accordance with the principles of the relevant provisions of the partnership tax regulations.
The client was dissatisfied. Not being a tax lawyer himself, he had no idea what those principles were. He reasoned, understandably enough, that there ought to be a mechanical approach to the allocations that could be expressed in a formula, whether expressed in words or in mathematical terms. After some effort, I was able to provide language that specified how the allocations were to be performed, without any reference to the tax regulations. That language incorporated the operation of the ceiling rule, which was a mandatory feature of the tax law at that time. As a drafting matter, it was a case of first impression, as I had never seen an example of a tax allocation clause with such a self-contained verbal formula, nor have I since.
The first version of this article was published in The Tax Lawyer under the title “Partnership Revaluations.” Years later, the relevant tax regulations were amended to allow partners to mitigate the effect of the ceiling rule by providing curative or remedial allocations. So I rewrote the article with curative and remedial allocations reflected in additional drafting examples. The revised article was also published in The Tax Lawyer, with the title “Revaluations Revisited.” Since then, the article has been updated and reprinted in the Practising Law Institute’s annual compendium on partnership taxation. The version here reflects updates through early 2012.
Although these drafting examples have been readily available to practitioners for years, they have never caught on. A principal reason for this, I believe, is the popularity of “stuffing” allocations, which preferentially allocate gain to investors that are cashing out, and therefore recognizing gain anyway. It is difficult to square these allocations with a principled reading of the regulations, but until the IRS affirmatively indicates that it will not respect stuffing allocations, they will continue to remain attractive.
Even if the drafting examples are not used, they nonetheless provide insight into how the regulations work. In particular, they also indicate the circumstances in which the allocation method preserves fungibility of interests, and also shed light on how the choice of methods affects the complexity of the allocation computations. Interestingly, the “exact” methods are in some respects conceptually simpler than the “simplified” methods offered by the regulations for investment partnerships.
You can read the full article here:
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