Example 2: Suppose partners A, B and C created ABC Partnership on January 1, 2012, at $990 990 having contributed 99% of common interests, B 10 USD for 1% of common interests and C 1,000 USD for all privileged interests. Interest income, preferably, generates an annual return of 10%, accumulated and accumulated each year (i.e., if there are not enough distributable cash to satisfy the preferential return of a given year, it is carried forward to the following year, interest is at an annual interest rate of 10%). Example 1 – Traditional Waterfall Approach: AB Partnership`s Partner A contributes $100,000 in cash to AB and Partner B to $50,000 in cash. The partnership agreement requires that profits be first allocated to each partner by means of a preferential annual return of 5% on unpaid capital and then 50% to A and 50% to B. Losses are first equal to positive balances of capital and, second, 50% on A and 50% on B. Cash is paid first to pay the preferred return. , second, to pay the unpaid capital, and last 50% to A and 50% to B. In the first year, AB had a net income from ordinary transactions of $60,000 and distributed a total of $60,000 in cash. With this traditional allocation of waterfalls, capital accounts would look like Object 1. In Year 2, the partnership had $10,000 in revenue and distributed $110,000.

(See Figure 5.) For example, the tax court has stated that capital transfers between partners and between partners are taxable. In the example of the ABC partnership in example 2, Partner C is guaranteed both (1) its initial capital contribution and (2) its preferred return before partners with common interests receive a payment. As a result, the entire $20 deficit would be paid into the capital accounts of the partner of common interest if the partnership were to be liquidated at the end of 2012. If a portion of Partner C`s capital deficit had been paid (for example.B. if the entire capital of the partners was depleted by common interests a result of either operating losses or pre-partner C capital transfers), Partner C would likely be taxable only to the extent that the deficit depletes the capital of a partner other than partner C`s capital.