Historically, drafters of partnership agreements guaranteed this union by requiring that (1) the partnership maintain a separate capital account for each partner that tracked each partner’s economic rights in the partnership and (2) the partnership liquidate in accordance with those capital accounts.
For partnerships liquidating in accordance with the partners’ capital accounts, partnership allocations were, and still are, drafted to attempt to cause the partners’ ending capital accounts to achieve the desired economic deal (so-called safe-harbor, or layer cake, allocations 4).
If so, it is crucial that the drafter make clear that an oral partnership agreement has been entered into effective as of formation and that the agreement previously entered into is now being memorialized in writing.
11 Alternate test for economic effect: Many state law entities taxed as partnerships for U. federal tax purposes afford their owners limited liability.
These three tests for economic effect are explained in the next three sections.
Often, upon inquiry, it turns out that the parties orally entered into a partnership agreement to be memorialized in writing at a future time.
Under this new method, a partnership liquidates not in accordance with partner capital accounts but, instead, in accordance with a negotiated distribution waterfall that reflects exactly the partners’ economic deal.
A “distribution waterfall” is just what the name implies.
First, capital accounts must be maintained in accordance with the regulatory requirements.
Second, partnership liquidating distributions are required to be made “in all cases” in accordance with the partners’ positive capital account balances (after taking into account all adjustments, if any, for the partnership tax year during which the liquidation occurs).