Substantial Economic Effect ‐ Requirements Key Requirements of SSE. (Again, these are based on the theory that the real economics should determine the tax consequences.): 1. Capital Account be kept for each member. A Capital Account is analogous to a person’s bank account balance At any point in time the balance shows you how much A Capital Account is analogous to a person s bank account balance. At any point in time, the balance shows you how much the bank has to give you if you decide to close down your account with the bank. One of the key premises that the partnership tax regulations are based on is that the Capital Account balance effectively represents the value of a member’s interest in the LLC. 2. The Capital Account balance must be increased or decreased in accordance with certain rules. You bank account balance is (i) increased by the amount of money you deposited, (ii) increased by the interest you earn on the deposit, (iii) decreased by withdrawals you make. Analogously, a Capital Account balance of a member is: ‐ increased by contributions of money or other property ‐ increased by income allocations to the members i d b i ll ti t th b ‐ decreased by loss allocations ‐ decreased by distributions to the member 3. On liquidation, the amount a member gets is equal to his/her Capital Account balance. Using the bank account balance as an analogy, when you close an account, you get what is equal to your bank account balance. Similarly, an LLC has to distribute an amount equal to the bank account balance when a member leaves the LLC. This has to be the rule in order for the rules described above for computing the Capital Account balance to have any meaning. It wouldn’t make sense that you had all these rules for computing your bank account or Capital Account balance, if on closing an account or on liquidation, the LLC/bank had to give you an amount completely unrelated to your balance. 14
Substantial Economic Effect – Simple Examples Ex. 1 – A & B form an LLC; each contributes $100. The operating agreement (“OA”) says profits and losses will be allocated 60% to A and 40% and losses will be allocated 60% to A and 40% to B. It also says CA will be kept for A and B and they will be increased by income B A allocation, contributions made and decreased by distributions and losses allocated + it says by distributions and losses allocated + it says on liquidation A and B will get their “capital account balance.” $100 $100 Operating Agreement says: • Profits and Losses to be allocated 60% to A and 40% to B • Capital accounts to be kept for A and B that are increased by income allocation, contributions, and decreased by distributions and losses allocated. • On liquidation A and B will get their capital account balances returned to them. 15
Substantial Economic Effect – Simple Examples • So, the LLC has $200 of taxable income. Under OA, $120 (60%)of this is allocated to A (bringing A’s Capital Account balance to thi i ll t d t A (b i i A’ C it l A t b l t $220),and $80 is allocated to B (bringing his CA to $180). Suppose at the end of the year, the LLC sells all its assets and liquidates. It has $400 of assets, so A gets $220 and B gets $180 $ , g $ g $ A B Beginning Capital $100 $100 Account $200 taxable income $120 (60%) $80 (40%) Capital Account at $220 $180 Year End • Because CA are properly kept and liquidating distributions are in accordance with CA balances, this LLC’s allocations will be respected by the IRS. 16
Substantial Economic Effect – Simple Examples • Ex. 2 – Same as before, except that when the nontax lawyer looked at the section of the Operating Agreement that says how distributions will be made on liquidation the lawyer thought – distributions will be made on liquidation, the lawyer thought “no way am I going to say liquidations will be made in accordance with capital account balances when neither I nor my client really understand what that’ll mean. I can’t take the chance that my clients gets out of the deal anything different from what they expect to get out. I don’t have the time or the patience to go talk to our tax person.” So, he changes the Operating Agreement to say that on liquidation A will receive 60% of the proceeds, and B will be entitled to receive 40% of the proceeds 40% of the proceeds. • So, now if the LLC liquidates when it has $400 of assets, everyone ignores Capital Account balances, and A gets $240 on liquidation (60% of $400) and B gets $160 (40% of 400). • Because the allocated income provided for in the Operating Agreement does not match the economic gain that would be realized by each member on liquidation, the contractually agreed upon allocations do not have SEE and will not be respected upon allocations do not have SEE and will not be respected. 17
Substantial Economic Effect – Simple Examples • Ex. 3 – A&B form an LLC and contribute $100 each; they decide that on ultimate liquidation, A will receive 60% of the proceeds and B will receive 40% of the proceeds. p A B Operating Agreement says: ‐ share distributions 60/40 / ‐ but liquidating distributions made in accordance with positive capital account balances. $100 $100 • The nontax lawyers uses the form used for the LLC in Ex. 2 as a starting point for drafting. If you’ll recall, that didn’t have liquidation in accordance with Capital d a t g. you eca , t at d d t a e qu dat o acco da ce t Cap ta Account balances. They give it to their tax lawyer to review. The tax lawyer and the nontax lawyer do not coordinate or communicate with each other at all as to what the business deal is. The tax lawyer “fixes” the OA to provide for liquidation in accordance with capital account balances (because s/he wants the OA to have allocations that the IRS will respect). But now, without realizing it, the tax lawyer ll ti th t th IRS ill t) B t ith t li i it th t l has completely altered the business deal of the parties. 18
Substantial Economic Effect – “Substantiality” Substantial Economic Effect Substantiality • The “substantiality” aspect of SEE comes up a bit less frequently. This test is more subjective. • In general, for an allocation to be substantial, there must be reasonable possibility that the allocation will affect substantially the dollar amounts received by the partners independent of tax considerations. • An example of a potential substantiality problem is when a partnership contains both a tax ‐ exempt partner and a taxable partner and the partnership specially allocates disproportionate taxable income to the tax ‐ exempt partner and then allocates disproportionate tax ‐ exempt income to d th ll t di ti t t t i t the taxable partner to have the 2 special allocations generally offset economically but lower the overall taxes paid by the partner in the aggregate paid by the partner in the aggregate. 19
Getting Distribution/Allocation Provisions Right • 2 Goals: (1) Get economic/business deal right, and (2) Ensure that allocations have SEE, so that no risk of IRS Ensure that allocations have SEE, so that no risk of IRS setting them aside. The Distribution provisions and the Allocation provisions of the OA have to work together to get these right to get these right. • The Distribution provisions set out what the parties economically get from the LLC. They are the most important The Allocation provisions allocate the important . The Allocation provisions allocate the income and loss to members. But since allocations also affect capital accounts, they can indirectly affect the business deal of the parties the business deal of the parties – particularly true particularly true where you are liquidating in accordance with capital account balances. 20
Allocation Provisions – Ways They Can Be Wrong With that it is important to understand that there are 2 ways in which allocations may be wrong. 1. If they don’t have SEE, the IRS can come along and reallocate them “in y g accordance with the partner’s interest in the partnership.” – In a simple case, such as one where the current and liquidating distributions are supposed to be shared by everyone pro ‐ rata, it is pretty easy to figure out what “in accordance with the partner’s interest in the partnership” means. – However, where the distribution scheme is more complicated, it is pretty hard to figure it out: Example: A & B form an LLC. A contributes $100, and B contributes $20. Economic deal between the parties is: 1. First, A gets his capital back, with a 5% rate of return 2. Then B gets his capital back 3. The next $100 of distributions is shared 75% by B and 25% by A; 4 4. The next $250 of distributions is shared 50% by A and B The next $250 of distributions is shared 50% by A and B 5. Any additional distributions are shared 67% by A and 33% by B If the allocations in the operating agreement do not have SEE, it may not be possible to predict with any degree of confidence who will be taxed on the LLC’s income This could result in some very unpleasant surprises to the members income. This could result in some very unpleasant surprises to the members, who entered into the deal believing that each member would be taxed in accordance with the allocations set forth in the operating agreement. 21
Allocation Provisions – Ways They Can Be Wrong • The IRS cannot invalidate provisions that call The IRS cannot invalidate provisions that call for contributions or distributions; these provisions are matters of agreement among provisions are matters of agreement among the parties. • What the IRS can do is invalidate allocations • What the IRS can do is invalidate allocations, reallocate, and assess interest and penalties. 22
Allocation Provisions – Ways They Can Be Wrong 2. The second way that the allocation provisions can be “wrong” is by not properly reflecting the economic deal of the members. • A common example In an effort to comply with the SEE regulations the • A common example: In an effort to comply with the SEE regulations, the operating agreement contains provisions under which (1) all income or loss allocated to a member is reflected in a member’s capital account, and (2) upon liquidation of the LLC, the members will be entitled to distributions in proportion to their positive capital account balances proportion to their positive capital account balances. • This means the effect of income allocations is not merely on the amount of tax that each members will be required to pay, but also on the number of real dollars that the member will get when the LLC ultimately liquidates. • So if the allocations are “wrong” (not because they fail to comply with the SEE rules, but because they don’t properly reflect the economic deal) the effect can be that the actual cash received by each member, regardless of tax consequences, may not be in accordance with the intention of the q , y parties. 23
Drafting Allocation/Distribution Provisions Drafting Allocation/Distribution Provisions There are many ways to draft an allocation There are many ways to draft an allocation provision. Very broadly, they can be placed in 2 categories: categories: 1 L 1. Layered approach d h 2. Targeted/Forced approach 24
2 Allocation Provision Approaches 2 Allocation Provision Approaches 1 Layered Approach 1. Layered Approach The tax lawyer carefully goes through the ordering rules in the Distribution Section (the ordering rules in the Distribution Section (the “Waterfall”) and thinks through how allocations should be made so as to (i) not alter the should be made so as to (i) not alter the business deal of the members, and (ii) so that the regulations have SEE the regulations have SEE. 25
1 st Approach: Layered Allocation 1 Approach: Layered Allocation Simple Example: A & B form an LLC. A puts in $100, and B puts in $50. Distributions: Distributions of available cash shall be made each year at he discretion of the Manager and shall be in the following order of priority: (i) (i) First to A until the Unpaid Preferred Amount has been reduced to zero; First, to A, until the Unpaid Preferred Amount has been reduced to zero; (ii) Then to return A’s capital contributions; and (iii) Then to return B’s capital contribution; and ( ) (iv) Thereafter, equally to A and B. , q y Allocations: ‐ Profits shall be allocated each year as follows: (i) First, if A’s capital account balance is less than the Unpaid Preferred Amount to A, until A’s Unpaid Preferred Amount has been reduced to zero; and (ii) (ii) Thereafter equally to A & B Thereafter, equally to A & B. 26
1 st Approach: Layered Allocation 1 Approach: Layered Allocation • Pros: – There is a greater emphasis placed on making sure the Capital Account balances get to the right place, which necessarily means there is a greater emphasis on making sure the client him/herself has thought through precisely what their business deal is. Once you start to ask business people some questions about their business deal, you often realize they haven’t fully thought it through. • Cons: – Time consuming. Time consuming – You will actually have to talk with tax lawyers. – Hard to explain to your client. – Even with all the discussion there can be no guarantee that the Even with all the discussion, there can be no guarantee that the allocations are correct. – The consequence of an error is that the business deal itself might be changed. So, there is a lot riding on making sure these are correct. 27
2 nd Approach: Targeted/Forced Allocations • Generally, this type of allocation provision says something along the lines of “profits and losses will be allocated in such a way so as to cause each member’s capital account balance to be equal to the amount that p q the member is entitled to receive if the LLC were to liquidate at the end of the year.” • In other words, the distributions should be very clear. If they are clear, then the LLC will allocate the income/losses to the members to force each member’s income/losses to the members to force each member s Capital Account balance to equal precisely what the member is supposed to receive on liquidation. 28
2 nd Approach: Targeted/Forced Allocation • Increasingly Popular. • There are many different ways to draft such a provision. • One example: Net Profits and Net Losses for the year shall be allocated among the partners in a manner such that, to the extent possible, the capital account balance of each partner at the end of such year shall be equal to the excess of: p y q (1)The amount that would be distributed to such partner if (a) the company were to sell the assets of the company for their Gross Asset Values, (b) all Company liabilities were settled in cash according to their terms (limited, with respect to each nonrecourse liability, to the book values of the assets securing such liability) and (c) the net proceeds thereof were distributed securing such liability), and (c) the net proceeds thereof were distributed in full pursuant to the distribution provisions, over (2)The sum of (a) the amount, if any, without duplication, that such Partner would be obligated to contribute to the capital of the Company, (b) such Partner’s share of Partnership Minimum Gain determined pursuant to p p Treas. Reg. Section 1.704 ‐ 2(g) and (c) such Partner’s share of Partner Nonrecourse Debt Minimum Gain determined pursuant to Treas. Reg. Section 1.704 ‐ 2(i)(5), all computed as of the date of the hypothetical sale described in (1) above. 29
2 nd Approach: Targeted/Forced Allocation pp g Way this practically works: (1) Each member’s Capital Account is adjusted based on the year’s contributions, distributions and book ‐ ups (i.e. everything other than the income/loss tax allocations). (2) Everyone pretends the LLC sells all its assets for cash at the end of the year at their fair market value, and that it took the proceeds and will distribute to the members pursuant to the waterfall. (3) The income/loss the LLC has is allocated among the members so that each member’s balance equals the q amount the member would be entitled to receive as described in Step (2). 30
2 nd Approach: Targeted/Forced Allocations Ex: A and B form an LLC. A contributes $90. B contributes $10. Distributions: Cash is paid first to return contributed capital + a 10% annual preferred return, and then is paid 80/20 to A and B respectively. The LLC earns $20 of income in year 1. A B Operating Agreement Distrib tions Operating Agreement Distributions 1. First to return contributed capital+ preferred return of 10% 2 2. Then 80/20 to A and B. Then 80/20 to A and B $90 $10 31
2 nd Approach: Targeted/Forced Allocations Step 1: Our example is really simple and we’re pretending there were no other contributions/distributions. So, A’s capital account is $90 and B’s is $10 Step 2: All the LLC’s assets at the end of the year are worth $120 ($100 contributions + $20 income). If the LLC liquidated at the end of the year, then under our distribution waterfall, A and B would get $107 and $13 respectively: respectively: A B Total Return of capital $90 $10 $100 Preferred returns $9 $1 $10 Residual return $8 $2 $10 Total Distribution if LLC sold all $107 $13 $120 assets and liquidated Step 3: Allocate income to that A’s capital account balance equals $107. ‐ For A: to get from $90 (beginning capital account) to $107 (ending capital For A to get from $90 (beginning capital account) to $107 (ending capital account), we have to add $17 to it. A gets allocated $17 of the taxable income. ‐ For B: to get from $10 to $13, we allocate $3 of taxable income to him or her. 32
2 nd Approach: Targeted/Forced Allocation 2 Approach: Targeted/Forced Allocation Pros: 1. Can’t alter the business arrangement. There is economic certainty. 2. You technically have SEE because liquidating distributions equal the amount of the capital account balance. balance. • Some people take position that it is unclear whether targeted/forced allocations have SEE because technically you are still liquidating in accordance with distributions scheme. However, most take the view that where the capital account balance must equal that amount to be received in the waterfall, it doesn’t matter that the liquidation section doesn’t precisely say “liquidate in accordance with capital account balances ” say liquidate in accordance with capital account balances. 33
2 nd Approach: Targeted/Forced Allocation 2 Approach: Targeted/Forced Allocation Cons: 1. They are the easy way out, so often no one (including the tax lawyers and the members of the LLC) stops to think through how income/losses will really be allocated. 2. 2 The work and the risk is shifted from the lawyer during the The work and the risk is shifted from the lawyer during the drafting of the OA to the accountant who will prepare the K ‐ 1s. (In all honesty, even in perfectly drafted allocation provisions, there are usually situations that come up that the accountant has to think through that the drafters didn’t anticipate or address.) 3. Practically, there is really no telling how the person actually doing the allocations is doing them and whether s/he really understands how the targeted allocation provision works (Same is true how the targeted allocation provision works. (Same is true, however, for layered allocations.) 34
Allocations with Respect to Built ‐ In Gain or Loss Property • If a member contributes assets with built ‐ in a e be co t butes assets t bu t appreciation or depreciation, special rules require that the built ‐ in tax gain or loss (when it is eventually recognized by the LLC) be allocated ll d b h ) b ll d back to the contributing partner. • Again, keep in mind that this only relates to the A i k i i d th t thi l l t t th allocations of gain and loss. The distributions of the proceeds from the sale of the property can be the proceeds from the sale of the property can be shared by the members in whatever manner they choose. 35
Allocations with Respect to Built ‐ in Gain or Loss Property ‐ Section 704(c) ( ) A B $100 Property with value of cash h $100 $100 and basis of $20 d b i f $20 When the partnership eventually sells the property, the $80 of taxable gain must be allocated to B. Unlike with a corporation, B can’t escape taxation on that just b ll d B U lik i h i B ’ i h j by contributing it to the LLC. If the property is sold for more than $100, then while the first $80 of gain must be allocated to B, the remainder of the economic g gain (i.e., the post contribution gain) can be allocated in accordance with the ( , p g ) parties’ agreement. 36
Allocations with Respect to Built ‐ in Gain or Loss Property ‐ Section 704(c) ( ) • Another way to look at this is that the tax ‐ basis ot e ay to oo at t s s t at t e ta bas s shortfall (i.e., to the extent that the tax basis is less than the value upon contribution) must be borne by the contributing partner. The tax basis b b h b h b shortfall can be borne by the contributing partner either by having (i) the taxable gain on the sale either by having (i) the taxable gain on the sale being allocated to the contributing partner, (ii) the tax depreciation deductions being allocated p g away from the contributing partner to the non ‐ contributing partner. 37
Nonrecourse Deductions & Minimum Gain Chargeback P Provisions i i • A special set of rules govern allocation of partnership deductions funded by nonrecourse debt Without the deductions funded by nonrecourse debt. Without the special rule, these allocations could not have SEE because no members bears the economic burden of the losses associated with these since the lender is really the one associated with these since the lender is really the one whose capital is at stake (and not a member’s). • Example: • A and B each contribute $100 to a LLC. A and B each contribute $100 to a LLC. • LLC borrows $800 on a nonrecourse basis to buy a building for $1 million. • Once the building was depreciated from $1000 to $800, A’s and B’s capital accounts would be zero capital accounts would be zero. • Any further allocations of depreciation would drive their capital accounts impermissibly negative but for the special nonrecourse deduction rules. 38
Nonrecourse Deductions & Minimum Gain Chargeback Provisions P i i • To address this situation, the regulations create the concept called “partnership minimum gain” to track deductions where a non ‐ “ t hi i i i ” t t k d d ti h partner lender is at risk for a partnership liability. Minimum gain is the amount by which the nonrecourse debt exceeds the basis in the property secured by the debt. (The debt will probably not start out p p y y ( p y as exceeding basis, but will get to that point when depreciation deductions are taken on the property, and eventually, the basis is below the debt encumbering the property.) The concept is that a nonrecourse deduction can be allocated to a partner to cause its nonrecourse deduction can be allocated to a partner to cause its capital account to be negative, even without a partner obligation to restore such negative capital account. • The IRS allows this so long as there is a “minimum gain chargeback.” g g g The idea is that when the property secured by the nonrecourse debt is disposed of, an amount of gain equal to the nonrecourse debt minus the basis will be “charged back” to those members that took the nonrecourse deductions So the IRS is protected overall took the nonrecourse deductions. So, the IRS is protected overall. 39
Nonrecourse Deductions & Minimum Gain Chargeback P Provisions i i Example: p • A and B each contribute $50k to an LLC • LLC borrows an additional $900k on a non ‐ recourse basis to acquire a $1 million building. g • Over the years, A and B take depreciation deductions of $500k ($250k each). Their capital accounts are decreased from $50k to negative $200. • Of the $500k in deductions ($250k each), the first $100k ($50k each) are attributed to A’s and B’s contributed capital. The remaining $200k each of deductions is attributed to the nonrecourse debt. • It is okay to allocate these deductions to A and B so long as the $400k of partnership minimum gain ($900k liability less $500k basis) is of partnership minimum gain ($900k liability less $500k basis) is allocated also to A and B. • The minimum gain will be triggered on the sale by the LLC of the building or if the lender forgives the loan. building or if the lender forgives the loan. 40
Nonrecourse Deductions & Minimum Gain Chargeback Provisions P i i • Only the first $50 of the depreciation deductions can have substantial economic effect, since neither of the parties contributed money greater than that. A B • However, since the partnership agreement Initial Capital p 50 50 contains a minimum gain chargeback contains a minimum gain chargeback provision, this means the partnership will Nonrecourse (250) (250) keep track of its minimum gain ($900 Deductions nonrecourse debt less $500 book basis will mean $400 of minimum gain). And when mean $400 of minimum gain). And when Net Capital Net Capital (200) (200) (200) (200) the partnership minimum gain of $400 is recognized, each of A and B has agreed to recognize their share of $200 each. This minimum gain will support their negative minimum gain will support their negative capital account of $200, and prevent them from having Adjusted Capital Account Deficits. 41
Nonrecourse Deductions & Minimum Gain Chargeback P Provisions i i If the partnership sells or otherwise disposes of If the partnership sells or otherwise disposes of the building, or if the creditor of the nonrecourse loan forgives all or a portion of the nonrecourse loan forgives all or a portion of the loan – the minimum gain will be recognized and the chargeback will kick in the chargeback will kick in. 42
Nonrecourse Deductions & Minimum Gain Chargeback Provisions P i i • The regulations create a parallel concept for g p p nonrecourse debt loaned or guaranteed by a partner (i.e., “partner nonrecourse debt”) except that those deductions and the related chargeback that those deductions and the related chargeback must be allocated to the lender/guarantor partner because that partner is indirectly at risk due to also being the lender/guarantor. In that d t l b i th l d / t I th t case, the regulations use the terms “partner minimum gain” and “partner minimum gain g p g chargeback” to have similar meanings to “partnership minimum gain” and “partnership minimum gain chargeback ” minimum gain chargeback. 43
Capital Shifts p • Why is it important? The IRS has historically successfully asserted th t that a “shift” in capital among partners produces a taxable event for “ hift” i it l t d t bl t f the receiving partner (and in some cases, for the transferring partners too). See Lehman v. Commissioner, 19 T.C. 659. • What is it? Capital shifts can take many forms but a capital shift What is it? Capital shifts can take many forms, but a capital shift generally occurs when a member with a capital interest agrees to forgo part or all of its right to proceeds on liquidation of the LLC. • As earlier discussed, one of the key concepts underlying partnership taxation is that the capital account balance represents what each partner is entitled to receive on the liquidation of a partnership, and thus, the capital account balance must represent the value of the partnership interest the value of the partnership interest. 44
Capital shift – simplest example Capital shift simplest example • A and B form a partnership. A contributes $0 and B contributes $100. The operating agreement says split the proceeds 50/50 on liquidation. • There is a capital shift of $50 from B to A. This shift is immediate because the operating agreement says that on an immediate liquidation, A and B would share equally. (In other words, it isn’t as if a hurdle has to be reached before this shift kicks in.) On liquidation: On liquidation: A A B A gets $50 B gets $50 $100 45
Capital Shift – Targeted/Forced Allocation With Preferred Return Ex: A & B form an LLC. A puts in $100, and B puts in $50. Distributions: A B (i) (i) Fi First, to A, until A gets preferred return ($10 for year 1); A il A f d ($10 f 1) (ii) Then to return A’s capital contributions; and $100 $50 (iii) Then to return B’s capital contribution; and (iv) Thereafter, equally to A and B. The LLC earns $7 for year 1. If the LLC allocated in accordance with a layered approach, allocations would go y pp , g something like this (1 st to A in an amount equal to A’s preferred return; then, equally to A & B): A B Total Beginning Capital Account l $100 $ $ $50 $ $150 Allocation of income $7 $0 $7 Ending Capital Account $107 $50 $157 So, on liquidation, this is the amount A and B would get. 46
Capital Shift – Targeted/Forced Allocation With Preferred Return If on the other hand, there was a targeted allocation provision: Step 1: Starting capital account balances: A=$100 and B = $50 Step 2: Distributions on hypothetical liquidation ‐ LLC has total of $157: Step 2: Distributions on hypothetical liquidation LLC has total of $157: A B Total Preferred Return $10 ‐ $10 Return of A’s Capital $100 ‐ $100 Residual Returns B’s Capital $47 $47 Total to be Distributed $110 $47 $147 So, on liquidation, this is the amount A and B would get. $3 of B’s capital got shifted to A. $3 of B s capital got shifted to A. 47
Capital Shift – Targeted/Forced Allocation With Preferred Return • So, the key difference is that in the case where there is not enough money to satisfy the preferred return priority, some of the capital will shift from B to A. What the parties probably really intended was that A gets a preferred return only if there is enough money in the LLC to satisfy the preferred return after the capital contributions of A and B are h f d f h l b f d satisfied. The potential taxable income occurs when the shift occurs. So, if for years, there was enough to give the preferred return, and only at a certain point there was insufficient income then that is when the capital certain point there was insufficient income, then that is when the capital shifted, and that is when the taxable income event would occur. • The allocation is technically correct. But the distributions may not be what the parties intended what the parties intended. • Maybe one way around this is to specify that the preferred return is to be paid to the extent there were sufficient net profits. 48
Capital Shift – When Service Providers Receives a Capital Interest l • Another typical example: LLC with A and B as members wants to give C, an employee, an interest in the LLC. l i t t i th LLC • Suppose A and B formed it on 1/1/12 by contributing $10 each. • On 1/1/13, the LLC is worth $150, and they want to bring in C, and give him a “1/3 interest.” At this point, the capital acccounts of A and B should reflect a booked up p , p p balance of $75 each. If C gets a right to 1/3 or $50 upon entering, then $50 of capital shifted from A and B to C. B A ‐ C’s interest would have been tax ‐ free if it had C s interest would have been tax free if it had been a “profits interest” instead of this. ‐ How do get it to be a profits interest? ‐ Say distribution/liquidation section provides that after first $10 is returned to id th t ft fi t $10 i t d t each of A and B, then everything is shared? 49
Capital Shift – Forfeit Interest on Failure to Meet Capital Call l l ll • The members of this LLC have agreed that Th b f thi LLC h d th t there will be regular capital calls; and that upon the failure of a member to meet a capital call, the member will forfeit a portion p , p A A of his interest, and it will revert to the other members. • Example: A has contributed $1,000. The LLC is worth $100 000 There is a capital call that is worth $100,000. There is a capital call that A fails to meet. Let’s assume A’s capital account balance at that time is $1,000. Under the terms of the operating agreement, A is to forfeit all of this (typically, it’ll probably be a portion). Upon the forfeiture, $1,000 of capital has shifted from A to the other members members. 50
Capital shift – Common examples Capital shift Common examples • When a service provider receives anything other than a p y g pure profits interest in an LLC. • When a non ‐ compensatory option is exercise to acquire an interest in an LLC. i i t t i LLC • When a preferred interest in an LLC “converts” to a common interest in an LLC at a point in time when the common interest in an LLC at a point in time when the common was already entitled to some value. • When someone a member forfeits his/her/its interest (perhaps because s/he or it couldn’t meet a capital call) / and their capital shifts to the account of other members. members. 51
Tax Consequences of Capital Shift • In the context of compensatory capital shifts, it is pretty clear that the IRS will tax the it is pretty clear that the IRS will tax the capital shift to the recipient. • In the case of the exercise of non ‐ t e case o t e e e c se o o compensatory options, the IRS has issued proposed regulations that take the position there is no capital shift or resulting income. • Outside these 2 contexts, however, there is relatively little law on the tax consequences of capital shifts. 52
Tax Consequences of Capital Shift Based on the limited case ‐ law, the partnership tax regulations and the commentary, below is a summary of the approaches that may be taken: 1. There is current taxable income to the remaining partners in the amount of the capital that g p p has shifted from the defaulting partners to them. 2. There is current taxable income to the remaining partners; however, the value of the current income should equal the fair market value of the forfeited interest of the defaulting partners; this may not necessarily be equal to the capital being shifted. Perhaps minority discounts and lack of marketability would make this lower lack of marketability would make this lower. 3. Instead of accounting for the capital shift by reporting current income to the remaining partners, the partnership should do "catch ‐ up" allocations of future losses of the partnership (gross, not net) to the defaulting partners and income to the remaining partners until such time as enough income has been allocated to the remaining partners. This approach seems like a reasonable one; though there isn't certainty that the IRS would agree with it like a reasonable one; though there isn t certainty that the IRS would agree with it. 4. Finally, some take the position that the IRS would be wrong in asserting that there should be current taxable income. Though not all the commentators supporting this view are able to clearly articulate the rationale for this, it appears to be based on either a “bargain purchase” theory, or along the lines of: When a partnership redeems the interest of a partner for less than his capital account balance, there isn't considered to be a capital shift or taxable income th hi it l t b l th i 't id d t b it l hift t bl i to the remaining partner. It should be noted that this position carries a good bit of risk with it, and it is not at all clear that the IRS would agree with this. 53
Additional Authorities/Sources • Jonathan R. Flora, Venture Capital, Meet Capital Shift, The M&A Tax Report, February 2008. • Kevin Thomason, The Myth of the Capital Shift, Journal of Passthrough Entities, September ‐ October 2002. • Robert P. Rothman, Translating Corporate Concepts into LLCs, 61 The Tax Lawyer 161 (2007). • Linda Z. Swartz, A Layman’s Guide to LLC Incentive Compensation, PLI’s Tax planning for domestic & foreign partnerships, LLCs, joint ventures & other strategic alliances, 2007. • Steven R. Schneider & Brian J. O’Connor, Partnership and LLC Agreements – Learning to Read and Write Again, Tax Notes, December 21, 2009. • William G. Cavanagh, Targeted Allocations Hit the Spot, Tax Notes, October 4, 2010. • L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, Journal of y g Business Entities, July/August 2009. 54
Tax Allocations in Partnerships and LLCs Partnerships and LLCs Strafford Publications February 6, 2013 JED A ROHER JED A. ROHER One East Main Street Suite 500 Madison, WI 53701 Madison, WI 53701 jroher@gklaw.com
Agenda Agenda II. II. Allocation of Contributed Property Allocation of Contributed Property III. Allocation of Liabilities IV. IV. Distribution Rules Distribution Rules 56
Allocations: Contributed Property ocat o s Co t buted ope ty • Capital accounts are economic / book concepts Capital accounts are economic / book concepts - So, capital accounts are increased by fair market value of contributed property - And fair market value of property is reflected on the partnership’s books • But, basis is a tax concept - So, contributor’s basis in partnership interest derived from basis in property d i d f i i t b - And partnership takes a basis in contributed property equal to contributor’s basis property equal to contributor s basis 57
Allocations: Contributed Property ocat o s Co t buted ope ty • Can create book / tax disparities Can create book / tax disparities • A contributes property with a basis of $5,000, FMV of $25,000; B contributes $75,000 cash , ; , - Assume 5-year, straight line depreciation A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 58
Allocations: Contributed Property ocat o s Co t buted ope ty • The Code’s answer: § 704(c)(1)(A) § ( )( )( ) - “ income , gain , loss , and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of the contribution” f i k t l t th ti f th t ib ti ” - “The purpose of section 704(c) is to prevent the shifting of tax consequences among partners shifting of tax consequences among partners with respect to precontribution gain or loss.” Treas. Reg. § 1.704-3(a)(1) 59
Allocations: Contributed Property ocat o s Co t buted ope ty • Goal is to bring book and tax into harmony Goal is to bring book and tax into harmony “using a reasonable method that is consistent with the purpose of section 704(c)”. Treas. Reg. § 1.704-3(a)(1). • 704(c) allocation rules apply on a property-by- property basis. Can choose different methods C ff for different properties. Treas. Reg. § 1.704- 3(a)(2) 3(a)(2). • Subject to an anti-abuse rule if allocations aimed at reducing aggregate tax liability aimed at reducing aggregate tax liability 60
Allocations: Contributed Property ocat o s Co t buted ope ty • Regulations detail three methods: Regulations detail three methods: - traditional (Treas. Reg. § 1.704-3(b)); - traditional with curative allocations (Treas. Reg. § ( g § 1.704-3(c)); - remedial ((Treas. Reg. § 1.704-3(d)) 61
Allocations: Contributed Property ocat o s Co t buted ope ty • Traditional method: Traditional method: - Tax allocations follow book allocations - But total income, gain, loss or deduction , g , allocated to the partners in a taxable year with respect to a property cannot exceed the total partnership income, gain, loss or deduction with t hi i i l d d ti ith respect to that property in that year • This is the “ ceiling rule ” This is the ceiling rule 62
Allocations: Contributed Property ocat o s Co t buted ope ty • Traditional method: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation Y1 Depreciation 0 0 (1 250) (1,250) (1 000) (1,000) (3 750) (3,750) (1,000) (1 000) (5,000) (5 000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 63
Allocations: Contributed Property ocat o s Co t buted ope ty • Traditional method with curative allocations: Traditional method with curative allocations: - Goal is to correct distortions caused by ceiling rule - Tax allocations follow book allocations, but partnership can use tax allocations from other property to mitigate effect of ceiling rule t t iti t ff t f ili l - Tax allocations from other property must be expected to have same effect on partners’ tax expected to have same effect on partners tax liability as tax item limited by ceiling rule 64
Allocations: Contributed Property ocat o s Co t buted ope ty • Traditional method with curative allocations: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation (A asset) Y1 Depreciation (A asset) 0 0 (1 250) (1,250) (1 000) (1,000) (3,750) (3 750) (1 000) (1,000) (5 000) (5,000) Y1 Depreciation (bought (1,000) (3,750) (14,000) (11,250) (15,000) (15,000) asset) Capital Accounts After Y1 Capital Accounts After Y1 4 000 4,000 20 000 20,000 60 000 60,000 60 000 60,000 64,000 64 000 80 000 80,000 65
Allocations: Contributed Property ocat o s Co t buted ope ty • Remedial method: Remedial method: - Goal is to eliminate distortions caused by ceiling rule - Partnership creates phantom tax items to allocate among the partners 66
Allocations: Contributed Property ocat o s Co t buted ope ty • Remedial method: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation Y1 Depreciation 0 0 (1 250) (1,250) (1 000) (1,000) (3,750) (3 750) (1 000) (1,000) (5 000) (5,000) Y1 Remedial Allocations 2,750 0 (2,750) 0 0 0 Capital Accounts After Y1 7,750 23,750 71,250 71,250 79,000 95,000 67
Allocations: Contributed Property ocat o s Co t buted ope ty • We have been talking about “operating” We have been talking about operating allocations with respect to property • On the sale of property, the basic rule is that p p y, built-in gain or loss remaining in property on sale is allocated to contributing partner 68
Allocations: Contributed Property ocat o s Co t buted ope ty • Sale of property: p p y A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Sale for $25,000 20,000 0 0 0 20,000 0 Capital Accounts After Sale 25,000 25,000 75,000 75,000 100,000 100,000 69
Allocations: Contributed Property ocat o s Co t buted ope ty • Sale of property after 1 year: p p y y A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation 0 (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 Sale for $20,000 Sale for $20 000 16 000 16,000 0 0 0 0 0 0 16 000 16,000 0 0 Capital Accounts After Sale 21,000 23,750 74,000 71,250 95,000 95,000 70
Allocations: Contributed Property ocat o s Co t buted ope ty • Sale of property after 1 year: p p y y A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation 0 (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 Sale for $25 000 Sale for $25,000 16 000 16,000 0 0 0 0 0 0 16,000 16 000 0 0 1,250 1,250 3,750 3,750 5,000 5,000 Capital Accounts After Sale 22,250 25,000 77,750 75,000 100,000 100,000 71
Allocations: Contributed Property ocat o s Co t buted ope ty • “Mixing Bowl” rules: Section 704(c)(1)(B) / Mixing Bowl rules: Section 704(c)(1)(B) / Treas. Reg. § 1.704-4 • If property contributed by 1 partner is distributed p p y y p to a different partner within 7 years of contribution, built-in gain or loss is allocated to contributing partner 72
Allocations: Contributed Property ocat o s Co t buted ope ty 3. Allocation of 3. Allocation of Partner 1 built-in gain to Partner 2 Partner 1 1. Contribution of appreciated property 2. Distribution of property w/in 7 t /i 7 years 704(c)(1)(B) 73
Allocations: Contributed Property ocat o s Co t buted ope ty • “Reverse” Mixing Bowl rules: Section 737(a) / Reverse Mixing Bowl rules: Section 737(a) / Treas. Reg. § 1.704-4 • If partner contributes property with built-in gain, p p p y g , and receives a distribution of other property within 7 years of contribution, contributing partner recognizes lesser of (i) excess of value f ( ) f of distributed property over partner’s outside basis or (ii) amount that would have been basis, or (ii) amount that would have been recognized by partner under the mixing bowl rules w/r/t all property contributed by partner rules w/r/t all property contributed by partner 74
Allocations: Contributed Property ocat o s Co t buted ope ty Partner 1 3. Allocation of built-in gain in built in gain in properties 2. Distribution of contributed by 1. Contribution of other property Partner 1 to appreciated w/in 7 years Partner 1 property property 737(a) 75
Allocations: Contributed Property ocat o s Co t buted ope ty • And watch out for the “disguised sale” rules of And watch out for the disguised sale rules of 707(a)(2)(B)! • If: - direct or indirect transfer of money or other property by a partner to a partnership, - related direct or indirect transfer of money or other property by partnership to contributing partner or another partner and partner or another partner, and - transfers properly characterized as a sale, • Then transaction treated as sale of property • Then transaction treated as sale of property 76
Agenda Agenda II. II. Allocation of Contributed Property Allocation of Contributed Property III. Allocation of Liabilities IV. IV. Distribution Rules Distribution Rules 77
Allocation of Liabilities Allocation of Liabilities • Increase in share of partner’s liabilities treated Increase in share of partner s liabilities treated as a contribution of money by the partner to the partnership. • Decrease in share of partner’s liabilities treated as a distribution of money by the partnership to the partner. - Any decrease in partner’s liabilities as a result of a sale or exchange of the partner’s interest in the a sale or exchange of the partner s interest in the partnership treated as an amount realized under § 1001. § 78
Allocation of Liabilities Allocation of Liabilities • Two types of liabilities: Two types of liabilities: - Recourse: liabilities for which a partner bears the “economic risk of loss” under Treas. Reg. § 1.752-2 - Nonrecourse: liabilities for which no partner bears the “economic risk of loss” b th “ i i k f l ” 79
Allocation of Liabilities Allocation of Liabilities • “Economic risk of loss”: Economic risk of loss : - Driven by obligation of a partner to make a payment to any person if the partnership constructively liquidates - Paying partner must not have any right of reimbursement from any other partner i b t f th t • Obligation can be derived from contractual obligations outside of partnership (guarantees obligations outside of partnership (guarantees, etc.) or from partnership agreement (capital contribution obligation, DRO) contribution obligation, DRO) 80
Allocation of Liabilities Allocation of Liabilities • Recourse liabilities are allocated among the Recourse liabilities are allocated among the partners that bear the economic risk of loss for those liabilities, to extent of economic risk. • Nonrecourse liabilities are allocated among all of the partners. Each partner is allocated: - Partner’s share of partnership minimum gain, + - Partner’s share of 704(c) gain for property subject to nonrecourse liabilities, + bj t t li biliti - Partner’s allocable share of any remaining nonrecourse liabilities based on share of profits nonrecourse liabilities, based on share of profits 81
Agenda Agenda II. II. Allocation of Contributed Property Allocation of Contributed Property III. Allocation of Liabilities IV. IV. Distribution Rules Distribution Rules 82
Distribution Rules Distribution Rules • Distributions by a partnership to a partner Distributions by a partnership to a partner generally trigger gain only if any money distributed exceeds the partner’s adjusted basis in the partner’s interest in the partnership. § 737(a)(1) • Any gain on distribution is treated as gain from f the sale or exchange of the distributee partner’s partnership interest partnership interest 83
Distribution Rules Distribution Rules • First , partner’s basis in partnership interest is First , partner s basis in partnership interest is reduced (but not below zero) by amount of cash distributed. - If basis is insufficient to soak up cash, gain to extent of excess • Second , partner’s remaining basis becomes the basis of any non-cash property distributed to the partner the partner 84
Distribution Rules Distribution Rules • If more than one property / type of property is If more than one property / type of property is distributed, remaining basis goes: - first to any distributed unrealized receivables and y inventory items, to the extent of the partnership’s basis in those items; - second to any other property distributed (first to d t th t di t ib t d (fi t t depreciated property, then to all property in proportion to inside basis) proportion to inside basis) 85
Distribution Rules Distribution Rules • If distribution operates to increase or decrease p a partner’s share of partnership hot assets (unrealized receivables or substantially appreciated inventory) in exchange for a appreciated inventory) in exchange for a decrease or increase in the partner’s share of other partnership property, distribution is treated as a sale or exchange. § 751(b). - Trap for the unwary: admission of new partner reduces existing partners’ share of nonrecourse reduces existing partners share of nonrecourse liabilities; deemed cash distribution / reduction in hot assets; 751(b) applies. Rev. Rul. 84-102. 86
Lynn E Fowler Kilpatrick, Townsend & Stockton LLP l k d k 1100 Peachtree Street, Suite 2800 Atlanta, Georgia 30309 404.815.6653 Lfowler@kilpatricktownsend.com V ADJUSTMENTS TO BASIS OF V. ADJUSTMENTS TO BASIS OF PARTNERSHIP/LLC ASSETS
Base Case ASSETS LIABILITIES/ CAPITAL TAX/BOOK FMV TAX/BOOK FMV Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500 P allocates profits and losses 1/3 to each of A, B and C 88
A A. Transfers of Partnership Transfers of Partnership Interests 89
D’s Purchase of A’s Interest ASSETS LIABILITIES/ CAPITAL TAX/BOOK TAX/BOOK FMV FMV TAX/BOOK TAX/BOOK FMV FMV Cash 2100 2100 Liabilities 600 600 Blackacre Blackacre 1200 1200 2400 A Capital 2400 A Capital 900 900 1300 1300 B Capital 900 1300 C C p C Capital 900 900 1300 300 Total 3300 4500 Total 3300 4500 A sells his interest to D for $1300 Partnership has made no Section 754 election 90
Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets IRC §743- Special rules where section 754 election or substantial built-in loss. (a) General rule. The basis of partnership property shall not be adjusted as the result of a ( ) p p p p y j transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 754 (relating to optional adjustment to basis of partnership property) is in effect with respect to such partnership or unless the partnership has a substantial built-in loss immediately after such transfer. the partnership has a substantial built in loss immediately after such transfer. 91
D’s Purchase of A’s Interest ASSETS LIABILITIES/ CAPITAL TAX/BOOK FMV TAX/BOOK FMV Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500 What happens if P sells Blackacre for $1200? P recognizes $1200 gain D taxable on $400 gain allocated to D Good result for D? 92
D’s Purchase of A’s Interest ASSETS LIABILITIES/ CAPITAL TAX/BOOK FMV TAX/BOOK FMV Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500 A sells his interest to D for $1300 Partnership makes Section 754 election 93
Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets IRC §743- Special rules where section 754 election or substantial built-in loss. (b) Adjustment to basis of partnership property. In the case of a transfer of an interest ( ) j p p p p y in a partnership by sale or exchange or upon the death of a partner, a partnership with respect to which the election provided in section 754 is in effect or which has a substantial built-in loss immediately after such transfer shall— ― (1) i (1) increase the adjusted basis of the partnership property by the excess of the th dj t d b i f th t hi t b th f th basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property, or ― (2) decrease the adjusted basis of the partnership property by the excess of ( ) j p p p p y y the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership. 94
Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets Treas Reg §743-1 - Optional adjustment to basis of Treas. Reg. §743-1 - Optional adjustment to basis of partnership property. (1) Generally. A transferee's share of the adjusted basis to the partnership of partnership propert is eq al to the s m of the transferee's interest as a partnership property is equal to the sum of the transferee's interest as a partner in the partnership's previously taxed capital, plus the transferee's share of partnership liabilities. Generally, a transferee's interest as a partner in the partnership's previously taxed capital is equal to— ― (i) The amount of cash that the transferee would receive on a liquidation of the partnership following the hypothetical transaction, as defined in paragraph (d)(2) of this section (to the extent attributable to the acquired partnership interest); increased by by ― (ii) The amount of tax loss (including any remedial allocations under §1.704-3(d)), that would be allocated to the transferee from the hypothetical transaction (to the extent attributable to the acquired partnership interest); and decreased by ― (iii) The amount of tax gain (including any remedial allocations under §1.704-3(d)), that would be allocated to the transferee from the hypothetical transaction (to the extent attributable to the acquired partnership interest). 95
Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets D’s basis in partnership interest = $1500 Cash purchase price for interest = $1300 Plus D’s share of partnership liabilities = p p $200 96
Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets D’s previously taxed capital = $900 Amount distributed on hypothetical sale = $1300 Plus loss allocated to D on hypothetical sale = yp $0 Minus gain allocated on hypothetical sale = ($400) 2400 FMV 1200 A/B 1200 A/B 1200 Gain x 1/3 = $400 Plus share of liabilities $200 P’s share of partnership basis P s share of partnership basis $1100 $1100 97
Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets • Section 743(b) Basis Adjustment = $400 D’s basis in partnership interest = $1500 Minus D’s share of partnership basis = p p $1100 98
D’s Purchase of A’s Interest ASSETS LIABILITIES/ CAPITAL TAX/BOOK FMV TAX/BOOK FMV Cash 2100 2100 Liabilities 600 600 Blackacre 1600 2400 D Capital 1300 1300 B Capital 900 1300 C Capital 900 1300 Total 3700 4500 Total 3700 4500 What happens if P sells Blackacre for $2400? P recognizes $800 gain No gain allocable to D Good result for D? 99
B B. Distributions of Partnership Distributions of Partnership Property p y 100
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