Transcript Slide 1

American Bar Association
BASIC PARTNERSHIPS TAX PRINCIPLES
July 22, 23, 2008
Michael Hirschfeld
Dechert LLP
New York, New York
(212) 698-3635
[email protected]
1
Are you a PS?
 LLC

PS for tax
 Check
the box
rules:

Single member
v Multi Member
• Use: Non-US
Entity
2
Form 8832
 Entity



Classification Election
No need for protective election
75 days to file
List of per se companies in Instructions
•
•
•
•
•
UK-Public Limited Company
Netherlands-NV
Germany-AK
France-SA
Canada-Corporation and Company
3
PS Interest for Cash
 Tax
free to
contributing
partner

What about
Promissory
Note?
• Not the same as
cash
• No basis until pay
it
4
Mix of Equity & Debt
 May
want to transfer cash for debt as well
as equity?

Why?
• Protect against creditors if things go bad

 Tax


But-will it work?
• Equitable subordination is a risk
Issues:
Is it good debt for tax purposes?
At risk rules-Will it count?
5
PS Interest for Property
 General
Rule:
Tax free to
contributing
partner
6
Exception: Investment Partnership

Property transfer taxable if:



Investment PS &
Diversification
Investment PS

More than 80% of value of assets are held for
investment
• Dollars, stock, debt, options, REIT, RIC, PTP

Key: Keep at least 20% in non-investment company
assets
7
Investment Partnership (cont)
 Diversification

If 2 or more partners transfer non-identical
assets to PS
 BUT


no diversification if:
Only 1 partner transfers assets or
Each partner transfers:
• Same portfolio or
• Diversified Portfolio


Not more than 25% in one asset &
Not more than 50% in 5 or fewer assets
8
Property Contribution
 No
investment PS & no cash then
non-taxable with tax attributes being:
 Carryover tax basis for PS interest
 Tacked holding period for property
contributions
9
But if get back cash then:
 Disguised
sale rules will make this in
part a taxable sale
 Part sale-Part tax free transfer
 Allocate basis between two events
10
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.”
Two year presumption but can rebut by showing
subject to entrepreneurial risk of business
11
Exceptions to Disguised Sale Rules
 Guaranteed
payments for capital &
preferred returns

Safe harbor: Very ltd-150% of AFR
 Operating
cash flow distributions
 Reimbursement of preformation
expenditures
12
Liabilities & Disguised Sale Rules
 Non-recourse

Usually, allocate liability to contributing partner
under §704(c)—reduces game playing
 Recourse


liabilities:
liabilities:
Could shift, which is treated as cash
distribution
Is that cash distribution caught by disguised
sale rules?
• Yes unless qualified liability
13
Exceptions to Disguised Sale Rules
 Qualified



Liability:
Incurred more than 2 years before
contribution
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
cannot exceed FMV of assets
14
Taxable Sale-Cap Gain?
 Code


Section 1239
Sale of depreciable property between PS and
controlling partner generates ordinary income
Controlling partner
• More than 50% ownership
15
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
A contributes $100 cash
B contributes land with FMV = $100, but tax
basis of zero
The next day, PS sells land for $100
How does PS allocate the $100 gain?
16
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
• Code Section 704(c) requires that
you allocate built in gain to B, the
contributing partner
• Why?
17
Capital Account Analysis if Use AB
of Assets





A
Increased by $100 due to
cash contribution
If allocate A 50% of gain
then increased to $150
If liquidate, A gets $150 if
follow capital accountsomething 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!
18
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
Can allocate excess gain of $50 to A and B
 KEY


ISSUE:
What is FMV of land on date of contribution?
MUST SPELL OUT IN YOUR AGREEMENT!
19
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
partner
Decreased by taxable loss/deductions allocated to a
partner
SO, LET’s APPLY THIS HERE
20
Contribution of Depreciable
Property-allocations:
 How
do you
handle
Allocations
Relating to a
Contribution of
Property
21
General Principle
 Tax
must follow book
§
704(c) addresses situations when a
disparity exists between a partnership’s
tax accounts and its book accounts.
22
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”

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
23
Section 704(c) Example

AB Partnership
 A contributes $390,000
 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
 But there is only $1,000 of depreciation to
split
 What happens?
24
Section 704(c) ExampleOutcome

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.
25
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”
26
The Game

The Players:



A & B each put in cash of $1,000
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
A and B-say tax free to us
C says great news—I just cashed out & fooled the tax
system BUT
27
Tax Traps if have Contributed
Property
 Distribution
of
contributed
property to other
partner
 Distribution of
other property to
contributing
partner
28
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
§737: Contributing partner redeemed
out for other property
29
Purchase of PS Interest & Impact
on Property AB
 If
you buy into a
PS with
property, are
you stuck with
tax basis of
assets?
30
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
 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
 Q.
How can we help
31
The Fix-Optional AB Adjustment
Elect
basis
adjustment
under Sections
754 and 743
 Gives “basis
boost” for C’s
benefit
32
Example Impact
 ABC

Partnership
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
• More depreciation/amortization &
• Less gain or greater loss on sale
33
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
 Section 734-If “substantial basis reduction,” then
PS must reduce basis
 $250,000 threshold
 Electing investment PS (“EIP”) exception
 If EIP election, then transferee partner’s share
of losses from PS is reduced

34
PS Interest for Services
 Can
you get
this tax free?
35
Carried Interests

Planning
Possibility:
Can get
PS/LLC
interest to a
person w/o
triggering tax!
36
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
• Need for Capital Contribution
• Code Section 83 Impact


Possible deduction to PS/LLC
Proposed tax legislation:
• PTP Issue
• Non-PTP Ordinary Income Exposure
37
Key: Profits Interest-Good; Capital
Interest-Bad
 Difference:
 If
you liquidate the PS, would you get
something back?


If yes, capital interest
If no, profits interest
 BUT,
should this liquidation analysis be the
proper test?
38
Carried Interest IRS Guidance

Background: Diamond v. Comm., 56 TC 530, aff’d, 492
F.2d 286 (7th Cir. 1974)

Rev. Proc. 93-27

Key factor: Profits v Capital Interest

Rev. Proc. 2001-43
 Notice 2005-43-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
39
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 2005 43 (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.”
40
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.
41
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.
42
Cookbook for PS Agreements-Tax Allocations
1) General Allocation
Rules--§ 704(b)
2) Allocation of Nonrecourse Deductions—
Treas. Reg. § 1.704-2
3) Allocation for
Contributed Property--§
704(c)
4) Reverse § 704(c)
Allocations
43
General Allocation Rules
General Principle
Tax must follow
economics
44
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”).
45
Two “Simple” Rules (cont’d)
 But
what is “substantial economic effect”?
 There
are dozens of pages of regulations
to explain this
46
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.
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”.
47
Economic Effect
 Test
#1—Safe Harbor
 Three



Prong Test
Agreement provides for maintenance of capital
accounts in accordance with Treas. Reg.
§ 1.704-1(b)(2)(iv);
Agreement provides for liquidation of
partnership interests in accordance with
positive capital accounts; and
Partners have a capital account “deficit
restoration obligation” upon liquidation.
48
Economic Effect (cont’d)
 Capital Account
Maintenance
 Two requirements must be satisfied


All items of income, loss, deduction, taxexempt 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.
49
Relevance of capital accounts



On the K-1
Non-liquidating distributions typically not tied
to capital accounts
Liquidating distributions
•
•
•
•
Based 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
50
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.”
51
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
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?
52
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.
53
Economic Effect (cont’d)
 Test
#2—Alternative Test
 Three



Prong Test
Agreement provides for maintenance of capital
accounts in accordance with Treas. Reg.
§ 1.704-1(b)(2)(iv);
Agreement provides for liquidation of
partnership interests in accordance with
positive capital accounts; and
Drop the DRO and in its place, do the following:
54
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
the partnership contains a “qualified income
offset.”
55
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.
56
Where do these rules make a BIG
difference?
 Distributions
that
are not straight up
(that is, they do not
remain the same)
57
Common Case: GP Carry
 Distributions:
100% to LPs
until they get
their capital back
& then,
 80% to LPs and
20% to GP
58
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
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
59
Special Case: Loss Allocation
 Can
you
specially allocate
a loss to one
member?
 Yes if ----
60
Loss Allocation Example

AB are equal partners
 Each contributes $1M
 PS borrows $8M non recourse debt
 1st year-Tax Loss =$1M


Q: Can you specially allocate that $1M loss to A?
A: Yes if take precautions.
• Explanation----
61





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
62
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
63
Hitting the Bullseye
 Other
Tax
Allocation Trivia
 Why needed?



Match the regs
Keep the IRS Agent
happy
Preserve your
allocations
64
“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.
-
65
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
1.704-1(b)(2)(ii)(d).
66
Qualified Income Offset
(cont’d)

Applies specifically to distributions described in
Treas. Reg. § 1.704-1(b)(2)(ii)(d)(4), (5) and (6)



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 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
67
“Substantiality”
 The
partnership must demonstrate that an
allocation has some economic effect
besides tax savings
 Two Tests


Before-Tax Test
After-Tax Test
68
Substantiality (cont’d)
 Specific Allocations
that Lack
Substantiality

Shifting Tax Consequences

Transitory Allocations
69
Added Concern:
How
do you
handle
allocation of
Non-recourse
Deductions?
70
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.
 Exceptions



Conversions and Refinancing
Contributions of Capital
Revaluations-Special Twist
71
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
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
72
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
 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)

73
Safe Harbor (cont’d)


The agreement must contain a minimum gain
chargeback provision
All other material allocations and capital
account adjustments must be respected
74
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 1.704-2(f) and 1.704-2(i)(4).”
75
Member Non-recourse Liability
 Non-recourse
debt from partner or related
person
 Specially allocates debt to that partner
 Specially allocate deductions to that
partner
76
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 1.704-2(c), 1.7042(i)(2) and 1.704-2(j)(1).”
77
Other Things
 Withholding
 Tax
Matters
Partner
 Tax Elections
 Fiscal Year
78
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.
79
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.
80
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.
81
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.”
82
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.
83
Now, let’s look at:

Examples from
the Field
84
Drafting Partnership Agreements
 Most


Important item: 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 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.
85
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
86
What do you mean by Percentage
Interests?

Does this mean Capital Percentages?

Initially based on ACTUAL contributions to the
partnership
• My contribution / Total contributions = My capital percentage
• Staggered capital contributions impact

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 else
• Many agreements use multiple terms, sometimes
interchangeably and sometimes inconsistently
87
What happens upon call for
additional capital – squeeze down?

GP calls for additional capital (or loans)
• Pro rata vs. non-pro rata
• Some partners contribute their shares; others
don’t.
• Non-contributing partners are penalized by a
reduction in their partnership interests.


Capital interests, profits interests, or both
Is this a revaluation event?
88
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?
89
Economic Deal


Problems arise when the business folks and the tax folks
are not involved from the beginning
Why:

Different approaches
• 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
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
90
Economic Deal
 Partnership Attributes

Income and loss flow though currently
• Affect return on investment
 Income

Items allocated
 Cash

and loss
and property
Items contributed and distributed
 Allocations
might not match contributions
and/or distributions
91
Economic Deal
What to do?
 Model/Projections
 Have
the business folks and tax folks talk
 Model/Projections Again
92
Figure out Distributions
 Cash
flow from operations
 Cash flow from sales
 Liquidating Distributions
 Tax Distributions-Can override the rest

Particular concern to GP-Managing MemberHolder of Carry who may get “phantom
income” if cash flow that generates taxable
income is used to repay capital contributions
93
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 & taxable income do not
match each other
94
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!
& Allocations follow distributions----95
In Year One
 Buy
asset with $1,000
 Generate $100 of taxable income & $100
of cash flow

Ignore depreciation to make life simpler
 Pay
off in part investor’s capital with $100
 How do you allocate the $100 of taxable
income?
96
Allocation in Year 1
What has happened to each of A and B?
Capital Accounts
Year 1
A
B
Opening Capital Account
10
990
Allocation of $1000 Income
-
+100
Distributions
-
-100
10
990
Ending Capital Account
97
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?
98
Allocation in Year 2
What has happened to each of A and B?
Capital Accounts
Year 1
A
B
Opening Capital Account
10
990
-
-
Distributions-return of capital
-10
-890
Distributions-excess proceeds
-20
-80
Ending Capital Account
-20
+20
No Income to Allocate
99
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
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.
100
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.
101
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:
102
Revised Allocation in Year 1
What has happened to each of A and B?
Capital Accounts
Year 1
A
B
Opening Capital Account
10
990
Allocation of $100 Income
+20
+80
-
-100
30
970
Distributions
Ending Capital Account
103
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?
104
Revised Allocation in Year 2
What has happened to each of A and B?
Capital Accounts
Year 1
A
B
Opening Capital Account
30
970
-
-
Distributions-return of capital
-10
-890
Distributions-excess proceeds
-20
-80
Zero!
Zero!
No Income to Allocate
Ending Capital Account
105
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
106
Tax Distributions
 Will
investor agree?
 If agree:

What rate do you use?
• Consider coming up with # & then adjust if law
changes


Estimated taxes may require multiple
payments
Impact of prior year losses
107
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.
108
Allocation Methods to Adopt
 Targeting

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
approach
LONG--Building up or taking down the capital
accounts to reflect the waterfall rights
 Others-Combination
(boot-strap)
109
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!

110
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 determining how cash flow goes out on liquidation,
you rely on the business deal
• Do not say follow capital accounts or else this is circular
111
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.”
112
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]”
113
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 ….”
114
Target Allocation Criticism/Praise
 Con:


What do these tax advisors want me to do?
I need a cookbook
 Pro:

“I want guidance”
“I want flexibility to get it right”
I can avoid all those awful steps and do the
“right thing”
115
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.
116
Layered Allocations


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
• 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?
117
Layered Allocations-Key Points
 Key




Questions
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 incorporate all Preferences?
Let’s see some examples:
118
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);
119
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;
120
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;
121
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;
122
5th layer-Residual Distribution

Then, to the Partners in accordance with
their respective Percentage Interests.
123
Sample Loss Allocation-1st LayerProfit 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);
124
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
125
3rd Layer-Residual Losses

Then, to the Partners in accordance with
their respective Percentage Interests.
126
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 § 1.704-1(b)(2)(ii)(d).
127
Common Allocation Provisions

Regulatory allocations

Minimum gain chargebacks
• Special problem for debt workouts


Allocating non-recourse deductions
Stop loss provisions

Adjusted capital account concept
• Increased for minimum gain shares
• Increased for allocations of recourse debt deductions

Avoid impermissible negative capital accounts
128
Other Possible Concerns?

Admission of a New
Partner
 Section 754 Elections
129
Admission of New Partner:
Achieving Retroactive Allocations
Legitimately!


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
130
Section 754 Elections
 Special Adjustments:


Section 743-Sale of PS Interest
Section 734-Partnership Redemption
131
Intangible Property and Partnerships
 Rule: Amortizable
Section 197 Intangibles15 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
132
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
However, they can use remedial allocations. Treas.
Reg. § 1.197-2(g)(4)(i)
Nonetheless, a partner related to the
contributing partner may not receive remedial
allocations of deductible amortization
133
Securities Partnerships
 Such
partnerships may have frequent
capital account restatements (“book-ups”)
 Sheer
number of assets makes
compliance with Regulations extremely
difficult
134
Securities Partnerships (cont’d)
 Solution—Qualified

Partnerships
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.

May use any reasonable approach to
aggregation that is consistent with § 704(c),
but must continue to use the same approach.
135
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
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 traded
136
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 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 rata
• Full Netting: nets all tax gains and losses together, and then
allocates net amounts according to the same rule as above
137
138
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.
 **********************
139