What is a Deficit Restoration Obligation

When a partnership is formed partners contribute property and/or cash into the partnership. The partners “capital account” keeps a record of these contributions. The capital account increases or decreases as a function of what the partner puts in or takes out of the partnership. For example, taking losses is treated as taking something out of the partnership. The partnership agreement or operating agreement details how these items are shared among partners.

If a particular allocation of the losses and distributions cause a partner’s or LLC member’s capital account to fall below zero that partner or LLC member is said to have a negative capital account.

A problem arises under Internal Revenue Code Section 704 in that a partnership cannot allocate losses to a partner that has (or will have as a result of the allocation of loss) a negative capital account. In this case the tax law requires losses to be shifted to other partners. An inflexible result not many partnerships or LLCs would be happy with.

So, what is a Deficit Restoration Obligation and how does a help?

A Deficit Restoration Obligation is an obligation by a partner in a partnership (or a member in an LLC taxed as a partnership) to restore the negative balance in its capital account when the partnership liquidates. The good news is that if such an obligation is in place the tax law deems a partner to have a positive capital account (even if it is “actually” negative). Thus, a partner or LLC member can avoid having its share of losses shifted away to other partners.