Deficit Restoration Obligations in Partnership Agreements

In last week’s blog post, we shared two concepts that are essential to understanding partnership allocations under Internal Revenue Code (IRC) Section 704. While last week’s blog post focused on the role of Substantial Economic Effect in partnership agreements, today’s blog post will stress the importance of Deficit Restoration Obligations (DROs) in partnership agreements.

DROs are typically used in partnership agreements to help meet the Economic Effect Test (also covered last week). A DRO requires a partner to restore any negative balance (deficit) in their capital account upon the liquidation of the partnership. The DRO demonstrates the partner’s willingness to assume the economic risk of loss in the partnership. With a DRO, the Internal Revenue Service is more likely to respect the allocations for tax purposes, given that the partner will meet the Economic Effect test.

In the absence of a DRO in a partnership agreement, a partner cannot be allocated a tax loss greater than their tax basis (the capital account plus the partner’s share of partnership liabilities) in the partnership. If losses are allocated to a partner absent a DRO in a partnership agreement, and those losses exceed the partner’s basis, the excess losses cannot be deductible. Instead, the losses will be suspended and carried forward until the partner has sufficient basis to absorb them.

It is essential to understand that for a DRO to be considered valid under IRC Section 704, the partner must be obligated to make good on their DRO, regardless of the reason for the partnership’s termination. Additionally, the partner’s obligation must continue even if they are no longer a partner at the time of liquidation.

It is important to note the role of limited liability in the context of DROs. Limited partners and members of a limited liability company may be reluctant to agree to a DRO, as it effectively negates the limited liability protection the partners or members would otherwise enjoy. The tax regulations respect this reality and provide an alternative test, the Qualified Income Offset (QIO) to meet the economic effect requirement absent a DRO. If the partnership agreement contains a QIO provision, then an allocation to a partner will be considered to have economic effect to the extent that the allocation will not create or increase a deficit balance in the partner’s capital account (in excess of the limited amount, if any, that the partner is obligated to restore as of the end of the partnership’s tax year to which the allocation relates).

Sources: Bloomberg Tax, RIA Checkpoint