In this partnership agreement template it states that

The Company will allocate items of income and losses as if the Company were liquidated, its assets sold at their fair market value, and the resulting proceeds (net of liabilities) distributed to the Founders in accordance with this agreement.

Taken at face value, this seems like a very odd way to run a company. If all incomes are distributed to Founders, (rather than being held by the company per se,) how is the company to maintain its own bank accounts for the purpose of paying expenses, just for starters? And if that's not what it literally means, as the words "as if" seem to suggest, what exactly does this clause mean and why is it a desirable thing?

1 Answer 1


This is almost certainly a company subject to U.S. tax law because the language is language tailored to the U.S. Internal Revenue Code. the question is answered with this in mind.

In General

The "allocation" referenced (a term distinct from "distributions" of property or management of property) is only for tax purposes and capital accounts in the books and records and tax returns of the company.

The company has its own income, bank accounts, etc. But, for tax and accounting purposes, income, revenue, expenses and tax credits are allocated to particular owners of the company each year.

Every company taxed as a partnership needs to have allocation language in its governing documents (although default terms can be supplied by statute in very simple degenerate cases when the governing documents fail to do so).

Background Re Types Of Entities And Taxation Of Them

In U.S. income tax law, most companies with more than one owner are taxed as partnerships under Subchapter K of the Internal Revenue Code (including most limited liability companies, limited liability partnerships, limited partnerships, limited liability limited partnerships, and limited partnership associations, and most comparable foreign entities that active elect this treatment, collectively called "eligible entities"). This is a "flow though regime".

The main exceptions for business companies are corporations taxed as "C-corporations" which are taxed as separate entities, corporations which are S-corporations which have a modified and more rigid partnership tax regime that is likewise a flow through regimes, eligible entities that elect to be taxed as C-corporations or S-corporations, and eligible entities with a single member that a disregarded as separate from their owner for income tax purposes.

In a flow though partnership tax regime, all items of income, revenue, and expense, and all tax credits of the company are allocated to the owners of the company, and the company itself doesn't actually pay taxes even though it fills out an information tax return on Form 1065 that reports income, revenue, expense and tax credits and then allocates 100% of these items to owners of the company on a Schedule K-1 for each owner to whom any tax item is allocated in that year.

The Novelty Or Lack Thereof Of The Clause Itself

It isn't that unusual an approach, although it is a minority approach. The purpose of having that term is to make sure that the allocation is legally valid because it has "substantial economic effect" which means that there are circumstances in which the allocation of tax items related to real world distributions from the company in some circumstance or other.

The most unusual part of the referenced language is that is uses "assets sold at their fair market value" rather than book value, which is called a "mark to market" system.

This is almost unheard of outside the financial industry, and is uncommon even in the commercial banking part of the financial industry. Instead, using book value for assets in accounting and tax allocations is much more common. Normally, this would only be found in a company invested in marketable securities with readily quotable fair market value prices.

Book value is more common than mark to market systems in most cases because otherwise the assets of the company have to be appraised each year in order to complete the company's tax returns and this can be a costly and inexact way to value assets, contrary to the certainty, clarity and much lower cost associated with using book value for assets that don't have a readily determined market value because they are fungible and frequently traded.

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