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Partnership Preferred Returns: Identifying Capital Shifts

and Recharacterization Risks

THURSDAY, DECEMBER 12, 2019, 1:00-2:50 pm Eastern

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December 12, 2019

Partnership Preferred Returns

Joseph C. Mandarino, Partner

Smith Gambrell & Russell, Atlanta

[email protected]

Crawford Moorefield, Member

Clark Hill, Houston

[email protected]

mailto:[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

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You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

ClarkHill.com

Target Allocations and

Preferred ReturnsDecember 12, 2019

CRAWFORD MOOREFIELD

Member, Houston

[email protected]

6

Disclaimer

•This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors.

•Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter.

7

Two Types of Agreements

• Allocation-based agreements

-Allocation provisions control economics

-First allocate income and loss to the capital

accounts according to detailed allocation rules

-Then liquidate according to capital accounts

• Operating cash flow distributions are often made according to

specified percentage interests, but liquidating distributions are

always made in proportion to capital account balances

• Distribution-based agreements

-Distribution provisions control economics

-Distribute cash according to specified sharing rules, and

allocate income or loss to track the distributions

8

Two Types of Allocations

• Layered allocations - Compute each partner’s share of profit and loss

directly based on detailed allocation rules - Generally results in “layers” of allocations

• Target allocations - Compute each partner’s share of profit and loss

indirectly based on the partner’s distributive share

of total partnership capital (target capital account)

- Each partner’s profit or loss is the amount needed to

cause the partner’s ending capital to equal the target capital account (net

of minimum gain; i.e., deductions and loss funded by debt)

• Hybrid

- Layered allocations for operating profit/loss and target

allocations for profit/loss on liquidation

9

Layered vs. Target Allocations

•Layered Allocation

Solve for ending capital using allocated income/loss:

Beginning capital

+ Contributions

– Distributions

+/– Allocated income / loss

= Ending capital

•Target Allocation

Solve for allocated income/loss using targeted ending capital:

Targeted ending capital*

– Contributions

+ Distributions

– Beginning capital

=Allocated income / loss

10

•Early practice - Initially, agreements were

the norm allocation-based

Evolution of Agreements

• Allocation-based agreements always use layered allocations

- As economic deals got more complex (carried interests, preferred returns, etc.), allocation-based agreements created problems • Errors in drafting complex layered allocation provisions could lead to

unintended economic results • Even if the drafting was correct, accounting errors could produce

untended economic results • Other disparities between cash distributed and capital accounts • Special allocations increase complexity and opportunities for errors

11

•Modern practice - Partners and lawyers responded by

moving to distribution-based agreements

Evolution of Agreements

- Initially, distribution-based agreements used layered

allocations that traced the expected cash distributions • Same economics/allocations disparity risks, but it was anaccounting problem not a deal economics problem

- Target allocations were invented to eliminate the need to draft complex layered allocation provisions

• The accountants just “plug” to the economics as necessary - Distribution-based agreements with target allocations are

now the norm in complex deals

12

•Facts - M contributes $1MM cash, and S contributes $0, to Newco

- Newco buys $1MM assets for a widget manufacturing business to

Ex. 1 - Allocation-Based Agreement

be managed by S - No debt

•Economic deal - First, 10% preferred return to M - Next, return of M’s capital - Next $1MM, 80% to M and 20% to S - Residual, 50% to M and 50% to S

13


•Distributions

-Operating cash is distributed according to the economic deal

- Liquidating distributions are distributed according to the

partners’ positive capital accounts (maintained according to

the Section 704(b) capital account maintenance rules)

• Note that capital accounts control final distributions, making

this an allocation-based agreement

- The operating agreement contains a qualified income offset in

lieu of a deficit restoration obligation (DRO)

14


•Allocations (layered allocation provision) ‒ a. Profits:

• (i) Excess Loss Recapture: First, to partners in proportion to and to the extent of the excess of (1) the cumulative losses allocated under Section b(v) over (2) the cumulative profits previously allocated under this Section a(i)

• (ii) Capital Loss Recapture: Next, to partners in proportion to and to the extent of the excess of (1) the cumulative losses allocated under Section b(iv) over (2) the cumulative profits previously allocated under this Section a(iii)

• (iii) Preferred Return: Next, to partners in proportion to excess of (1) the sum of (A) cumulative losses under Section b(iii) plus (B) Preferred Return over (2) the

cumulative profits previously allocated under this Section a(ii) • (iv) 80/20 Allocation: Next, 80% to M and 20% to S to the extent

the cumulative profits allocated under this Section a(iv) is less than $1MM minus the cumulative losses allocated under Section b(ii),

• (v) 50/50 Allocation: Thereafter, 50% to M and 20% to S

15


•Allocations (layered allocation provision) •- b. Losses:

• (i) 50/50 Profit Chargeback: First, to partners in proportion to and to the extent of the excess of (1) the cumulative profits allocated under Section a(v) over (2) the cumulative losses allocated under this Section b(i)

• (ii) 80/20 Profit Chargeback: Next, to partners in proportion to and to the extent of the excess of (1) the cumulative profits allocated under Section a(iv) over (2) the cumulative losses allocated under this Section b(ii)

• (iii) Preferred Return Profit Chargeback: Next, to partners in proportion to and to the extent of the excess of (1) the cumulative profits allocated under Section a(iii) over (2) the cumulative losses allocated under this Section b(iii)

• (iv) Capital Loss: Next, to partners in proportion to and to the extent of their unreturned capital contributions

• (v) Excess Loss: Thereafter, 50% to M and 50% to S (subject to regulatory prohibition on adjusted capital account deficits)

16

Ex. 2 - Distribution-Based Agreement

• Same facts and deal terms as Example 1 •Distributions

- All distributions are made according to the economic deal (i.e., not according to capital account balances)

• Allocations (target allocation provision) - Net profit or loss is allocated to the members as necessary to cause each member’s capital account to equal, as nearly as possible, (i) the amount the

•member would receive if all Newco assets at the end of the allocation period were sold for cash at their [book values], all Newco liabilities were satisfied according to their terms, and any remaining cash was distributed to the members according to the distribution waterfall, minus (ii) [minimum gain].

17

Defining the Preferred Return

setting up potential future disputes regarding the preferred equity holder’s economic rights - A related area of concern is determining whether the preferred return and return of capital thresholds in the distribution waterfall have been satisfied such that distributions are made according to the residual sharing provisions.

•Fertile ground for disputes! - The definition of preferred return in the

operating agreement is often poorly drafted,

18

• Example

Distributable Cash will be distributed in the following order of priority:

a. First, to the Members until each Member has received a 6% preferred return on Invested Capital.

b. Second, to the Members until each Member’s Adjusted Capital Contribution has been reduced to zero.c. Finally, to the Members in proportion to their Percentage Interests.

• Issues

- Allocation among Members within tiers 1 and 2 - Definitions of Invested Capital and Adjusted Capital Contribution - One-time or repeated application of preferred return (“until” issue) - Preferred return compounding and compounding period; measurement period; conventions (e.g., 360/365 day year); proration within periods


19


•Planning - Pay special attention to the definition of preferred return and to the operation of the distribution waterfall to make sure they work as intended - Avoid complex financial concepts (such as internal rate of return) and Excel® formulas; those provisions often create unrecognized problems - Prepare a financial model for forecasted operations; it can identify gaps and ambiguities in the definitions and distribution mechanics and thereby minimize the risk of future disputes

20

Preferred Return Example (Simple)

• Facts- Distribution waterfall (same as prior examples)

• First, 10% preferred return to M

• Next, return of M’s capital

• Next $1MM, 80% to M and 20% to S

• Residual, 50% to M and 50% to S

- Operating Results

• Year 1: $120,000 book/tax profit and cash distribution

• Year 2: $150,000 book/tax profit and cash distribution

• Year 3: Sale of property for $2,400,000

21


Year 1 and 2 capital accounts (layered allocations)

22


• Year 3 capital accounts (layered allocations)

23


• Year 1 capital accounts (target allocations)

24

Part I Summary

•Two types of agreements: - Allocation-based: the allocation provisions control the

economics (distributions are determined by capital accounts) --Distribution-based: the distribution provisions control the •economics (capital accounts are not controlling)

•Two types of allocations: - Layered: profit/loss is allocated to the partners based on

specified shares and layers - Target: profit/loss is allocated based on targeted capital

account balances

25

Part I Summary (con’t)

• For “straight up” deals where each partner sharesaccording to contributed cash, an allocation-based agreementwith layered allocations is workable

• For more complex deals (including deals withpreferred returns), current practice prefers adistribution-based agreement using target allocations

• In either case, pay careful attention to definitions and todeal specific issues (such as tax distributions, specialallocations, debt-funded expenses, character issues, etc.)

‒ Target allocations are not a cure-all!

© 2019 Smith, Gambrell & Russell, LLP, All Rights Reserved © 2019 Smith, Gambrell & Russell, LLP, All Rights Reserved

December 12, 2019

Joseph C. Mandarino

Smith, Gambrell & Russell, LLP

Promenade II, Suite 3100

1230 Peachtree Street

Atlanta, Georgia 30309

www.sgrlaw.com

Partnership Preferred Returns: Identifying Capital Shifts and

Recharacterization Risks

http://www.seblaw.com/

© 2019 Smith, Gambrell & Russell, LLP, All Rights Reserved

• Preferred Returns and Guaranteed Payment

Issues

• Preferred Returns and Capital Shift Issues

• Preferred Returns and Disguised Sale Issues

• Mitigating Risks

• Preferred Returns and §199A Issues

Overview

28


PREFERRED RETURNS AND GUARANTEED PAYMENT ISSUES

29


Preferred Returns and Guaranteed Payment Issues

30

• In general, an allocation or payment to partner

that is made without regard to partnership income

is treated as a guaranteed payment.

• The guaranteed payment rules were originally

devised to handle compensatory payments by a

partnership to a partner.

• Example 1: Newco's operating agreement

provides that Jones, the managing member,

receives $1,000 each week.

• Generally, this would be viewed as a guaranteed

payment because it is not dependent on the

income of Newco.

© 2019 Smith, Gambrell & Russell, LLP, All Rights Reserved 31

• Example 2: Newco's operating agreement

provides that Jones, the managing member,

receives the first $1,000 of Newco's income each

week.

• Generally, this would be not be viewed as a

guaranteed payment because it is dependent on

the income of Newco – if there is no income, then

Jones is not paid anything.



• A preferred return arrangement could be treated

as a guaranteed payment.

• As noted, in many instances, the arrangement will

be drafted so that a return is accrued or earned or

credited to a partner regardless of whether the

partnership actually has any income.

• Here we have to separate preferred return

arrangements that are more in the nature of

preferred distributions and those arrangements

that provide (directly or indirectly) for allocations

of income.



• Assuming that a preferred return arrangement is

subject to the guaranteed payment rules, then what are

the consequences?

• This, unfortunately, is unclear. There are two main

views here:

• treat the income as interest income to the partner

and create an offsetting interest for the rest of the

partnership

• treat the income as "distributive share" income – it

is composed of the same items and attributes as

any allocation of income.



• If income allocations under a preferred return

arrangement can be treated as allocations of interest, it

may open up several planning opportunities.

• For example, an tax-exempt partner may prefer this

treatment because interest income is generally not

included in UBTI.

• Assuming a partnership earns income from the active

conduct of a trade or business. If a pension fund

investors receives a distributive share of such income,

the fund may have to include the income in UBTI and

pay tax on it.



• If, instead, the pension fund is allocated income under

a preferred return arrangement and that income is

treated as interest, then it may be excluded from UBTI

and the fund would avoid having to pay tax.

• Similarly, a foreign investor may also prefer that the

income from a preferred return arrangement be treated

as interest.

• For example, if a foreign person becomes a partner in a

partnership that conducts a U.S. trade or business then

the foreign person will generally be subject to U.S.

income tax on his or her distributive share of

partnership income.



• Moreover, such an arrangement would also subject the

foreign person to a U.S. tax filing obligation.

• If, instead, the foreign person is allocated income under

a preferred return arrangement and that income is

treated as interest, and if such interest comes within

the portfolio debt exclusion, then the foreign person

may be able to avoid U.S. tax on the income and avoid

filing a U.S. tax return.

• Even if the requirements of the portfolio debt exclusion

are not met, the interest income may be subject to a

reduced rate of withholding under a U.S. tax treaty (or

even a zero rate).



• However, in some instances a partner may not want

interest treatment and may prefer distributive share

treatment.

• For example, assume that a partnership sells capital

assets at a gain. A distributive share of the partnership

income in that year could include a significant amount

of capital gain income.

• An individual partner might prefer to be allocated a

distributive share of such income, rather than received

interest income.



• Unfortunately, a very old regulation suggests that

guaranteed payments are always ordinary income.

• Treas. Reg. §1.707-1(c):

• Guaranteed payments do not constitute an interest in

partnership profits for purposes of sections 706(b)(3),

707(b), and 708(b). For the purposes of other

provisions of the internal revenue laws, guaranteed

payments are regarded as a partner's distributive share

of ordinary income.

• This suggests that, with certain exceptions, guaranteed

payments, even under the distributive share view,

cannot include capital gain income.



• While this regulation appears to preclude interest-

treatment, it appears to be contradicted by a more

recent regulation – Treas. Reg. §1.704-1(b)(2)(iv)(o) –

which can be read to suggest that interest treatment is

the appropriate view.

• Even under Treas. Reg. §1.707-1(c), the apparent all-

ordinary-income approach that is advocated breaks

down if the partnership has no actual income in the year

of allocation.



• For foreign and exempt investors, the characterization

can be critical – treatment as interest may result in a

higher after-tax yield.

• Conversely, the distributive share approach could force

such investors to use corporate blockers and/or could

reduce the after-tax yield.



PREFERRED RETURNS AND CAPITAL SHIFT ISSUES

41


• Capital shift issues can also be triggered by preferred

return arrangements.

• Example

• X and Y form Newco with $500 cash each. Newco

buys real estate (Redacre) for $1,000 and plans to hold

it for five years and then sell it. X is more risk-averse

than Y. The partnership agreement provides that if

Redacre is sold, the first $1,000 of proceeds will be

distributed $750 to X and $250 to Y, and thereafter,

25% to X and 75% to Y.

Preferred Returns and Capital Shift Issues


• Thus, X is trading off the right to participate pro rata in

all profits for a greater certainty of return.

• Key – this arrangement turns on proceeds, not income.


sales price total income proceeds to X proceeds to Y income to X income to Y

1,000$ -$ 750$ 250$ 250$ (250)$

1,333$ 333$ 833$ 500$ 333$ -$

1,500$ 500$ 875$ 625$ 375$ 125$

2,000$ 1,000$ 1,000$ 1,000$ 500$ 500$

2,500$ 1,500$ 1,125$ 1,375$ 625$ 875$


• This arrangement creates a hypothetical capital shift.

• If Redacre is sold the day after it is purchased, and

assuming no increase in the value of Redacre, then X

is entitled to $750, while Y is entitled to only $250.

• If this occurred, then X has a $250 gain and Y has a

$250 loss.

• Practitioners will say that $250 of Y's capital has shifted

to X.



• Is this capital shift a taxable event?

• It is not clear under the capital account rules that Newco

would be required to adjust the capital accounts of X and

Y for a hypothetical event (i.e., a sale that causes a loss to

Y).

• The IRS might argue that in order to come within the

704(b) safe harbor, Newco must maintain capital accounts

and liquidate in accordance with capital account balances.

• Thus, the IRS would argue that in order to so liquidate, it

is necessary to adjust the capital accounts of X and Y

today.



• And, to adjust the capital accounts appropriately, it is

necessary to allocate $250 of income to X and allocate

a loss or expense of $250 to Y.

• Key – would the IRS ever be comfortable with Y

taking a loss on a hypothetical event?

• Then, in subsequent periods, it would be necessary to

adjust Y's capital account further based on changes in

the value of Redacre.

• Thus, if Redacre increased in value by $100, Y would

be allocated $100 of income so that Y's capital account

reflected an increase of $100.



• Assume that Newco does sell in year 5, but has no

income or loss until then.

• Nonetheless, under this view, Newco is required to

book annual income and/or loss amounts based on the

sharing waterfall and changes in the value of Redacre.

• Thus, Newco is required, effectively, to report Redacre

on a mark-to-market basis.

• There is no specific authority for this.

• There is analogous authority in the compensatory

equity area.



• Assume instead that the Newco operating arrangement

provides for a return of capital plus a 10% preferred

annual return to X, then a return of capital to Y, and

then all income is split 25/75 between X and Y.

• Again, the IRS could argue that if Redacre is sold the

next day, then X would be entitled to a distribution of

$550 (i.e., a return of capital of $500, plus a 10%

preferred return of $50).

• If Newco has no actual income, do we force through a

phantom income amount of $50 to X and a phantom

loss or expense amount of $50 to Y?



• In year 2, assuming there is still no income at the

Newco level, do we nonetheless make another $50

phantom income allocation to X and a $50 phantom

loss or expense allocation to Y?

• Here we have reduced the first year phantom income

hit, and instead we make smaller allocations each year

equal to the preferred return amount.

• Note that under this approach the phantom allocations

are driven by the preferred return rate and not by the

value of Redacre.



• In fact, the value of Redacre could be taken into account

to determine the necessary capital account balances.

• For example, if Redacre increased in value by $50 at the

end of year 1, then the phantom loss allocation to Y is

unnecessary.

• If Redacre increased in value by $150 by the end of year

1, then there would still be a phantom income allocation

of $50 to X to reflect the preferred return, and the

balance of $100 would be split 25/75, for a total

allocation of $75 to X and a $75 to Y.

• Key – will the IRS permit this?



• However, again, Newco has no actual income.

• And it is extremely odd that changes in the value of a

partnership's assets should drive changes in capital

account balances.

• Indeed, the general approach in the Code is to wait for

a disposition event before a change in the value of an

asset triggers taxable income or loss.

• Thus, absent some other provision of the operating

agreement, Newco might take the position that no

capital account adjustments (and therefore no phantom

income or loss allocations) are necessary until there is a

disposition event.



• Now let us assume that X is very risk averse. Instead

of a preferred return or preferred distribution, X wants

its capital account to increase in real time so that, if

Newco is liquidated, X will have a strong argument for a

preference in that liquidation.

• Thus, the preferred return arrangement is drafted so

that X's capital account is increase annually by a 10%

return on equity.

• In this instance, it would appear that an income

allocation is needed to change X's capital account

balance. Moreover, if Newco has no income, then this

must be a phantom allocation.



• And, if Newco has no income and if X is allocated

phantom income, then it would follow that Y must be

allocated a phantom loss.

• Assuming this is done, what is the nature of the income

or loss?

• If Newco merely holds a capital asset for investment

purposes, there is an argument under Arrowsmith that

the income and loss items should be of the same

character as the event that they relate to – i.e., the

eventual sale of Redacre.

• Thus, the allocations should be of capital gain and

capital loss.



• If Newco was engaged in a trade or business, then it

would follow that the phantom allocations should be of

ordinary income or loss.

• What if, due to other activities that Newco engages in

after the year 1 allocation, Redacre ceases to be a

capital asset and its disposition triggers ordinary income

or loss.

• Arguably, the year 1 allocations as capital gain and loss

could be defended on the basis that Redacre was still a

capital asset.

• This lesson here is the complexity of engaging in

phantom allocations.



• Assume now that X's 10% return is treated as a

guaranteed payment. This will not run through X's

capital account. Instead, Newco's accounting method

will come into play.

• For example, if Newco is an accrual basis taxpayer,

then the accrual of X's 10% preferred return would be

the key event: at that time, X would have $50 of

income, Y would have a $50 loss or expense item, and

Y's capital account would be reduced by $50. Note that

because the preferred return qualifies as a guaranteed

payment, it does not add to or run through X's capital

account.



• If Newco were a cash basis taxpayer, then the payment

of X's 10% preferred return would be the key event: at

that time, X would have $50 of income, Y would have a

$50 loss or expense item, and Y's capital account

would be reduced by $50. Again, because the

preferred return qualifies as a guaranteed payment, it

does not add to or run through X's capital account.

• Note that during the period between the accrual of X's

preferred return and its actual payment, there are no

consequences to X or Y or their capital accounts. Thus,

if Newco is a cash basis taxpayer, the use of preferred

return arrangements that are guaranteed payments

may permit some planning.



PREFERRED RETURNS AND DISGUISED SALE ISSUES

57


• The disguised sale rules of the Code can convert a

transaction or series of transactions that the parties

assumed would not be taxable into one or more taxable

events.

• There are several "disguised sale" rules within the Code,

but our focus here is on IRC 707(b).

Preferred Returns and Disguised Sale Issues


• In order to come within IRC 707(b), three elements

must be present:

• there is a direct or indirect transfer of money or

other property by a partner to a partnership,

• there is a related direct or indirect transfer of money

or other property by the partnership to such partner

(or another partner), and

• these transfers, when viewed together, are properly

characterized as a sale or exchange of property.



• The most difficult element in many cases is proving that

the transfers are related.

• The regulations provide a presumption that if the

transfers occur within 2 years of each other, they are

related.

• Conversely, if the transfers occur more than 2 years

apart, they are presumed to be not related.



• In the case of a preferred return, it would appear that

there is a transfer to the partnership (a capital

contribution), followed by a transfer by the partnership

to the same partner (the preferred return).

• Thus, practitioners have generally been concerned that

many common preferred return provisions would trigger

the disguised sale rules.

• The relevant regulations provide an important safe-

harbor that overrules the 2-year presumption.



• Generally, a preferred return will not trigger disguised

sale treatment if it is reasonable.

• Regardless of the labels used by the parties, such

payments must actually be for the use of capital.

• The key is that such payments must be to provide the

partner with a return on investment in the partnership.



• The §1.707-4 regulations set up the safe harbor noted

above that overrides the 2-year presumption in the

§1.707-3 regulations.

• Safe Harbor:

• The partnership agreement must provide for a

preferred return in writing for the use of capitol.

• The rate must not exceed 150% of the highest AFR

for the unreturned capital balance.



• The December/2016 long-term AFR is 2.09%.

• Under the §1.707-4 regulations, then, a preferred return

in excess of 3.135% would be outside of the safe

harbor. Such a preferred return would be subject to the

2-year presumption of the §1.707-3 regulations.

• As a practical matter, most preferred returns will exceed

the safe harbor.

• What happens?



• Cash Contributions

• Non-Cash Contributions



• Assume a partner makes a cash contribution on which

the partnership pays a preferred return.

• If the transactions are treated as triggering the

disguised sale rules, the original contribution can be

treated as a taxable event, rather than a tax-free

contribution to capital.

• But, if the contribution was all-cash, the partner would

not recognize any gain or loss, because cash has a

basis equal to FMV.

• Thus, re-casting such a contribution as a taxable sale

generally would not have any tax consequences.



• Assume a partner makes a non-cash contribution on

which the partnership pays a preferred return.

Furthermore, assume the contributed property has a

significant amount of built-in gain.

• In that case, the application of the disguised sale rules

could trigger the built-in gain.

• However, the type of preferred return will be important.

• For example, if the partnership agreement allocates

income to the partner, then the effect of the disguised

sale rules may be mitigated.



MITIGATING RISK

69


Mitigating Risk –Guaranteed Payment Issues

70

• Determine whether you want guaranteed payment

treatment

• Draft arrangement so that it provides for preferred

distributions rather than income allocations

• Link guarantee payment to partnership income

• Re-structure as a loan for overt interest treatment


• Avoid use of targeted capital account allocations

• Rely on compensatory capital shift regulations

• Partner's interest in the partnership/non-safe harbor

approach

• Preferred returns that are not tied to adjustments to

capital account balances

• Open transaction approach

• Income allocation approach – nature of income and

loss

• Guaranteed payments – cash vs. accrual basis

timing



• Safe-harbor (150% of AFR)

• Link preferred return to income (entrepreneurial risk

doctrine)

• Effect of disguised sale on cash contribution

• Effect of disguised sale on non-cash contribution



PREFERRED RETURNS AND §199A ISSUES

73


• Allocating Wages and UBIA

• Guaranteed Payment Exclusion

Preferred Returns and §199A Issues


• Generally, the 199A deduction is the lesser of:

• 20% of the taxpayer's QBI, or

• the alternative base amount.

• The alternative base amount is the greater of:

• 50% of the W-2 wages with respect to a business, or

• the sum of 25% of the W-2 wages and 2.5% of the tax basis of the qualified property of the business.

• These limitations are meant to restrict the deduction to "real" businesses rather than investment partnerships or structured arrangements.

Allocating W-2 Wages


• In the case of a partnership, the pass-through deduction is determined at the partner level. Accordingly, the amount of W-2 wages allocated to the partner must be determined.

• Each partner is treated as having W-2 wages equal to such person's "allocable share" of the partnership's W–2 wages.

• For these purposes, a partner's allocable share of W-2 wages is determined in the same manner as the partner's allocable share of wage expense.

Allocating W-2 Wages


• The tax basis of qualified property of a business is referred to as the "unadjusted basis immediately after acquisition" (UBIA).

• As with the wage component, the tax basis of the qualified property of the UBIA allocated to a partner must be determined.

• Each partner is treated as having an "allocable share" of the partnership's UBIA.

• For these purposes, a partner's allocable share of UBIA is determined in the same manner as the partner's or shareholder's allocable share of depreciation expense.

Allocating UBIA


• Example 1: A, B and C are equal owners of Newco, an LLC taxed as a partnership. Under the operating agreement, all items of income and deduction are allocated equally among A, B and C.

• In 2018, Newco has $90 of W-2 wages. For purposes of Section 199A, each member is allocated $30 of W-2 wages.

• Example 2: Same facts, A is entitled to a preferred return. If Newco does not generate sufficient income, then B and C are allocated expense items as necessary. Assume as a result that B and C are allocated $45 each of W-2 expense. Accordingly B and C are each allocated $45 of W-2 wages for Section 199A purposes.

Interaction of Preferred Returns and Allocating W-2 Wages


• Example 3: Same facts, but the operating agreement provides that no allocations are permitted that would result in negative capital accounts.

• Assume that at the start of 2018, A and B have zero capital accounts and that any allocation of W-2 wages to A or B is barred because it would create negative capital accounts. Thus, all $75 of wages are allocated to C for tax purposes. Accordingly C is allocated $75 of W-2 wages for Section 199A purposes.

Interaction of Preferred Returns and Allocating W-2 Wages


• QBI excludes payments for certain services. In

general, amounts paid as compensation to the taxpayer

by a QTB are potentially excluded.

• This includes so-called "guaranteed payments" to

partners for services, even if treated as allocations for

tax purposes.

• Preferred return arrangements that could be treated as

guaranteed payments fro capital, however, raise

different issues.

Guaranteed Payment Exclusion


• As noted, it is unclear in the tax law whether preferred

return income should be treated as interest income or

as a distributive share of underlying partnership

income.

• If treated as interest income, then a different provision

of the pass-through deduction rules is implicated.

• Specifically, the definition of QBI excludes any interest

income "other than interest income which is properly

allocable to a trade or business." IRC 199A(c)(3)(b)(iii).

• If preferred return income is treated as partnership

income, then this issue is mooted.

Guaranteed Payment Exclusion


December 12, 2019

Joseph C. Mandarino

Smith, Gambrell & Russell, LLP

Promenade II, Suite 3100

1230 Peachtree Street

Atlanta, Georgia 30309

www.sgrlaw.com

Partnership Preferred Returns: Identifying Capital Shifts and

Recharacterization Risks

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