IRC Sect. 704(b): Allocations to Partners Navigating Complex Rules - PowerPoint PPT Presentation

Presenting a live 110-minute teleconference with interactive Q&A IRC Sect. 704(b): Allocations to Partners Navigating Complex Rules on Determining Validity of Partnership Allocations WEDNESDAY, DECEMBER 12, 2012 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: Brian O'Connor, Partner, Venable LLP , Baltimore Steven Schneider, Director, Tax Group, Goulston & Storrs PC , Washington, D.C. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions emailed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .

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IRC Sect. 704(b): Allocations to Partners Seminar Dec. 12, 2012 Brian O'Connor, Venable LLP Steven R. Schneider, Goulston & Storrs PC bjoconnor@venable.com sschneider@goulstonstorrs.com

Today’s Program Review Of Partnership Allocation Rules Slide 7 – Slide 64 [Steven R. Schneider and Brian O'Connor] Rules For Allocations Related to Non-Recourse Debt; Slide 65 – Slide 76 Cancellation Of Debt Income [Steven R. Schneider and Brian O'Connor] Targeted Capital Accounts Vs. Liquidating With Capital Slide 77 – Slide 89 Accounts [Brian O'Connor and Steven R. Schneider]

Steven R. Schneider, Goulston & Storrs PC Brian O’Connor, Venable LLP REVIEW OF PARTNERSHIP ALLOCATION RULES

Sect. 704(a) And (b) Overview • Sect. 704(a): A partner’s share of tax items is determined by partnership agreement. • Sect. 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) 8

Sect. 704(c) And (d) Overview • Sect. 704(c): Governs allocations of tax items related to property that have a tax basis different from the Sect. 704(b) book value • Sect. 704(d): Partner is only entitled to deduct allocated losses to extent of partner’s basis in his or her partnership interest at end of year. 9

Basic Principles: Reg. 1.704-1(b)(1)(i) • Tax allocations of economic income = “distributive share” • Distributive share determined under general partner’s interest in the partnership (PIP) test if: – No partnership agreement – Partnership agreement allocations fail substantial economic effect (SEE) test 10

Sect. 704(b) Allocations = Economic Deal • Sect. 704(b) capital accounts are intended to reflect the economic “deal” between the partners and allocate the related tax items according to the same deal. • If the capital accounts do not equal the economic deal, then the economics will govern, and the Sect. 704(b) allocations will not be respected. Tax must follow the economics. 11

Basic Principles: Reg. 1.704-1(b)(1)(i) • Three ways allocations you can have SEE: – Satisfy primary, alternative or economic equivalence test under Reg. 1.704-1(b)(2) – Allocations fail safe harbors but are still consistent with facts and circumstances PIP test under Reg. 1.704-1(b)(3). – Allocations do not affect economics (credits, and non-recourse deductions) but are deemed to have SEE under Reg. 1.704- 1(b)(4) or Reg. 1.704-2. • In all other cases, distributive share will be reallocated in accordance with PIP. This creates uncertainty. 12

Effects Of Other Sections: Reg. 1.704-1(b)(1)(iii) • Allocation may not be respected if fails economic substance ( Goldstein ). • Allocations of deductions may be suspended due to lack of actual or at-risk basis ( 704(d) and 465). • Allocations may be reallocated under common law or statutory assignment of income principles ( 482, 704(e)(2), 706(d)). • Hot asset rules may mandate allocations of gain or loss (Reg. 1.751- 1(b)(2)(ii)). • Recharacterization of debt-to-equity can override prior debt-sourced deductions. 13

Other Possible Tax Consequences: Reg. 1.704-1(b)(1)(iv) And (v) • Gift tax consequences ( 2501) • Compensation ( 61 and 83) • Capital shifts (Reg. 1.721-1(b)(1)) • Sect. 38 credit recapture (Reg. 1.47-6) • Sect. 704(b) is not applicable if person is not respected as a partner, or to a partner who is not acting in the capacity as a partner. 14

Bottom Line Allocations: Reg. 1.704-1(b)(1)(vii) • Gross vs. net allocations: Sect. 704(b) is applicable to allocations of income, gain, loss, deduction and credit; of specific items of income, gain, loss, deduction and credit; and of partnership net or “bottom line” taxable income and loss. • Effect of net allocations : “Bottom line” allocations of net or residual income are treated as an allocation to such partner of the same share of each item of income, gain, loss and deduction that is taken into account in computing such net or “bottom line” taxable income or loss. 15

Capital Account Maintenance In General • Contributions (at FMV net of liabilities) • Distributions (at FMV net of liabilities) • Income: – Increase for taxable income – Increase for non-taxable income • Deductions and losses – Decrease for deductible losses and expenditures. – Decrease for nondeductible, non-capitalizable expenditures • Depreciation and gain or loss on sale of property computed using book basis 16

Must Maintain Capital Accounts • Except as otherwise provided under the economic equivalence test, an allocation of income, gain, loss or deduction will not have economic effect under paragraph Reg. 1.704-1(b)(2)(ii) (primary or alternative test), and will not be deemed to be in accordance with PIP under Reg. 1.704-1(b)(4) (credits etc.), unless the capital accounts of the partners are determined and maintained throughout the full term of the partnership in accordance with the capital accounting rules of Reg. 1.704-1(b)(2)(iv). See Reg. 1.704- 1(b)(2)(iv)(a) 17

Basic Rules: Reg. 1.704-1(b)(2)(iv)(b) • Increase capital accounts by: – (1) The amount of money contributed by the partner to the partnership – (2) The fair market value of property contributed by the partner to the partnership (net of liabilities that the partnership is considered to assume or take subject to) – (3) Allocations to the partner of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in Reg. 1.704-1(b)(2)(iv)(g) (book ups), but excluding income and gain described in Reg. 1.704- 1(b)(4)(i) (reverse 704(c) taxable income/loss) 18

Basic Rules: Reg. 1.704-1(b)(2)(iv)(b) (Cont.) • Decrease capital accounts by: – (1) The amount of money distributed to the partner by the partnership – (2) The fair market value of property distributed to the partner by the partnership (net of liabilities that such partner is considered to assume or take subject to) – (3) Allocations to the partner of expenditures of the partnership described in 705(a)(2)(B) (non-deductible, non-capitalizable expenses such as the non-deductible portion of M&E expenses) – (4) Allocations of partnership loss and deduction, including loss and deduction described in Reg. 1.704-1(b)(2)(iv)(g) (book downs), but excluding items described in (6) above and loss or deduction described in Reg. 1.704-1(b)(4)(i) (reverse 704(c)) or Reg. 1.704-1(b)(4)(iii) (excess percentage depletion) 19

Single Capital Account: Reg. 1.704-1(b)(2)(iv)(b) • A partner who has more than one interest in a partnership shall have a single capital account that reflects all such interests, regardless of the class of interests owned by such partner (e.g., general or limited) and regardless of the time or manner in which such interests were acquired. 20

Liabilities: Reg. 1.704-1(b)(2)(iv)(c) • Increase capital account by partner’s deemed contribution, if partner assumes partnership liability • Decrease capital account by partner’s deemed distribution, if partnership assumes partner liability • Do not adjust for mere shifts in partner’s share of partnership liabilities under sections 752(a) and 752(b) • Obligee must be aware of liability assumption and can enforce. 21