Let’s say a partner in your law firm exits part way through the firm’s tax year. How are partnership tax items for that year allocated between the departing partner and the remaining partners? There is more than one way to handle this situation. In general, three methods are allowed for making such allocations. (Source: Treasury Regulation 1.706-1(c)(2))
Here is a quick summary of how the three methods can work.
1. Proration Method
This option is very simple, but it may not accurately reflect economic reality. Under the proration method, the departing partner’s share of the firm’s tax items for the entire year are determined based on:
- The portion of the year that he or she is a partner and
- His or her percentage share of profits and losses during that period.
Example: A partner with a 10 percent share of profits and losses leaves on June 30 of the current year. The partnership uses a calendar tax year and the proration method. Since the departing partner was present for half the tax year (six months out of 12), he is allocated 5 percent (10 percent times ½ equals 5 percent) of all partnership tax items for the year – including any gains or losses from asset dispositions.
As you can see, the proration method is very simple. However, it may not be very fair if, for example, the firm earns 75 percent of its income from professional services in the second half of the year and has a large capital gain in December from selling its office building. In that case, using the proration method would effectively allocate “too much” income and gain to the departing partner and “too little” to the remaining partners.
2. Interim Closing of the Books Method
As an alternative to the proration method, the partnership can conduct an interim closing of the books at the time the partner departs. Under this procedure, the partnership’s books are closed on the exit date, and the tax items from the beginning of the tax year up to the exit date are totaled.
Then, the departing partner is allocated his or her normal percentage share of those amounts.
The partner is allocated zero percent of the tax items for the period after his or her exit. This method more accurately reflects economic reality, but it is more complex. In some cases, the cost of conducting an interim closing of the books is deemed to be prohibitive.
Example: Assume the same basic scenario as in the example above. Assume the firm earns 75 percent of its income from professional services in the second half of the year and has a big capital gain in December from selling its office building. Under the interim closing of the books method, the departing partner is allocated only 2.5 percent (10 percent times 25 percent equals 2.5 percent) of the income from professional services and zero percent of the capital gain from selling the office building. Obviously, this is a much better reflection of economic reality than allocating the departing partner 5 percent of the income from professional services and 5 percent of the capital gain, as would happen under the proration method.
3. Another “Reasonable Method”
Federal tax regulations also allow partnerships to use “other reasonable methods” to allocate tax items to departing partners. For instance, your partnership could choose to allocate most tax items using the simple proration method while allocating tax items arising from certain non-recurring events (such as income from major litigation settlements and gains or losses from major asset sales) only to those partners who are actually on board when the transactions occur.
Example: Again, assume the same basic facts as in the first example when a partner with a 10 percent share of profits and losses leaves on June 30 of the current year. Except in this case, assume the firm’s income from professional services is earned relatively evenly throughout the year. Therefore, a decision is made to allocate income from professional services using the proration method and gain from selling the office building only to those partners who are still with the firm on the sale date.
Under this “reasonable” method, the departing partner is allocated 5 percent (10 percent times ½ equals 5 percent) of the income from professional services and zero percent of the capital gain from selling the office building. This is a reasonable reflection of economic reality that is likely to be acceptable to all concerned, and it doesn’t impose any extra accounting burden on the partnership.
Federal income tax regulations allow your firm’s partners to select a method that will be used to allocate tax items between a departing partner and the remaining partners. The firm’s partnership agreement could stipulate that one specific method will always be used. Alternatively, the method to be used could be determined on a case-by-case basis by agreement between the partners (this option could also be specified in the partnership agreement).
The important factor to understand is that the allocation method used can have significant positive or negative tax ramifications for both the partner who is leaving and the remaining partners. We encourage you to contact your Geffen Mesher tax adviser to explain the best option in your firm’s situation.