American Bar Association

American Bar Association BASIC PARTNERSHIPS TAX PRINCIPLES July 22, 23, 2008 Michael HirschfeldDechert LLPNew York, New York(212) 698-3635michael.hirschfeld@dechert.com

Are you a PS? • LLC • PS for tax • Check the box rules: • Single member v Multi Member • Use: Non-US Entity

Form 8832 • Entity Classification Election • No need for protective election • 75 days to file • List of per se companies in Instructions • UK-Public Limited Company • Netherlands-NV • Germany-AK • France-SA • Canada-Corporation and Company

PS Interest for Cash • Tax free to contributing partner • What about Promissory Note? • Not the same as cash • No basis until pay it

Mix of Equity & Debt • May want to transfer cash for debt as well as equity? • Why? • Protect against creditors if things go bad • But-will it work? • Equitable subordination is a risk • Tax Issues: • Is it good debt for tax purposes? • At risk rules-Will it count?

PS Interest for Property • General Rule: Tax free to contributing partner

Exception: Investment Partnership • Property transfer taxable if: • Investment PS & • Diversification • Investment PS • More than 80% of value of assets are held for investment • Dollars, stock, debt, options, REIT, RIC, PTP • Key: Keep at least 20% in non-investment company assets

Investment Partnership (cont) • Diversification • If 2 or more partners transfer non-identical assets to PS • BUT no diversification if: • Only 1 partner transfers assets or • Each partner transfers: • Same portfolio or • Diversified Portfolio • Not more than 25% in one asset & • Not more than 50% in 5 or fewer assets

Property Contribution • No investment PS & no cash then non-taxable with tax attributes being: • Carryover tax basis for PS interest • Tacked holding period for property contributions

But if get back cash then: • Disguised sale rules will make this in part a taxable sale • Part sale-Part tax free transfer • Allocate basis between two events

Disguised Sale Rules The game: Get cash back later in time after property contribution is made Why? Cash distributions from a PS are not generally taxable until they exhaust your tax basis BUT • Later distribution of cash may be combined with earlier contribution of property to have a “disguised sale.” • Two year presumption but can rebut by showing subject to entrepreneurial risk of business

Exceptions to Disguised Sale Rules • Guaranteed payments for capital & preferred returns • Safe harbor: Very ltd-150% of AFR • Operating cash flow distributions • Reimbursement of preformation expenditures

Liabilities & Disguised Sale Rules • Non-recourse liabilities: • Usually, allocate liability to contributing partner under §704(c)—reduces game playing • Recourse liabilities: • Could shift, which is treated as cash distribution • Is that cash distribution caught by disguised sale rules? • Yes unless qualified liability

Exceptions to Disguised Sale Rules • Qualified Liability: • Incurred more than 2 years before contribution • Allocable to capital expenditures • Liability incurred in ordinary course of business but only if all the assets held in that trade or business are transferred to PS • Liability cannot exceed FMV of assets

Taxable Sale-Cap Gain? • Code Section 1239 • Sale of depreciable property between PS and controlling partner generates ordinary income • Controlling partner • More than 50% ownership

So, tax free contribution—are there any tax concerns? • Yes if AB is not equal to FMV of property • Why? • Consider 2 partners, A & B • A contributes $100 cash • B contributes land with FMV = $100, but tax basis of zero • The next day, PS sells land for $100 • How does PS allocate the $100 gain?

Allocating Gain from Sale of Contributed Property • Could PS allocate $100 gain to both partners in the same way that regular PS income is allocated (thaf is, 50-50)? • NO • Code Section 704(c) requires that you allocate built ingain to B, the contributing partner • Why?

A Increased by $100 due to cash contribution If allocate A 50% of gain then increased to $150 If liquidate, A gets $150 if follow capital account-something is wrong since A thinks he should get only $100 B Increased by zero upon property contribution since AB of property was zero If allocate B 50% of gain then increased to $50 If liquidate, B gets $50 if follow capital account—something is wrong since B thinks she should get $100! Capital Account Analysis if Use AB of Assets

Variation on a Sale • Sell land that had AB = 0 & was worth $100 on date of contribution for $150 then • Allocate $100 gain to B BUT • Can allocate excess gain of $50 to A and B • KEY ISSUE: • What is FMV of land on date of contribution? • MUST SPELL OUT IN YOUR AGREEMENT!

Allocation of Gain & Capital Accounts • Capital accounts used for tax allocation purposes: • Increased by AB or FMV of property contribution? • Decreased by AB or FMV of property distribution? • Increased by taxable income/gain allocable to a partner • Decreased by taxable loss/deductions allocated to a partner • SO, LET’s APPLY THIS HERE

Contribution of Depreciable Property-allocations: • How do you handle Allocations Relating to a Contribution of Property

General Principle • Tax must follow book • § 704(c) addresses situations when a disparity exists between a partnership’s tax accounts and its book accounts.

Methods for § 704(c) Allocations • Traditional Method: each partner is treated as if it purchase a pro rata interest in the property • Beware the “Ceiling Rule” • Traditional Method with Curatives: allows for “reasonable curative allocations” to prevent distortions resulting from the “ceiling rule” • Remedial Method: permits partners to ignore the ceiling rule and create tax allocations to match and offset their book allocations

Section 704(c) Example • AB Partnership • A contributes $390,000 • B contributes depreciable property worth $390,000, but with a $39,000 tax basis • Property depreciated over 39 years so: • A hopes there is $10,000/ year of depreciation to split & she will get $5,000 • But there is only $1,000 of depreciation to split • What happens?

Section 704(c) Example-Outcome • Traditional method: specially allocate $1,000 to A so A is short changed—she thought she would get $5,000 • Traditional Method With Curative Allocations: can specially allocate other depreciation to A so as to get A $5,000 BUT if no other depreciation, you are stuck • Remedial method: A gets $5,000.

Diversion of sorts: Basic PS Tax Rule: • Property distributions to a partner do not normally trigger tax! • Could you take advantage of this rule to “play games”

The Game • The Players: • A & B each put in cash of $1,000 • C puts in property worth $2,000 • The Game: • 3 years later, A and B are redeemed out of PS by giving them each a ½ interest in the property • A and B-say tax free to us • C says great news—I just cashed out & fooled the tax system BUT

Tax Traps if have Contributed Property • Distribution of contributed property to other partner • Distribution of other property to contributing partner

Anti ”Mixing Bowl” Rules • If property leaves PS within 7 years, then that may trigger tax to contributing partner • Watch out for these rules • §704(c)(1)(B): Contributed property goes out to another partner • §737: Contributing partner redeemed out for other property

Purchase of PS Interest & Impact on Property AB • If you buy into a PS with property, are you stuck with tax basis of assets?

Section 754 Election-Example: • ABC PS acquired Property for $9M • Tax basis of property is now $6M • X buys C’s interest for $6M • Thus, current value of PS is $18M • But, C’s share of tax basis of PS property is only $2M and not $6M • Absent help, X is stuck with that $2M basis • Q. How can we help

The Fix-Optional AB Adjustment • Elect basis adjustment under Sections 754 and 743 • Gives “basis boost” for C’s benefit

Example Impact • ABC Partnership • Tax basis = $6M allocable $2M to A, $2M to B and $2M to Xm purchaser of C’s interest • BUT Now • Special tax basis adjustment for only X • X’s tax basis = $6M • More depreciation/amortization & • Less gain or greater loss on sale

BUT Mandatory Downward Basis Adjustments-now required under Section 754 • Section 743-If “substantial built in loss,” then PS must reduce basis • $250,000 threshold • Section 734-If “substantial basis reduction,” then PS must reduce basis • $250,000 threshold • Electing investment PS (“EIP”) exception • If EIP election, then transferee partner’s share of losses from PS is reduced

PS Interest for Services • Can you get this tax free?

Carried Interests • Planning Possibility: Can get PS/LLC interest to a person w/o triggering tax!

Carried Interest • The grant of an interest to a service provider raises a host of issue: • Taxability of holder on date of grant or date when vesting restrictions lapse • Need for Capital Contribution • Code Section 83 Impact • Possible deduction to PS/LLC • Proposed tax legislation: • PTP Issue • Non-PTP Ordinary Income Exposure

Key: Profits Interest-Good; Capital Interest-Bad • Difference: • If you liquidate the PS, would you get something back? • If yes, capital interest • If no, profits interest • BUT, should this liquidation analysis be the proper test?

Carried Interest IRS Guidance • Background: Diamond v. Comm., 56 TC 530, aff’d, 492 F.2d 286 (7th Cir. 1974) • Rev. Proc. 93-27 • Key factor: Profits v Capital Interest • Rev. Proc. 2001-43 • Notice 2005-43-Proposed Safe Harbor • Caveat: substantially certain & predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, (b) transferred in anticipation of a subsequent disposition, or (c) an interest in PTP

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

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

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

Cookbook for PS Agreements-Tax Allocations • General Allocation Rules--§ 704(b) • Allocation of Non-recourse Deductions—Treas. Reg. § 1.704-2 • Allocation for Contributed Property--§ 704(c) • Reverse § 704(c) Allocations

General Allocation Rules General Principle Tax must follow economics

Two “Simple” Rules • Allocations must have “substantial economic effect” (“SEE”) • If an allocation fails this test, then amounts are reallocated among partners in accordance with the partners’ interests in the partnership (“PIP”).

Two “Simple” Rules (cont’d) • But what is “substantial economic effect”? • There are dozens of pages of regulations to explain this

SEE vs. PIP • Why might it be preferable to rely on SEE rather than PIP in setting partner allocations? • More certainty in dealing with the IRS. • For pension plan investors in debt financed real estate partnership desirous of avoiding UBIT, the partnership agreement must meet “fractions rule” and allocations must have “substantial economic effect”.

Economic Effect • Test #1—Safe Harbor • Three Prong Test • Agreement provides for maintenance of capital accounts in accordance with Treas. Reg. § 1.704-1(b)(2)(iv); • Agreement provides for liquidation of partnership interests in accordance with positive capital accounts; and • Partners have a capital account “deficit restoration obligation” upon liquidation.

Economic Effect (cont’d) • Capital Account Maintenance • Two requirements must be satisfied • All items of income, loss, deduction, tax-exempt income and non-deductible expenditures as well as capital contributions and distributions are reflected in determining capital accounts; and • Capital contributions and distributions of property are taken into account in computing their capital account at fair market value.

Relevance of capital accounts • On the K-1 • Non-liquidating distributions typically not tied to capital accounts • Liquidating distributions • Based on capital accounts? • Specified waterfall? • Both (belt and suspenders) • If not based on capital accounts, care must be taken, but it is still possible to survive, as discussed later vis a vis Target Allocations

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