Capital Account

A limited partnership dissolves with insufficient assets to pay all of its creditors and return all partners' capital in full. The limited partners have no personal assets pledged beyond their capital contributions. What happens to the unpaid shortfall?

1. A.All partners, limited and general alike, must contribute personal assets in proportion to their original ownership percentagesWrong. Limited partners' liability remains capped at their capital contributions regardless of a shortfall.
2. B.The shortfall is simply absorbed by the partnership's creditors, who have no further recourse against anyoneWrong. Creditors may still pursue the general partner personally due to that partner's unlimited liability.
3. C.The limited partners are not required to cover it from personal assets; the general partner, with unlimited liability, may be pursued personally for the remaining shortfallCorrect. Limited partners' liability stays capped at their contributions, while the general partner's unlimited liability may expose personal assets to the shortfall.
4. D.The limited partners must cover the shortfall first, since their capital accounts were lower priority than the general partner'sWrong. This misstates both the priority order and the liability exposure of limited partners.

Why: The limited partners are not required to contribute personal assets beyond their capital contributions to cover the shortfall, since their liability is capped at the amount they agreed to contribute. The general partner, by contrast, bears unlimited personal liability for partnership obligations and may be required to satisfy the remaining shortfall from personal assets beyond any capital account, to the extent creditors pursue that general partner directly for the partnership's unpaid debts. This is a direct consequence of the different liability status the two types of partners hold, which does not change simply because the partnership is winding up rather than operating.

A limited partner's Schedule K-1 reports her capital account balance, maintained under the partnership's books using tax-basis or Section 704(b) book methods. How does this reported capital account relate to her adjusted outside tax basis in her partnership interest, which governs her loss limitation?

1. A.They are always identical figures; whatever capital account balance appears on her K-1 is by definition also her outside tax basis for loss limitation purposes.Wrong. Capital account and outside tax basis are related but distinct figures that can diverge, not automatically identical.
2. B.Her outside tax basis is simply her capital account balance divided by her ownership percentage in the partnership.Wrong. This is a fabricated formula with no basis in how capital account and outside tax basis actually relate.
3. C.The two are related but distinct figures tracked separately; her capital account, as reported on the K-1, does not necessarily equal her outside tax basis, since outside basis also reflects her share of partnership liabilities and can diverge from the capital account over time.Correct. Capital account and outside tax basis are related but distinct, diverging because outside basis also reflects partnership liabilities.
4. D.Capital account balances are purely optional disclosures with no defined relationship to basis at all, appearing on K-1s only as a courtesy and carrying no analytical meaning.Wrong. Capital accounts are a meaningful, defined figure; they are simply not interchangeable with outside basis.

Why: Capital account and outside tax basis are related but distinct figures tracked separately; her capital account, as reported on the K-1, does not necessarily equal her outside tax basis, since outside basis also reflects her share of partnership liabilities and can diverge from the capital account over time.

Two limited partners each originally contributed equal amounts of capital and were each allocated a 25% ownership interest at formation. Over the years, due to different amounts of income and loss allocated to each under the partnership agreement's terms, their capital accounts have diverged significantly, even though their stated 25% ownership percentages have never changed. In liquidation, are these two limited partners' distributions based on their original 25% ownership percentages or on their current capital account balances?

1. A.On their current capital account balances, which reflect each partner's actual accumulated economic stake, not the original ownership percentageCorrect. Liquidating distributions follow actual capital account balances, which reflect each partner's real accumulated economic stake.
2. B.On their original 25% ownership percentages, since that figure was fixed at formation and does not changeWrong. Capital account balances, not the original static percentage, govern liquidation distributions.
3. C.Equally between the two, regardless of either their capital accounts or their original percentagesWrong. This is an invented, unsupported basis for the distribution.
4. D.On whichever of the two figures produces the larger distribution for each partnerWrong. This is an invented mechanism; liquidation distributions follow actual capital account balances, not whichever figure is more favorable.

Why: Liquidating distributions to partners are generally based on each partner's remaining capital account balance, not on an original, static ownership percentage that may no longer reflect each partner's actual economic stake after years of differing allocations. Capital accounts track each partner's contributions, allocated income, allocated losses, and prior distributions over time, and by the time of liquidation, two partners who started with identical ownership percentages can have meaningfully different capital account balances. Liquidation distributions follow those actual account balances, not the original percentage figure from formation.

A limited partner's capital account, as maintained on the partnership's books, has fallen to zero after several years of allocated losses and cash distributions. She has also personally guaranteed $18,000 of the partnership's recourse debt, with no right of reimbursement. Does her at-risk amount also stand at zero? (Figures are illustrative only.)

1. A.Yes, because the capital account and the at-risk amount are the same figure computed under different namesWrong. They are distinct measures; the capital account is a book record while the at-risk amount separately captures personally guaranteed recourse debt.
2. B.Yes, because once a partner's capital account reaches zero, the at-risk rules deem all further debt nonrecourse regardless of personal guaranteesWrong. There is no such deeming rule; a personal guarantee with no reimbursement right creates at-risk basis regardless of what the capital account shows.
3. C.No, because a capital account can never fall below the partner's original cash contribution, so the two figures cannot both be at different levelsWrong. A capital account can absolutely fall to zero or below through allocated losses and distributions; that premise about capital accounts is false.
4. D.No, because her at-risk amount separately includes the $18,000 of recourse debt she personally guarantees, which is not reflected in the book capital accountCorrect. The guaranteed recourse debt is a separate source of at-risk basis that does not run through the book capital account, so her at-risk amount can be above zero even though her capital account is not.

Why: The book capital account and the at-risk amount are two distinct measures. The capital account tracks contributions, allocated income and loss, and distributions on the partnership's books; the at-risk amount separately includes personally guaranteed recourse debt that never appears in the capital account at all.