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1 American Bar Association BASIC PARTNERSHIPS TAX PRINCIPLES July 22, 23, 2008 Michael Hirschfeld Dechert LLP New York, New York (212) 698-3635

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Presentation on theme: "1 American Bar Association BASIC PARTNERSHIPS TAX PRINCIPLES July 22, 23, 2008 Michael Hirschfeld Dechert LLP New York, New York (212) 698-3635"— Presentation transcript:

1 1 American Bar Association BASIC PARTNERSHIPS TAX PRINCIPLES July 22, 23, 2008 Michael Hirschfeld Dechert LLP New York, New York (212)

2 2 Are you a PS?  LLC PS for tax PS for tax  Check the box rules: Single member v Multi Member Single member v Multi Member Use: Non-US EntityUse: Non-US Entity

3 3 Form 8832  Entity Classification Election No need for protective election No need for protective election 75 days to file 75 days to file List of per se companies in Instructions List of per se companies in Instructions UK-Public Limited CompanyUK-Public Limited Company Netherlands-NVNetherlands-NV Germany-AKGermany-AK France-SAFrance-SA Canada-Corporation and CompanyCanada-Corporation and Company

4 4 PS Interest for Cash  Tax free to contributing partner What about Promissory Note? What about Promissory Note? Not the same as cashNot the same as cash No basis until pay itNo basis until pay it

5 5 Mix of Equity & Debt  May want to transfer cash for debt as well as equity? Why? Why? Protect against creditors if things go badProtect against creditors if things go bad But-will it work? But-will it work? Equitable subordination is a riskEquitable subordination is a risk  Tax Issues: Is it good debt for tax purposes? Is it good debt for tax purposes? At risk rules-Will it count? At risk rules-Will it count?

6 6 PS Interest for Property  General Rule: Tax free to contributing partner

7 7 Exception: Investment Partnership  Property transfer taxable if: Investment PS & Investment PS & Diversification Diversification  Investment PS More than 80% of value of assets are held for investment More than 80% of value of assets are held for investment Dollars, stock, debt, options, REIT, RIC, PTPDollars, stock, debt, options, REIT, RIC, PTP Key: Keep at least 20% in non-investment company assets Key: Keep at least 20% in non-investment company assets

8 8 Investment Partnership (cont)  Diversification If 2 or more partners transfer non-identical assets to PS If 2 or more partners transfer non-identical assets to PS  BUT no diversification if: Only 1 partner transfers assets or Only 1 partner transfers assets or Each partner transfers: Each partner transfers: Same portfolio orSame portfolio or Diversified PortfolioDiversified Portfolio Not more than 25% in one asset & Not more than 25% in one asset & Not more than 50% in 5 or fewer assets Not more than 50% in 5 or fewer assets

9 9 Property Contribution  No investment PS & no cash then non-taxable with tax attributes being: Carryover tax basis for PS interest Carryover tax basis for PS interest Tacked holding period for property contributions Tacked holding period for property contributions

10 10 But if get back cash then:  Disguised sale rules will make this in part a taxable sale Part sale-Part tax free transfer Part sale-Part tax free transfer Allocate basis between two events Allocate basis between two events

11 11 Disguised Sale Rules The game: Get cash back later in time after property contribution is made Why? Cash distributions from a PS are not generally taxable until they exhaust your tax basis BUT Later distribution of cash may be combined with earlier contribution of property to have a “disguised sale.” Later distribution of cash may be combined with earlier contribution of property to have a “disguised sale.” Two year presumption but can rebut by showing subject to entrepreneurial risk of business Two year presumption but can rebut by showing subject to entrepreneurial risk of business

12 12 Exceptions to Disguised Sale Rules  Guaranteed payments for capital & preferred returns Safe harbor: Very ltd-150% of AFR Safe harbor: Very ltd-150% of AFR  Operating cash flow distributions  Reimbursement of preformation expenditures

13 13 Liabilities & Disguised Sale Rules  Non-recourse liabilities: Usually, allocate liability to contributing partner under §704(c)—reduces game playing Usually, allocate liability to contributing partner under §704(c)—reduces game playing  Recourse liabilities: Could shift, which is treated as cash distribution Could shift, which is treated as cash distribution Is that cash distribution caught by disguised sale rules? Is that cash distribution caught by disguised sale rules? Yes unless qualified liabilityYes unless qualified liability

14 14 Exceptions to Disguised Sale Rules  Qualified Liability: Incurred more than 2 years before contribution Incurred more than 2 years before contribution Allocable to capital expenditures Allocable to capital expenditures Liability incurred in ordinary course of business but only if all the assets held in that trade or business are transferred to PS Liability incurred in ordinary course of business but only if all the assets held in that trade or business are transferred to PS  Liability cannot exceed FMV of assets

15 15 Taxable Sale-Cap Gain?  Code Section 1239 Sale of depreciable property between PS and controlling partner generates ordinary income Sale of depreciable property between PS and controlling partner generates ordinary income Controlling partner Controlling partner More than 50% ownershipMore than 50% ownership

16 16 So, tax free contribution—are there any tax concerns?  Yes if AB is not equal to FMV of property  Why? Consider 2 partners, A & B Consider 2 partners, A & B A contributes $100 cash A contributes $100 cash B contributes land with FMV = $100, but tax basis of zero B contributes land with FMV = $100, but tax basis of zero The next day, PS sells land for $100 The next day, PS sells land for $100 How does PS allocate the $100 gain? How does PS allocate the $100 gain?

17 17 Allocating Gain from Sale of Contributed Property  Could PS allocate $100 gain to both partners in the same way that regular PS income is allocated (thaf is, 50-50)? NO NO Code Section 704(c) requires that you allocate built in gain to B, the contributing partnerCode Section 704(c) requires that you allocate built in gain to B, the contributing partner Why?Why?

18 18 Capital Account Analysis if Use AB of Assets  A Increased by $100 due to cash contribution Increased by $100 due to cash contribution If allocate A 50% of gain then increased to $150 If allocate A 50% of gain then increased to $150  If liquidate, A gets $150 if follow capital account- something is wrong since A thinks he should get only $100  B Increased by zero upon property contribution since AB of property was zero If allocate B 50% of gain then increased to $50  If liquidate, B gets $50 if follow capital account— something is wrong since B thinks she should get $100!

19 19 Variation on a Sale  Sell land that had AB = 0 & was worth $100 on date of contribution for $150 then Allocate $100 gain to B BUT Allocate $100 gain to B BUT Can allocate excess gain of $50 to A and B Can allocate excess gain of $50 to A and B  KEY ISSUE: What is FMV of land on date of contribution? What is FMV of land on date of contribution? MUST SPELL OUT IN YOUR AGREEMENT! MUST SPELL OUT IN YOUR AGREEMENT!

20 20 Allocation of Gain & Capital Accounts  Capital accounts used for tax allocation purposes: Increased by AB or FMV of property contribution? Increased by AB or FMV of property contribution? Decreased by AB or FMV of property distribution? Decreased by AB or FMV of property distribution? Increased by taxable income/gain allocable to a partner Increased by taxable income/gain allocable to a partner Decreased by taxable loss/deductions allocated to a partner Decreased by taxable loss/deductions allocated to a partner SO, LET’s APPLY THIS HERE SO, LET’s APPLY THIS HERE

21 21 Contribution of Depreciable Property-allocations:  How do you handle Allocations Relating to a Contribution of Property

22 22 General Principle  Tax must follow book  § 704(c) addresses situations when a disparity exists between a partnership’s tax accounts and its book accounts.

23 23 Methods for § 704(c) Allocations  Traditional Method: each partner is treated as if it purchase a pro rata interest in the property Beware the “Ceiling Rule” Beware the “Ceiling Rule”  Traditional Method with Curatives: allows for “reasonable curative allocations” to prevent distortions resulting from the “ceiling rule”  Remedial Method: permits partners to ignore the ceiling rule and create tax allocations to match and offset their book allocations

24 24 Section 704(c) Example  AB Partnership A contributes $390,000 A contributes $390,000 B contributes depreciable property worth $390,000, but with a $39,000 tax basis B contributes depreciable property worth $390,000, but with a $39,000 tax basis  Property depreciated over 39 years so: A hopes there is $10,000/ year of depreciation to split & she will get $5,000 A hopes there is $10,000/ year of depreciation to split & she will get $5,000 But there is only $1,000 of depreciation to split But there is only $1,000 of depreciation to split  What happens?

25 25 Section 704(c) Example- Outcome  Traditional method: specially allocate $1,000 to A so A is short changed—she thought she would get $5,000  Traditional Method With Curative Allocations: can specially allocate other depreciation to A so as to get A $5,000 BUT if no other depreciation, you are stuck  Remedial method: A gets $5,000.

26 26 Diversion of sorts: Basic PS Tax Rule: Property distributions to a partner do not normally trigger tax! Could you take advantage of this rule to “play games”

27 27 The Game  The Players: A & B each put in cash of $1,000 A & B each put in cash of $1,000 C puts in property worth $2,000 C puts in property worth $2,000  The Game: 3 years later, A and B are redeemed out of PS by giving them each a ½ interest in the property 3 years later, A and B are redeemed out of PS by giving them each a ½ interest in the property A and B-say tax free to us A and B-say tax free to us C says great news—I just cashed out & fooled the tax system BUT C says great news—I just cashed out & fooled the tax system BUT

28 28 Tax Traps if have Contributed Property  Distribution of contributed property to other partner  Distribution of other property to contributing partner

29 29 Anti ”Mixing Bowl” Rules  If property leaves PS within 7 years, then that may trigger tax to contributing partner  Watch out for these rules §704(c)(1)(B): Contributed property goes out to another partner §704(c)(1)(B): Contributed property goes out to another partner §737: Contributing partner redeemed out for other property §737: Contributing partner redeemed out for other property

30 30 Purchase of PS Interest & Impact on Property AB  If you buy into a PS with property, are you stuck with tax basis of assets?

31 31 Section 754 Election-Example :  ABC PS acquired Property for $9M  Tax basis of property is now $6M  X buys C’s interest for $6M Thus, current value of PS is $18M Thus, current value of PS is $18M But, C’s share of tax basis of PS property is only $2M and not $6M But, C’s share of tax basis of PS property is only $2M and not $6M Absent help, X is stuck with that $2M basis Absent help, X is stuck with that $2M basis  Q. How can we help

32 32 The Fix-Optional AB Adjustment  Elect basis adjustment under Sections 754 and 743  Gives “basis boost” for C’s benefit

33 33 Example Impact  ABC Partnership Tax basis = $6M allocable $2M to A, $2M to B and $2M to Xm purchaser of C’s interest Tax basis = $6M allocable $2M to A, $2M to B and $2M to Xm purchaser of C’s interest  BUT Now  Special tax basis adjustment for only X X’s tax basis = $6M X’s tax basis = $6M More depreciation/amortization &More depreciation/amortization & Less gain or greater loss on saleLess gain or greater loss on sale

34 34 BUT Mandatory Downward Basis Adjustments-now required under Section 754  Section 743-If “substantial built in loss,” then PS must reduce basis $250,000 threshold $250,000 threshold  Section 734-If “substantial basis reduction,” then PS must reduce basis $250,000 threshold $250,000 threshold Electing investment PS (“EIP”) exception Electing investment PS (“EIP”) exception If EIP election, then transferee partner’s share of losses from PS is reduced If EIP election, then transferee partner’s share of losses from PS is reduced

35 35 PS Interest for Services  Can you get this tax free?

36 36 Carried Interests Planning Possibility: Can get PS/LLC interest to a person w/o triggering tax!

37 37 Carried Interest  The grant of an interest to a service provider raises a host of issue: Taxability of holder on date of grant or date when vesting restrictions lapse Taxability of holder on date of grant or date when vesting restrictions lapse Need for Capital ContributionNeed for Capital Contribution Code Section 83 ImpactCode Section 83 Impact Possible deduction to PS/LLC Possible deduction to PS/LLC Proposed tax legislation: Proposed tax legislation: PTP IssuePTP Issue Non-PTP Ordinary Income ExposureNon-PTP Ordinary Income Exposure

38 38 Key: Profits Interest-Good; Capital Interest-Bad  Difference:  If you liquidate the PS, would you get something back? If yes, capital interest If yes, capital interest If no, profits interest If no, profits interest  BUT, should this liquidation analysis be the proper test?

39 39 Carried Interest IRS Guidance  Background: Diamond v. Comm., 56 TC 530, aff’d, 492 F.2d 286 (7 th Cir. 1974)  Rev. Proc Key factor: Profits v Capital Interest Key factor: Profits v Capital Interest  Rev. Proc  Notice Proposed Safe Harbor Caveat: substantially certain & predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, (b) transferred in anticipation of a subsequent disposition, or (c) an interest in PTP Caveat: substantially certain & predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, (b) transferred in anticipation of a subsequent disposition, or (c) an interest in PTP

40 40 Sample LLC Insert  “By executing this Agreement, each Unitholder authorizes and directs the Company to elect to have the ‘Safe Harbor’ described in the proposed Revenue Procedure set forth in Internal Revenue Service Notice (the ‘Notice’) apply to any interest in the Company transferred to a service provider by the Company on or after the effective date of such Revenue Procedure in connection with services provided to the Company.”

41 41 Sample LLC Insert (cont)  For purposes of making such Safe Harbor election, the Tax Matters Partner is hereby designated as the “partner who has responsibility for federal income tax reporting by the Company and, accordingly, execution of such Safe Harbor election by the Tax Matters Partner constitutes execution of a “Safe Harbor Election” in accordance with Section 3.03(1) of the Notice.

42 42 Sample LLC Insert (cont)  The Company and each Unitholder hereby agrees to comply with all requirements of the Safe Harbor described in the Notice, including, without limitation, the requirement that each Unitholder shall prepare and file all federal income tax returns reporting the income tax effects of each interest in the Company issued by the Company covered by the Safe Harbor in a manner consistent with the requirements of the Notice.

43 43 1)General Allocation Rules--§ 704(b) 2)Allocation of Non- recourse Deductions— Treas. Reg. § )Allocation for Contributed Property--§ 704(c) 4)Reverse § 704(c) Allocations Cookbook for PS Agreements-Tax Allocations

44 44 General Allocation Rules General Principle Tax must follow economics

45 45 Two “Simple” Rules  Allocations must have “substantial economic effect” (“SEE”)  If an allocation fails this test, then amounts are reallocated among partners in accordance with the partners’ interests in the partnership (“PIP”).

46 46 Two “Simple” Rules (cont’d)  But what is “substantial economic effect”?  There are dozens of pages of regulations to explain this

47 47 SEE vs. PIP  Why might it be preferable to rely on SEE rather than PIP in setting partner allocations? More certainty in dealing with the IRS. More certainty in dealing with the IRS. For pension plan investors in debt financed real estate partnership desirous of avoiding UBIT, the partnership agreement must meet “fractions rule” and allocations must have “substantial economic effect”. For pension plan investors in debt financed real estate partnership desirous of avoiding UBIT, the partnership agreement must meet “fractions rule” and allocations must have “substantial economic effect”.

48 48 Economic Effect  Test #1—Safe Harbor  Three Prong Test Agreement provides for maintenance of capital accounts in accordance with Treas. Reg. § (b)(2)(iv); Agreement provides for maintenance of capital accounts in accordance with Treas. Reg. § (b)(2)(iv); Agreement provides for liquidation of partnership interests in accordance with positive capital accounts; and Agreement provides for liquidation of partnership interests in accordance with positive capital accounts; and Partners have a capital account “deficit restoration obligation” upon liquidation. Partners have a capital account “deficit restoration obligation” upon liquidation.

49 49 Economic Effect (cont’d)  Capital Account Maintenance  Two requirements must be satisfied All items of income, loss, deduction, tax- exempt income and non-deductible expenditures as well as capital contributions and distributions are reflected in determining capital accounts; and All items of income, loss, deduction, tax- exempt income and non-deductible expenditures as well as capital contributions and distributions are reflected in determining capital accounts; and Capital contributions and distributions of property are taken into account in computing their capital account at fair market value. Capital contributions and distributions of property are taken into account in computing their capital account at fair market value.

50 50 Relevance of capital accounts On the K-1 On the K-1 Non-liquidating distributions typically not tied to capital accounts Non-liquidating distributions typically not tied to capital accounts Liquidating distributions Liquidating distributions Based on capital accounts?Based on capital accounts? Specified waterfall?Specified waterfall? Both (belt and suspenders)Both (belt and suspenders) If not based on capital accounts, care must be taken, but it is still possible to survive, as discussed later vis a vis Target AllocationsIf not based on capital accounts, care must be taken, but it is still possible to survive, as discussed later vis a vis Target Allocations

51 51 Economic Effect (cont’d)  Deficit Restoration Obligation (“DRO”) If the partnership were to liquidate and a partner had a capital account deficit as a result of previous allocations, that partner would be required to restore the deficit in her capital account, generally through the contribution of cash during the liquidation. If the partnership were to liquidate and a partner had a capital account deficit as a result of previous allocations, that partner would be required to restore the deficit in her capital account, generally through the contribution of cash during the liquidation. As Tony Soprano would say, “forget about it.” As Tony Soprano would say, “forget about it.”

52 52 Economic Effect (cont’d)  Why would someone ever agree to a deficit makeup? Consider: Partner A wakes up on April 14, 2008, to the fact that he has received cash distributions for 2007 that exceed his tax basis Consider: Partner A wakes up on April 14, 2008, to the fact that he has received cash distributions for 2007 that exceed his tax basis Absent relief, A has a taxable event. A expects to generate capital losses in 2008, but she cannot carry them back Absent relief, A has a taxable event. A expects to generate capital losses in 2008, but she cannot carry them back What do you do? What do you do?

53 53 Solution The partnership can revise the partnership agreement until April 15, 2008 and could amend the allocation provisions to add a deficit restoration obligation, thereby eliminating the taxable event if there are sufficient liabilities to allocate to the DRO partner. The partnership can revise the partnership agreement until April 15, 2008 and could amend the allocation provisions to add a deficit restoration obligation, thereby eliminating the taxable event if there are sufficient liabilities to allocate to the DRO partner.

54 54 Economic Effect (cont’d)  Test #2—Alternative Test  Three Prong Test Agreement provides for maintenance of capital accounts in accordance with Treas. Reg. § (b)(2)(iv); Agreement provides for maintenance of capital accounts in accordance with Treas. Reg. § (b)(2)(iv); Agreement provides for liquidation of partnership interests in accordance with positive capital accounts; and Agreement provides for liquidation of partnership interests in accordance with positive capital accounts; and Drop the DRO and in its place, do the following: Drop the DRO and in its place, do the following:

55 55 Alternate Test  DRO Surrogate  Partnership agreement must contain a provision that accomplishes the following: no allocation will create for any partner a deficit in the partner’s capital account that exceeds the partner’s obligation to restore the deficit and no allocation will create for any partner a deficit in the partner’s capital account that exceeds the partner’s obligation to restore the deficit and the partnership contains a “qualified income offset.” the partnership contains a “qualified income offset.”

56 56 Alternate Test (cont.)  If the partner’s obligation to pay back a deficit is limited to a specific amount (e.g., the amount of a partnership’s loan), the partner’s deficit cannot exceed the amount of that obligation. The calculations of these deficits are made after taking into account all distributions and allocations expected to be made for the taxable year.

57 57 Where do these rules make a BIG difference?  Distributions that are not straight up (that is, they do not remain the same)

58 58 Common Case: GP Carry  Distributions: 100% to LPs until they get their capital back & then,  80% to LPs and 20% to GP

59 59 GP Carry Example  LPs contribute $100M; GP contributes zero  Sell assets with AB = $50M for $100M and all cash goes to LPs  How do you allocate $50M of gain? If allocate 100% to LPs, their capital account is now at $50M If allocate 100% to LPs, their capital account is now at $50M BUT if you then sell remaining assets with AB =$50M for $50M, cash is to go $40M for LPs & $10M for GP—something is wrong since LP capital account = $50M & GP’s capital account = zero.. BUT if you then sell remaining assets with AB =$50M for $50M, cash is to go $40M for LPs & $10M for GP—something is wrong since LP capital account = $50M & GP’s capital account = zero.. Should have allocated $40M to LPs & $10M to GP Should have allocated $40M to LPs & $10M to GP

60 60 Special Case: Loss Allocation  Can you specially allocate a loss to one member?  Yes if ----

61 61 Loss Allocation Example  AB are equal partners  Each contributes $1M  PS borrows $8M non recourse debt  1 st year-Tax Loss =$1M Q: Can you specially allocate that $1M loss to A? Q: Can you specially allocate that $1M loss to A? A: Yes if take precautions. A: Yes if take precautions. Explanation----Explanation----

62 62  A’s Cap Acc = $1M  A’s share of loss = 0  A’s Cap Acc after Loss Allocation = $1M  SO WHAT DOES THIS MEAN---If then sold property for $9M, pay off debt of &8M and who gets $1M cash  A gets all the cash  B’s Cap Acc = $1M  B’s share of loss = $1M  B’s Cap. Acc = 0

63 63 Special Gain Allocation to make things right!  OK, if sold property for $9M, A gets all the cash so how can we help B to get some cash?  Provide for Special Allocation of Income upon sale to offset Prior Loss Allocation, which works if we have enough gain  Example: Sell property for $10M, with $1M gain recognition, then allocate that $1M gain to B  After that happens, both A’s and B’s Cap Acc are now at $1M & each gets $1M

64 64 Hitting the Bullseye  Other Tax Allocation Trivia  Why needed? Match the regs Keep the IRS Agent happy Preserve your allocations

65 65 “Qualified Income Offset” provision - Regulations require this! - Governs unexpected distributions by PS to partner in excess of partner’s obligation to restore her capital account deficiency. - Provision must direct PS to allocate subsequent items of income to partner in order to eliminate partner’s capital account deficiency as quickly as possible.

66 66 Sample QIO Provision  The LLC shall specifically allocate Net Loss and items of income and gain when and to the extent required to satisfy the “qualified income offset” requirement within the meaning of Regulations Section (b)(2)(ii)(d).

67 67 Qualified Income Offset (cont’d)  Applies specifically to distributions described in Treas. Reg. § (b)(2)(ii)(d)(4), (5) and (6) Expected adjustments for depletion allowances with respect to oil and gas properties of the partnership Expected adjustments for depletion allowances with respect to oil and gas properties of the partnership Expected allocations of loss/deduction to be made by reason of a partner acquiring a partnership interest by gift (§ 704(e)(2)), by reason a partner’s share of prior excess losses (§ 704(d)), and by reason of a distribution of § 751 property Expected allocations of loss/deduction to be made by reason of a partner acquiring a partnership interest by gift (§ 704(e)(2)), by reason a partner’s share of prior excess losses (§ 704(d)), and by reason of a distribution of § 751 property Expected distributions to the extent they exceed offsetting expected increases to such partner’s capital account that occur during or prior to the same tax year Expected distributions to the extent they exceed offsetting expected increases to such partner’s capital account that occur during or prior to the same tax year

68 68 “Substantiality”  The partnership must demonstrate that an allocation has some economic effect besides tax savings  Two Tests Before-Tax Test Before-Tax Test After-Tax Test After-Tax Test

69 69 Substantiality (cont’d)  Specific Allocations that Lack Substantiality Shifting Tax Consequences Shifting Tax Consequences Transitory Allocations Transitory Allocations

70 70 Added Concern:  How do you handle allocation of Non-recourse Deductions?

71 71 Definitions  Partnership Minimum Gain (PMG) The minimum amount of gain the partnership would realize if it made a taxable disposition of property secured by nonrecourse debt. The minimum amount of gain the partnership would realize if it made a taxable disposition of property secured by nonrecourse debt.  Exceptions Conversions and Refinancing Conversions and Refinancing Contributions of Capital Contributions of Capital Revaluations-Special Twist Revaluations-Special Twist

72 72 Definitions (cont’d)  Minimum Gain Chargeback Provision A provision in the agreement that allocates to each partner its allocable share of any net decrease in PMG for a taxable year A provision in the agreement that allocates to each partner its allocable share of any net decrease in PMG for a taxable year Requires a partner to recognize income from a net decrease in PMG when that partner previously enjoyed the economic benefit of a nonrecourse deduction associated with the property Requires a partner to recognize income from a net decrease in PMG when that partner previously enjoyed the economic benefit of a nonrecourse deduction associated with the property

73 73 Safe Harbor  An allocation of nonrecourse deductions will be respected if the following conditions are met: Partnership must satisfy the substantial economic effect safe harbor or alternative test Partnership must satisfy the substantial economic effect safe harbor or alternative test Nonrecourse deductions must be allocated in a manner “reasonably consistent” with other “significant” partnership items that have substantial economic effect. Nonrecourse deductions must be allocated in a manner “reasonably consistent” with other “significant” partnership items that have substantial economic effect. (cont’d on next slide)

74 74 Safe Harbor (cont’d) The agreement must contain a minimum gain chargeback provision The agreement must contain a minimum gain chargeback provision All other material allocations and capital account adjustments must be respected All other material allocations and capital account adjustments must be respected

75 75 Sample Short Cut Provision  “The LLC shall allocate items of LLC income and gain among the Members at such times and in such amounts as necessary to satisfy the minimum gain chargeback requirements of Regulations Sections (f) and (i)(4).”

76 76 Member Non-recourse Liability  Non-recourse debt from partner or related person  Specially allocates debt to that partner  Specially allocate deductions to that partner

77 77 Sample Provision  “Any nonrecourse deductions attributable to a Member Nonrecourse Liability shall be allocated among the Members that bear the economic risk of loss for such Member Nonrecourse Liability in accordance with the ratios in which such Members share such economic risk of loss and in a manner consistent with the requirements of Regulations Sections (c), (i)(2) and (j)(1).”

78 78 Other Things  Withholding  Tax Matters Partner  Tax Elections  Fiscal Year

79 79 Withholding  Notwithstanding anything else contained in this Agreement, the Managing Member may in its discretion withhold from any distribution to any Member pursuant to this Agreement any amounts required to pay or reimburse (x) any withholding or other taxes legally payable by the LLC that are properly attributable to a Member of the LLC or (y) the Managing Member for any advances made by the Managing Member for such purpose.

80 80 Withholding (cont)  Any amounts so withheld pursuant to this Section 6.9 shall be applied by the Managing Member to discharge the obligation in respect of which such amounts were withheld.  All amounts withheld pursuant to this Section 6.9 with respect to any Member shall be treated as amounts distributed to such Member for all purposes under this Agreement.  The Managing Member shall give written notice of any such withholding to each Member subject thereto within five Business Days after such withholding.

81 81 Std. Clause: Tax Matters Partner  The Managing Member shall act as the “tax matters partner” of the LLC within the meaning of Section 6231(a)(7) of the Code and in any similar capacity under applicable state or local tax law. All expenses incurred by the Tax Matters Member while acting in such capacity shall be paid or reimbursed by the LLC.

82 82 Tax Elections  “Except as otherwise expressly provided herein, all elections required or permitted to be made by the LLC under the Code or other applicable tax law, and all decisions with respect to the calculation of its taxable income or tax loss under the Code or other applicable tax law, shall be made in such manner as may be determined by the Tax Matters Member.”

83 83 Fiscal Year  Except as otherwise required by the Code, the fiscal year of the LLC (the “Fiscal Year”) for tax and accounting purposes shall be the 12-month (or shorter) period ending on the last day of December of each year.

84 84 Now, let’s look at: Examples from the Field

85 85 Drafting Partnership Agreements  Most Important item: The Economic Deal Tax rules/tax lawyers are meaningless without an understanding of the economic deal Tax rules/tax lawyers are meaningless without an understanding of the economic deal The terms of the agreement define the deal The terms of the agreement define the deal The tax lawyers and accountants do not define the deal – they follow the dealThe tax lawyers and accountants do not define the deal – they follow the deal  What is the deal? Get the term sheet if there is one. Get the term sheet if there is one.

86 86 Operating cash flow vs. capital transaction Read carefully the defined terms – available cash vs. net cash flow Cash from operations often does NOT reduce unreturned capital Proceeds of capital transactions typically does return capital AFTER preferences fully repaid What is a capital transaction? Interim capital transaction – refinancing or partial sale Terminating capital transaction – sale of all or substantially all assets

87 87 What do you mean by Percentage Interests?  Does this mean Capital Percentages? Initially based on ACTUAL contributions to the partnership Initially based on ACTUAL contributions to the partnership My contribution / Total contributions = My capital percentageMy contribution / Total contributions = My capital percentage Staggered capital contributions impactStaggered capital contributions impact Beware of terminology, and scrutinize the agreement Beware of terminology, and scrutinize the agreement Capital percentage vs. Percentage interest vs. Partnership percentage vs. Partnership interest vs. Unit percentage vs. Who knows what elseCapital percentage vs. Percentage interest vs. Partnership percentage vs. Partnership interest vs. Unit percentage vs. Who knows what else Many agreements use multiple terms, sometimes interchangeably and sometimes inconsistentlyMany agreements use multiple terms, sometimes interchangeably and sometimes inconsistently

88 88 What happens upon call for additional capital – squeeze down? GP calls for additional capital (or loans) GP calls for additional capital (or loans) Pro rata vs. non-pro rataPro rata vs. non-pro rata Some partners contribute their shares; others don’t.Some partners contribute their shares; others don’t. Non-contributing partners are penalized by a reduction in their partnership interests.Non-contributing partners are penalized by a reduction in their partnership interests. Capital interests, profits interests, or both Capital interests, profits interests, or both Is this a revaluation event? Is this a revaluation event?

89 89 What do you mean by Preferred Returns-What exactly is it? Also called preference amount, accrued preference, cumulative unpaid preference, unpaid preferred return, etc. Also called preference amount, accrued preference, cumulative unpaid preference, unpaid preferred return, etc. Does the preference accrue on a daily, monthly, quarterly, or annual basis?Does the preference accrue on a daily, monthly, quarterly, or annual basis? Does the preference compound?Does the preference compound? Is the preference specified as a simple percentage or as an internal rate of return?Is the preference specified as a simple percentage or as an internal rate of return?

90 90 Economic Deal  Problems arise when the business folks and the tax folks are not involved from the beginning  Why: Different approaches Different approaches For example, distribution might mean one thing to a tax lawyer and a different thing to a business person.For example, distribution might mean one thing to a tax lawyer and a different thing to a business person. Tax guys might be able to tell if the “magic” tax language is present Tax guys might be able to tell if the “magic” tax language is present  Business guy might think an “OK” from the tax guy means the agreement reflects the economic deal Tax guy is merely saying the “magic” tax language is there Tax guy is merely saying the “magic” tax language is there

91 91 Economic Deal  Partnership Attributes Income and loss flow though currently Income and loss flow though currently Affect return on investmentAffect return on investment  Income and loss Items allocated Items allocated  Cash and property Items contributed and distributed Items contributed and distributed  Allocations might not match contributions and/or distributions

92 92 Economic Deal What to do?  Model/Projections  Have the business folks and tax folks talk  Model/Projections Again

93 93 Figure out Distributions  Cash flow from operations  Cash flow from sales  Liquidating Distributions  Tax Distributions-Can override the rest Particular concern to GP-Managing Member- Holder of Carry who may get “phantom income” if cash flow that generates taxable income is used to repay capital contributions Particular concern to GP-Managing Member- Holder of Carry who may get “phantom income” if cash flow that generates taxable income is used to repay capital contributions

94 94 Allocations: Possible Trouble Spot  If you then say that “allocations follow distributions,” then you may get in trouble.  When? Where cash flow that generates taxable income is used to repay capital contributions Where cash flow that generates taxable income is used to repay capital contributions Where cash flow & taxable income do not match each other Where cash flow & taxable income do not match each other

95 95 Let’s see how-Basic Example  AB Partnership  A is the service provider, contributes $10, and owns 1%  B is the investor, contributes $990, owns 99%  Business deal: After return of capital to B, return capital to A and then, cash flow shared 20% to A and 80% to B Upon liquidation, do not follow capital account balances—just follow economics! Upon liquidation, do not follow capital account balances—just follow economics!  & Allocations follow distributions-----

96 96 In Year One  Buy asset with $1,000  Generate $100 of taxable income & $100 of cash flow Ignore depreciation to make life simpler Ignore depreciation to make life simpler  Pay off in part investor’s capital with $100  How do you allocate the $100 of taxable income?

97 97 Allocation in Year 1 What has happened to each of A and B? Capital Accounts Year 1 AB Opening Capital Account Allocation of $1000 Income Distributions--100 Ending Capital Account 10990

98 98 In Year Two  Sell asset for $1,000  Generate no gain or loss, but generate $1,000 of cash flow  Business deal: Use $890 of cash flow to pay off A’s (investor’s) unreturned capital, then pay off B’s $10 unreturned capital and then distribute excess of $100--$80 to A & $20 to B  What is the impact on capital accounts?

99 99 Allocation in Year 2 What has happened to each of A and B? Capital Accounts Year 1 AB Opening Capital Account No Income to Allocate -- Distributions-return of capital Distributions-excess proceeds Ending Capital Account

100 100 Oops!!!  A has a +$20 capital account while B has a -$20 capital account  This means that allocations did NOT have substantial economic effect in year one Note, if liquidating distributions followed capital account balances, the tax allocations work Note, if liquidating distributions followed capital account balances, the tax allocations work BUT then, cash goes out $990 to B & $10 to B, which is NOT business deal, which would have B only get $970 and A get $30. BUT then, cash goes out $990 to B & $10 to B, which is NOT business deal, which would have B only get $970 and A get $30.

101 101 Aside  Sometimes, people draft agreement & say, don’t worry, we will fix things up by specially allocating income/loss in last year to make everything right.  However, as this example shows, this does NOT help if there is no income or loss in last year Or income & loss in last year may not be enough to make things right. Or income & loss in last year may not be enough to make things right.

102 102 Year One Revisited  Drop idea of allocations following distributions, but what do you then do?  Allocations should follow how cash flow over and above return of capital would have been made  Thus, allocate $80 to A (not $100 to A) & allocate $20 to B (not no income allocation) & LET”S SEE WHAT HAPPENS NOW:

103 103 Revised Allocation in Year 1 What has happened to each of A and B? Capital Accounts Year 1 AB Opening Capital Account Allocation of $100 Income Distributions--100 Ending Capital Account 30970

104 104 Year Two Again  Sell asset for $1,000  Generate no gain or loss, but generate $1,000 of cash flow  Business deal: Use $890 of cash flow to pay off A’s (investor’s) unreturned capital, then pay off B’s $10 unreturned capital and then distribute excess of $100--$80 to A & $20 to B  What is the impact on capital accounts NOW?

105 105 Revised Allocation in Year 2 What has happened to each of A and B? Capital Accounts Year 1 AB Opening Capital Account No Income to Allocate -- Distributions-return of capital Distributions-excess proceeds Ending Capital Account Zero!Zero!

106 106 Is there a need for a Tax Distribution in Prior Example?  In this example, we saw how A was allocated $20 of phantom income in Year One.  A may want to request a Tax Distribution to cover its taxes on that income

107 107 Tax Distributions  Will investor agree?  If agree: What rate do you use? What rate do you use? Consider coming up with # & then adjust if law changesConsider coming up with # & then adjust if law changes Estimated taxes may require multiple payments Estimated taxes may require multiple payments Impact of prior year losses Impact of prior year losses

108 108 Added Lesson-Must you say that liquidating distributions follow capital accounts?  NO  This is a safe harbor BUT if you get allocations right, you do not have to incorporate that, which may make your client happier  However, watch out since it may be hard to actually get it right especially in complex deals & may make agent look harder.

109 109 Allocation Methods to Adopt  Targeting approach SHORT--At end of year, book capital accounts should equal the amounts of cash that partners would receive if all partnership assets sold for §704(b) book value, i.e., assume assets’ FMV = book value SHORT--At end of year, book capital accounts should equal the amounts of cash that partners would receive if all partnership assets sold for §704(b) book value, i.e., assume assets’ FMV = book value  Layering approach LONG--Building up or taking down the capital accounts to reflect the waterfall rights LONG--Building up or taking down the capital accounts to reflect the waterfall rights  Others-Combination (boot-strap)

110 110 Targeted Tax Allocations  The “substantial economic effect” test is intended to make sure that tax allocations have real impact on the parties.  But, shouldn’t cash, not tax allocations, be king?  If so, why not have tax follow how cash should go, which is the essence of targeted capital accounts!  However, this does NOT work well if trying to specially allocate losses!

111 111 Target Allocation Section  Allocations: Profits and Losses are allocated among the Members such that, as of the end of any Year, the Capital Account of each Member equals the net amounts that would be distributed to the Member on liquidation of the Company. In computing net amount that may be distributed, all property is deemed sold at its Book Value In computing net amount that may be distributed, all property is deemed sold at its Book Value In determining how cash flow goes out on liquidation, you rely on the business deal In determining how cash flow goes out on liquidation, you rely on the business deal Do not say follow capital accounts or else this is circularDo not say follow capital accounts or else this is circular

112 112 Targeted Tax Allocations (cont’d)  § 5.1(a)(iv): “All items of income, gain, loss … shall be allocated to the partners in a manner which causes … each partner’s adjusted capital account balance to equal the amount (for each partner, its “target amount”) that would be distributed to such partner … upon a hypothetical liquidation of the partnership.”

113 113 Targeted Tax Allocations (cont’d)  Hypothetical Liquidation  § 5.1(b): “In determining the amounts distributable to the partners … upon a hypothetical liquidation, it shall be presumed that (a) all of the partnership assets are sold for cash at their respective [book] values …, and (b) the proceeds of such hypothetical sale are …distributed in accordance with … [the liquidation provisions]”

114 114 Targeted Tax Allocations (cont’d)  Contributed/Revalued Property  § 5.4(a): “If any property is contributed to the Partnership in kind, or if the Book Value of any Partnership property is adjusted …, all income, gain, loss and deduction with respect to such … property shall, solely for income tax purposes, be allocated among the Partners so as to take account of any variation between the adjusted basis of such property … and its initial or revalued Book Value ….”

115 115 Target Allocation Criticism/Praise  Con: “I want guidance” What do these tax advisors want me to do? What do these tax advisors want me to do? I need a cookbook I need a cookbook  Pro: “I want flexibility to get it right” I can avoid all those awful steps and do the “right thing” I can avoid all those awful steps and do the “right thing”

116 116 Short Cookbook for Target Allocation If Profits exceed Losses, (i) Losses shall first be allocated to Members whose Capital Accounts are to be reduced, and (ii) Profits and any remaining Losses shall be allocated to Members whose Capital Accounts are to be increased. If Profits exceed Losses, (i) Losses shall first be allocated to Members whose Capital Accounts are to be reduced, and (ii) Profits and any remaining Losses shall be allocated to Members whose Capital Accounts are to be increased. If Losses exceed Profits, (i) Profits shall first be allocated to Members whose Capital Accounts are to be increased, and (ii) Losses and any remaining Profits shall be allocated to Members whose Capital Accounts are to be reduced. If Losses exceed Profits, (i) Profits shall first be allocated to Members whose Capital Accounts are to be increased, and (ii) Losses and any remaining Profits shall be allocated to Members whose Capital Accounts are to be reduced.

117 117 Layered Allocations Building up or taking down the capital accounts to reflect the waterfall rights Building up or taking down the capital accounts to reflect the waterfall rights Separation of allocations for operations, interim capital transactions, and terminating capital transactions Separation of allocations for operations, interim capital transactions, and terminating capital transactions Within a given year, a partnership may have both income/loss from operations and income/loss from one or more capital transactions.Within a given year, a partnership may have both income/loss from operations and income/loss from one or more capital transactions. Which items are allocated first? Which items are allocated first?

118 118 Layered Allocations-Key Points  Key Questions At year-end, do partners’ book capital accounts properly reflect economic rights on sale for book value? At year-end, do partners’ book capital accounts properly reflect economic rights on sale for book value? Do layers match the corresponding waterfall distribution right? Do layers match the corresponding waterfall distribution right? Do layers incorporate all Preferences? Do layers incorporate all Preferences? Let’s see some examples: Let’s see some examples:

119 119 Sample Agreement-1 st Layer-Loss Reversal Except as otherwise provided herein and after application of Sections 1.3 and 1.4 hereof, Profits for any fiscal year shall be allocated as follows:Except as otherwise provided herein and after application of Sections 1.3 and 1.4 hereof, Profits for any fiscal year shall be allocated as follows: First, to the Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(b)(iv) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(a)(i); First, to the Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(b)(iv) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(a)(i); Second, to the Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(b)(iii) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(a)(ii); Second, to the Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(b)(iii) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(a)(ii);

120 120 2 nd Layer-Operating Income Cash Flow  Third, to those Partners who shall have received (or be entitled to receive) a distribution of cash flow from operating income for such year pursuant to Section 9(a) of the Partnership Agreement (but excluding, for this purpose, any distributions deemed to be made pursuant to Section 9(a)(iv)) in proportion to, and to the extent of, the cash flow actually received (or to be received) by each such Partner for such year;

121 121 3 rd Layer-Capital Partner Liquidation Preference  Fourth, to the Capital Partners in accordance with, and in proportion to, their respective Capital Partner’s Liquidation Preference until the capital account balances of each such partner (before taking into account any distribution to such Partner for such year relating to a sale of the Project or a liquidation distribution) shall be equal to their Capital Partner’s Liquidation Preference;

122 122 4 th Profit Partner Liquidation Preference, if any  Fifth, to the Profit Partners, in accordance with and in proportion to, their respective Profit Partner’s Liquidation Preferences until the capital account balances of each such Profit Partner (before taking into account any distribution to such Partner for such year relating to a sale of the Project or a liquidating distribution) shall be equal to such Profit Partner’s Liquidation Preference;

123 123 5 th layer-Residual Distribution  Then, to the Partners in accordance with their respective Percentage Interests.

124 124 Sample Loss Allocation-1 st Layer- Profit Reversal Except as otherwise provided herein and after application of Sections 1.3 and 1.4 hereof, Losses for any fiscal year shall be allocated as follows:Except as otherwise provided herein and after application of Sections 1.3 and 1.4 hereof, Losses for any fiscal year shall be allocated as follows: First, to the Partners in proportion to, and to the extent of, (A) any Profits allocated to each pursuant to Section 1.2(a)(vi) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(b)(i); First, to the Partners in proportion to, and to the extent of, (A) any Profits allocated to each pursuant to Section 1.2(a)(vi) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(b)(i); Second, to each of the Profit Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(a)(v) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(b)(ii); Second, to each of the Profit Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(a)(v) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(b)(ii);

125 125 2 nd Layer-Wipe out capital accounts  Third, to the Partners in accordance with, and in proportion to, their respective positive capital account balances (after taking into account of any allocations of Losses under Section 1.2(b)(i) and (ii)); and

126 126 3 rd Layer-Residual Losses  Then, to the Partners in accordance with their respective Percentage Interests.

127 127 Loss Allocation Override  However, any Loss allocation in accordance with this Section 1.2(b) shall not exceed the maximum amount of Loss that can be so allocated without causing any Partner to have a negative capital account balance at the end of the Partnership’s fiscal year. In the event some but not all of the Partners would have negative capital account balances as a consequence of an allocation of losses pursuant to Section 1.2(b) hereof, the limitation set forth in this Section 1.2(b) shall be applied on a Partner by Partner basis so as to maximize permissible losses to each Partner under Regulation § (b)(2)(ii)(d).

128 128 Common Allocation Provisions  Regulatory allocations Minimum gain chargebacks Minimum gain chargebacks Special problem for debt workoutsSpecial problem for debt workouts Allocating non-recourse deductions Allocating non-recourse deductions  Stop loss provisions Adjusted capital account concept Adjusted capital account concept Increased for minimum gain sharesIncreased for minimum gain shares Increased for allocations of recourse debt deductionsIncreased for allocations of recourse debt deductions  Avoid impermissible negative capital accounts

129 129 Other Possible Concerns?  Admission of a New Partner  Section 754 Elections

130 130 Admission of New Partner: Achieving Retroactive Allocations Legitimately! Section 706(d) limits the ability to perform retroactive allocations for a new partner Section 706(d) limits the ability to perform retroactive allocations for a new partner However, if you disproportionately allocate losses after admission of a new partner, you may be able to legitimately achieve the same result However, if you disproportionately allocate losses after admission of a new partner, you may be able to legitimately achieve the same result

131 131 Section 754 Elections  Special Adjustments: Section 743-Sale of PS Interest Section 743-Sale of PS Interest Section 734-Partnership Redemption Section 734-Partnership Redemption

132 132 Intangible Property and Partnerships  Rule: Amortizable Section 197 Intangibles- 15 year straight line amortization  Exception: Anti-churning Rules  Purchase of Partnership Interest Section 754/743 Election-Creates new amortizable asset for step up even if the intangible was non-amortizable before Section 754/743 Election-Creates new amortizable asset for step up even if the intangible was non-amortizable before

133 133 Intangible Property (cont’d)  § 704(c) Intangible Predicament: if a partner contributes a non-amortizable section 197 intangible to the Partnership Curative allocations are not available for the other partners Curative allocations are not available for the other partners However, they can use remedial allocations. Treas. Reg. § (g)(4)(i) However, they can use remedial allocations. Treas. Reg. § (g)(4)(i)  Nonetheless, a partner related to the contributing partner may not receive remedial allocations of deductible amortization

134 134 Securities Partnerships  Such partnerships may have frequent capital account restatements (“book-ups”)  Sheer number of assets makes compliance with Regulations extremely difficult

135 135 Securities Partnerships (cont’d)  Solution—Qualified Partnerships May consistently aggregate gains and losses from securities and similar investments when making reverse § 704(c) allocations May consistently aggregate gains and losses from securities and similar investments when making reverse § 704(c) allocations Only applies to allocations on/after Dec 31, 1993.Only applies to allocations on/after Dec 31, May use any reasonable approach to aggregation that is consistent with § 704(c), but must continue to use the same approach. May use any reasonable approach to aggregation that is consistent with § 704(c), but must continue to use the same approach.

136 136 Securities Partnerships (cont’d)  Requirements of Securities Partnerships Must be either a management company registered with the SEC under the Investment Company Act of 1940, or an investment partnership Must be either a management company registered with the SEC under the Investment Company Act of 1940, or an investment partnership On each book-up date, 90% of an investment partnership’s noncash assets must consist of “qualified financial assets” On each book-up date, 90% of an investment partnership’s noncash assets must consist of “qualified financial assets” Qualified Financial Asset: any personal property that is actively tradedQualified Financial Asset: any personal property that is actively traded

137 137 Securities Partnerships (cont’d)  Permissible Aggregation Methods Step 1: establish “revaluation account” for each partner to track book allocations not matched with tax allocations Step 1: establish “revaluation account” for each partner to track book allocations not matched with tax allocations Step 2: select aggregation method Step 2: select aggregation method Partial Netting: tax gains and losses for each asset are netted separately; gains/losses are then allocated to partners with positive/negative accounts in proportion to their positive/negative balances; excess is allocated pro rataPartial Netting: tax gains and losses for each asset are netted separately; gains/losses are then allocated to partners with positive/negative accounts in proportion to their positive/negative balances; excess is allocated pro rata Full Netting: nets all tax gains and losses together, and then allocates net amounts according to the same rule as aboveFull Netting: nets all tax gains and losses together, and then allocates net amounts according to the same rule as above

138 138

139 139 IRS Circular 230 disclosure  * * * * * * * * * * * * * * * * * * * * * *  To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.  * * * * * * * * * * * * * * * * * * * * * *


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