partnership taxation carried interests, economic substance, and debt issues

Partnership TaxationCarried Interests, Economic Substance, and Debt Issues

American Institute of CPAs

Howard E. Abrams

Professor of Law at Emory Law School in Atlanta, GA, is a partnership tax specialist, receiving his B.A. from the University of California (Irvine) and his J.D. from Harvard University. He has written four books, the BNA Tax Management Portfolio on Disregarded Entities, and more than forty articles on taxation. Professor Abrams has been at Emory University since 1983, spent the 1999-2000 academic year with the national office of Deloitte as the Director of Real Estate Tax Knowledge, and from January of 2003 through August of 2004 was of counsel to Steptoe & Johnson in Washington, DC. He teaches regularly at the University of Georgia and at Leiden University in the Netherlands and is a member of the American Law Institute and the DC Bar. Prior to joining the Emory faculty, Professor Abrams was a law clerk to Chief Judge Theodore Tannenwald, Jr., of the United States Tax Court and practiced in Los Angeles with the firm of Brobeck, Phleger & Harrison. Professor Abrams has taught as a Visiting Professor at Cornell, Berkeley and Yale Law Schools.


Business Advice or Tax Advice?

Suppose you can pay $10,000 for business advice that will double your money through day trading or will save you $11,000 in taxes. Which is the better investment? Remember: tax advice is deductible!

$10,000 profit less $4,000 in taxes divided by after-tax investment of $10,000 = 60% return.

$5,000 profit less $0 in taxes divided by after-tax investment of $6,000 = 83% return.


Carried Interest Defined

Proposed section 710 defines an “Investment Services Partnership Interest” as an interest received in exchange for services provided (directly or indirectly) to a partnership with respect to “specified assets” including financial assets, real estate held for sale or investment, and any lower-tier partnerships.


Carried Interest Disabilities

• Distributive share (all, three-quarters, or half) is treated as ordinary income subject to social security taxes.

• Gain from disposition (all or some) is treated as ordinary income (overrides most nonrecognition provisions).

• Losses in excess of prior income are deferred.• Distributed property is taxable (possibly twice).


Qualified Capital Defined

“Qualified Capital” includes:• The value of contributions less distributions• The excess of allocations of income over losses• Debt allocated to the service partner is ignored as is payment

on such debt• Debt allocated to other partners is not ignored


Qualified Capital

Allocations on QC are not recharacterized, but• The statute imposes a cliff effect• A benchmark is needed and is hard to satisfy

Gain from the disposition of a partnership interest is not recharacterized to the extent allocable to QC

Excess losses allocable to QC are not disallowed

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Economic Substance

• “Application of doctrine. In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if--– (A) the transaction changes in a meaningful way (apart from

Federal income tax effects) the taxpayer's economic position, and

– (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”


“Economic Substance Doctrine”

Economic substance doctrine. The term “economic substance doctrine” means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.


Profit Potential

• “The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.”


Tax and Accounting Benefits

• “(3) State and local tax benefits. For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect.

• “(4) Financial accounting benefits. For purposes of paragraph (1)(B), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax.”


Penalty Provisions

Section 6622(b) imposes a 20% penalty on any underpayment attributable to the disallowance of claimed tax benefits by reason of a transaction lacking economic substance.“

Section 6662(i)(2) increases this penalty when the relevant facts “are not adequately disclosed in the return nor in a statement attached to the return.”

No reasonable cause defense.


Limitation on Application

Section 7701(o)(5)(C) provides that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”


The Joint Committee Report

“(1) the choice between capitalizing a business enterprise with debt or equity;

“(2) a U.S. person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment;

“(3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and


JCT Report (continued)

“(4) the choice to utilize a related-party entity in a transaction, provided that the arm's length standard of section 482 and other applicable concepts are satisfied.”

The Treasury has announced that no “angel list” will be forthcoming, essentially repudiating the JCT Report.


Extension of the Penalties

Section 6662(b)(6) extends the 20% and 40% penalties to transactions “failing to meet the requirements of any similar rule of law.”

Note this language does not say “any similar statutory rule of law.”

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Allocation of Recourse Debt

A “recourse liability” is defined as “[any] partnership liability. . . to the extent that any partner or related person bears the economic risk of loss for th[e] liability. . . .” Reg. §1.752-1(a)(1).

A “nonrecourse liability” is any partnership liability “to the extent that no partner or related person bears the economic risk of loss.” Reg. §1.752-1(a)(2).


Zero-Value Sale and Liquidation

A partner bears the economic risk of loss of a partnership liability to the extent the partner would be forced to make a payment to any person (including a contribution to the partnership) as the result of a constructive zero-value sale and liquidation of the partnership. Reg. §1.752-2(b)(1).


Simple Example - Facts

A contributes $600 and B contributes $400 to form the AB general partnership, and each partner has an obligation to restore a deficit capital account if one exists upon liquidation. A is allocated 50% of partnership profits and 60% of partnership losses, and AB borrows $9,000 on a fully recourse basis. How should the $9,000 indebtedness be allocated?


Simple Example - Analysis

If all the partnership's assets become worthless and are sold for $0, there is a $10,000 book loss on the sale, reducing A’s capital account to minus $5,400 and B’s capital account to minus $3,600. If the partnership now liquidates, each partner’s deficit restoration obligation is triggered.

(Note typo at bottom of page 10)


Alternate Test for Economic Effect

Capital accounts must be maintained properly.

Liquidation proceeds must be distributed in accordance with positive balances.

In lieu of unlimited DRO –• No excess loss allocations• Capital account look-ahead requirement• Qualified Income Offset provision


No Excess Loss Allocations

No allocation of book loss may be allocated to the extent if drives the partner’s capital account more negative than the sum of• the maximum amount, if any, that the partner can be required to

contribute to the partnership, plus• The partner’s share, if any, of the partnership’s previously

allocated nonrecourse deductions (i.e., the partner’s share of minimum gain).


Capital Account Look-Ahead

A partner’s capital account must be reduced immediately once it is recently likely that a future transaction will result in a net reduction to the partner’s capital account.

This is most likely to be triggered by distributions of recourse refinancings as well as by anticipated distributions of profit disproportionate to profit sharing.


Qualified Income Offset Provision

If an unanticipated distribution (or other transaction) drives a partner’s capital account balance more negative than it is permitted to become, items of gross income must be allocated as quickly as possible to drive it back up.


Indebtedness and Allocations

P and Q form PQ-LLC by contributing $100 each. In its first year, PQ-LLC incurs deductions of $120 and no income. What is the maximum deduction that can be allocated to one partner?

$100 because of the capital account limitation of the alternate test for economic test.


Add Debt

Suppose PQ-LLC also incurs $60 of debt by borrowing from some unrelated third party. Now what is the maximum deduction that can be allocated deduction that can be allocated to any one partner in the first year?

Still $100 because there is no partnership minimum gain until all of the equity has been lost.


Add Guarantee of the Debt

Suppose P gives a personal guarantee of the $50 nonrecourse debt? What is the maximum deduction that can be allocated to P in year 1?

Still $100 because while the guarantee increases P’s outside basis is does not affect the capital account limitation until the book value of the debt is less than the debt. See Rev. Rul. 97-38.


The 704(d) Outside Basis Limitation

Entity-level deductions properly allocated to a partner are suspended to the extent they exceed the partner’s outside basis.

Despite the suspension, capital account is reduced by the full amount.

If multiple deductions are allocated, a portion of each is suspended.


The 465 At-Risk Limitation

Applicable at the partner level.

Debt will increase amount at-risk only if fully recourse or “qualified nonrecourse financing.”

If the lender of the debt is a partner, not “QNF” unless the lender/partner’s interest does not exceed 10%


Guarantee of Nonrecourse Debt

Does a partner’s promise to restore a capital account deficit in favor of a lender of otherwise nonrecourse debt always increase amount at-risk?

Unclear: the deficit restoration obligation converts the debt to “recourse” for purposes of section 752, but that may not satisfy section 465. See Hubert Enterprises cites at page 20.


The 469 Passive Loss Limitation

Section 469(a)(2) provides: “except as provided in regulations, no interest as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.”

Does “limited partner” in 469(a)(2) include a member of an LLC? Not if the member sufficiently participates in management. See p. 21.


Exiting: Prefer Property to Cash

To avoid gain to the distributee partner, distribute property rather than cash. Note: marketable securities are treated much like cash.

Can the distributee partner go shopping with the partnership’s money? In ILM 200650014, the Service determined that, when no other partner would at any time have an economic interest in the property, the answer is no.


Exiting: Loss Inventory

If a partner exits via cash distribution a partnership owning loss inventory, the partner’s share of the loss will be recognized as a capital loss because §751(b) speaks only to inventory that is “substantially appreciated.” But if the partner exits via a sale of the interest, the loss will be ordinary under §751(a).


Exiting: Loss Capital Assets

If a partner exits a partnership owning loss capital assets, the exiting loss will be capital if the partner exits by sale, exchange, or liquidating distribution.

Abandonment of the interest will convert the loss into an ordinary loss so long as the exiting partner has no share of partnership liabilities.


Exiting: Section 734 Reduction

If a partner exits the venture in exchange for a cash distribution, capital loss recognized by the exiting partner will reduce the partnership’s inside basis if a §754 election is in effect or the basis reduction is “substantial.” Here, “substantial” means that the basis reduction exceeds $250,000.


Exiting: Section 743 Reduction

If the partners sells his partnership interest, a “substantial” basis reduction means that the partnership’s assets have a net loss in excess of $250,000. The adjustment is only the exiting partner’s share of that loss.


Basis Reduction Example

X has a 10% interest in the profits, losses and capital of P. P’s assets have aggregate value of $500,000 and inside basis of $800,000. X has an outside basis of $80,000 though the interest is worth only $50,000.

A cash distribution of $50,000 does not trigger a mandatory inside basis adjustment but a sale for $50,000 does.


Exiting: Depreciated Real Estate

A partner who sells an interest in a partnership owning depreciated real estate is subject to the 25% capital gain rate applicable to “unrecaptured §1250 gain.”

But an exit in exchange for a liquidating distribution is not subject that this higher rate. And an election under §754 will eliminate the exiting partner’s share of the higher-rate gain permanently.


Exiting: Partner Rate Arbitrage

EO and TO each contribute $100 to the partnership in exchange for a 50% interest in profits, losses, and capital. The partnership purchases two capital assets for $100 each. CA #1 increases in value to $200 while CA #2 increases in value to $190. CA #2 is distributed to EO and CA #1 is sold for cash. How do the books of the venture read?


Exiting: Partner Rate Arbitrage

EO TO Explanation

CA OB CA OB

100 100 100 100Formation

45 0 45 0

Book-Up ofAsset #2

( 190) ( 100) 0 0

Distribution ofAsset # 2

50 50 50 50

Sale ofAsset # 1

5 50 195 150 Totals


Disguised Sale of Property Definition

There must be a contribution of cash or property.

There must be a distribution of cash or property to the contributing partner. Either can come first.

The contribution and distribution, when considered together, properly are characterized parts of a single transaction.


Which Debts Count?

“Qualified Liabilities” are ignored!• Old and cold debt (more than two years old);• Not incurred in anticipation of contribution;• Allocable to capital improvements made to the property

under Reg. §1.163-8T; or• Incurred in the ordinary course of a trade or business and

all the assets used in the trade or business are contributed to the partnership.


Liability Example

X contributes Blackacre to the P partnership when Blackacre has a value of $100,000 and is subject to a debt of $60,000. Assume X has an adjusted basis of $35,000 in Blackacre and that one-half of the liability shifts to other partners.• If the liability is “qualified,” the contribution is tax-free, X’s

outside basis equals $5,000, X’s capital account equals $40,000, and outside basis of other partners increases by $30,000. Inside basis equals $35,000.


Liability Example Continued

If the debt is not “qualified,” the transaction is treated as the sale of $30,000 worth of Blackacre and a contribution of the remaining 70%.

On the sale portion, gain equals $30,000 less $10,500, or $19,500.

On the contribution portion, X takes a capital account of $70,000 less $30,000, or $40,000. X’s outside basis equals $24,500. This equals the prior outside basis plus the gain recognized.


Recomputing the Sale Price

X contributes property to the P partnership with an adjusted basis of $10,000 and value of $100,000. $100,000 in cash is distributed to X one year later, and the contribution and distribution are treated as a disguised sale.

Implicit interest under section 1272 must be backed-out of the sale price for the one-year deferral. If $10,000 is the proper interest component, then X has sold 90% of the property at a taxable gain of $81,000.


Deferred Sale Example

X and Y form the XY partnership, with X contributing Blackacre with adjusted basis of $60,000 and value of $100,000. Y contributes cash of $50,000. Subsequently, the cash is distributed to X.• Case 1: No disguised sale.• Case 2: Disguised sale, deferred interest equals

$2,000, no special allocation of interest.• Case 3: Disguised sale, deferred interest equals

$2,000, special allocation of interest.


Case 1: No Disguised Sale

___________X___________ __________Y___________ Capital Basis Capital Basis $ 100,000 $ 60,000 $ 50,000 $ 50,000( 50,000) ( 50,000) 0 0 $ 50,000 $ 10,000 $ 50,000 $ 50,000

Note that capital accounts are equal, showing that each partner has contributed $50,000 to the venture.


Case 2: Disguised Sale, No Special Allocation

___________X___________ __________Y___________ Capital Basis Capital Basis $ 52,000 $ 31,200 $ 50,000 $ 50,000( 1,000) ( 1,000) ( 1,000) ( 1,000) $ 51,000 $ 30,200 $ 49,000 $ 49,000

Note that capital accounts no longer are equal, giving X a dominant interest in the venture.


Case 3: Disguised Sale With Special Allocation

___________X___________ __________Y___________ Capital Basis Capital Basis $ 52,000 $ 31,200 $ 50,000 $ 50,000( 2,000) ( 2,000) 0 0 $ 50,000 $ 29,200 $ 50,000 $ 50,000

Note that capital accounts again are equal, showing that each partner has contributed $50,000 to the venture.


Preformation Expenditures Problem

X owns unimproved real estate with adjusted basis of $400,000 and fair market value of $2,000,000. X improves the property by constructing a building at a cost of $2,500,000, increasing the value of the property to $5,000,000. Can X contribute the property and get reimbursed for the construction costs?

No! The maximum tax-free reimbursement is $1,000,000 because the value of the property exceeds 120% of its adjusted basis ($5M as compared with $2.9M).


Preformation Expenditure Solution

Construct the building with borrowed funds. Then contribute the building subject to the debt. The debt will be a “qualified liability” because it is allocable, under the rules of Reg. § 1.163-8T, to capital improvements.

Note that there is no related party limitation, so that the debt can be borrowed from an affiliate so long as the the form of the loan will be respected.

Partnership TaxationCarried Interests, Economic Substance, and Debt Issues

partnership taxation carried interests, economic substance, and debt issues

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