10.1.

6: Capital Account
The mechanics of partnership accounting involve the creation of an animal called the capital account, a
bookkeeping entry established for each partner and maintained in accordance with very precise rules
established by Treasury Regulations.
[1]
In this case, the tax treatment and sound economic and
accounting principles are generally in agreement.
[2]
The initial credit to the capital account is the amount
of money (or the fair market value of property) contributed by the partner to the capital of the
partnership. Realized profits and losses are run through the partners capital account, meaning that, as of
the end of each accounting period, the partnerships books are closed and profits or losses realized since
the last closing are allocated to the capital accounts of the partners in accordance with the allocation
formula then in effect. Distributions decrease the capital account of the partner to whom the distribution is
made in the amount of the distribution: If the distribution is in kind - that is, if property other than cash
is distributed - the property is deemed sold as of the date of the distribution and the fair market value of
the property is the measuring stick for the deduction from the distributees capital account. A capital
account is a book entry, a parking vehicle where profits and losses are parked and then held
[3]
pending
distribution. One might compare it with a checking account at a bank. It is the vehicle for all deposits and
withdrawals. Upon final liquidation, proceeds are distributed in accordance with a hierarchy of instructions
that entails distributing the remaining assets through each partners capital account.
[4]

Qualification as a Partnership
Pursuant to the applicable Regulations, a partnership will not be treated as an association taxable as a
corporation under 7701(a)(2) and 761(a) of the Code if it meets two out of the four tests specified in
the Regulations meaning that it lacks two out of the four corporate characteristics.
[5]
Up until recently,
the most critical factor in the eyes of most practitioners had been unlimited liability. In a true partnership,
it was deemed necessary by the tax bar that some individual entity (other than the partnership itself) was
liable for the debts of the partnership. In a limited partnership, this meant, of course, that the general
partners must be liable and, in the view of the Service, not only technically but in fact-that is, there had to
be resources at stake.
[6]
A corporation without assets or an insolvent individual would not do as the sole
general partner of a limited partnership, according to the most authoritative source: the celebrated
Revenue Procedure 72-13.
[7]
Law firms advising clients were not bound to the strict letter of Revenue
Procedure 72-13, since it adumbrates only the facts on which the Treasury will grant advance rulings, but
it provided the basic framework. Thus, it was generally the view that a sole corporate general partner had
to maintain a net worth (exclusive of its interest in the partnership) of approximately 10 percent or more
of the partnerships contributed capital (15 percent if total contributions were less than $2.5 million),
different law firms varying in how far they would depart from the 10 percent standard.
For reasons not entirely obvious, but perhaps driven by the Revenue Ruling 88-76 (which energized limited
liability companies), tax practitioners in the late 80s began to opine that a limited partnership was tax
transparent even though only two noncorporate characteristics - limited life and lack of free transferability
- were present. It became unnecessary to stretch for devices creating general partner substance, such as a
Page 1 of 2 10.1.6: Capital Account - Encyclopedia - Library - VC Experts
VC Experts, Inc., Expertise and Opportunity in Private Equity and Venture Capital

Copyright 2000 - 2009 VC Experts, Inc. All Rights Reserved.
Privacy Policy | Terms Of Use | Site Map | Contact Us
Website developed and powered by Rare Ideas, LLC.
Disclaimer: Literature and other private equity and venture capital-related materials publicly available on this website are provided
by VC Experts, Inc., and are for general informational and educational purposes only. VC Experts provides content and services that
are not legal services. An attorney-client relationship does not exist in connection with the non-legal services VC Experts provides.
(1) corporate general partner owning as an asset a note drawn on the sponsor of the partnership in the
necessary amount; or (2) addition of an individual general partner of some personal substance (or a
general partnership made up of such individuals).
[8]


[1]
Treas.Reg. 1.704-1(b)(2)(iv). See generally McKee, Nelson, & Whitmire, Drafting, Amending, and
Analyzing Partnership Agreements Under the New Partnership Allocation Regulations 3.02[l] (1986).
[2]
Id. 3.01 [1].

[3]
Ordinarily, a PIV will expressly provide that partners are not entitled to interest on their capital.

[4]
If profits and losses are religiously run through capital accounts, as they should be, then at the end of
the day the final distribution should zero all balances. Unfortunately, mistakes not worth tracing may leave
something over at the end of this process, requiring a provision in the agreement for distributing leftovers.
[5]
Treas. Reg. 301.7701-2(a).

[6]
Substantial assets (other than [the GPGPs] interest in the [investor] partnership). Id. 301.7701-2
(d)(1).
[7]
1972-1 C.B. 735.

[8]
Counsels opinion on partnership qualification will ordinarily deal with additional requirements e.g., that
the partnership will be conducted in accordance with the local version of the Uniform Act, Treas. Reg.
301.7701-2(d), and that the limited partners not own over 20% of the stock in a sole corporate general
partner. Rev. Proc. 72-13, 1972-1 C.B. 735. For partnerships considering the use of a C Corporation as a
corporate general partner (and which do not have any corporations as limited partners), attention should
be paid to 448 of the Code, added by 801 of the Tax Reform Act of 1986, which now provides that
partnerships with a C Corporation as a partner may no longer use the cash method of accounting.
Page 2 of 2 10.1.6: Capital Account - Encyclopedia - Library - VC Experts