capital account challenges for partnerships and...

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

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Capital Account Challenges for Partnerships and LLCs

Gregory M. Levy, Kaufman Rossin & Co.

[email protected]

July 23, 2013

Leo HItt, Reed Smith

[email protected]

Telma Nadvorny, Ernst & Young

[email protected]

Today’s Program

General Overview

[Telma Nadvorny]

Traditional Layered Approach

[Gregory M. Levy]

Targeted Capital Account Approach

[Leo Hitt]

Slide 7 – Slide 29



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

Partnership Allocations Overview

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

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

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

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

Three Tests For Economic Effect

► Primary test

► Alternate test for economic effect

► Economic equivalence test

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)

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.?

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

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

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

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

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

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.

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

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)

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

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.

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

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:

[email protected]

561.394.5100

www.kaufmanrossin.com

mailto:[email protected]

http://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

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


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


45


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


46



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


47



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


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


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


50


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


52


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


53


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


54


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


55


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


56


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


57


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


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


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