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Provision for a “Minimum Gain Chargeback” exists in nearly every partnership agreement and limited liability company operating agreement. Few people, however, actually understand the need for such provision or its function, and few attorneys – even those experienced in basic tax matters – are capable of explaining it.

A Minimum Gain Chargeback provision is required as a matter of law to be included in partnership agreements in order for non-recourse deductions to be allocated to the partners in any manner other than strictly according to the partners’ overall percentage capital interests in the partnership.

In brief, Minimum Gain is created as a partnership claims deductions (typically depreciation) that decrease the partnership’s book basis in the property below the balance of the non-recourse debt on the property.

Minimum Gain Chargeback is an allocation of gain, for tax purposes only, to partners or members who have received the benefit of prior non-recourse deductions or who have received distributions of partnership proceeds attributable to non-recourse borrowing.

These deductions or distributions are “charged back” to such partners or members upon either (a) a disposition of the underlying property(ies) subject to the non-recourse debt, or (b) a change in the character of the non-recourse debt (most commonly by a conversion to recourse debt, or by forgiveness of the debt).

A partnership’s minimum gain is generally equal to the excess of a partnership’s non-recourse liabilities over the adjusted tax basis of the property securing the debt. For example, if a partnership purchased a property for $100,000, took $50,000 in depreciation deductions, and then refinanced the property with $150,000 of non-recourse debt because the fair market value of the property was now $200,000, the Minimum Gain would be $100,000 ($150,000 minus the property’s adjusted basis (purchase price minus depreciation)).

Several important exceptions to the mandatory minimum gain chargeback do exist. In particular, a partner is not subject to a Minimum Gain chargeback to the extent that his share of the net decrease in partnership Minimum Gain is attributable to the conversion of a non-recourse liability to a recourse liability (e.g., as a result of a guarantee or refinancing). Likewise, a partner is not subject to the chargeback to the extent that he contributes capital to the partnership to repay a non-recourse liability. And a partnership may also request a waiver of the chargeback requirement if it would lead to certain unintended economic distortions.

Minimum Gain Chargeback provisions are by necessity complex, because of the need to anticipate a variety of situations in which the amount of phantom gain can change or the partners’ shares of the gain can change.

If you have questions regarding the operation or allocation of recourse or non-recourse deductions from a partnership or limited liability company, please feel free to call our office.

1 For tax purposes, a partnership liability is deemed non-recourse to the extent that no partner bears the economic risk of loss for that liability, even though the partnership itself is liable.

2 Where differences exist between book value and basis for contributed property, minimum gain is calculated by reference to the book value of an asset, rather than to its tax basis.