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]

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American Bar AssociationAmerican Bar Association

BASIC PARTNERSHIPS TAX PRINCIPLESBASIC PARTNERSHIPS TAX PRINCIPLES

July 22, 23, 2008July 22, 23, 2008

Michael HirschfeldDechert LLPNew York, New York(212) [email protected]

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Are you a PS?Are you a PS?LLCLLC

PS for taxPS for taxCheck the box Check the box

rules:rules: Single member v Single member v

Multi MemberMulti Member• Use: Non-US Use: Non-US

EntityEntity

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Form 8832Form 8832

Entity Classification ElectionEntity Classification Election No need for protective electionNo need for protective election 75 days to file75 days to file List of List of per seper se companies in Instructions companies in Instructions

• UK-Public Limited CompanyUK-Public Limited Company• Netherlands-NVNetherlands-NV• Germany-AKGermany-AK• France-SAFrance-SA• Canada-Corporation and CompanyCanada-Corporation and Company

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PS Interest for CashPS Interest for CashTax free to Tax free to

contributing contributing partnerpartner What about What about

Promissory Note?Promissory Note?• Not the same as cashNot the same as cash• No basis until pay itNo basis until pay it

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Mix of Equity & DebtMix of Equity & Debt

May want to transfer cash for debt as well May want to transfer cash for debt as well as equity?as equity? Why?Why?

• Protect against creditors if things go badProtect against creditors if things go bad But-will it work?But-will it work?

• Equitable subordination is a riskEquitable subordination is a risk

Tax Issues:Tax Issues: Is it good debt for tax purposes?Is it good debt for tax purposes? At risk rules-Will it count?At risk rules-Will it count?

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PS Interest for PropertyPS Interest for PropertyGeneral Rule: General Rule:

Tax free to Tax free to contributing contributing partnerpartner

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Exception: Investment PartnershipException: Investment Partnership

Property transfer taxable if:Property transfer taxable if: Investment PS &Investment PS & DiversificationDiversification

Investment PSInvestment PS More than 80% of value of assets are held for More than 80% of value of assets are held for

investmentinvestment• Dollars, stock, debt, options, REIT, RIC, PTPDollars, stock, debt, options, REIT, RIC, PTP

Key: Keep at least 20% in non-investment company Key: Keep at least 20% in non-investment company assetsassets

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Investment Partnership (cont)Investment Partnership (cont)

DiversificationDiversification If 2 or more partners transfer non-identical If 2 or more partners transfer non-identical

assets to PSassets to PS BUT no diversification if:BUT no diversification if:

Only 1 partner transfers assets Only 1 partner transfers assets oror Each partner transfers:Each partner transfers:

• Same portfolio orSame portfolio or• Diversified PortfolioDiversified Portfolio

Not more than 25% in one asset &Not more than 25% in one asset & Not more than 50% in 5 or fewer assetsNot more than 50% in 5 or fewer assets

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Property ContributionProperty Contribution

No investment PS & no cash No investment PS & no cash thenthen non-taxable with tax attributes being:non-taxable with tax attributes being: Carryover tax basis for PS interest Carryover tax basis for PS interest Tacked holding period for property Tacked holding period for property

contributionscontributions

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ButBut if get back cash then: if get back cash then:

Disguised sale rules will make this in Disguised sale rules will make this in part a taxable salepart a taxable sale Part sale-Part tax free transferPart sale-Part tax free transfer Allocate basis between two eventsAllocate basis between two events

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Disguised Sale RulesDisguised Sale Rules

The gameThe game: Get cash back later in time after : Get cash back later in time after property contribution is madeproperty contribution is made

WhyWhy? Cash distributions from a PS are not ? Cash distributions from a PS are not generally taxable until they exhaust your tax generally taxable until they exhaust your tax basis basis BUTBUT Later distribution of cash may be combined with Later distribution of cash may be combined with

earlier contribution of property to have a “disguised earlier contribution of property to have a “disguised sale.” sale.”

Two year presumption but can rebut by showing Two year presumption but can rebut by showing subject to entrepreneurial risk of businesssubject to entrepreneurial risk of business

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Exceptions to Disguised Sale RulesExceptions to Disguised Sale Rules

Guaranteed payments for capital & Guaranteed payments for capital & preferred returnspreferred returns Safe harbor: Very ltd-150% of AFRSafe harbor: Very ltd-150% of AFR

Operating cash flow distributionsOperating cash flow distributions Reimbursement of preformation Reimbursement of preformation

expendituresexpenditures

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Liabilities & Disguised Sale RulesLiabilities & Disguised Sale Rules

Non-recourse liabilities:Non-recourse liabilities: Usually, allocate liability to contributing Usually, allocate liability to contributing

partner under partner under §704(c)—reduces game playing§704(c)—reduces game playing Recourse liabilities:Recourse liabilities:

Could shift, which is treated as cash Could shift, which is treated as cash distributiondistribution

Is that cash distribution caught by disguised Is that cash distribution caught by disguised sale rules?sale rules?• Yes Yes unlessunless qualified liability qualified liability

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Exceptions to Disguised Sale RulesExceptions to Disguised Sale Rules

Qualified Liability:Qualified Liability: Incurred more than 2 years before Incurred more than 2 years before

contributioncontribution Allocable to capital expendituresAllocable to capital expenditures Liability incurred in ordinary course of Liability incurred in ordinary course of

business business butbut only if all the assets held in that only if all the assets held in that trade or business are transferred to PStrade or business are transferred to PS

Liability cannot exceed FMV of assetsLiability cannot exceed FMV of assets

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Taxable Sale-Cap Gain?Taxable Sale-Cap Gain?

Code Section 1239Code Section 1239 Sale of depreciable property between PS and Sale of depreciable property between PS and

controlling partner generates ordinary incomecontrolling partner generates ordinary income Controlling partnerControlling partner

• More than 50% ownership More than 50% ownership

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So, tax free contribution—are there So, tax free contribution—are there any tax concerns?any tax concerns?

Yes if AB is not equal to FMV of propertyYes if AB is not equal to FMV of property Why?Why?

Consider 2 partners, A & BConsider 2 partners, A & B A contributes $100 cashA contributes $100 cash B contributes land with FMV = $100, but tax B contributes land with FMV = $100, but tax

basis of zerobasis of zero The next day, PS sells land for $100The next day, PS sells land for $100 How does PS allocate the $100 gain?How does PS allocate the $100 gain?

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Allocating Gain from Sale of Allocating Gain from Sale of Contributed PropertyContributed Property

Could PS allocate $100 gain to both Could PS allocate $100 gain to both partners in the same way that regular PS partners in the same way that regular PS income is allocated (thaf is, 50-50)?income is allocated (thaf is, 50-50)? NONO

• Code Section 704(c) requires that Code Section 704(c) requires that you allocate built inyou allocate built in gain to B, the gain to B, the contributing partnercontributing partner

• Why?Why?

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Capital Account Analysis if Use AB Capital Account Analysis if Use AB of Assetsof Assets

AA Increased by $100 due to Increased by $100 due to

cash contributioncash contribution If allocate A 50% of gain If allocate A 50% of gain

then increased to $150then increased to $150

If liquidate, A gets $150 if If liquidate, A gets $150 if follow capital account-follow capital account-something is wrong since something is wrong since A thinks he should get A thinks he should get only $100only $100

BB Increased by zero upon Increased by zero upon

property contribution since property contribution since AB of property was zeroAB of property was zero

If allocate B 50% of gain If allocate B 50% of gain then increased to $50then increased to $50

If liquidate, B gets $50 if If liquidate, B gets $50 if follow capital account—follow capital account—something is wrong since something is wrong since B thinks she should get B thinks she should get $100!$100!

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Variation on a SaleVariation on a Sale

Sell land that had AB = 0 & was worth Sell land that had AB = 0 & was worth $100 on date of contribution for $150 then$100 on date of contribution for $150 then Allocate $100 gain to B BUTAllocate $100 gain to B BUT Can allocate excess gain of $50 to A and BCan allocate excess gain of $50 to A and B

KEY ISSUE:KEY ISSUE: What is FMV of land on date of contribution?What is FMV of land on date of contribution? MUST SPELL OUT IN YOUR AGREEMENT!MUST SPELL OUT IN YOUR AGREEMENT!

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Allocation of Gain & Capital Allocation of Gain & Capital AccountsAccounts

Capital accounts used for tax allocation Capital accounts used for tax allocation purposes:purposes: Increased by AB or FMV of property contribution?Increased by AB or FMV of property contribution? Decreased by AB or FMV of property distribution?Decreased by AB or FMV of property distribution? Increased by taxable income/gain allocable to a Increased by taxable income/gain allocable to a

partnerpartner Decreased by taxable loss/deductions allocated to a Decreased by taxable loss/deductions allocated to a

partnerpartner SO, LET’s APPLY THIS HERESO, LET’s APPLY THIS HERE

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Contribution of Depreciable Contribution of Depreciable Property-allocations:Property-allocations:

How do you How do you handle handle Allocations Allocations Relating to a Relating to a Contribution of Contribution of PropertyProperty

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General PrincipleGeneral Principle

Tax must follow bookTax must follow book

§ 704(c) addresses situations when a § 704(c) addresses situations when a disparity exists between a partnership’s disparity exists between a partnership’s tax accounts and its book accounts.tax accounts and its book accounts.

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Methods for Methods for § 704(c) Allocations§ 704(c) Allocations

Traditional MethodTraditional Method: each partner is treated as if : each partner is treated as if it purchase a pro rata interest in the propertyit purchase a pro rata interest in the property Beware the “Ceiling Rule”Beware the “Ceiling Rule”

Traditional Method with CurativesTraditional Method with Curatives: allows for : allows for “reasonable curative allocations” to prevent “reasonable curative allocations” to prevent distortions resulting from the distortions resulting from the “ceiling rule”“ceiling rule”

Remedial MethodRemedial Method: permits partners to ignore the : permits partners to ignore the ceiling rule and ceiling rule and createcreate tax allocations to match tax allocations to match and offset their book allocationsand offset their book allocations

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Section 704(c) ExampleSection 704(c) Example AB PartnershipAB Partnership

A contributes $390,000A contributes $390,000 B contributes depreciable property worth B contributes depreciable property worth

$390,000, but with a $39,000 tax basis$390,000, but with a $39,000 tax basis Property depreciated over 39 years so:Property depreciated over 39 years so:

A hopes there is $10,000/ year of depreciation A hopes there is $10,000/ year of depreciation to split & she will get $5,000to split & she will get $5,000

But there is only $1,000 of depreciation to splitBut there is only $1,000 of depreciation to split What happens?What happens?

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Section 704(c) Example-Section 704(c) Example-OutcomeOutcome

Traditional methodTraditional method: specially allocate $1,000 : specially allocate $1,000 to A so A is short changed—she thought she to A so A is short changed—she thought she would get $5,000would get $5,000

Traditional Method With Curative AllocationsTraditional Method With Curative Allocations: : can specially allocate other depreciation to A can specially allocate other depreciation to A so as to get A $5,000 BUT if no other so as to get A $5,000 BUT if no other depreciation, you are stuckdepreciation, you are stuck

Remedial methodRemedial method: A gets $5,000.: A gets $5,000.

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Diversion of sorts: Basic PS Tax Rule:Diversion of sorts: Basic PS Tax Rule:

Property Property distributions distributions to a partner to a partner do not do not normally normally trigger tax!trigger tax!

Could you take Could you take advantage of this rule advantage of this rule to “play games” to “play games”

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The GameThe Game

The Players:The Players: A & B each put in cash of $1,000A & B each put in cash of $1,000 C puts in property worth $2,000C puts in property worth $2,000

The Game:The Game: 3 years later, A and B are redeemed out of PS by 3 years later, A and B are redeemed out of PS by

giving them each a ½ interest in the propertygiving them each a ½ interest in the property A and B-say tax free to usA and B-say tax free to us C says great news—I just cashed out & fooled the tax C says great news—I just cashed out & fooled the tax

system system BUTBUT

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Tax Traps if have Contributed Tax Traps if have Contributed PropertyProperty

Distribution of Distribution of contributed contributed property to other property to other partnerpartner

Distribution of Distribution of other property to other property to contributing contributing partnerpartner

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Anti ”Mixing Bowl” RulesAnti ”Mixing Bowl” Rules

If property leaves PS within 7 years, If property leaves PS within 7 years, then that may trigger tax to then that may trigger tax to contributing partnercontributing partner

Watch out for these rulesWatch out for these rules §§704(c)(1)(B): Contributed property 704(c)(1)(B): Contributed property

goes out to another partnergoes out to another partner §§737: Contributing partner redeemed 737: Contributing partner redeemed

out for other propertyout for other property

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Purchase of PS Interest & Impact Purchase of PS Interest & Impact on Property ABon Property AB

If you buy into a If you buy into a PS with PS with property, are property, are you stuck with you stuck with tax basis of tax basis of assets? assets?

3131

Section 754 Election-ExampleSection 754 Election-Example:: ABC PS acquired Property for $9MABC PS acquired Property for $9M Tax basis of property is now $6MTax basis of property is now $6M X buys C’s interest for $6MX buys C’s interest for $6M

Thus, current value of PS is $18MThus, current value of PS is $18M But, C’s share of tax basis of PS property But, C’s share of tax basis of PS property

is only $2M and not $6Mis only $2M and not $6M Absent help, X is stuck with that $2M basisAbsent help, X is stuck with that $2M basis

Q. How can we helpQ. How can we help

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The Fix-Optional AB AdjustmentThe Fix-Optional AB Adjustment

Elect basis Elect basis adjustment adjustment under Sections under Sections 754 and 743754 and 743

Gives “basis Gives “basis boost” for C’s boost” for C’s benefitbenefit

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Example ImpactExample Impact

ABC PartnershipABC Partnership Tax basis = $6M allocable $2M to A, $2M to B Tax basis = $6M allocable $2M to A, $2M to B

and $2M to Xm purchaser of C’s interestand $2M to Xm purchaser of C’s interest BUT NowBUT Now Special tax basis adjustment for only XSpecial tax basis adjustment for only X

X’s tax basis = $6MX’s tax basis = $6M• More depreciation/amortization &More depreciation/amortization &• Less gain or greater loss on saleLess gain or greater loss on sale

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BUT Mandatory Downward Basis BUT Mandatory Downward Basis Adjustments-now required under Adjustments-now required under

Section 754Section 754 Section 743-If “substantial built in loss,” then PS Section 743-If “substantial built in loss,” then PS

must reduce basismust reduce basis $250,000 threshold$250,000 threshold

Section 734-If “substantial basis reduction,” then Section 734-If “substantial basis reduction,” then PS must reduce basisPS must reduce basis $250,000 threshold$250,000 threshold Electing investment PS (“EIP”) exception Electing investment PS (“EIP”) exception If EIP election, then transferee partner’s share If EIP election, then transferee partner’s share

of losses from PS is reducedof losses from PS is reduced

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PS Interest for ServicesPS Interest for Services

Can you get Can you get this tax free?this tax free?

3636

Carried InterestsCarried Interests

Planning Planning PossibilityPossibility: : Can get Can get PS/LLC PS/LLC interest to a interest to a person w/o person w/o triggering tax!triggering tax!

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Carried InterestCarried Interest

The grant of an interest to a service The grant of an interest to a service provider raises a host of issue:provider raises a host of issue: Taxability of holder on date of grant or date Taxability of holder on date of grant or date

when vesting restrictions lapsewhen vesting restrictions lapse• Need for Capital ContributionNeed for Capital Contribution• Code Section 83 ImpactCode Section 83 Impact

Possible deduction to PS/LLCPossible deduction to PS/LLC Proposed tax legislation:Proposed tax legislation:

• PTP IssuePTP Issue• Non-PTP Ordinary Income ExposureNon-PTP Ordinary Income Exposure

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Key: Profits Interest-Good; Capital Key: Profits Interest-Good; Capital Interest-BadInterest-Bad

Difference:Difference: If you liquidate the PS, would you get If you liquidate the PS, would you get

something back?something back? If yes, capital interestIf yes, capital interest If no, profits interestIf no, profits interest

BUT, should this liquidation analysis be BUT, should this liquidation analysis be the proper test?the proper test?

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Carried Interest Carried Interest IRS GuidanceIRS Guidance

Background: Background: Diamond v. Comm., 56 TC 530, aff’d, Diamond v. Comm., 56 TC 530, aff’d, 492 F.2d 286 (7492 F.2d 286 (7thth Cir. 1974) Cir. 1974)

Rev. Proc. 93-27Rev. Proc. 93-27 Key factor: Profits v Capital InterestKey factor: Profits v Capital Interest

Rev. Proc. 2001-43Rev. Proc. 2001-43 Notice 2005-43-Proposed Safe HarborNotice 2005-43-Proposed Safe Harbor

Caveat: substantially certain & predictable stream of Caveat: substantially certain & predictable stream of income from partnership assets, such as income from income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, high-quality debt securities or a high-quality net lease, (b) transferred in anticipation of a subsequent (b) transferred in anticipation of a subsequent disposition, or (c) an interest in PTPdisposition, or (c) an interest in PTP

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Sample LLC InsertSample LLC Insert

““By executing this Agreement, each Unitholder By executing this Agreement, each Unitholder authorizes and directs the Company to elect to authorizes and directs the Company to elect to have the ‘Safe Harbor’ described in the have the ‘Safe Harbor’ described in the proposed Revenue Procedure set forth in proposed Revenue Procedure set forth in Internal Revenue Service Notice 2005 43 (the Internal Revenue Service Notice 2005 43 (the ‘‘Notice’Notice’) apply to any interest in the Company ) apply to any interest in the Company transferred to a service provider by the transferred to a service provider by the Company on or after the effective date of such Company on or after the effective date of such Revenue Procedure in connection with Revenue Procedure in connection with services provided to the Company.” services provided to the Company.”

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Sample LLC Insert (cont)Sample LLC Insert (cont)

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

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Sample LLC Insert (cont)Sample LLC Insert (cont)

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

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1)General Allocation Rules--§ 704(b)

2)Allocation of Non-recourse Deductions—Treas. Reg. § 1.704-2

3)Allocation for Contributed Property--§ 704(c)

4)Reverse § 704(c) Allocations

Cookbook for PS Agreements-Tax Allocations

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General Allocation RulesGeneral Allocation Rules

General PrincipleGeneral Principle

Tax must follow Tax must follow economicseconomics

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Two “Simple” RulesTwo “Simple” Rules

Allocations must have “substantial Allocations must have “substantial economic effect” (“SEE”)economic effect” (“SEE”)

If an allocation fails this test, then amounts If an allocation fails this test, then amounts are reallocated among partners in are reallocated among partners in accordance with the partners’ interests in accordance with the partners’ interests in the partnership (“PIP”).the partnership (“PIP”).

4646

Two “Simple” Rules (cont’d)Two “Simple” Rules (cont’d)

But what is “substantial economic effect”?But what is “substantial economic effect”?

There are dozens of pages of regulations There are dozens of pages of regulations to explain thisto explain this

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SEE vs. PIPSEE vs. PIP

Why might it be preferable to rely on SEE Why might it be preferable to rely on SEE rather than PIP in setting partner rather than PIP in setting partner allocations?allocations? More certainty in dealing with the IRS. More certainty in dealing with the IRS. For pension plan investors in debt financed For pension plan investors in debt financed

real estate partnership desirous of avoiding real estate partnership desirous of avoiding UBIT, the partnership agreement must meet UBIT, the partnership agreement must meet “fractions rule” and allocations must have “fractions rule” and allocations must have “substantial economic effect”. “substantial economic effect”.

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Economic EffectEconomic Effect Test #1—Safe HarborTest #1—Safe Harbor

Three Prong TestThree Prong Test Agreement provides for maintenance of capital Agreement provides for maintenance of capital

accounts in accordance with Treas. Reg. accounts in accordance with Treas. Reg. § 1.704-1(b)(2)(iv);§ 1.704-1(b)(2)(iv);

Agreement provides for liquidation of Agreement provides for liquidation of partnership interests in accordance with partnership interests in accordance with positive capital accounts; andpositive capital accounts; and

Partners have a Partners have a capital account “deficit capital account “deficit restoration obligation”restoration obligation” upon liquidation. upon liquidation.

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Economic Effect (cont’d)Economic Effect (cont’d)

Capital Account MaintenanceCapital Account Maintenance Two requirements must be satisfiedTwo requirements must be satisfied

All items of income, loss, deduction, tax-All items of income, loss, deduction, tax-exempt income and non-deductible exempt income and non-deductible expenditures as well as capital contributions expenditures as well as capital contributions and distributions are reflected in determining and distributions are reflected in determining capital accounts; andcapital accounts; and

Capital contributions and distributions of Capital contributions and distributions of property are taken into account in computing property are taken into account in computing their capital account at fair market value.their capital account at fair market value.

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Relevance of capital accountsRelevance of capital accounts On the K-1On the K-1 Non-liquidating distributions typically Non-liquidating distributions typically notnot tied tied

to capital accountsto capital accounts Liquidating distributionsLiquidating distributions

• Based on capital accounts?Based on capital accounts?• Specified waterfall?Specified waterfall?• Both (belt and suspenders)Both (belt and suspenders)• If not based on capital accounts, care must be If not based on capital accounts, care must be

taken, but it is still possible to survive, as taken, but it is still possible to survive, as discussed later vis a vis Target Allocationsdiscussed later vis a vis Target Allocations

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Deficit Restoration Obligation (“DRO”)Deficit Restoration Obligation (“DRO”) If the partnership were to liquidate and a If the partnership were to liquidate and a

partner had a capital account deficit as a partner had a capital account deficit as a result of previous allocations, that partner result of previous allocations, that partner would be required to restore the deficit in her would be required to restore the deficit in her capital account, generally through the capital account, generally through the contribution of cash during the liquidation. contribution of cash during the liquidation.

As Tony Soprano would say, “forget about it.” As Tony Soprano would say, “forget about it.”

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Why would someone ever agree to a Why would someone ever agree to a deficit makeup?deficit makeup? Consider: Partner A wakes up on April 14, Consider: Partner A wakes up on April 14,

2008, to the fact that he has received cash 2008, to the fact that he has received cash distributions for 2007 that exceed his tax distributions for 2007 that exceed his tax basisbasis

Absent relief, A has a taxable event. A Absent relief, A has a taxable event. A expects to generate capital losses in 2008, expects to generate capital losses in 2008, but she cannot carry them back but she cannot carry them back

What do you do?What do you do?

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SolutionSolution

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

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Economic Effect (cont’d)Economic Effect (cont’d) Test #2—Alternative TestTest #2—Alternative Test

Three Prong TestThree Prong Test Agreement provides for maintenance of capital Agreement provides for maintenance of capital

accounts in accordance with Treas. Reg. accounts in accordance with Treas. Reg. § 1.704-1(b)(2)(iv);§ 1.704-1(b)(2)(iv);

Agreement provides for liquidation of Agreement provides for liquidation of partnership interests in accordance with partnership interests in accordance with positive capital accounts; andpositive capital accounts; and

Drop the DRO and in its place, do the following:Drop the DRO and in its place, do the following:

5555

Alternate TestAlternate Test

DRO SurrogateDRO Surrogate Partnership agreement must contain a Partnership agreement must contain a

provision that accomplishes the following:provision that accomplishes the following: no allocation will create for any partner a no allocation will create for any partner a

deficit in the partner’s capital account that deficit in the partner’s capital account that exceeds the partner’s obligation to restore the exceeds the partner’s obligation to restore the deficit anddeficit and

the partnership contains a “qualified income the partnership contains a “qualified income offset.”offset.”

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Alternate Test (cont.)Alternate Test (cont.)

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

5757

Where do these rules make a BIG Where do these rules make a BIG difference?difference?

Distributions that Distributions that are not straight up are not straight up (that is, they do not (that is, they do not remain the same)remain the same)

5858

Common Case: GP CarryCommon Case: GP Carry

Distributions: Distributions: 100% to LPs 100% to LPs until they get until they get their capital back their capital back & then,& then,

80% to LPs and 80% to LPs and 20% to GP20% to GP

5959

GP Carry ExampleGP Carry Example

LPs contribute $100M; GP contributes zeroLPs contribute $100M; GP contributes zero Sell assets with AB = $50M for $100M and all Sell assets with AB = $50M for $100M and all

cash goes to LPscash goes to LPs How do you allocate $50M of gain?How do you allocate $50M of gain?

If allocate 100% to LPs, their capital account is now at If allocate 100% to LPs, their capital account is now at $50M $50M

BUT if you then sell remaining assets with AB =$50M BUT if you then sell remaining assets with AB =$50M for $50M, cash is to go $40M for LPs & $10M for GPfor $50M, cash is to go $40M for LPs & $10M for GP—something is wrong since LP capital account = —something is wrong since LP capital account = $50M & GP’s capital account = zero..$50M & GP’s capital account = zero..

Should have allocated $40M to LPs & $10M to GPShould have allocated $40M to LPs & $10M to GP

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Special Case: Loss AllocationSpecial Case: Loss Allocation

Can you Can you specially allocate specially allocate a loss to one a loss to one member?member?

Yes if ----Yes if ----

6161

Loss Allocation ExampleLoss Allocation Example

AB are equal partnersAB are equal partners Each contributes $1MEach contributes $1M PS borrows $8M non recourse debtPS borrows $8M non recourse debt 11stst year-Tax Loss =$1M year-Tax Loss =$1M

QQ: Can you specially allocate that $1M loss to A?: Can you specially allocate that $1M loss to A? AA: Yes if take precautions.: Yes if take precautions.

• Explanation-Explanation-------

6262

A’s Cap Acc = $1MA’s Cap Acc = $1M A’s share of loss = 0A’s share of loss = 0 A’s Cap Acc after Loss A’s Cap Acc after Loss

Allocation = $1MAllocation = $1M SO WHAT DOES THIS SO WHAT DOES THIS

MEAN---If then sold MEAN---If then sold property for $9M, pay off property for $9M, pay off debt of &8M and who debt of &8M and who gets $1M cashgets $1M cash

A gets all the cashA gets all the cash

B’s Cap Acc = $1MB’s Cap Acc = $1M B’s share of loss = $1MB’s share of loss = $1M B’s Cap. Acc = 0B’s Cap. Acc = 0

6363

Special Gain Allocation to make Special Gain Allocation to make things right!things right!

OK, if sold property for $9M, A gets all the cash OK, if sold property for $9M, A gets all the cash so so how can we help B to get some cash?how can we help B to get some cash?

Provide for Provide for Special Allocation of Income upon Special Allocation of Income upon salesale to offset Prior Loss Allocation, which works to offset Prior Loss Allocation, which works ifif we have enough gain we have enough gain

ExampleExample: Sell property for $10M, with $1M gain : Sell property for $10M, with $1M gain recognition, then allocate that $1M gain to Brecognition, then allocate that $1M gain to B

After that happens, both A’s and B’s Cap Acc After that happens, both A’s and B’s Cap Acc are now at $1M & each gets $1Mare now at $1M & each gets $1M

6464

Hitting the BullseyeHitting the Bullseye

Other Tax Other Tax Allocation TriviaAllocation Trivia

Why needed?Why needed? Match the regsMatch the regs Keep the IRS Agent Keep the IRS Agent

happyhappy Preserve your Preserve your

allocationsallocations

6565

““Qualified Income Offset” provisionQualified Income Offset” provision

- Regulations require this!Regulations require this!- Governs unexpected distributions by PS to Governs unexpected distributions by PS to

partner in excess of partner’s obligation to partner in excess of partner’s obligation to restore her capital account deficiency.restore her capital account deficiency.

- Provision must direct PS to allocate - Provision must direct PS to allocate subsequent items of income to partner in subsequent items of income to partner in order to eliminate partner’s capital account order to eliminate partner’s capital account deficiency as quickly as possible.deficiency as quickly as possible.

6666

Sample QIO ProvisionSample QIO Provision

The LLC shall specifically allocate Net The LLC shall specifically allocate Net Loss and items of income and gain when Loss and items of income and gain when and to the extent required to satisfy the and to the extent required to satisfy the “qualified income offset” requirement “qualified income offset” requirement within the meaning of Regulations Section within the meaning of Regulations Section 1.704-1(b)(2)(ii)(d). 1.704-1(b)(2)(ii)(d).

6767

Qualified Income Offset Qualified Income Offset (cont’d)(cont’d)

Applies specifically to distributions described in Applies specifically to distributions described in Treas. Reg. § 1.704-1(b)(2)(ii)(d)(4), (5) and (6)Treas. Reg. § 1.704-1(b)(2)(ii)(d)(4), (5) and (6) Expected adjustments for depletion allowances with respect to Expected adjustments for depletion allowances with respect to

oil and gas properties of the partnershipoil and gas properties of the partnership Expected allocations of loss/deduction to be made by reason Expected allocations of loss/deduction to be made by reason

of a partner acquiring a partnership interest by gift (§ 704(e)of a partner acquiring a partnership interest by gift (§ 704(e)(2)), by reason a partner’s share of prior excess losses (§ (2)), by reason a partner’s share of prior excess losses (§ 704(d)), and by reason of a distribution of § 751 property704(d)), and by reason of a distribution of § 751 property

Expected distributions to the extent they exceed offsetting Expected distributions to the extent they exceed offsetting expected increases to such partner’s capital account that expected increases to such partner’s capital account that occur during or prior to the same tax yearoccur during or prior to the same tax year

6868

““Substantiality”Substantiality”

The partnership must demonstrate that an The partnership must demonstrate that an allocation has some economic effect allocation has some economic effect besides tax savingsbesides tax savings

Two TestsTwo Tests Before-Tax TestBefore-Tax Test After-Tax TestAfter-Tax Test

6969

Substantiality (cont’d)Substantiality (cont’d)

Specific Allocations that Lack Specific Allocations that Lack SubstantialitySubstantiality

Shifting Tax ConsequencesShifting Tax Consequences

Transitory AllocationsTransitory Allocations

7070

Added Concern:Added Concern:

How do you How do you handle handle allocation of allocation of Non-recourse Non-recourse Deductions?Deductions?

7171

DefinitionsDefinitions

Partnership Minimum Gain (PMG)Partnership Minimum Gain (PMG) The minimum amount of gain the partnership The minimum amount of gain the partnership

would realize if it made a taxable disposition would realize if it made a taxable disposition of property secured by nonrecourse debt.of property secured by nonrecourse debt.

ExceptionsExceptions Conversions and RefinancingConversions and Refinancing Contributions of CapitalContributions of Capital Revaluations-Special TwistRevaluations-Special Twist

7272

Definitions (cont’d)Definitions (cont’d)

Minimum Gain Chargeback ProvisionMinimum Gain Chargeback Provision A provision in the agreement that allocates to A provision in the agreement that allocates to

each partner its allocable share of any net each partner its allocable share of any net decrease in PMG for a taxable yeardecrease in PMG for a taxable year

Requires a partner to recognize income from Requires a partner to recognize income from a net decrease in PMG when that partner a net decrease in PMG when that partner previously enjoyed the economic benefit of a previously enjoyed the economic benefit of a nonrecourse deduction associated with the nonrecourse deduction associated with the propertyproperty

7373

Safe HarborSafe Harbor

An allocation of nonrecourse deductions An allocation of nonrecourse deductions will be respected if the following conditions will be respected if the following conditions are met:are met: Partnership must satisfy the substantial Partnership must satisfy the substantial

economic effect safe harbor or alternative testeconomic effect safe harbor or alternative test Nonrecourse deductions must be allocated in Nonrecourse deductions must be allocated in

a manner “reasonably consistent” with other a manner “reasonably consistent” with other “significant” partnership items that have “significant” partnership items that have substantial economic effect.substantial economic effect.

(cont’d on next slide)(cont’d on next slide)

7474

Safe Harbor (cont’d)Safe Harbor (cont’d)

The agreement must contain a minimum gain The agreement must contain a minimum gain chargeback provisionchargeback provision

All other material allocations and capital All other material allocations and capital account adjustments must be respectedaccount adjustments must be respected

7575

Sample Short Cut ProvisionSample Short Cut Provision

““The LLC shall allocate items of LLC The LLC shall allocate items of LLC income and gain among the Members at income and gain among the Members at such times and in such amounts as such times and in such amounts as necessary to satisfy the minimum gain necessary to satisfy the minimum gain chargeback requirements of Regulations chargeback requirements of Regulations Sections 1.704-2(f) and 1.704-2(i)(4).”Sections 1.704-2(f) and 1.704-2(i)(4).”

7676

Member Non-recourse LiabilityMember Non-recourse Liability

Non-recourse debt from partner or related Non-recourse debt from partner or related personperson

Specially allocates debt to that partnerSpecially allocates debt to that partner Specially allocate deductions to that Specially allocate deductions to that

partnerpartner

7777

Sample ProvisionSample Provision

““Any nonrecourse deductions attributable Any nonrecourse deductions attributable to a Member Nonrecourse Liability shall be to a Member Nonrecourse Liability shall be allocated among the Members that bear allocated among the Members that bear the economic risk of loss for such Member the economic risk of loss for such Member Nonrecourse Liability in accordance with Nonrecourse Liability in accordance with the ratios in which such Members share the ratios in which such Members share such economic risk of loss and in a such economic risk of loss and in a manner consistent with the requirements manner consistent with the requirements of Regulations Sections 1.704-2(c), 1.704-of Regulations Sections 1.704-2(c), 1.704-2(i)(2) and 1.704-2(j)(1).” 2(i)(2) and 1.704-2(j)(1).”

7878

Other ThingsOther Things

WithholdingWithholding Tax Matters Tax Matters

PartnerPartner Tax ElectionsTax Elections Fiscal YearFiscal Year

7979

WithholdingWithholding

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

8080

Withholding (cont)Withholding (cont) Any amounts so withheld pursuant to this Any amounts so withheld pursuant to this

Section 6.9 shall be applied by the Managing Section 6.9 shall be applied by the Managing Member to discharge the obligation in respect of Member to discharge the obligation in respect of which such amounts were withheld. which such amounts were withheld.

All amounts withheld pursuant to this Section 6.9 All amounts withheld pursuant to this Section 6.9 with respect to any Member shall be treated as with respect to any Member shall be treated as amounts distributed to such Member for all amounts distributed to such Member for all purposes under this Agreement. purposes under this Agreement.

The Managing Member shall give written notice The Managing Member shall give written notice of any such withholding to each Member subject of any such withholding to each Member subject thereto within five Business Days after such thereto within five Business Days after such withholding. withholding.

8181

Std. Clause: Tax Matters PartnerStd. Clause: Tax Matters Partner

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

8282

Tax ElectionsTax Elections

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

8383

Fiscal YearFiscal Year

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

8484

Now, let’s look at:Now, let’s look at: Examples from Examples from

the Fieldthe Field

8585

Drafting Partnership AgreementsDrafting Partnership Agreements

Most Important item: The Economic DealMost Important item: The Economic Deal Tax rules/tax lawyers are meaningless without Tax rules/tax lawyers are meaningless without

an understanding of the economic dealan understanding of the economic deal The terms of the agreement define the dealThe terms of the agreement define the deal

• The tax lawyers and accountants do not define the The tax lawyers and accountants do not define the deal – they deal – they followfollow the deal the deal

What is the deal?What is the deal? Get the term sheet if there is one.Get the term sheet if there is one.

8686

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

8787

What do you mean by Percentage What do you mean by Percentage Interests?Interests?

Does this mean Capital Percentages?Does this mean Capital Percentages? Initially based on ACTUAL contributions to the Initially based on ACTUAL contributions to the

partnershippartnership• My contribution / Total contributions = My capital percentageMy contribution / Total contributions = My capital percentage• Staggered capital contributions impactStaggered capital contributions impact

Beware of terminology, and scrutinize the agreementBeware of terminology, and scrutinize the agreement• Capital percentage vs. Percentage interest vs. Partnership Capital percentage vs. Percentage interest vs. Partnership

percentage vs. Partnership interest vs. Unit percentage vs. percentage vs. Partnership interest vs. Unit percentage vs. Who knows what elseWho knows what else

• Many agreements use multiple terms, sometimes Many agreements use multiple terms, sometimes interchangeably and sometimes inconsistentlyinterchangeably and sometimes inconsistently

8888

What happens upon call for What happens upon call for additional capital – squeeze down?additional capital – squeeze down?

GP calls for additional capital (or loans)GP calls for additional capital (or loans)• Pro rata vs. non-pro rataPro rata vs. non-pro rata

• Some partners contribute their shares; others Some partners contribute their shares; others don’t.don’t.

• Non-contributing partners are penalized by a Non-contributing partners are penalized by a reduction in their partnership interests.reduction in their partnership interests.

Capital interests, profits interests, or bothCapital interests, profits interests, or both Is this a revaluation event?Is this a revaluation event?

8989

What do you mean by Preferred What do you mean by Preferred Returns-What Returns-What exactlyexactly is it? is it?

Also called preference amount, accrued Also called preference amount, accrued preference, cumulative unpaid preference, preference, cumulative unpaid preference, unpaid preferred return, etc.unpaid preferred return, etc.• Does the preference accrue on a daily, monthly, Does the preference accrue on a daily, monthly,

quarterly, or annual basis?quarterly, or annual basis?• Does the preference compound?Does the preference compound?• Is the preference specified as a simple percentage Is the preference specified as a simple percentage

or as an internal rate of return?or as an internal rate of return?

9090

Economic DealEconomic Deal

Problems arise when the business folks and the tax folks Problems arise when the business folks and the tax folks are not involved from the beginningare not involved from the beginning

Why:Why: Different approachesDifferent approaches

• For example, distribution might mean one thing to a tax lawyer and For example, distribution might mean one thing to a tax lawyer and a different thing to a business person.a different thing to a business person.

Tax guys might be able to tell if the “magic” tax language is Tax guys might be able to tell if the “magic” tax language is presentpresent

Business guy might think an “OK” from the tax guy Business guy might think an “OK” from the tax guy means the agreement reflects the economic dealmeans the agreement reflects the economic deal

Tax guy is merely saying the “magic” tax language is thereTax guy is merely saying the “magic” tax language is there

9191


Partnership AttributesPartnership Attributes Income and loss flow though currentlyIncome and loss flow though currently

• Affect return on investmentAffect return on investment

Income and lossIncome and loss Items allocatedItems allocated

Cash and propertyCash and property Items contributed and distributedItems contributed and distributed

Allocations might not match contributions Allocations might not match contributions and/or distributions and/or distributions

9292


What to do?What to do?

Model/ProjectionsModel/Projections Have the business folks and tax folks talkHave the business folks and tax folks talk Model/Projections AgainModel/Projections Again

9393

Figure out DistributionsFigure out Distributions

Cash flow from operationsCash flow from operations Cash flow from salesCash flow from sales Liquidating DistributionsLiquidating Distributions Tax Distributions-Can override the restTax Distributions-Can override the rest

Particular concern to GP-Managing Member-Particular concern to GP-Managing Member-Holder of Carry who may get “phantom Holder of Carry who may get “phantom income” if cash flow that generates taxable income” if cash flow that generates taxable income is used to repay capital contributionsincome is used to repay capital contributions

9494

Allocations:Allocations:Possible Trouble SpotPossible Trouble Spot

If you then say that “allocations follow If you then say that “allocations follow distributions,” then you may get in trouble.distributions,” then you may get in trouble.

When?When? Where cash flow that generates taxable Where cash flow that generates taxable

income is used to repay capital contributionsincome is used to repay capital contributions Where cash flow & taxable income do not Where cash flow & taxable income do not

match each othermatch each other

9595

Let’s see how-Basic Example Let’s see how-Basic Example

AB PartnershipAB Partnership A is the service provider, contributes $10, and A is the service provider, contributes $10, and

owns 1%owns 1% B is the investor, contributes $990, owns 99%B is the investor, contributes $990, owns 99% Business deal: After return of capital to B, return Business deal: After return of capital to B, return

capital to A and then, cash flow shared 20% to A capital to A and then, cash flow shared 20% to A and 80% to Band 80% to B Upon liquidation, do not follow capital account Upon liquidation, do not follow capital account

balances—just follow economics!balances—just follow economics! & Allocations follow distributions-----& Allocations follow distributions-----

9696

In Year OneIn Year One

Buy asset with $1,000Buy asset with $1,000 Generate $100 of taxable income & $100 Generate $100 of taxable income & $100

of cash flowof cash flow Ignore depreciation to make life simplerIgnore depreciation to make life simpler

Pay off in part investor’s capital with $100Pay off in part investor’s capital with $100 How do you allocate the $100 of taxable How do you allocate the $100 of taxable

income?income?

9797

Allocation in Year 1Allocation in Year 1What has happened to each of A and B?What has happened to each of A and B?

Capital AccountsCapital Accounts

Year 1Year 1 AA BB

Opening Capital AccountOpening Capital Account 1010 990990

Allocation of $1000 IncomeAllocation of $1000 Income -- +100+100

DistributionsDistributions -- -100-100

Ending Capital AccountEnding Capital Account 1010 990990

9898

In Year TwoIn Year Two

Sell asset for $1,000Sell asset for $1,000 Generate no gain or loss, but generate Generate no gain or loss, but generate

$1,000 of cash flow$1,000 of cash flow Business deal: Use $890 of cash flow to Business deal: Use $890 of cash flow to

pay off A’s (investor’s) unreturned capital, pay off A’s (investor’s) unreturned capital, then pay off B’s $10 unreturned capital then pay off B’s $10 unreturned capital and then distribute excess of $100--$80 to and then distribute excess of $100--$80 to A & $20 to BA & $20 to B

What is the impact on capital accounts?What is the impact on capital accounts?

9999

Allocation in Year 2Allocation in Year 2What has happened to each of A and B?What has happened to each of A and B?


Year 1Year 1 AA BB


No Income to AllocateNo Income to Allocate -- --

Distributions-return of capitalDistributions-return of capital -10-10 -890-890

Distributions-excess proceedsDistributions-excess proceeds -20-20 -80-80

Ending Capital AccountEnding Capital Account -20-20 +20+20

100100

Oops!!!Oops!!!

A has a +$20 capital account while B has A has a +$20 capital account while B has a -$20 capital accounta -$20 capital account

This means that allocations did NOT have This means that allocations did NOT have substantial economic effect in year onesubstantial economic effect in year one Note, if liquidating distributions followed Note, if liquidating distributions followed

capital account balances, the tax allocations capital account balances, the tax allocations work work

BUT then, cash goes out $990 to B & $10 to BUT then, cash goes out $990 to B & $10 to B, which is NOT business deal, which would B, which is NOT business deal, which would have B only get $970 and A get $30.have B only get $970 and A get $30.

101101

AsideAside

Sometimes, people draft agreement & say, Sometimes, people draft agreement & say, don’t worry, we will fix things up by don’t worry, we will fix things up by specially allocating income/loss in last specially allocating income/loss in last year to make everything right.year to make everything right.

However, as this example shows, this However, as this example shows, this does NOT help if there is no income or does NOT help if there is no income or loss in last yearloss in last year Or income & loss in last year may not be Or income & loss in last year may not be

enough to make things right.enough to make things right.

102102

Year One RevisitedYear One Revisited

Drop idea of allocations following Drop idea of allocations following distributions, but what do you then do?distributions, but what do you then do?

Allocations should follow how cash flow Allocations should follow how cash flow over and above return of capitalover and above return of capital would would have been madehave been made

Thus, allocate $80 to A (not $100 to A) & Thus, allocate $80 to A (not $100 to A) & allocate $20 to B (not no income allocate $20 to B (not no income allocation) & LET”S SEE WHAT allocation) & LET”S SEE WHAT HAPPENS NOW:HAPPENS NOW:

103103

Revised Allocation in Year 1Revised Allocation in Year 1What has happened to each of A and B?What has happened to each of A and B?


Year 1Year 1 AA BB


Allocation of $100 IncomeAllocation of $100 Income +20+20 +80+80

DistributionsDistributions -- -100-100

Ending Capital AccountEnding Capital Account 3030 970970

104104

Year Two AgainYear Two Again

Sell asset for $1,000Sell asset for $1,000 Generate no gain or loss, but generate $1,000 of Generate no gain or loss, but generate $1,000 of

cash flowcash flow Business deal: Use $890 of cash flow to pay off Business deal: Use $890 of cash flow to pay off

A’s (investor’s) unreturned capital, then pay off A’s (investor’s) unreturned capital, then pay off B’s $10 unreturned capital and then distribute B’s $10 unreturned capital and then distribute excess of $100--$80 to A & $20 to Bexcess of $100--$80 to A & $20 to B

What is the impact on capital accounts NOW?What is the impact on capital accounts NOW?

105105

Revised Allocation in Year 2Revised Allocation in Year 2What has happened to each of A and B?What has happened to each of A and B?


Year 1Year 1 AA BB


No Income to AllocateNo Income to Allocate -- --

Distributions-return of capitalDistributions-return of capital -10-10 -890-890

Distributions-excess proceedsDistributions-excess proceeds -20-20 -80-80

Ending Capital AccountEnding Capital Account Zero!Zero! Zero!Zero!

106106

Is there a need for a Tax Is there a need for a Tax Distribution in Prior Example?Distribution in Prior Example?

In this example, we saw how A was In this example, we saw how A was allocated $20 of phantom income in Year allocated $20 of phantom income in Year One.One.

A may want to request a Tax Distribution A may want to request a Tax Distribution to cover its taxes on that incometo cover its taxes on that income

107107

Tax DistributionsTax Distributions

Will investor agree?Will investor agree? If agree:If agree:

What rate do you use?What rate do you use?• Consider coming up with # & then adjust if law Consider coming up with # & then adjust if law

changeschanges Estimated taxes may require multiple Estimated taxes may require multiple

paymentspayments Impact of prior year lossesImpact of prior year losses

108108

Added Lesson-Must you say that Added Lesson-Must you say that liquidating distributions follow capital liquidating distributions follow capital

accounts?accounts? NONO This is a safe harbor BUT if you get This is a safe harbor BUT if you get

allocations right, you do not have to allocations right, you do not have to incorporate that, which may make your incorporate that, which may make your client happierclient happier

HoweverHowever, watch out since it may be hard , watch out since it may be hard to actually get it right especially in complex to actually get it right especially in complex deals & may make agent look harder.deals & may make agent look harder.

109109

Allocation Methods to AdoptAllocation Methods to Adopt

Targeting approach Targeting approach SHORT--At end of year, book capital SHORT--At end of year, book capital

accounts should equal the amounts of cash accounts should equal the amounts of cash that partners would receive if all partnership that partners would receive if all partnership assets sold for assets sold for §§704(b) book value, i.e., 704(b) book value, i.e., assume assets’ FMV = book valueassume assets’ FMV = book value

Layering approachLayering approach LONG--Building up or taking down the capital LONG--Building up or taking down the capital

accounts to reflect the waterfall rightsaccounts to reflect the waterfall rights Others-Combination (boot-strap)Others-Combination (boot-strap)

110110

Targeted Tax AllocationsTargeted Tax Allocations

The “substantial economic effect” test is The “substantial economic effect” test is intended to make sure that tax allocations have intended to make sure that tax allocations have real impact on the parties.real impact on the parties.

But, shouldn’t cash, not tax allocations, be king?But, shouldn’t cash, not tax allocations, be king? If so, why not have tax follow how cash should If so, why not have tax follow how cash should

go, which is the essence of targeted capital go, which is the essence of targeted capital accounts!accounts!

However, this does NOT work well if trying to However, this does NOT work well if trying to specially allocate losses!specially allocate losses!

111111

Target Allocation SectionTarget Allocation Section

Allocations: Profits and Losses are allocated Allocations: Profits and Losses are allocated among the Members such that, as of the end of among the Members such that, as of the end of any Year, the Capital Account of each Member any Year, the Capital Account of each Member equals the net amounts that would be distributed equals the net amounts that would be distributed to the Member on liquidation of the Company.to the Member on liquidation of the Company. In computing net amount that may be distributed, all In computing net amount that may be distributed, all

property is deemed sold at its Book Valueproperty is deemed sold at its Book Value In determining how cash flow goes out on liquidation, In determining how cash flow goes out on liquidation,

you rely on the business dealyou rely on the business deal• Do not say follow capital accounts or else this is circularDo not say follow capital accounts or else this is circular

112112

Targeted Tax Allocations (cont’d)Targeted Tax Allocations (cont’d)

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

113113


Hypothetical LiquidationHypothetical Liquidation §§ 5.1(b): “In determining the amounts 5.1(b): “In determining the amounts

distributable to the partners … upon a distributable to the partners … upon a hypothetical liquidation, it shall be presumed hypothetical liquidation, it shall be presumed that (a) all of the partnership assets are sold that (a) all of the partnership assets are sold for cash at their respective [book] values …, for cash at their respective [book] values …, and (b) the proceeds of such hypothetical sale and (b) the proceeds of such hypothetical sale are …distributed in accordance with … [the are …distributed in accordance with … [the liquidation provisions]”liquidation provisions]”

114114


Contributed/Revalued PropertyContributed/Revalued Property §§ 5.4(a): “If any property is contributed to the 5.4(a): “If any property is contributed to the

Partnership in kind, or if the Book Value of any Partnership in kind, or if the Book Value of any Partnership property is adjusted … , all income, Partnership property is adjusted … , all income, gain, loss and deduction with respect to such … gain, loss and deduction with respect to such … property shall, solely for income tax purposes, property shall, solely for income tax purposes, be allocated among the Partners so as to take be allocated among the Partners so as to take account of any variation between the adjusted account of any variation between the adjusted basis of such property … and its initial or basis of such property … and its initial or revalued Book Value ….”revalued Book Value ….”

115115

Target Allocation Criticism/PraiseTarget Allocation Criticism/Praise

ConCon: “I want guidance”: “I want guidance” What do these tax advisors want me to do?What do these tax advisors want me to do? I need a cookbookI need a cookbook

ProPro: “I want flexibility to get it right”: “I want flexibility to get it right” I can avoid all those awful steps and do the I can avoid all those awful steps and do the

“right thing”“right thing”

116116

Short Cookbook for Target Short Cookbook for Target Allocation Allocation

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

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

117117

Layered Allocations Layered Allocations

Building up or taking down the capital Building up or taking down the capital accounts to reflect the waterfall rightsaccounts to reflect the waterfall rights

Separation of allocations for operations, Separation of allocations for operations, interim capital transactions, and terminating interim capital transactions, and terminating capital transactionscapital transactions• Within a given year, a partnership may have both Within a given year, a partnership may have both

income/loss from operations and income/loss from income/loss from operations and income/loss from one or more capital transactions.one or more capital transactions.

Which items are allocated first?Which items are allocated first?

118118

Layered Allocations-Key Points Layered Allocations-Key Points

Key QuestionsKey Questions At year-end, do partners’ book capital At year-end, do partners’ book capital

accounts properly reflect economic rights on accounts properly reflect economic rights on sale for book value? sale for book value?

Do layers match the corresponding waterfall Do layers match the corresponding waterfall distribution right?distribution right?

Do layers incorporate all Preferences?Do layers incorporate all Preferences? Let’s see some examples:Let’s see some examples:

119119

Sample Agreement-1Sample Agreement-1stst Layer-Loss Layer-Loss ReversalReversal

• Except as otherwise provided herein and after Except as otherwise provided herein and after application of Sections 1.3 and 1.4 hereof, application of Sections 1.3 and 1.4 hereof, Profits for any fiscal year shall be allocated as Profits for any fiscal year shall be allocated as follows:follows:

First, to the Partners in proportion to, and to the extent First, to the Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to of, (A) any Losses allocated to each pursuant to Section 1.2(b)(iv) over (B) the cumulative Profits Section 1.2(b)(iv) over (B) the cumulative Profits allocated to such Partners pursuant to this Section allocated to such Partners pursuant to this Section 1.2(a)(i);1.2(a)(i);

Second, to the Partners in proportion to, and to the Second, to the Partners in proportion to, and to the extent of, (A) any Losses allocated to each pursuant to extent of, (A) any Losses allocated to each pursuant to Section 1.2(b)(iii) over (B) the cumulative Profits Section 1.2(b)(iii) over (B) the cumulative Profits allocated to such Partners pursuant to this Section allocated to such Partners pursuant to this Section 1.2(a)(ii);1.2(a)(ii);

120120

22ndnd Layer-Operating Income Cash Layer-Operating Income Cash FlowFlow

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

121121

33rdrd Layer-Capital Partner Layer-Capital Partner Liquidation PreferenceLiquidation Preference

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

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44thth Profit Partner Liquidation Profit Partner Liquidation Preference, if anyPreference, if any

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

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55thth layer-Residual Distribution layer-Residual Distribution

Then, to the Partners in accordance with Then, to the Partners in accordance with their respective Percentage Interests.their respective Percentage Interests.

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Sample Loss Allocation-1Sample Loss Allocation-1stst Layer- Layer-Profit ReversalProfit Reversal

• Except as otherwise provided herein and after Except as otherwise provided herein and after application of Sections 1.3 and 1.4 hereof, application of Sections 1.3 and 1.4 hereof, Losses for any fiscal year shall be allocated as Losses for any fiscal year shall be allocated as follows:follows:

First, to the Partners in proportion to, and to the extent First, to the Partners in proportion to, and to the extent of, (A) any Profits allocated to each pursuant to Section of, (A) any Profits allocated to each pursuant to Section 1.2(a)(vi) over (B) the cumulative Profits allocated to 1.2(a)(vi) over (B) the cumulative Profits allocated to such Partners pursuant to this Section 1.2(b)(i);such Partners pursuant to this Section 1.2(b)(i);

Second, to each of the Profit Partners in proportion to, Second, to each of the Profit Partners in proportion to, and to the extent of, (A) any Losses allocated to each and to the extent of, (A) any Losses allocated to each pursuant to Section 1.2(a)(v) over (B) the cumulative pursuant to Section 1.2(a)(v) over (B) the cumulative Profits allocated to such Partners pursuant to this Profits allocated to such Partners pursuant to this Section 1.2(b)(ii);Section 1.2(b)(ii);

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22ndnd Layer-Wipe out capital accounts Layer-Wipe out capital accounts

Third, to the Partners in accordance Third, to the Partners in accordance with, and in proportion to, their with, and in proportion to, their respective positive capital account respective positive capital account balances (after taking into account of balances (after taking into account of any allocations of Losses under Section any allocations of Losses under Section 1.2(b)(i) and (ii)); and1.2(b)(i) and (ii)); and

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33rdrd Layer-Residual Losses Layer-Residual Losses

Then, to the Partners in accordance with Then, to the Partners in accordance with their respective Percentage Interests.their respective Percentage Interests.

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Loss Allocation OverrideLoss Allocation Override

However, any Loss allocation in accordance with this However, any Loss allocation in accordance with this Section 1.2(b) shall not exceed the maximum amount Section 1.2(b) shall not exceed the maximum amount of Loss that can be so allocated without causing any of Loss that can be so allocated without causing any Partner to have a negative capital account balance at Partner to have a negative capital account balance at the end of the Partnership’s fiscal year. In the event the end of the Partnership’s fiscal year. In the event some but not all of the Partners would have negative some but not all of the Partners would have negative capital account balances as a consequence of an capital account balances as a consequence of an allocation of losses pursuant to Section 1.2(b) hereof, allocation of losses pursuant to Section 1.2(b) hereof, the limitation set forth in this Section 1.2(b) shall be the limitation set forth in this Section 1.2(b) shall be applied on a Partner by Partner basis so as to applied on a Partner by Partner basis so as to maximize permissible losses to each Partner under maximize permissible losses to each Partner under Regulation § 1.704-1(b)(2)(ii)(d).Regulation § 1.704-1(b)(2)(ii)(d).

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Common Allocation ProvisionsCommon Allocation Provisions

Regulatory allocationsRegulatory allocations Minimum gain chargebacksMinimum gain chargebacks

• Special problem for debt workoutsSpecial problem for debt workouts Allocating non-recourse deductionsAllocating non-recourse deductions

Stop loss provisionsStop loss provisions Adjusted capital account conceptAdjusted capital account concept

• Increased for minimum gain sharesIncreased for minimum gain shares• Increased for allocations of recourse debt deductionsIncreased for allocations of recourse debt deductions

Avoid impermissible negative capital accountsAvoid impermissible negative capital accounts

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Other Possible Concerns?Other Possible Concerns?

Admission of a New Admission of a New PartnerPartner

Section 754 ElectionsSection 754 Elections

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Admission of New Partner:Admission of New Partner:Achieving Retroactive Allocations Achieving Retroactive Allocations

Legitimately!Legitimately!

Section 706(d) limits the ability to perform Section 706(d) limits the ability to perform retroactive allocations for a new partnerretroactive allocations for a new partner

However, if you disproportionately allocate However, if you disproportionately allocate losses after admission of a new partner, you losses after admission of a new partner, you may be able to legitimately achieve the same may be able to legitimately achieve the same resultresult

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Section 754 ElectionsSection 754 Elections

Special Adjustments:Special Adjustments: Section 743-Sale of PS InterestSection 743-Sale of PS Interest Section 734-Partnership RedemptionSection 734-Partnership Redemption

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Intangible Property and PartnershipsIntangible Property and Partnerships

Rule: Amortizable Section 197 Intangibles-Rule: Amortizable Section 197 Intangibles-15 year straight line amortization15 year straight line amortization

Exception: Anti-churning Rules Exception: Anti-churning Rules

Purchase of Partnership InterestPurchase of Partnership Interest Section 754/743 Election-Creates new Section 754/743 Election-Creates new

amortizable asset for step up even if the amortizable asset for step up even if the intangible was non-amortizable beforeintangible was non-amortizable before

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Intangible Property (cont’d)Intangible Property (cont’d)

§ 704(c) Intangible Predicament: i§ 704(c) Intangible Predicament: if a partner f a partner contributes a non-amortizable section 197 contributes a non-amortizable section 197 intangible to the Partnershipintangible to the Partnership Curative allocations are not available for the other Curative allocations are not available for the other

partnerspartners However, they can use remedial allocations. Treas. However, they can use remedial allocations. Treas.

Reg. § 1.197-2(g)(4)(i)Reg. § 1.197-2(g)(4)(i)

Nonetheless, a partner related to the Nonetheless, a partner related to the contributing partner may not receive remedial contributing partner may not receive remedial allocations of deductible amortizationallocations of deductible amortization

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Securities PartnershipsSecurities Partnerships

Such partnerships may have frequent Such partnerships may have frequent capital account restatements (“book-ups”)capital account restatements (“book-ups”)

Sheer number of assets makes Sheer number of assets makes compliance with Regulations extremely compliance with Regulations extremely difficultdifficult

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Securities Partnerships (cont’d)Securities Partnerships (cont’d)

Solution—Qualified PartnershipsSolution—Qualified Partnerships May consistently aggregate gains and losses May consistently aggregate gains and losses

from securities and similar investments when from securities and similar investments when making reverse making reverse § 704(c) allocations§ 704(c) allocations• Only applies to allocations on/after Dec 31, 1993.Only applies to allocations on/after Dec 31, 1993.

May use any reasonable approach to May use any reasonable approach to aggregation that is consistent with § 704(c), aggregation that is consistent with § 704(c), but must continue to use the same approach.but must continue to use the same approach.

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Requirements of Securities PartnershipsRequirements of Securities Partnerships Must be either a management company registered Must be either a management company registered

with the SEC under the Investment Company Act with the SEC under the Investment Company Act of 1940, or an investment partnershipof 1940, or an investment partnership

On each book-up date, 90% of an investment On each book-up date, 90% of an investment partnership’s noncash assets must consist of partnership’s noncash assets must consist of “qualified financial assets”“qualified financial assets”

• Qualified Financial Asset: any personal property that is Qualified Financial Asset: any personal property that is actively tradedactively traded

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Permissible Aggregation MethodsPermissible Aggregation Methods Step 1: establish “revaluation account” for each Step 1: establish “revaluation account” for each

partner to track book allocations not matched with partner to track book allocations not matched with tax allocationstax allocations

Step 2: select aggregation methodStep 2: select aggregation method• Partial Netting: tax gains and losses for each asset are Partial Netting: tax gains and losses for each asset are

netted separately; gains/losses are then allocated to netted separately; gains/losses are then allocated to partners with positive/negative accounts in proportion to partners with positive/negative accounts in proportion to their positive/negative balances; excess is allocated pro ratatheir positive/negative balances; excess is allocated pro rata

• Full Netting: nets all tax gains and losses together, and then Full Netting: nets all tax gains and losses together, and then allocates net amounts according to the same rule as aboveallocates net amounts according to the same rule as above

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IRS Circular 230 disclosureIRS Circular 230 disclosure * * * * * * * * * * * * * * * * * * * * * ** * * * * * * * * * * * * * * * * * * * * * To ensure compliance with requirements To ensure compliance with requirements

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

* * * * * * * * * * * * * * * * * * * * * ** * * * * * * * * * * * * * * * * * * * * *

Documents

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]