1. Partnership Hot Topics Howard E. Abrams Professor of Law

2. #AICPA_Banks Howard E. Abrams Howard E. Abrams, Professor of Law at Emory Law School in Atlanta, GA, is a partnership and corporate tax specialist, receiving his B.A. from the University of California (Irvine) and his J.D. from Harvard University. He has written four books, the BNA Tax Management Portfolio on Disregarded Entities, and more than fifty articles on taxation. Professor Abrams has been at Emory University since 1983, spent the 1999-2000 academic year with the national office of Deloitte Tax as the Director of Real Estate Tax Knowledge, and from January of 2003 through August of 2004 was of counsel to Steptoe & Johnson in Washington, DC. He teaches regularly at Leiden University in the Netherlands and is a member of the American Law Institute and the DC Bar. Prior to joining the Emory faculty, Professor Abrams was a law clerk to Chief Judge Theodore Tannenwald, Jr., of the United States Tax Court and practiced in Los Angeles with the firm of Brobeck, Phleger & Harrison. Professor Abrams has taught as a Visiting Professor at USD, Cornell, Berkeley and Yale Law Schools. Professor Abrams will spend the 2013-14 academic year as a Visiting Professor at Harvard Law School. 2

3. #AICPA_Banks Topics Partnership Noncompensatory Options Partnership Self-Employment Issues LLCs and the Passive Loss Limitations Partnerships and Income from the Cancellation of Indebtedness The Section 752 Anti-Abuse Rule and Disguised Sales 3

4. #AICPA_Banks Options Basics An option is the right (but not an obligation) to purchase or sell certain property. A “call” option is the right to purchase; a “put” option is the right to sell. If the underlying property is fungible, the option can be settled by delivery of the underlying property or by a payment of cash. If the underlying property is unique, the underlying property always is delivered if the option is exercised. 4

5. #AICPA_Banks Option Basics (continued) The option holder’s rights are limited in time. If the option can be exercised at any time until expiration, it is called an “American-style” option. If the option can be exercised only upon expiration, it is called a “European-style” or “digital” option. If the option can be exercised at specific dates prior to (and including) expiration, it is called a “Bermuda- style” option. Most partnership noncompensatory options are America-style call options, and exercise can be settled only by actual delivery. 5

6. #AICPA_Banks Basic Terminology Option Premium: Usually called the option “cost,” it is what the holder of the option pays to acquire the option. Exercise Price: Usually called the the “strike” price, it is the amount the holder must pay to exercise the option. In the case of convertible debt, the exercise price includes the “adjusted issue price” of the debt increased by any accrued but unpaid stated interest. In the case of convertible equity, the exercise price includes that portion of the holder’s capital account allocable to the convertible interest. 6

7. #AICPA_Banks Option Valuation The value of an option is composed of two amounts, the intrinsic value of the option and the time value of the option. The intrinsic value of an option at any point in time is the excess of the value of the underlying property over the exercise price. The time value of an option is the value of the option in excess of its intrinsic value. The time value of an option is dependent on the exercise price, the current value of the underlying, the anticipated volatility of the value of the underlying, and the duration of the option. The time value of an option declines to zero as the expiration date approaches. For an excellent introduction to options, see Andrew M. Chisholm, Derivatives demystified (Wiley Finance 2d ed. 2010). 7

8. #AICPA_Banks Taxation of a Noncompensatory Option Acquisition of a noncompensatory partnership interest is a taxable event to the option holder. Unless the option is recharacerized as equity, the option holder is not treated as a partner and so no taxable income can be allocated to the option holder. When the option is exercised, the partnership must revalue its assets immediately after the exercise and allocate book gain or loss to the (former) option holder. If there is insufficient book gain or loss, curative allocation must be used. If the option lapses, the option premium is income to the partnership. 8

9. #AICPA_Banks Exercise and Book-Up: Example 1 X and Y form XY LLC by contributing $10,000 each. Z contributes $1,000 for an option to acquire a one- third interest for $15,000. XY purchases nondepreciable property for $20,000. When the property is worth $35,000, Z exercises the option by contributing $15,000 in exchange for a one-third interest in the venture. At this point, XY owns cash of $16,000 and property with adjusted basis of $20,000 and value of $35,000. Each partner’s interest is worth $17,000. 9

10. #AICPA_Banks Example 1 continued XYZ CAOBCAOBCAOB $ 10,000 $ 16,000 7,0000 01,0000 $ 17,000$ 10,000$ 17,000$ 10,000$ 17,000$ 16,000 10

11. #AICPA_Banks Sale and Exercise: Example 2 X and Y form XY LLC by contributing $10,000 each. Z contributes $1,000 for an option to acquire a one- third interest for $15,000. XY purchases nondepreciable property for $20,000. The property is sold for $35,000, and then Z exercises the option by contributing $15,000 in exchange for a one-third interest in the venture. At this point, XY owns cash of $51,000. Each partner’s interest is worth $17,000. 11

12. #AICPA_Banks Example 1 continued XYZ CAOBCAOBCAOB $ 10,000 7,500 16,000 -500 1,000 2,0001,5002,0001,5002,0003,000 $ 19,000 12 This example assumes the partnership has income of $6,000 in the following taxable year, allocated $2,000 to each partner under the partnership agreement.

13. #AICPA_Banks Nonconpensatory Option Issues Not “In Connection With” Services Application to “Preferred” Interests Option as Equity Taxation of Option Issuance Option Lapse Conversion of Convertible Debt 13

14. #AICPA_Banks Not “In Connection With” Services “In connection with” is broader than “in exchange for.” Alves v. Commissioner, 79 T.C. 864 (1982), aff’d, 734 F.2d 478 (9th Cir. 1984). Consider a contractual arrangement akin to phantom stock. If investors are corporations and gain will be capital, compensatory interest treatment usually provides optimal results. 14

15. #AICPA_Banks Application to “Preferred” Interests The noncompensatory option regulations apply to the conversion feature of preferred equity if it is convertible into common equity. “Preferred” equity is an interest that entitles the partner to a preferred return on equity. For a partner who is entitled to a guaranteed payment or preferred allocation, is the entire interest “preferred”? Apparently not, although how the interest is bifurcated is not defined. Note that conversion of a common interest into a larger common interest is not covered by the regulations. 15

16. #AICPA_Banks Option as Equity An option will be treated as equity prior to conversion if it provides the holder “with rights that are substantially similar to the rights afforded to a partner.” An option that is deep in the money when issued presumably will be treated as equity. The proposed regulations focus on both benefits and detriments associated with equity. 16

17. #AICPA_Banks Taxation of Option Issuance For the partnership: Open transaction treatment. For the option holder: gain or loss if the option is acquired for property (section 721 does not apply), and capitalization of the cost. Note: Transfer of the option can trigger gain to the option holder. What is the partnership’s basis in such property. Presumably equal to fair market value although there is no statement of that result. 17

18. #AICPA_Banks Option Lapse To the Partnership: Ordinary income equal to the option premium (open transaction is closed). To the Partner: Loss equal to option premium. Is it capital under section 1234A? Unclear. Does character of the loss turn on the character of the underlying assets? No clear authority for a look-thru rule. 18

19. #AICPA_Banks Conversion of Convertible Debt If the holder of convertible debt elects to convert the debt into equity, the partner’s capital account will be credited with the adjusted basis of the debt (accounting for application of the OID rules) plus any accrued but unpaid stated interest. The proposed regulations do not specify the tax consequences of the conversion to the partnership, but given section 108(e)(8), presumably the partnership will recognize COD income as if the debt had been satisfied with cash equal in value to the value of the partnership interest. 19

20. #AICPA_Banks Self-Employment Taxes For determining whether an LLC member should be treated as a “general” partner, it is the participation of the partner in the activities that is relevant. Renkemeyer v. Comm’r, 136 T.C. 137 (2011). Howell v. Commissioner, T.C. Memo 2012-303 (Nov. 1, 2012), follows Renkemeyer in outcome and tone. In Howell, Husband worked for the LLC but put ownership of the LLC interest in the hands of Wife. The Tax Court found that Wife performed some labor for the LLC and held that the taxpayer failed to prove exactly how much. 20

21. #AICPA_Banks Incentive Partnership Options It is the Service’s position that a partner cannot receive a W-2 from the partnership and cannot be treated as an employee (although a partner can be treated as an independent contractor). Note: a disregarded entity that has one or more employees is treated as a corporation for purposes of the collection and reporting of the self- employment taxes. 21

22. #AICPA_Banks Employee Through a Disregarded Entity? P1 P2 Ee P P DE Employment Relationship 22

23. #AICPA_Banks LLCs and Passive Loss Limitations The Service interpreted §469(h)(2) as treating all LLC members as “limited” partners. That interpretation was rejected by the courts. Proposed regulations now provide that an LLC member will be treated as a limited partner unless the member has the power to manage the entity under applicable state law and under the LLC agreement where “manage” must include a power to bind the entity. 23

24. #AICPA_Banks COD Basics Cancellation of recourse debt Reduction of recourse debt Reduction of nonrecourse debt How is “recourse” defined? Unclear if the §752 regulations apply in this context. If not, presumably turns on the lender’s rights against the partnership. Allocation of COD income subject to general “substantial economic effect” test. 24

25. #AICPA_Banks PRS Land - $10,000 Nonrecourse debt - $8,000 A B’s Interest - 50% GP - $5,000 Basis - $1,000 Capital Acct. A’s Interest - 50% GP - $5,000 Basis - $1,000 Capital Acct. Rev. Rul. 99-43: Partnership Formation PRS must revalue assets pursuant to agreement B 25

26. #AICPA_Banks Rev. Rul 99-43: End of Year One Facts FMV of Land falls from $10,000 to $6,000. Principle loan balance remains at $8,000. B is insolvent Debt workout: Bank agrees to reduce principle balance on loan by $2,000 ($8,000 - $2,000 = $6,000). Post work-out, A will have a 60% and B will have a 40% interest in profits and losses of PRS. Assets and capital accounts revalued. 26

27. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward Opening capital account balances 27

28. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward COD Income - $2,000 28

29. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward Asset Revaluation - ($4,000) 29

30. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward Opening capital account balances 30

31. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward COD Income - $2,000 31

32. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward Asset Revaluation - ($4,000) 32

33. #AICPA_Banks “Substantiality”: Reg. §1.704-1(b)(2)(iii) Shifting violation But what if no asset revaluation? 33

34. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward Opening capital account balances 34

35. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward COD Income - $2,000 35

36. #AICPA_Banks Rev. Rul 99-43: Capital Account Rollforward Asset Revaluation - ($4,000) 36

37. #AICPA_Banks Computation of Partner Insolvency Asset #1: Value of $1,000,000 subject to recourse debt of $1,200,000. Asset #2: Value of $1,000,000 subject to nonrecourse debt of $1,200,000. If the recourse debt is reduced to $900,000, then T can exclude $200,000 under §108(a)(1)(B). If the nonrecourse debt is reduced to $900,000, then T can exclude the entire $300,000. Under Rev. Rul. 2012-14, same result if assets and liabilities are inside a partnership. 37

38. #AICPA_Banks Canal Corp. Transaction 38 LLC Canal Corp. WISCOGP Business assets

39. #AICPA_Banks Canal Corp. Transaction 39 LLC Canal Corp. WISCOGP Bank Business assets Loan Proceeds

40. #AICPA_Banks Canal Corp. Transaction 40 LLC Canal Corp. WISCOGP Bank Business assets Loan Proceeds Cash distribution

41. #AICPA_Banks Canal Corp. Transaction 41 LLC Canal Corp. WISCOGP Bank Business assets Loan Proceeds Cash distributionObligation

42. #AICPA_Banks Canal Corp. Transaction 42 LLC Canal Corp. WISCOGP Bank Indemnity Business assets Loan Proceeds Cash distributionObligation

43. #AICPA_Banks Canal Corp. Transaction 43 LLC Canal Corp. WISCOGP Bank Indemnity Business assets Loan Proceeds Cash distribution Intercompany Note Obligation

44. #AICPA_Banks 44 Canal Corporation Does Canal Corp mean the leveraged partnership structure is dead? Canal Corp involved a consolidated subsidiary; does the anti-abuse rule have equal application in other circumstances? If not, what should tax advisors planning a leveraged partnership transaction think about? Scope of the indemnity Identity of the indemnitor Indemnitor’s net worth Restrictions on indemnitor

45. Poorly-Funded Intermediary Regulation §1.752-2(j) X Co. Y Partnership Recourse Debt Owns little but interest in lower tier partnership. Sub Co.

46. Poorly-Funded Intermediary Regulation §1.752-2(j) X Co. Y P X Partnership Recourse Debt Owns little but interest in lower tier partnership.

47. Disregarded Intermediary Prop. Reg. §1.752-2(k) Y Partnership Recourse Debt Owns little but interest in lower tier partnership. X LLC X