partnership character planning before and after the audit

College of William & Mary Law SchoolWilliam & Mary Law School Scholarship Repository

William & Mary Annual Tax Conference Conferences, Events, and Lectures

2017

Partnership Character Planning Before and Afterthe AuditSteven R. Schneider

Brian J. O'Connor

Copyright c 2017 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository.https://scholarship.law.wm.edu/tax

Repository CitationSchneider, Steven R. and O'Connor, Brian J., "Partnership Character Planning Before and After the Audit" (2017). William & MaryAnnual Tax Conference. 766.https://scholarship.law.wm.edu/tax/766

https://scholarship.law.wm.edu

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vVILLIArvf & l\1ARY LA\VSCHOOL

Partnership character planning before and after the audit

Presenters: Steven Schneider, Director, Baker & McKenzie, Washington, D.C.

Brian O'Connor, Partner, Venable, Baltimore, Washington, and Tysons Corner

November 9, 2017

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Capital losses do not net against ordinary income BUT ordinary losses do net against capital gains- IRS Says: Heads I win, Tails you lose

• Corporations - no preferred rate for cap gains AND can only carry forward capital losses for 5 years (or back 3 years)

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Concepts: • Corporations don't mind soaking up ordinary income (e.g.,

partnership with corporation and individual as partners)

• Avoid wasting capital gains against ordinary losses

• Avoid capital losses, but if have them, match with capital gains

• Fund sells good investments early for $1OOM of capital gains and saves the $1OM loss dogs until the end of the fund term. Result: $1OM capital loss at end without offsetting capital gain to use it. Solution, Fund could have sold $1OM of the gain assets on an installment basis to defer the capital gains until the later loss year.

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Section 736(b) payments are treated as distributions: Can mean capital gain (or capital loss) to partner being redeemed

• Section 736(a) payments are allocations/guaranteed payments: reduce income taxed to continuing partners

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Section 736(a) vs. (b) redemption payment to corporate "blocker" partner who is indifferent as to income character but can't use a net capital loss

• Total payment of $5M, Corporate Blocker Partner's basis is $1M. Compare: $5M §736(a) vs. $4M §736(a) and $1M §736(b)

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• X owns 100% of S corp with zero inside and outside tax basis. S corp owns $2M of ordinary income assets, borrows $1M and distributes to X. Result: $1M of capital gain currently, BUT when S corp is eventually liquidated or sells the assets, there is $2M of ordinary income and $1M of potentially useless capital loss.

9 Alternatives: Loan to X (with possible guarantee by S corp but subject to· Plantation Patterns "who is borrower"); Back-to-back loan from bank to S corp and S corp to X.

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long-term land and short-term building, higher purchase price allocation land h ps seller, a ough harms buyer.

~ uunere is the value add? Consider when selling long-term building that has recent short-term tenant improvements. resuma e value is in the long-term uil ing and e tenant build out constru on is real just a cost (especial a ifferent construction entity is earning the construction profit).

® uy property in year 1 for $20M, ake improvements in year 3 for $10 and sell six months after improvements complete for $40 . ere is the gain attri utable to? Distinguish Rev. Rul. 75-524.


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Estate/term for years • IRS held that sale of "lead" and "remainder" interest in §1231 asset to

unrelated parties creates capital gain. Lead interest was a 50-year "estate for years." See Richard Hansen Land, Inc., T.C. 1993-248, PLR 200846012, and PLR 200850009

• Lead interest buyer gives up remainder interest but benefits by depreciating 1 00°/o of purchase. But see § 167 (e)( 1) (denying amortization for term interest if remainder is held by related party)

ait on sale until long-te • Forward contract to sell

• Put/call options

• Consider impact of other factors such as deposits, intervening loans, and §460 (if there is a construction contingency).

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a 1 ol g pe uired r I ca ital a1. ..

For real property, starts with placed-in-service d eeds to be property used in trade or business)

Independent of inventory/dealer property test (i.e., ealer property, gain is ordina n if held for over 12 months). See Fargo case (T.C. emo. 2015-96)

carnes over basis ete ed i le or i pa ·or 1 3

Contribution to partnership replicates holding period onto partnership basis and inside partnership assets

• ~-~olding period from exchanged property carries over to replaceme property in §1 031

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11 If partnership sells asset, holding period determined based on partnership's holding period, not partner's. Rev. Rul. 68-79

11 If property is distributed from a partnership to a partner, tne inside olding period carries out. §735(b)

11 •'det cash contributions by a partner to a partnership in a 12-month window create a split holding period. Reg. §1.1223-3

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• If partner has long-term partnership interest and partnership has short-term assets, beware of technical terminations or partnership d. isions that may convert partnership interest to short-term

• If have a long-term option or purchase contract and instead decide to sell in the near future

• Sell the option/purchase contract- see Long v. Comm'r (2014)

• Contribute the option to a partnership or REIT to replicate holding period onto partnership or REIT interest and then sell interest in the entity. (Note, sale of REIT stock means buyer's basis increase not immediately pushed to assets.)


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on-real estate depreciation is ful recaptured at ordina income rates. Consider i pact of cost segregation study on future §1245 recapture (e.g., is reasonable to assume value equals basis).

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I estate depreciation subject to § 1250 recapture on to the extent of accelerated depreciation.

't foraet check to see if bonus depreciation was taken.

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25o/o rate a icable to straight-line portion of real property depreciation


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Sales of partnershio interest

• If a partner sells its interest, §754 election is important to wipe out seller's share of recapture. See § 1.1245-1 ( e )(3) & §1.1250-1 (f)

• Similarly, a §754 election is necessary to wipe out seller's share of ordinary income (beyond just recapture).

• Example. Seller's partnership interest contains $1M of ordinary income and $1.5M of capital loss. Even though seller has net loss on sale, need §754 election to step up ordinary assets and step down capital losses.

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a • ('.1 an § 1250 recapture s ifting is general prevented by

§751 (b) asset rules. If a redemption I resu in as ...... , ere is a deemed distributio pro rata s are at/cold assets

a d dee ed taxable exchan e. ate at posed § 1 ( ) reg lati s ·u fix the i here aw i existi les at are

eoretical based on gross I e of assets i stead or e o co e com e of assets.

reca red § 1250 gain excl 1 ( ) les per reg lati s. e res bypass a pa r's s are of 0/o rate ai. .,

pa ers are left hoi e bag. If .

er 1s o , o et cost.


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• Contributions of property to partnerships

• Historical depreciation carries over into the partnership. Although traced to the contributing partner, if gain limitation is applicable to contributing partner, excess recapture can apply to non-contributing partner.

• Example: A bought §1245 property for $300 and depreciated it to $100. When the property was worth $150, A contributed it for a 50o/o interest in the A8 partnership (8 contributed $150 cash). A8 partnership sells the property later for $200. $50 is allocated to A as §704( c) and the other $50 is allocated $25 each to A and 8 as §704(b) gain.

.. Recomputed basis of $300 exceeds $100 tax basis by $200, which exceeds the $1 00 of gain recognized by AB partnership. Because recapture exceeds N.s share of gain, it is then allocated to B. See Reg. §1.1245-1 (e)(2)(i).

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• • If land er begins to develop real estate ld r investme

Ia er can i adverte convert a ca ita! asset into a o i a invento asset. As a resu , a s bse ue sale of e prope can produce ordi ary income as pposed to capital . ga1 ...

• If Ia d er sells investment property to a lated partners i so at partners i can develop the prope e sale can

ge erate ordinary income nder §707(b) ) e rope is er an a ca ital asset i e han s of e related pa ers

Possi le Solution: sale of investme a co rano evelopment co pa See, ::::~·' ______________ _ Commissioner, 960 F. d 526 (5th Cir. 1 92).

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• Capitalization of development co.

• Purchase price and financing

• Profit potential for development co.

• Debt vs. equity issues with deferred payments

• Final payment obligation under note

• Sale formalities

• Pre-selling

• Common ownership

Separateness


• • Example: PE Fund seeks to buy S corporation ed 80o/o by A and

20o/o . and B consider conve ng S corporation into an LLC tax as a partnership in advance of sale.

• Conversion II inadvertently trigger §1239 and potential create ordina income for A on the deemed liquidation at results from the entity conversion.

• §1239 triggers ordinary income on dispositions of depreciable rope between related parties

• For purposes of §1239, property amortized under §1 presumab II be treated as depreciable property

at if e S corporation holds all of its assets roug a partnership interest? Distinguish Rev. Rul. 72-172.

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A couple years later ...

The New Partnership Audit Rules


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~~ Brian O'Connor is a partner in the Baltimore, DC and Tysons Corner offices of Venable, where he provides sophisticated tax and business advice to publicly traded and closely held businesses and their owners. His practice focuses on foreign and domestic tax matters for partnerships, LLCs, both C and S corporations, REITs, and RIGs. Mr. O'Connor is also an Adjunct Professor at the Georgetown University Law Center LL.M. program, teaching Drafting Partnership and LLC Agreements and Taxation of Real Estate Transactions.

~~ Steven Schneider is a partner in the DC office of Baker & McKenzie, where he concentrates on the tax aspects of commercial transactions, with a concentration in the taxation of pass-through entities such as partnerships, S corporations, and REITs. He also has significant experience in crossborder issues, real estate, investment funds, tax policy and tax controversy. Mr. Schneider is also an Adjunct Professor at the Georgetown University Law Center LL.M. program, teaching Drafting Partnership and LLC Agreements.


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partnership character planning before and after the audit

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