capital account challenges for partnerships and...
TRANSCRIPT
Capital Account Challenges for Partnerships and LLCs Tackling Targeted Capital Account Calculations, Complex Operating Agreements and Other Tax-Related Issues
TUESDAY, JULY 23, 2013, 1:00-2:50 pm Eastern
WHOM TO CONTACT
For Additional Registrations:
-Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10)
For Assistance During the Program:
- On the web, use the chat box at the bottom left of the screen
- On the phone, press *0 (“star” zero)
IMPORTANT INFORMATION
This program is approved for 2 CPE credit hours. To earn credit you must:
• Respond to verification codes presented throughout the seminar. If you have not printed out the “Official Record of
Attendance”, please print it now. (see “Handouts” tab in “Conference Materials” box on left-hand side of your
computer screen). To earn Continuing Education credits, you must write down the verification codes in the corresponding
spaces found on the Official Record of Attendance form.
• Complete and submit the “Official Record of Attendance for Continuing Education Credits,” which is available on the
program page along with the presentation materials. Instructions on how to return it are included on the form.
• To earn full credit, you must remain on the line for the entire program.
For this program, attendees must listen to the audio over the telephone.
Tips for Optimal Quality
Sound Quality
Call in on the telephone by dialing
1-866-869-6667 and enter your PIN when prompted, and view the presentation slides online.
If you have any difficulties during the call, press *0 for assistance. You may also send us a
chat or e-mail [email protected] so we can address the problem.
Viewing Quality
To maximize your screen, press the F11 key on your keyboard. To exit full screen,
press the F11 key again.
Program Materials
If you have not printed or downloaded the conference materials for this program, please
complete the following steps:
• Click on the + sign next to “Conference Materials” in the middle of the left-hand column
on your screen.
• Click on the tab labeled “Handouts” that appears, and there you will see a PDF of the
slides and the Official Record of Attendance for today's program.
• Double-click on the PDF and a separate page will open.
• Print the slides by clicking on the printer icon.
Capital Account Challenges for Partnerships and LLCs
Gregory M. Levy, Kaufman Rossin & Co.
July 23, 2013
Leo HItt, Reed Smith
Telma Nadvorny, Ernst & Young
Today’s Program
General Overview
[Telma Nadvorny]
Traditional Layered Approach
[Gregory M. Levy]
Targeted Capital Account Approach
[Leo Hitt]
Slide 7 – Slide 29
Slide 43 – Slide 59
Slide 30 – Slide 42
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
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
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.
GENERAL OVERVIEW
Telma Nadvorny, Ernst & Young
Slide 8
Partnership Allocations Overview
Slide 9
Contrasting Basis And Capital Accounts
Outside tax basis Book capital accounts
Tax capital accounts
Increased by Tax basis of contributions
Share of taxable income
Share of partnership liabilities
Increased by FMV of contributions
Share of book income
Increased by Tax basis of contributions
Share of taxable income
Decreased by Tax basis of distributions
Share of taxable loss
Decreased by FMV of distributions
Share of book loss
Decreased by
Tax basis of distributions
Share of taxable loss
Slide 10
Section 704 Overview
► Section 704(a): a partner’s share of tax items is determined by
partnership agreement
► Section 704(b): ensures that allocations of partnership items match
economics of deal (i.e., ensures each partner receives economic
benefit or bears economic burden associated with allocations of
income and deduction)
► Section 704(c): governs allocations of tax items related to property
that has a tax basis different from its §704(b)
book value
► Section 704(d): partner is entitled to deduct allocated losses only to
extent of partner’s basis in his or her partnership interest at end of
year
Slide 11
Partnership Agreement: Starting Place For Partnership Allocations
► Includes all agreements
► Among all partners
► Between some partners
► Need not be called “partnership agreement”
► Can consist of more than one document
► May be oral or written
► Includes applicable non-tax law
► In case of hybrids (i.e., U.S. partnership, foreign corp.), should include
shareholders’ agreement
Slide 12
Allocations Satisfy §704(b) If:
► Substantial economic effect
► Economic effect test requirements must be satisfied
► Allocations must be substantial
► Partners’ Interest in the Partnership (PIP)
► Deemed to be in accordance with PIP (e.g., nonrecourse deductions, tax credits)
► Note: An allocation respected under §704(b) may nevertheless be reallocated under another provision of the Internal Revenue Code (e.g., §482)
Slide Intentionally Left Blank
Slide 14
Three Tests For Economic Effect
► Primary test
► Alternate test for economic effect
► Economic equivalence test
Slide 15
Economic Effect Test Requirements
► Primary test
► Capital account
maintenance
► Liquidation in accordance
with positive capital
accounts
► Deficit restoration obligation
(DRO)
► Alternate test
► Capital account maintenance
► Liquidation in accordance with
positive capital accounts
► Loss allocation may not cause
or increase adjusted capital
account deficit
► Qualified income offset (QIO)
Slide 16
Example 1, Stage 1: Capital Account Maintenance – In General
JV
Cash
$200
FMV ATB
Equipment $100 $40
Land 100 80
Total $200 $120
Money
Co. Op. Co.
Op. Co.
Book Tax Basis
$200 $120 $120
Money Co.
Book Tax Basis
$200 $200 $200
$200 $200 $500 $200 $120 $120
► What are the partners’ book and tax capital accounts? Outside basis?
What if JV borrowed $300 from Bank, with loan guaranteed by Money Co.?
Slide 17
Example 1, Stage 2: Computing JV’s Book Depreciation
► Annual tax depreciation on the equipment is $10. What is the annual book depreciation?
JV
Money
Co. Op. Co.
Cash
$200
FMV ATB
Equipment $100 $40
Land 100 80
Total $200 $120
Slide 18
Example 1, Stage 3: Reflecting Partnership Income/(Loss)
Year 1 Activity:
► Operating income - $40
► Operating expenses - $240
► Tax depreciation - $10; Book - $25
► Long-term gain on sale of land - $20
► Current distributions - $30
► Assume all split 50-50 Equipment FMV=100 ATB=40
Money Co. Op. Co.
50% 50%
Land FMV=100 ATB=80
Cash FMV=200 ATB=200
Op. Co. Book Basis
$200.0 $120.0
Money Co. Book Basis
Beginning $200.0 $200.0 (100.0) (100.0) Net. op. loss (100.0) (100.0) (12.5) (0.0) Depreciation (12.5) (10.0)
0.0 20.0 Gain on sale 0.0 0.0
(15.0) (15.0) Distributions (15.0) (15.0)
$72.5 $25.0 Ending $72.5 $75.0
JV
Slide 19
Capital Account Maintenance: Revaluations Of Partnership Property
► Reasons needed:
► Maintain relative economic interests of the partners
► Prevent capital shifts
► Mandatory vs. optional
► Mandatory for property distributed to a partner
► Optional for all assets on contributions, distributions, and in accordance with industry standards for securities partnerships
► Differences created between partners’ book and tax capital accounts; must be taken into account under §704(c) principles
Slide 20
Liquidating Distributions
► Must be made in accordance with the partners’ positive capital
account balances
► Determined after taking into account all capital account adjustments
for partnership taxable year during which liquidation occurs
► Generally, must be made by the earlier of:
► The end of the year of liquidation
► Ninety days following the date of liquidation
Slide 21
Deficit Restoration Obligation
► Requires partner with deficit capital account balance upon liquidation
of his partnership interest to unconditionally restore the amount of
such deficit
► Actual DRO in partnership agreement
Or
► Deemed DRO
► State law requirements
► Promissory notes of partner or related entity that are
contributed to partnership
► Unconditional obligation to contribute
► Ultimate payor on partnership recourse debt
► Minimum gain
Slide 22
Qualified Income Offset Provision
► In lieu of DRO required under primary test for economic effect,
alternate test requires that partnership agreement contain a QIO.
► Partnership agreement must provide that unexpected distributions
causing/increasing deficit balance in partner’s capital account will
be eliminated as quickly as possible.
► Some agreements contain protective allocation provision to
prevent future deficit capital accounts by requiring the allocation of
gross income to partner with deficit capital account balance at end
of any year (i.e., protective gross income allocation).
► Agreement must also restrict loss allocations so as not to cause or
increase adjusted capital account deficit.
Slide 23
Substantiality
► An allocation is substantial “if there is a reasonable possibility that the
allocation will affect substantially the dollar amounts to be received by
the partners from the partnership, independent of tax consequences.”
► Three general rules:
1. Intra-year shifting rule
2. Inter-year transitory allocation rule
3. Overall tax effect rule
Slide 24
Shifting Allocations
► Taxable vs. tax-exempt income
► Ordinary income vs. capital gain
► Ordinary loss vs. capital loss
► Domestic vs. foreign source income
► Active vs. passive income (loss)
► Passive vs. portfolio income (loss)
Slide Intentionally Left Blank
Slide 26
Transitory Allocations
► Testing period: All tax years in which allocations may occur
► Hallmarks
► Aggregate tax reduction
► Minimal capital impact
► Exceptions
► Five-year waiting period
► Value equals basis rule
Slide 27
Overall Tax Effect Rule
► Strikes down allocation if after-tax economic consequences of at least one partner may, in present value terms, be enhanced, and a strong likelihood exists that after-tax consequences of no partner will, in present value terms, be substantially diminished (taking into account partners’ non-partnership tax attributes).
► Requires that projected after-tax economic results to each partner under prescribed allocation scheme be compared to same after-tax economics that would result under allocation scheme if the allocations being tested were not included in the agreement.
► However, virtually no guidance as to the various factors that should be considered in arriving at this “base-line” allocation is provided.
Slide 28
Partner’s Interest in Partnership (PIP)
► Allocations failing either the economic effect or substantiality safe
harbors will be respected if the allocation is based on PIP
► Facts-and-circumstances test including:
► Relative contributions of partners
► Relative interests in distributions upon liquidation
► Relative interests in cash flow
► Relative interests in economic profit and loss sharing ratios
Slide 29
Section 704(b) Recap
► To be respected, partnership allocations must:
► Have substantial economic effect
► Be in accordance with the partners’ interests in the partnership
Or
► Be deemed to be in accordance with the partners’ interests in the
partnership
► If allocations are not respected, income, loss, etc. will be allocated in
accordance with PIP rules.
TRADITIONAL LAYERED APPROACH
Gregory M. Levy, Kaufman, Rossin & Co.
Gregory M. Levy CPA
Contact Information:
561.394.5100
www.kaufmanrossin.com
Hedge Fund Tax Allocations: Discussion Topics
• The basics of book and tax allocations
• Examples of book/tax differences
• Tax allocation methods
• The aggregate method and break periods
• Stuffing/fill-up
32
Hedge Fund Tax Allocations: Basics Of Book And Tax Allocations
• Two broad categories of income:
– Ordinary items (interest, dividends, operating expenses)
– Capital items (realized gain/loss, change in unrealized appreciation(depreciation)
• Book allocations – all items generally allocated pro rata
33
Hedge Fund Tax Allocations: Basics Of Book And Tax Allocations
(Cont.) • Tax allocations – ordinary items generally allocated
pro rata
• Capital items allocated IN CONCEPT so that partners who are allocated unrealized gain/loss are allocated the realized gain/loss associated with the sale of such securities
• TIMING generally drives book/tax differences associated with allocation of capital items.
34
Hedge Fund Tax Allocations: Examples Of Book/Tax Differences
• Unrealized gain/loss
• Tax realization before book realization
– Constructive sales, 1256 positions, OID
• Tax realization after book realization
– Wash sales, straddles
• Tax recharacterizations
– Foreign currency, market discount
35
Hedge Fund Tax Allocations: Tax Allocation Methods
• Layering
• Aggregate
• Full netting vs. partial netting
• Layering:
– Involves allocating unrealized gain (loss) to each partner on a security-by-security basis
– Very precise, can be cumbersome
– Best done by a tax allocation software package
36
Hedge Fund Tax Allocations: Tax Allocation Methods (Cont.)
• Aggregate
– Allocates unrealized gain(loss) for all investments together (hence the name), rather than on a security-by-security basis
– Introduces judgment, flexibility, subjectivity into the allocation process
– Must meet criteria for use of aggregate method
37
Hedge Fund Tax Allocations Tax Allocation Methods (Cont.)
• Qualifications for aggregate method
– Management company, or investment partnership
• 90% are qualified financial assets
• Revaluations made annually
• Allocations in accordance with capital accounts
38
Slide Intentionally Left Blank
Hedge Fund Tax Allocations: Aggregate Method And Break Periods
• Break period
– General definition
– Impact on allocations
– For capital allocations:
• Each break period stands alone?
• Can the taxable year override break periods?
40
Hedge Fund Tax Allocations: Stuffing/Fill-Up
• To stuff or not to stuff?
• Stuff both gains and losses?
• Stuff partial withdrawals?
• Stuff long-term investors with short-term gains?
• Stuff short-term investors with long-term gains?
• Impact of ceiling rule?
• Impact of American Job Creation Act of 2004 on stuffing losses
41
Hedge Fund Tax Allocations Stuffing/Fill-Up (Cont.)
• Distributions in kind as a solution to stuffing issues
42
TARGETED CAPITAL ACCOUNT APPROACH
Leo Hitt, Reed Smith
Basic Structure Of Safe Harbor Provisions
The [g]old standard of allocations [tax practitioner’s view] is a “safe
harbor” allocation provisions.
Under IRC Section 704(a) and (b), allocations of partnership
income, gain, loss, deduction or credit between or among the
partners are generally respected so long as the allocations to each
partner:
(1) Are set forth in the partnership agreement, and
(2) Have substantial economic effect.
Otherwise, allocations will be made in accordance with the “partners’
interest in the partnership.”
Strafford
Capital Account Challenges for Partnerships and LLCs
Basic Structure Of Safe Harbor Provisions (Cont.)
Substantial economic effect
Basic test for economic effect - throughout the full term of the
partnership, the partnership agreement provides that:
Capital accounts are maintained in accordance with the
regulatory requirements.
Partnership liquidating distributions are required to be made in
accordance with the partners’ positive capital account
balances (after liquidation year adjustments).
Any partner having a deficit in his or her capital account is
unconditionally obligated to restore the deficit no later than the
end of the tax year, or, if later, within 90 days after the
liquidation date (a “deficit restoration obligation”).
Strafford
Capital Account Challenges for Partnerships and LLCs
45
Basic Structure Of Safe Harbor Provisions (Cont.)
Substantial economic effect (Cont.)
Alternate test for economic effect
The partnership agreement must first satisfy the first two
requirements of the basic test.
The partnership agreement must contain a “qualified income
offset” provision.
The allocation must not cause or increase a deficit balance in
the capital account of the partner receiving the allocation.
Strafford
Capital Account Challenges for Partnerships and LLCs
46
Basic Structure Of Safe Harbor Provisions (Cont.)
Substantial economic effect (Cont.)
Economic effect equivalence test
As of the end of each partnership tax year, a liquidation of the
partnership would produce the same economic results to the
partners as if each requirement of the basic test were satisfied
regardless of the partnership’s economic performance.
This test is made as of the end of each tax year of the
partnership.
This test is the heart of the argument that targeted capital
account allocations are compliant with the safe harbor
regulations and is sometimes (unfortunately) known as the
“dumb but lucky” rule.
Strafford
Capital Account Challenges for Partnerships and LLCs
47
Basic Structure Of Safe Harbor Provisions (Cont.)
Substantial economic effect (Cont.)
Substantiality
Even if an allocation has economic effect, as previously, it will
not be respected unless the economic effect of the allocation
is “substantial.”
Is there a reasonable possibility that the allocation will
affect substantially the amounts the partners will receive
from the partnership, independent of tax consequences?
The test includes an analysis of the after-tax economic
consequences to determine if one partner is benefited,
while there is a strong likelihood that the after-tax economic
consequences of no partner will, in present-value terms, be
substantially diminished.
Strafford
Capital Account Challenges for Partnerships and LLCs
48
Targeted Capital Account Provisions
Approaches
Safe harbor approach: Draft the allocation and liquidation
provisions to rely on the basic or alternative economic effect
tests. The allocation provisions would be structured so that
capital accounts are intended to equal the agreed waterfall by the
liquidation year.
The concern with this approach is that there may not be
enough tax attributes at the time of liquidation (see below for
discussion of continuing versus liquidation year provisions), to
accomplish the equalization.
If the agreement is safe harbor compliant, the distributions will
not follow the waterfall if there is a shortfall of tax attributes.
Strafford
Capital Account Challenges for Partnerships and LLCs
49
Targeted Capital Account Provisions (Cont.)
Approaches
Targeted capital account approach: Draft a distribution
waterfall (i.e., the partners’ economic deal) and then draft a
simple allocation provision that provides:
Partnership profit or loss be allocated to cause the partners’
ending capital account balances to equal what they must be in
order to liquidate the partnership in accordance with the
distribution waterfall
This causes each partner’s ending capital account balance to
be reduced to exactly zero by the partnership liquidating
distribution).
Strafford
Capital Account Challenges for Partnerships and LLCs
50
Slide Intentionally Left Blank
Targeted Capital Account Provisions (Cont.)
Approaches (Cont.)
Targeted capital account approach (Cont.)
This allocation provision is generally designed to satisfy the
economic effect equivalence test or be viewed as in
accordance with the “partners’ interest in the partnership,” but
if there’s a shortfall in tax attributes, the waterfall controls!
Many investors prefer this approach because of the certainty
of the sharing of liquidation proceeds and will accept the
inherent tax risk of this method.
As a practice tip, make sure that the investors know that this is
the choice that they have made in selecting the targeted
capital account approach over a safe harbor provision.
Strafford
Capital Account Challenges for Partnerships and LLCs
52
Targeted Capital Account Provisions (Cont.)
Approaches (Cont.)
Comparison of targeted capital account approach versus
safe harbor approach
Cash is king, versus tax is king choice
The IRS has never specifically approved the targeted
capital account approach. Recent pronouncements
indicate that guidance may be coming forth soon or at least
that the IRS is feeling some pressure to do so.
Practitioners have been requesting guidance for years.
The targeted capital account provision is easy for the investor
to understand in concept but problematic for the tax return
preparer to apply in practice, particularly with a continuing
provision (see next slide).
Strafford
Capital Account Challenges for Partnerships and LLCs
53
Targeted Capital Account Provisions (Cont.)
Timing of targeted capital account provision
Year of liquidation provision: The allocations to cause capital
accounts to equal the waterfall is made only in the year of
liquidation (and possibly at major capital transactions).
The primary advantage is simplicity, because it is a single
application of the deemed (or actual) sale approach and the
balancing of capital accounts to achieve the target.
The primary disadvantage is that this approach greatly
increases the risk the IRS will view the allocations as being
non-compliant with substantial economic effect regulations,
and will reallocate income/loss in accordance with its view of
the economic arrangement of the partners or members.
Strafford
Capital Account Challenges for Partnerships and LLCs
54
Targeted Capital Account Provisions (Cont.)
Timing of targeted capital account provision (Cont.)
Continuing provision: For each year, allocations will be made
as if there is a deemed sale of assets at Section 704(b) book
value and a liquidation.
The primary advantage is an increased prospect of the
allocations being viewed as Section 704(b)-compliant.
The primary disadvantage is complexity and uncertainty. It
requires annual compliance with the complex capital account
maintenance rules and dealing with the uncertainty associated
with those rules.
Strafford
Capital Account Challenges for Partnerships and LLCs
55
Targeted Capital Account Provisions (Cont.)
Sample language
Distribution in liquidation:
Section [X.Y] Distributions in liquidation: In the event of a
Liquidation of the Company, distributions shall be made as
follows: [Insert the agreed waterfall]. Such liquidating
distributions shall be made in accordance with the timing rules
set forth in Regs. Sec. 1.704-1(b)(2)(ii)(b)(2).
A sample waterfall – Liquidating distributions shall be made
as follows: first, to Partner A in an amount equal to Partner
A’s contributions; second, to Partner B in an amount equal
to Partner B’s contributions; and, thereafter, to Partner A
and Partner B in their respective Percentage Interests.
Strafford
Capital Account Challenges for Partnerships and LLCs
56
Targeted Capital Account Provisions (Cont.)
Sample language (Cont.)
Allocation provision
Section [Y.X] Allocations: Partnership Profit or Loss [in each
taxable year / in the taxable year of Liquidation] shall be
allocated in a manner to cause the Partners’ ending Capital
Accounts to equal the amount they would receive if the
Partnership were to sell all of its assets for Book Value and
liquidate pursuant to Section [X.Y] of this Agreement.
If a “continuing” targeted allocation is adopted, this would be
the only allocation provision. If the year of liquidation
approach is adopted, there would be other allocation
provisions (e.g. in accordance with percentage interests) for
all other years.
Strafford
Capital Account Challenges for Partnerships and LLCs
57
Targeted Capital Account Provisions (Cont.)
Open issues to be addressed
Treatment of capital shifts as a result of targeted capital account
provisions (compensatory interests and non-compensatory
interests)
Treatment of preferred returns as guaranteed payments in
targeted capital account provisions
Nature of required support of conclusion that the allocations
comply with the economic effect equivalence test or are in
accordance with the “partners’ interest in the partnership,”
particularly if allocations are not strictly in proportion to
partnership interests.
Strafford
Capital Account Challenges for Partnerships and LLCs
58
To ensure compliance with Treasury Department regulations, we
inform you that, unless otherwise expressly indicated, any U.S.
Federal tax advice contained herein was not intended or written to
be used, and cannot be used, for the purpose of (1) avoiding tax-
related penalties under the Internal Revenue Code or (2) promoting,
marketing, or recommending to another party the tax-related matters
addressed herein.
Strafford
Capital Account Challenges for Partnerships and LLCs