Presentation on theme: "American Bar Association"— Presentation transcript:
1 American Bar Association BASIC PARTNERSHIPS TAX PRINCIPLESJuly 22, 23, 2008Michael Hirschfeld Dechert LLP New York, New York (212)
2 Are you a PS? LLC Check the box rules: PS for tax Single member v Multi MemberUse: Non-US Entity
3 Form 8832 Entity Classification Election No need for protective election75 days to fileList of per se companies in InstructionsUK-Public Limited CompanyNetherlands-NVGermany-AKFrance-SACanada-Corporation and Company
4 PS Interest for Cash Tax free to contributing partner What about Promissory Note?Not the same as cashNo basis until pay it
5 Mix of Equity & DebtMay want to transfer cash for debt as well as equity?Why?Protect against creditors if things go badBut-will it work?Equitable subordination is a riskTax Issues:Is it good debt for tax purposes?At risk rules-Will it count?
6 PS Interest for Property General Rule: Tax free to contributing partner
7 Exception: Investment Partnership Property transfer taxable if:Investment PS &DiversificationInvestment PSMore than 80% of value of assets are held for investmentDollars, stock, debt, options, REIT, RIC, PTPKey: Keep at least 20% in non-investment company assets
8 Investment Partnership (cont) DiversificationIf 2 or more partners transfer non-identical assets to PSBUT no diversification if:Only 1 partner transfers assets orEach partner transfers:Same portfolio orDiversified PortfolioNot more than 25% in one asset &Not more than 50% in 5 or fewer assets
9 Property Contribution No investment PS & no cash then non-taxable with tax attributes being:Carryover tax basis for PS interestTacked holding period for property contributions
10 But if get back cash then: Disguised sale rules will make this in part a taxable salePart sale-Part tax free transferAllocate basis between two events
11 Disguised Sale RulesThe game: Get cash back later in time after property contribution is madeWhy? Cash distributions from a PS are not generally taxable until they exhaust your tax basis BUTLater 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
12 Exceptions to Disguised Sale Rules Guaranteed payments for capital & preferred returnsSafe harbor: Very ltd-150% of AFROperating cash flow distributionsReimbursement of preformation expenditures
13 Liabilities & Disguised Sale Rules Non-recourse liabilities:Usually, allocate liability to contributing partner under §704(c)—reduces game playingRecourse liabilities:Could shift, which is treated as cash distributionIs that cash distribution caught by disguised sale rules?Yes unless qualified liability
14 Exceptions to Disguised Sale Rules Qualified Liability:Incurred more than 2 years before contributionAllocable to capital expendituresLiability incurred in ordinary course of business but only if all the assets held in that trade or business are transferred to PSLiability cannot exceed FMV of assets
15 Taxable Sale-Cap Gain? Code Section 1239 Sale of depreciable property between PS and controlling partner generates ordinary incomeControlling partnerMore than 50% ownership
16 So, tax free contribution—are there any tax concerns? Yes if AB is not equal to FMV of propertyWhy?Consider 2 partners, A & BA contributes $100 cashB contributes land with FMV = $100, but tax basis of zeroThe next day, PS sells land for $100How does PS allocate the $100 gain?
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)?NOCode Section 704(c) requires that you allocate built in gain to B, the contributing partnerWhy?
18 Capital Account Analysis if Use AB of Assets Increased by $100 due to cash contributionIf allocate A 50% of gain then increased to $150If liquidate, A gets $150 if follow capital account-something is wrong since A thinks he should get only $100BIncreased by zero upon property contribution since AB of property was zeroIf allocate B 50% of gain then increased to $50If liquidate, B gets $50 if follow capital account—something is wrong since B thinks she should get $100!
19 Variation on a SaleSell land that had AB = 0 & was worth $100 on date of contribution for $150 thenAllocate $100 gain to B BUTCan allocate excess gain of $50 to A and BKEY ISSUE:What is FMV of land on date of contribution?MUST SPELL OUT IN YOUR AGREEMENT!
20 Allocation of Gain & Capital Accounts Capital accounts used for tax allocation purposes:Increased by AB or FMV of property contribution?Decreased by AB or FMV of property distribution?Increased by taxable income/gain allocable to a partnerDecreased by taxable loss/deductions allocated to a partnerSO, LET’s APPLY THIS HERE
21 Contribution of Depreciable Property-allocations: How do you handle Allocations Relating to a Contribution of Property
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 Methods for § 704(c) Allocations Traditional Method: each partner is treated as if it purchase a pro rata interest in the propertyBeware 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 Section 704(c) Example AB Partnership A contributes $390,000 B contributes depreciable property worth $390,000, but with a $39,000 tax basisProperty depreciated over 39 years so:A hopes there is $10,000/ year of depreciation to split & she will get $5,000But there is only $1,000 of depreciation to splitWhat happens?
25 Section 704(c) Example-Outcome Traditional method: specially allocate $1,000 to A so A is short changed—she thought she would get $5,000Traditional 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 stuckRemedial method: A gets $5,000.
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 The Game The Players: The Game: A & B each put in cash of $1,000 C puts in property worth $2,000The Game:3 years later, A and B are redeemed out of PS by giving them each a ½ interest in the propertyA and B-say tax free to usC says great news—I just cashed out & fooled the tax system BUT
28 Tax Traps if have Contributed Property Distribution of contributed property to other partnerDistribution of other property to contributing partner
29 Anti ”Mixing Bowl” Rules If property leaves PS within 7 years, then that may trigger tax to contributing partnerWatch out for these rules§704(c)(1)(B): Contributed property goes out to another partner§737: Contributing partner redeemed out for other property
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 Section 754 Election-Example: ABC PS acquired Property for $9MTax basis of property is now $6MX buys C’s interest for $6MThus, current value of PS is $18MBut, C’s share of tax basis of PS property is only $2M and not $6MAbsent help, X is stuck with that $2M basisQ. How can we help
32 The Fix-Optional AB Adjustment Elect basis adjustment under Sections 754 and 743Gives “basis boost” for C’s benefit
33 Example Impact ABC Partnership BUT Now Tax basis = $6M allocable $2M to A, $2M to B and $2M to Xm purchaser of C’s interestBUT NowSpecial tax basis adjustment for only XX’s tax basis = $6MMore depreciation/amortization &Less gain or greater loss on sale
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 thresholdSection 734-If “substantial basis reduction,” then PS must reduce basisElecting investment PS (“EIP”) exceptionIf EIP election, then transferee partner’s share of losses from PS is reduced
35 PS Interest for Services Can you get this tax free?
36 Carried InterestsPlanning Possibility: Can get PS/LLC interest to a person w/o triggering tax!
37 Carried InterestThe 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 lapseNeed for Capital ContributionCode Section 83 ImpactPossible deduction to PS/LLCProposed tax legislation:PTP IssueNon-PTP Ordinary Income Exposure
38 Key: Profits Interest-Good; Capital Interest-Bad Difference:If you liquidate the PS, would you get something back?If yes, capital interestIf no, profits interestBUT, should this liquidation analysis be the proper test?
39 Carried Interest IRS Guidance Background: Diamond v. Comm., 56 TC 530, aff’d, 492 F.2d 286 (7th Cir. 1974)Rev. ProcKey factor: Profits v Capital InterestRev. ProcNotice Proposed Safe HarborCaveat: 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 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 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 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 Cookbook for PS Agreements-Tax Allocations General Allocation Rules--§ 704(b)Allocation of Non-recourse Deductions—Treas. Reg. §Allocation for Contributed Property--§ 704(c)Reverse § 704(c) Allocations
44 General Allocation Rules General PrincipleTax must follow economics
45 Two “Simple” RulesAllocations 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 Two “Simple” Rules (cont’d) But what is “substantial economic effect”?There are dozens of pages of regulations to explain this
47 SEE vs. PIPWhy might it be preferable to rely on SEE rather than PIP in setting partner allocations?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”.
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 liquidation of partnership interests in accordance with positive capital accounts; andPartners have a capital account “deficit restoration obligation” upon liquidation.
49 Economic Effect (cont’d) Capital Account MaintenanceTwo requirements must be satisfiedAll 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; andCapital contributions and distributions of property are taken into account in computing their capital account at fair market value.
50 Relevance of capital accounts On the K-1Non-liquidating distributions typically not tied to capital accountsLiquidating distributionsBased on capital accounts?Specified waterfall?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 Allocations
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.As Tony Soprano would say, “forget about it.”
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 basisAbsent relief, A has a taxable event. A expects to generate capital losses in 2008, but she cannot carry them backWhat do you do?
53 SolutionThe 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 Economic Effect (cont’d) Test #2—Alternative TestThree Prong TestAgreement 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; andDrop the DRO and in its place, do the following:
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 andthe partnership contains a “qualified income offset.”
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 Where do these rules make a BIG difference? Distributions that are not straight up (that is, they do not remain the same)
58 Common Case: GP CarryDistributions: 100% to LPs until they get their capital back & then,80% to LPs and 20% to GP
59 GP Carry Example LPs contribute $100M; GP contributes zero Sell assets with AB = $50M for $100M and all cash goes to LPsHow do you allocate $50M of gain?If allocate 100% to LPs, their capital account is now at $50MBUT 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
60 Special Case: Loss Allocation Can you specially allocate a loss to one member?Yes if ----
61 Loss Allocation Example AB are equal partnersEach contributes $1MPS borrows $8M non recourse debt1st year-Tax Loss =$1MQ: Can you specially allocate that $1M loss to A?A: Yes if take precautions.Explanation----
62 A’s Cap Acc = $1MA’s share of loss = 0A’s Cap Acc after Loss Allocation = $1MSO WHAT DOES THIS MEAN---If then sold property for $9M, pay off debt of &8M and who gets $1M cashA gets all the cashB’s Cap Acc = $1MB’s share of loss = $1MB’s Cap. Acc = 0
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 gainExample: Sell property for $10M, with $1M gain recognition, then allocate that $1M gain to BAfter that happens, both A’s and B’s Cap Acc are now at $1M & each gets $1M
64 Hitting the Bullseye Other Tax Allocation Trivia Why needed? Match the regsKeep the IRS Agent happyPreserve your allocations
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 Sample QIO ProvisionThe 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 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 partnershipExpected 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 propertyExpected 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 “Substantiality”The partnership must demonstrate that an allocation has some economic effect besides tax savingsTwo TestsBefore-Tax TestAfter-Tax Test
69 Substantiality (cont’d) Specific Allocations that Lack SubstantialityShifting Tax ConsequencesTransitory Allocations
70 Added Concern:How do you handle allocation of Non-recourse Deductions?
71 Definitions Partnership Minimum Gain (PMG) Exceptions The minimum amount of gain the partnership would realize if it made a taxable disposition of property secured by nonrecourse debt.ExceptionsConversions and RefinancingContributions of CapitalRevaluations-Special Twist
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 yearRequires 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 Safe HarborAn allocation of nonrecourse deductions will be respected if the following conditions are met:Partnership must satisfy the substantial economic effect safe harbor or alternative testNonrecourse 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 Safe Harbor (cont’d)The agreement must contain a minimum gain chargeback provisionAll other material allocations and capital account adjustments must be respected
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 Member Non-recourse Liability Non-recourse debt from partner or related personSpecially allocates debt to that partnerSpecially allocate deductions to that partner
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 Other ThingsWithholdingTax Matters PartnerTax ElectionsFiscal Year
79 WithholdingNotwithstanding 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 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 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 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 Fiscal YearExcept 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.
85 Drafting Partnership Agreements Most Important item: The Economic DealTax rules/tax lawyers are meaningless without an understanding of the economic dealThe terms of the agreement define the dealThe tax lawyers and accountants do not define the deal – they follow the dealWhat is the deal?Get the term sheet if there is one.
86 Operating cash flow vs. capital transaction Read carefully the defined terms – available cash vs. net cash flowCash from operations often does NOT reduce unreturned capitalProceeds of capital transactions typically does return capital AFTER preferences fully repaidWhat is a capital transaction?Interim capital transaction – refinancing or partial saleTerminating capital transaction – sale of all or substantially all assets
87 What do you mean by Percentage Interests? Does this mean Capital Percentages?Initially based on ACTUAL contributions to the partnershipMy contribution / Total contributions = My capital percentageStaggered capital contributions impactBeware of terminology, and scrutinize the agreementCapital percentage vs. Percentage interest vs. Partnership percentage vs. Partnership interest vs. Unit percentage vs. Who knows what elseMany agreements use multiple terms, sometimes interchangeably and sometimes inconsistently
88 What happens upon call for additional capital – squeeze down? GP calls for additional capital (or loans)Pro rata vs. non-pro rataSome partners contribute their shares; others don’t.Non-contributing partners are penalized by a reduction in their partnership interests.Capital interests, profits interests, or bothIs this a revaluation event?
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.Does the preference accrue on a daily, monthly, quarterly, or annual basis?Does the preference compound?Is the preference specified as a simple percentage or as an internal rate of return?
90 Economic DealProblems arise when the business folks and the tax folks are not involved from the beginningWhy:Different approachesFor 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 presentBusiness guy might think an “OK” from the tax guy means the agreement reflects the economic dealTax guy is merely saying the “magic” tax language is there
91 Economic Deal Partnership Attributes Income and loss Cash and property Income and loss flow though currentlyAffect return on investmentIncome and lossItems allocatedCash and propertyItems contributed and distributedAllocations might not match contributions and/or distributions
92 Economic Deal What to do? Model/Projections Have the business folks and tax folks talkModel/Projections Again
93 Figure out Distributions Cash flow from operationsCash flow from salesLiquidating DistributionsTax Distributions-Can override the restParticular 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 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 contributionsWhere cash flow & taxable income do not match each other
95 Let’s see how-Basic Example AB PartnershipA 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 BUpon liquidation, do not follow capital account balances—just follow economics!& Allocations follow distributions-----
96 In Year One Buy asset with $1,000 Generate $100 of taxable income & $100 of cash flowIgnore depreciation to make life simplerPay off in part investor’s capital with $100How do you allocate the $100 of taxable income?
97 Allocation in Year 1 What has happened to each of A and B? Capital AccountsYear 1ABOpening Capital Account10990Allocation of $1000 Income-+100Distributions-100Ending Capital Account
98 In Year Two Sell asset for $1,000 Generate no gain or loss, but generate $1,000 of cash flowBusiness 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 BWhat is the impact on capital accounts?
99 Allocation in Year 2 What has happened to each of A and B? Capital AccountsYear 1ABOpening Capital Account10990No Income to Allocate-Distributions-return of capital-10-890Distributions-excess proceeds-20-80Ending Capital Account+20
100 Oops!!!A has a +$20 capital account while B has a -$20 capital accountThis means that allocations did NOT have substantial economic effect in year oneNote, if liquidating distributions followed capital account balances, the tax allocations workBUT 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 AsideSometimes, 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 yearOr income & loss in last year may not be enough to make things right.
102 Year One RevisitedDrop 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 madeThus, allocate $80 to A (not $100 to A) & allocate $20 to B (not no income allocation) & LET”S SEE WHAT HAPPENS NOW:
103 Revised Allocation in Year 1 What has happened to each of A and B?Capital AccountsYear 1ABOpening Capital Account10990Allocation of $100 Income+20+80Distributions--100Ending Capital Account30970
104 Year Two Again Sell asset for $1,000 Generate no gain or loss, but generate $1,000 of cash flowBusiness 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 BWhat is the impact on capital accounts NOW?
105 Revised Allocation in Year 2 What has happened to each of A and B?Capital AccountsYear 1ABOpening Capital Account30970No Income to Allocate-Distributions-return of capital-10-890Distributions-excess proceeds-20-80Ending Capital AccountZero!
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 Tax Distributions Will investor agree? If agree: What rate do you use? Consider coming up with # & then adjust if law changesEstimated taxes may require multiple paymentsImpact of prior year losses
108 Added Lesson-Must you say that liquidating distributions follow capital accounts? NOThis is a safe harbor BUT if you get allocations right, you do not have to incorporate that, which may make your client happierHowever, watch out since it may be hard to actually get it right especially in complex deals & may make agent look harder.
109 Allocation Methods to Adopt Targeting approachSHORT--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 valueLayering approachLONG--Building up or taking down the capital accounts to reflect the waterfall rightsOthers-Combination (boot-strap)
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 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 ValueIn determining how cash flow goes out on liquidation, you rely on the business dealDo not say follow capital accounts or else this is circular
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 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 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 Target Allocation Criticism/Praise Con: “I want guidance”What do these tax advisors want me to do?I need a cookbookPro: “I want flexibility to get it right”I can avoid all those awful steps and do the “right thing”
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 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 Layered AllocationsBuilding up or taking down the capital accounts to reflect the waterfall rightsSeparation of allocations for operations, interim capital transactions, and terminating capital transactionsWithin 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?
118 Layered Allocations-Key Points Key QuestionsAt 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 incorporate all Preferences?Let’s see some examples:
119 Sample Agreement-1st 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: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);
120 2nd 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 3rd 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 4th 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 5th layer-Residual Distribution Then, to the Partners in accordance with their respective Percentage Interests.
124 Sample Loss Allocation-1st 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: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);
125 2nd 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 3rd Layer-Residual Losses Then, to the Partners in accordance with their respective Percentage Interests.
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 Common Allocation Provisions Regulatory allocationsMinimum gain chargebacksSpecial problem for debt workoutsAllocating non-recourse deductionsStop loss provisionsAdjusted capital account conceptIncreased for minimum gain sharesIncreased for allocations of recourse debt deductionsAvoid impermissible negative capital accounts
129 Other Possible Concerns? Admission of a New PartnerSection 754 Elections
130 Admission of New Partner: Achieving Retroactive Allocations Legitimately! Section 706(d) limits the ability to perform retroactive allocations for a new partnerHowever, if you disproportionately allocate losses after admission of a new partner, you may be able to legitimately achieve the same result
131 Section 754 Elections Special Adjustments: Section 743-Sale of PS InterestSection 734-Partnership Redemption
132 Intangible Property and Partnerships Rule: Amortizable Section 197 Intangibles-15 year straight line amortizationException: Anti-churning RulesPurchase of Partnership InterestSection 754/743 Election-Creates new amortizable asset for step up even if the intangible was non-amortizable before
133 Intangible Property (cont’d) § 704(c) Intangible Predicament: if a partner contributes a non-amortizable section 197 intangible to the PartnershipCurative allocations are not available for the other partnersHowever, 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 Securities Partnerships Such partnerships may have frequent capital account restatements (“book-ups”)Sheer number of assets makes compliance with Regulations extremely difficult
135 Securities Partnerships (cont’d) Solution—Qualified PartnershipsMay consistently aggregate gains and losses from securities and similar investments when making reverse § 704(c) allocationsOnly applies to allocations on/after Dec 31, 1993.May use any reasonable approach to aggregation that is consistent with § 704(c), but must continue to use the same approach.
136 Securities Partnerships (cont’d) Requirements of Securities PartnershipsMust be either a management company registered with the SEC under the Investment Company Act of 1940, or an investment partnershipOn 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 traded
137 Securities Partnerships (cont’d) Permissible Aggregation MethodsStep 1: establish “revaluation account” for each partner to track book allocations not matched with tax allocationsStep 2: select aggregation methodPartial 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 rataFull Netting: nets all tax gains and losses together, and then allocates net amounts according to the same rule as above
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.