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How A.I. Will F*** Up Partnership Allocations
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Confession - this is the second newsletter I wrote this week. The first one was a wrap-up of the last few weeks talking about how business owners can turn their business finances around in three steps - accounting, tax, and cash forecasting. But it felt bland AF so I'm shelving it for now. If you want to read it, let me know. This week, what's really been on my mind is partnership allocations. π¬ Mainly because we finally hit our stride and hit a record number of partnership returns filed for the last two months in a row - and so I'm reading operating agreements (OA) non-stop. And it got me thinking how when AI finally starts to do allocations, what will they get wrong and how will it impact GPs and LPs. π€·ββοΈ Let's walk through an example. Year 1 - GP raises $10 million of equity and buys a $30 million asset
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Year 2 through 5 - Asset operates and does well
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Year 6 - Asset is sold, and GP takes a 30% carried interest on the profit and closes the entity
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Year 8 - IRS audits the return. It finds that final distributions were not done in accordance with positive capital accounts - rather they were done according to distribution ratios (which is what the OA said).
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They reallocate based on positive capital accounts, force amended K1s to go out showing LPs with more income than they got previously. But the GP has closed up shop and is not paying out any more cash to "true-up" anyone. Doomsday.
How can this happen? Easily. If the property was cost segregated and had non-recourse debt, the capital accounts of the investors could have gone negative. π» This happens because the basis in the building was financed with equity and debt. And the depreciation from the total basis is more than the equity piece. This results in everyone going negative in their capital account - usually pro-rata based on equity contributions. But when the property is sold, the proceeds from the sale got split out according to promoted sharing ratios. So the GP gets a distribution of 30% and a corresponding allocation of income of the same 30%. π Here's the example spelled out: The problem is in the calculation of "Gain on Sale" in Year 6. The issue is that some of the recapture gain has shifted from LPs to GPs because the GP participated in Year 1 losses at a lower sharing ratio (10%) than the promoted sharing ratio (30%). So when you allocate income strictly according to this sharing ratio in Year 6 without regard to capital accounts, you wind up with distributions not in accordance with positive capital accounts and not in accordance with the tax code. π This puts the LPs at significant audit risk, as all the IRS has to do is look at a partnership returns marked "Final" that has a K1 with negative ending capital accounts. And once identified, they'll reallocate them more income - sometimes years later. Will AI eventually learn or be trained to catch this? Probably. π€ But if you're the one signing the return to save a few grand, you should be pretty rock solid that it's right. π«‘ π₯ Latest News in Tax and Accounting π₯
BOI is Dead Again - For real this time, we think. Treasury announced it won't be assessing fines or requiring filings until new rules are proposed. Those new rules are expected to target the higher risk entities rather than every-freaking-business. Linkβ
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Tariff Drama and Tax Impacts - What a wild week of tariff drama. The market got whiplash early in the week between Ukraine and the tariff announcements and back-offs. But this has a significant impact on your taxes - as every trade deal struck moves the likelihood that income tax is ever abolished and funded by tariffs that much further from reality. Linkβ
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Legislation Update - Nothing to add... kidding.... kinda. The House has the amounts they can spend and they have to cut lined out. The "Trump" tax cuts extensions are now being drafted. The hope was that they'd be ready by 3/14 when the government is set to run out of money. But that looks less and less likely, as Trump has called for a funding extension instead of rushing this bill. Linkβ
β Want to read previous issues? Click here.β |
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