tax issues for operating agreements - amazon s3 · • liquidation proceeds are distributed in...

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Tax Issues For Operating Agreements

William A. Price, Growthlaw.com

Tax Issue Life Cycle

•  Entity Selection •  Entity Capitalization •  Entity Operations •  Entity Sale Or Other Disposition

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Entity Selection And Location Issues

•  Federal Tax: Pass-Through Or Other Tax Status? Conversion Problems? Operations Taxability, Rates?

•  State Income Tax: Tax-Free State Parent Entity? •  State Sales Tax: Tax-Free State Operations

Entity? •  State Franchise and Other Special Taxes: DE or

franchise free? Any minefields out there?

Entity Selection: Federal Tax

•  LLC Can Select Any Entity Status, Including Entity Level Taxation As Association, S Corp.

•  Existing Entity Conversion Issues •  S Corp vs. LLC: Citizenship, tax basis, classes

of ownership, Social Security/Medicaid tax reduction

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LLC Entity Federal Tax Type Selection

•  Default LLC tax status is Partnership: International Entities: May have to be taxed as business associations

•  Domestic: if income not needed, reserve retention in entity a tax shelter, vs. annual realization of income/outgo: LLC Elects C Corp. Status

•  Not for profit LLC Can Be Tax Exempt

Entity Selection: Federal Tax Incidence on Entity Conversions

•  Partnership To Other Partnership: No tax due unless deemed sale

Code references: Under Rev.Rul. 95-37, a partnership-to-LLC conversion is treated as a contribution of property from the partnership in exchange for an interest in the LLC, which generally is a tax-free transaction under Code §721. Such a transaction is not a “sale or exchange” within the meaning of the termination rules set forth in Code §708(b)(1)(B).

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Entity Selection: Federal Tax on C To LLC Entity Conversions

•  C Corporation To Partnership (GP, LP, or LLC): Capital gain or loss from deemed liquidation usually taxable under IRX Sections 331(a) and 336

•  Savings options: Wind-down: continue corporation for old business, all new business through new LLC

•  Lease equipment, facilities to new LLC from old entity, or provide rent free to realize income in new entity

Entity Selection: Federal Tax on S Corp Entity Conversions: None

•  S Corporation To Partnership (GP, LP, or LLC): Capital gain or loss from deemed liquidation. IRC Section 336(a)

•  However: S Corporation Shareholders Get Step-Up In Basis Equivalent To Gain On Deemed Liquidation, IRC §1367(a)(1)(A).

•  Generally speaking, therefore, no taxable gain

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Entity Selection: S Corporation versus LLC

•  S Corporation: Status election not allowed for corporations with nonresident aliens as shareholders, 26 USC Section 1361(B)(1)(C ): LLC (partnership or C Corp) status no citizenship requirements

•  LLC taxed as partnership member can have debt in tax basis, not just cash

•  S Corp only one class of stock •  S Corp easier to avoid Social Sec/Medicaid tax

on distributions

Entity Capitalization:

•  LLC’s And Other Partnerships: Income, Tax, And Debt Allocations May Differ Among Individual Members And Classes of Members

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Entity Capitalization: Capital Contributions

•  IRC §721 – No gain or loss to partner or partnership on contribution of property for an interest in partnership capital – Exceptions: Investment company (§721(b)); Company takes on member liabilities >contributions; Disguised sales (Sec. 707(a)(2)

•  IRC §722 – Partner takes a substitute basis in partnership interest equal to her basis in contributed property(ies) and cash

•  IRC §723 – Partnership takes carryover basis in contributed property equal to partner’s basis in such property prior to contribution

Entity Capitalization: Capital Accounts

•  Operating Agreement Should Provide For Same •  Accounts Are Proof of “Economic Substance” In Partner

Income Allocations •  Simple table by partner, columns for increase (decrease)

by date, resulting basis, and reason for change

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Entity Capitalization: Partner Capital Accounts Basis Should Decrease If

•  Money distributed to the partner •  FMV of property distributed to the partner (net of

liabilities encumbering the distributed property) •  Partner’s distributive share of nondeductible,

noncapitalizable expenditures described in IRC §705(a)(2)(B)

•  Partner’s distributive share of the partnership’s book loss and deductions (or items thereof) other than items already accounted for as distributive shares of partnership expenditures under §705(a)(2)(B)

Entity Capitalization: Partner Capital Accounts Basis Should Increase If

•  Money contributed to the partnership •  FMV of property contributed to the partnership (net of

liabilities encumbering the contributed property) •  Partner’s distributive share of the partnership’s book

income and gain (or items thereof), including tax-exempt income

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Entity Capitalization: Capital Accounts Gain Exceptions

•  IRC §731(a)(1) – Partner recognizes gain only if she receives cash in excess of the basis of his or her partnership interest

•  IRC §731(a)(2) – Partner may recognize loss if: – Receives nothing other than cash and/or unrealized receivables and inventory, and – Amount of cash and basis of unrealized receivables and inventory is less than basis in partnership interest

Entity Capitalization: Capital Accounts and Gain Or Loss Rules

– Distribution of marketable securities (= Cash) – Payments to a retiring partner or a deceased partner’s successor in interest subject to IRC §736, 707 (Taxable income to recipient, some retirement plan tax deferral possible, repayment of capital account balance not income.) – Distributions subject to IRC §751 (Deemed sale gain if ordinary income assets share > Partner share of entity) – Distributions subject to IRC §737 (re: recognition of pre-contribution gain in the case of certain distributions)

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Entity Capitalization: Flexibility In LLC Interest Types

•  LLC Acts permit almost any type of income, control, and other interest (e.g. tax-deferred phantom stock/interest plan based on uncertain future sales amount of company)

•  Recapitalization often triggers rules to benefit new investors/owners

Entity Capitalization: Distributive Share Of Taxable Income

•  Partners must recognize their “distributive shares” of short and long term capital gains, ordinary income, etc…

•  IRC Section 704 and rules under same determine rules for partner (in LLC, member) distributive shares

•  Operating agreements can reallocate responsibility for tax payments among members: such payments are taxable to benefiting member or not depending on Section 704 rules

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Entity Capitalization: Allocation Of Income Among Partners

•  IRC 704 (A) and (B): Operating Agreement controls allocations unless an allocation lacks “economic substance.” (Cf. Treas. Reg. § 1.704-1(b).)

•  To have substance, an income or loss allocation must have a reasonable possibility of substantially affecting the dollar amounts to be received by the partners, independent of tax consequences.

Entity Capitalization: “Standard” Safe Harbor For Allocation Of Income

•  Partner’s capital account must reflect allocations per agreement

•  Liquidation proceeds are distributed in accordance with partners' positive capital account balances

•  Partners must restore capital account deficits on liquidation of their interest in partnership by end of taxable year or within 90 days of liquidation (Note: this means unlimited partner liability for entity debts, so almost no agreements ever actually contain this DRO.)

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Entity Capitalization: Allocation Of Income If Shifts Taxable Gain/Loss

•  Shifting allocation could allow partner with a large net operating loss carryforward is allocated all of the partnership’s taxable dividends while a high tax bracket partner is allocated an equal amount of the partnership’s tax exempt interest income, all during one tax period: substantial economics tests in Treas. Reg. § 1.704- 1(b)(2)(iii)(b)

Entity Capitalization: Allocation Of Income If Allocation Is Transitory

•  Transitory allocations could cause disallowance of the above: eg agreement allocates Yr. 1, removes allocation later. Level of real economic risk in deal causing allocation, five year time before reallocation likely, and a capital basis sufficient to cover allocation effects all safe harbors for allocation provisions in operating agreement

•  Treas. Reg. § 1.704-1(b)(2)(iii)(c) contains rule and these safe harbor examples

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Entity Capitalization: Alternative Safe Harbors for Substantial Effect

•  Benefit limited to basis contribution on liquidation: no allocation of tax benefit beyond whatever limited amount partner (member) would have to contribute on liquidation of entity

•  Qualified income offset: If surprise misallocation of income relative to partner (member) basis, then agreement allocates other income as quickly as possible

Entity Capitalization: Contributed Property Rules

•  Property which is contributed to partnership does not result in realization of gain or loss to contributing partner, Section 721, but must, in partnership capital account, be valued at FMV, not “book value” (tax basis of contributed property

•  Section 704(c) “substantial economic effect” rules address tax/book value differences, cf Treas. Reg. § 1.704-3 for ways partners eventually realize built-in gain or loss, unless property held by partnership for 7 years

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Entity Operations: IRS/State Tax: Operating Agreement Sections

• Tax Matters Partner (Who can sign returns) • Notice Partner (Who is to receive tax notices) •  Power to Bind Settlement •  Illinois Reg-1 Personal undertaking that all taxes will

be paid

Entity Operations: Multiple State Operations: Out of State Parent?

•  No state income tax in Nevada, South Dakota, Texas, Washington, Wyoming, Kansas moving to none for pass-throughs

•  Note limits on allocation of income through licensing fees by no tax state entity in many other state’s tax codes, precedents

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Entity Operations: Multiple States Out of State Sales?

•  No state sales tax is imposed in Alaska; Delaware; Montana; New Hampshire; and Oregon

•  May mean those states preferable for internet sales, distribution centers (with own entities to book sales/shipment costs), net income may be allocable to no income tax parent (if local rules allow licensing, etc.. fees as deductions against income)

Entity Operations: Multiple States Out of State Sales?

•  No state sales tax is imposed in Alaska; Delaware; Montana; New Hampshire; and Oregon

•  May mean those states preferable for internet sales, distribution centers (with own entities to book sales/shipment costs), net income may be allocable to no income tax parent

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Entity Operations: Joint Venture Income Allocations: Cash Waterfall

•  Developers normally contribute much less cash than capital sources

•  Traditional waterfall provisions: (a) Cash Distributions from Operations

•  (i) First, among the members in proportion to and in the amount of their accrued but unpaid Additional Capital Preferred Return;

•  (ii) Second, among the members in proportion to and in the amount of their Unreturned Additional Capital Contribution Amounts [the amount of Additional Capital Contributions beyond the Initial Capital Contributions];

•  (iii) Third, among the members in proportion to and in the amount of their accrued but unpaid Initial Capital Contribution Preferred Return [the cumulative, compounded monthly return on Initial Capital Contributions, say 10%]; and

•  (iv) The balance, if any, among the members in proportion to and in the amount of their Percentage Interests [say 30% to sponsor/developer and 70% to the capital member].

•  (b) Cash Distributions from Capital Events [sale, refinance proceeds, casualty insurance proceeds or condemnation proceeds]:

•  (i) First, among the members in proportion to and in the amount of their accrued but unpaid Additional Capital Contribution Preferred Return;

•  (ii) Second, among the members in proportion to and in the amount of their Unreturned Additional Capital Contribution Amounts;

•  (iii) Third, among the members in proportion to and in the amount of their accrued but unpaid Initial Capital Contribution Preferred Return;

•  (iv) Fourth, among the members in proportion to and in the amount of their Unreturned Initial Capital Contribution Amounts; and

•  (v) Fifth, the balance, if any, among the members in proportion to their Percentage Interests.


•  (ii) Second, among the members in proportion to and in the amount of Additional Capital Contributions beyond the Initial Capital Contributions;

•  (iii) Third, among the members in proportion to and in the amount of their accrued but unpaid Initial Capital Contribution Preferred Return [the cumulative, compounded monthly return on Initial Capital Contributions, say 10%]; and

•  (iv) The balance, if any, among the members in proportion to and in the amount of their Percentage Interests [say 30% to sponsor/developer and 70% to the capital member].

•  (b) Cash Distributions from Capital Events [sale, refinance proceeds, casualty insurance proceeds or condemnation proceeds]:

•  (i) First, among the members in proportion to and in the amount of their accrued but unpaid Additional Capital Contribution Preferred Return;

•  (ii) Second, among the members in proportion to and in the amount of their Unreturned Additional Capital Contribution Amounts;

•  (iii) Third, among the members in proportion to and in the amount of their accrued but unpaid Initial Capital Contribution Preferred Return;

•  (iv) Fourth, among the members in proportion to and in the amount of their Unreturned Initial Capital Contribution Amounts; and

•  (v) Fifth, the balance, if any, among the members in proportion to their Percentage Interests.

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(iv) The balance, if any, among the members in proportion to and in the amount of their Percentage Interests [say 30% to sponsor/developer and 70% to the capital member].


(b) Cash Distributions from Capital Events [sale, refinance proceeds, casualty insurance proceeds or condemnation proceeds]: (i) First, among the members in proportion to and in the amount of their accrued but unpaid Additional Capital Contribution Preferred Return; (ii) Second, among the members in proportion to and in the amount of their Unreturned Additional Capital Contribution Amounts; (iii) Third, among the members in proportion to and in the amount of their accrued but unpaid Initial Capital Contribution Preferred Return;

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(iv) Fourth, among the members in proportion to and in the amount of their Unreturned Initial Capital Contribution Amounts; and (v)  Fifth, the balance, if any, among the members in

proportion to their Percentage Interests.

Entity Operations: Cash Waterfall Economic Substance

•  Fails both standard and alternative Sec 704 tests •  Driven by cash needs of developer, investors seeking

guaranteed returns, not capital account balances •  Still can meet “economic substance” tests: The net

income and net loss are allocated to follow the cash distributions (so called “forced allocations” or “chase allocations”) so that income is allocated to force the book capital accounts to equal cash distributions on liquidation. Operating agreement just allows allocations to “comply with IRS regulations.”

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Entity Operations: Cash Waterfall Economic Substance

•  Fails both standard and alternative Sec 704 tests •  Driven by cash needs of developer, investors seeking

guaranteed returns, not capital account balances •  Still can meet “economic substance” tests: The net

income and net loss are allocated to follow the cash distributions (so called “forced allocations” or “chase allocations”) so that income is allocated to force the book capital accounts to equal cash distributions on liquidation. Operating agreement just allows allocations to “comply with IRS regulations.”

Entity Operations: Preferred Interests

•  “Preferred Interest” rights are normal in VC or P/E investments

•  Non-distribution provisions include management rights, rights to convert debt to equity on exit, etc…

•  Distribution rights on liquidation giving a preference routine

•  Fails both standard and alternative Sec 704 tests •  “Economic Substance” Justification: liquidation

preference necessary to attract capital, all of preferred amount at risk in deal, so 100% of basis return (and maybe none to other owners) not unreasonable

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Entity Operations: P/E Fund “Carried Interest”

•  Partnership distributions in excess of basis are referred to as “carried interest.”

•  Such distributions can be long term capital gains, get lower tax rate than individual income (20% capital gains plus 3.4% “Obamacare” tax, not max. 39% ordinary income rate.)

•  Long term gains treatment available for interests held more than one year, See http://www.irs.gov/taxtopics/tc409.html

Entity Operations: P/E Fund Service Pd. Interests, Not Ordinary Income

•  The partner who receives an entity profits interest in exchange for services is not taxed when an interest is received, because the amount of future income is very uncertain, though some immediate tax may apply if the value of the interest can be determined. See generally Campbell v. Commissioner, 59 T.C.M. (CCH) 236 (1990).

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Entity Operations: Family LP or LLC

•  Settlor/Creator of same cannot continue to treat as own property after creation of LP/LLC, or no “economic substance”, Estate of Reichardt v. Commissioner, 114 T.C. 144 (2000)

•  Complete control of distributions by the general partnership, etc.), resulted in defeat for the taxpayer in Estate of Harper v. Commissioner, 83 T.C.M. (CCH) 1641 (2002).

•  Implied agreement to continue economic benefits invalidated under IRC Sec 2036, Estate of Thompson v. Commissioner, 84 T.C.M. (CCH) 374 (2002)

Entity Operations: Family LP or LLC Minority Interest/Lack of Control

•  Minority interest and non-control interest donations are often made in less than the annual gift tax exclusion amount because of lack of value of such types of interests relative to control shares

•  In Estate of Godley v. Commissioner, 286 F.3d 210 (U.S.C.A. 4th Cir. 2002), a 50-percent ownership share retained by a father who was actively involved in operations of housing partnerships was denied a lack-of-control discount despite super-majority provisions for major decisions by the partnership

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Based on Estate of Strangi v. Commissioner, 85 T.C.M. (CCH) 1331 (2003), possible circumstances which could deny minority interest/lack of control discounts include: a. control of the entity by the transferor (In the facts underlying Strangi, control was exercised through Mr. Strangi’s son-in-law as attorney-in-fact.);

b. presence of a power of attorney, deathbed planning, or incapacity when the entity is created;


c. transfer of substantially all of the transferor’s assets to the entity; d. transfer of a residence to the entity, with continued occupancy by the transferor; e. tax-sensitive transfers defined by audit-proofing formulas;

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f. insubstantial interests in the entity held by other persons; g. a token interest in the entity given to charity; h. a pattern of administering the entity as a trust, such as responding to the needs of the partner as a trustee would respond to the needs of a trust beneficiary;


i. an entity that arguably has no cash needs of its own and therefore lends itself to this pattern, including an entity holding only passive investments, such as stocks and bonds; j. terms in a partnership agreement or other operating document that foster such a pattern, including (but not limited to) negation or limitation of a general partner’s or manager’s ordinary fiduciary duties;

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k. absence of an interposed independent trustee holding entity interests; l. commingling of personal and entity funds or payment of personal expenses by the entity;


m. other conduct that disregards the structure or purpose of the entity; or n. accomplishing no change or only a nominal change in the use and management of the assets transferred to the entity.

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Entity Sale

•  Basic Section 704 Rule: Sale of more than 50% of entity interests in course of a year is deemed to be a sale, so a liquidation of the entity is deemed to occur

•  Sale results in recognition of gain or loss in amounts received which exceed member’s capital account basis

Entity Sale

•  Basic Section 704 Rule: Sale of more than 50% of entity interests in course of a year is deemed to be a sale, so a liquidation of the entity is deemed to occur

•  Sale results in recognition of gain or loss in amounts received which exceed member’s capital account basis

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Entity Sale: Income On Deemed Liquidation: Property and Liabilities

•  IRC §732(B) – Partner takes basis in property received equal to basis in partnership interest less any cash received

•  Liability relief treated as cash received •  Assumption of liabilities treated as cash contribution

Entity Sale: Income On Deemed Liquidation: Property and Liabilities

•  Partner’s Holding Period in Property Received •  IRC §735(b) – Partnership’s holding period tacks onto partner’s holding period for distributed property •  IRC §735(a) – Partnership inventory retains its ordinary income character for five years

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Entity Sale: Member/Partner Recognition of Gain Or Loss

•  IRC §731(a)(1) – Partner recognizes gain only if she receives cash in excess of the basis of her partnership interest

•  IRC §731(a)(2) – Partner may recognize loss if:

– Receives nothing other than cash and/or unrealized receivables and inventory – Amount of cash and basis of unrealized receivables and inventory is less than basis in partnership interest

Questions?

William A. Price Attorney at Law www.growthlaw.com Tel/Fax 1-800-630-4780 P.O. Box 1425 Warrenville, IL 60555

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