Presenting a live 90-minute webinar with interactive Q&A Tax Strategies for Real Estate LLC and LP Agreements: Capital Commitments, Tax Allocations, Distributions, and More Structuring Provisions to Achieve Tax Benefits and Avoid Common Pitfalls THURS DAY, MAY 8, 2014 1pm East ern | 12pm Cent ral | 11am Mount ain | 10am Pacific Today’s faculty features: Brian O'Connor, Partner, Venable , Baltimore S teven S chneider, Director, Goulston & Storrs , Washington, D.C. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .
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Tax Strategies for Real Estate LLC and LP Agreements Strafford May 8, 2014 Brian J. O’Connor Steven R. Schneider
Introduction Understand the partners and their tax characteristics. Learn the general economics/business deal (e.g., capital commitments, preferred versus common interests, compensatory interests, distributions (including tax distributions), special partners, etc.). Create an everyday working relationship, therefore needs to be cooperative in addition to adversarial. 6
Review the Cash Flow and Allocations Terms of preferred interests. Operating versus liquidating distributions. Other: Tax distributions. Capital calls and partner loans. 7
Types of Preferred Interests Distribution-based preferred. Liquidate with cash waterfall. Preferred return typically paid even if there is no net profit. Section 704(b) allocation-based preferred. Liquidate with section 704(b) capital accounts. Guaranteed payments. Not part of profit and loss allocation section. Separate section generally referencing section 707(c) and providing specific interest like return to preferred partner. 8
Tax Distributions Many agreements contain minimum distributions to a partner to ensure that it has sufficient funds to satisfy taxes relating to its share of partnership income. Typically documented as an advance on the partner’s rights under the more general distribution provisions. Sometimes distributions are treated as a loan to the partner. Generally equal to share of net income multiplied by maximum applicable rate for type of income. Variables: Actual versus assumed rates, partners subject to different tax rates, losses followed by profits, quarterly versus annual distributions. 9
Liquidation Alternatives This section may be the key to learning whether the agreement intends to follow the regulatory book allocation safe harbors. An agreement likely follows safe harbors if, after paying creditors and setting up reserves, the agreement distributes the remaining proceeds according to the partners’ positive capital accounts. If the agreement instead liquidates with a cash waterfall, then the agreement must rely on a more limited tax safe harbor to get comfort that the IRS will respect the income and loss allocations (the partners would receive the same economic distributions as had they liquidated in accordance with each partner’s capital account). This would occur, for example, in a simple 50-50 partnership where all capital is contributed equally and all profits, losses, and distributions are shared equally. 10
Elections and Audits Elections : Agreement should address how partnership-level tax elections are made. The two main elections unique to partnerships relate to section 754 inside basis adjustments and section 704(c) allocations of built-in gains or losses among the partners. Audits : Tax Matters Partner (TMP) generally represents the partnership before the IRS and in federal civil tax litigation and is required to keep the other partners informed. Generally, the TMP must be a manager and member. Although the identity and authority of the TMP may sound boring, it is often a critical question when later controversy arises and the details are often overlooked in the drafting process. 11
Special Partners REITs Tax-Exempts Foreign Partners 12
REIT Partners Where one of the members is a REIT, it will seek to impose the following types of restrictions on the joint venture’s operations in order to ensure compliance with the REIT requirements: Real estate asset holding and income limitations; No prohibited transactions (e.g., condo sales); Limitations on loans (mezz debt or secured by real property); Limitations on leases (related party and personal property restrictions); and Arm’s-length transactions with REIT owners. 13
Tax-Exempt Partners Tax-exempt entities are generally subject to the unrelated business income tax for investment returns funded with “acquisition debt.” However, there is a Real Estate Financing Exception for “qualified organizations” that use specific types of debt to acquire or improve real property. To meet the Real Estate Financing Exception, qualified organizations who invest through a partnership must meet the Fractions Rule. To be Fractions Rule compliant, partnership allocations must satisfy the following two requirements on actual and prospective basis: Safe harbor allocations: The most significant economic factor in satisfying these rules is that the partnership liquidate with positive capital accounts in lieu of a cash waterfall. Disproportionate allocation rule: A qualified organization’s share of overall income for any year cannot exceed its lowest share of overall loss for any year. 14
Foreign Partners Partnerships are required to withhold taxes on a foreign investor’s share of real estate income because special “FIRPTA” rules treat the partner’s income from real estate as subject to U.S. taxation even if the income is not otherwise subject to U.S. tax. A partnership agreement typically treats this withholding as a partner distribution or loan. Certain partners may be subject to reduced withholding, but the partnership should require the partner to provide specific documentation to the partnership to receive the reduced rate. 15
Example 1: Capital Account Basics Section 704(b) 16
Property contribution; income allocation; distribution Facts: A contributes Building with $100 gross fair market value, subject to $30 of debt. In year one the partnership allocates $10 of section 704(b) book income to A and distributes $4 of cash to A. Effect on Capital Ending Capital Account Account Increase by net FMV of +$70 $70 property contributed Increase by income +$10 $80 allocation Decrease by -$4 $76 distributions 17
Tax Allocations – sections 704(b) and 704(c) How taxable income and loss are shared among the partners. Most of the allocation language relates to the economic/book allocations and in general taxable income will follow these book allocations. If a partner contributed an asset with built-in appreciation or depreciation, special rules require that such built-in tax gain or loss is allocated back to the contributing partner. 18
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