Applying target allocations is one way to allocate income, gain, loss, deduction from a partnership. Target allocations say how cash is distributed from operations and in liquidation. This allocates income and loss to partners capital accounts so these accounts conform to cash distribution schemes in liquidation. This is not always superior or inferior to other models. 

Author Terence Cuff writes: Despite the appeal of such an allocation strategy, target allocation provisions appear to fail to comply with the economic effect test under the Allocation Regulations. Additionally, target allocation provisions have substantial risk of not satisfying the alternate test of economic effect ("alternate economic effect") or the economic effect equivalence test ("economic effect equivalence"). The matter is not resolved especially with respect to economic effect equivalence.

...

Advisors disagree on the issue of whether a target allocation provision can satisfy the alternate test of economic effect. The debate usually is conducted at a level of sufficient sophistication about partnership tax theory that most advisors will decline to participate.

[Treas. Reg. 1.704-1(b)(2)(ii)(d) provides alternate test of economic effect parameters.]

...

Many advisors are comfortable that target allocation provisions can satisfy the economic effect equivalence test and have deemed economic effect. The economic effect equivalence test is a results-oriented test.

A partnership may have considerably greater difficulty satisfying the economic effect equivalence test than is generally supposed. Economic effect equivalence may apply only to a very limited class of partnerships, which may exclude practically all limited liability companies. Economic effect equivalence may be of profoundly limited usefulness for a limited partnership or limited liability company. A partnership agreement may have to have a capital account deficit restoration obligation (or such an obligation may need to be supplied under state law) if allocations are to satisfy economic effect equivalence, but this matter is not unambiguously clear from the Allocation Regulations.

[Treas. Reg. 1.704-1(b)(2)(ii)(i) provides economic effect equivalence test parameters.]

The economic effect equivalence test ties to the basic test of economic effect but does not appear to tie at all to the alternate test of economic effect. At least, the portion of the Allocation Regulations considering economic effect equivalence does not refer explicitly to the alternate test of economic effect. Economic effect equivalence must be satisfied at the end of the current year and at the end of any future year.

...

Few limited liability company agreements or limited partnership agreements provide for deficit capital account restoration. Depending on the resolution of this issue, many or few partnership agreements will satisfy economic effect equivalence. Economic effect equivalence may be the minnow that swallows the whale if economic effect equivalence is applied as a more practical test that does not require deficit capital account restoration for limited liability companies. Economic effect equivalence might become the most common defense for partnership allocations.

Subscribers can access the complete commentary on LEXIS.com.  Additional fees may be incurred. (Approx. 12 pages)