Effect of a Deficit Restoration Obligation
A deficit restoration obligation is a partner’s unconditional obligation within a partnership agreement to restore any deficit balance in their capital account when the partnership liquidates. The presence (or absence) of a deficit restoration obligation within a partnership agreement impacts which partners can be allocated losses & deductions generated by a partner’s equity or partnership recourse debt, but also the allocation of partnership liabilities under I.R.C. Section 752. A Denver business attorney and tax attorney at The McGuire Law Firm assist partners and partnerships regarding partnership agreements including deficit restoration obligations within a partnership agreement.
Allocations within a partnership agreement are respected to the extent that the allocation has substantial economic effect or are made in accordance with the partner’s partnership interest. When reviewing an allocation and the substantial economic effect, the 704 Regulations apply a three-part test. As part of this test, capital accounts must be maintained in accordance with the 704 Regulations, liquidating distributions must be in accordance with positive capital account balances and each partner must have a deficit restoration obligation.
Under the 704 Regulations the value of property is assumed to be the basis of the property and not the actual fair market value of the property. Further, stacking rules deem deductions to be funded first by those with the least rights to receive proceeds upon the sale of the assets. In general, lenders or creditors have a higher priority right than do owners. Thus, deductions that are generated from a partnership are considered to have first come from the partner’s equity (lower priority) than from partnership debt (higher priority). The equity deductions can generally be allocated amongst the partners to the extent that such deductions do not create a negative capital account balance for the partner in excess of the partner’s actual or deemed obligation to make contributions to the partnership upon the liquidation of the partnership. Therefore, when a partner agrees to a deficit restoration obligation within the partnership agreement, the partner is more or less allowed to be allocated a deduction that can be attributed to other partner’s equity.
For example, John, Mike & Joe form an LLC. John and Mike contribute $50 each and Joe contributes $25. The LLC purchases an asset with the $125. The partnership agreement holds that profits are to be allocated per the monies contributed, but that losses are to be allocated 1/3 to each partner. If Joe agrees to a deficit restoration obligation, he can receive the 1/3 allocation of the partnership’s net equity losses. If Joe does not agree to the restoration, he can only receive his pro-rate share (20%) of the partnership’s net equity losses.
A Denver tax attorney and business attorney at The McGuire Law Firm can assist you and your partnership regarding partnership taxation and transaction issues.