21st Annual Health Sciences Tax Conference

Transcription

1 21st Annual Health Sciences Tax Conference Something old, something new(ish) partnerships and REITs 5 December 2011

2 Disclaimer Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Page 2

3 Disclaimer Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client serving member of EYGM in the US. For more information about our organization, please visit This presentation is 2011 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are not necessarily those of Ernst & Young LLP. Page 3

4 Presenters Matt Musso Vice President, Tax Services Symbion Healthcare Nashville, Tennessee David Miller Principal, National Tax Ernst & Young LLP Dallas, Texas Rick Solway Partner, National Tax Ernst & Young LLP New York, New York Stephen Thome Senior Manager, Health Care Advisory Ernst & Young LLP Cleveland, Ohio Page 4

5 Agenda Partnership tax issues Impact of accountable care organizations (ACOs) and bundled payments on the use of partnerships in the health care industry Partnership formations common traps for the unwary Allocation issues Acquisition of a partnership interest due diligence issues Monetization of corporate real estate Spin-offs Monetization of owned real estate to recycle capital into core activities Real estate investment trusts (REITs) Page 5

6 Impact of ACOs and bundled payments Potential for significant increase in number of partnerships and joint ventures ACO must be organized as a legal entity Is an ACO necessarily taxed as a corporation or a partnership? Increase in burden on tax departments Capital accounting Allocations Reporting, timing of K-1s, etc. Special considerations where a tax-exempt entity is a partner in an ACO partnership Funding ACOs potential impact of advances and loans on allocations, etc. Page 6

7 Partnership formations common traps for the unwary Disguised sale issues Section 704(c)(1)(C) Page 7

8 Disguised sales: basic rules General rules: The transfer of property to a partnership in exchange for an interest therein is not taxable to the contributing partner or the partnership. The distribution of money from a partnership to a partner is not taxable to the extent of the partner s basis in its partnership interest. Exception disguised sale rule A transfer of property from a partner to a partnership is presumed to be a sale of the property to the extent the partnership makes a distribution to the partner within two years. A reduction in a contributing partner s share of a non-qualified liability is treated as a distribution of money and, as a result, part of a disguised sale. Page 8

9 Impact of liabilities Non-qualified liabilities All liabilities other than qualified liabilities Qualified liabilities A liability is a qualified liability if, and only if: It was incurred more than two years prior to the contribution or was not incurred in anticipation of the transfer and has been secured by the property during those two years It was incurred to acquire the property being contributed It was incurred in the ordinary course of the trade or business and all assets associated with the business are being transferred If the transferor receives any consideration in the transfer other than equity and the assumption of qualified liabilities, a portion of the qualified liability will be reclassified as a non-qualified liability. Page 9

10 Non-qualified liability trap Assumption of non-qualified liability TP Third party 1. TP contributes asset to JV subject to $40 of non-recourse debt. 2. TP receives $60 of units (50% of the equity of PS). FMV = $100 Debt = $40 AB = $40 $60 units $60 $60 units 3. TP receives a deemed distribution of $20 due to debt shift of $20 of debt to third party. 4. TP is treated as selling 20% of asset to JV. As a result, TP recognizes 20% of its gain ($12). JV 5. TP may NOT rely upon the favorable rules in the regulations regarding the allocation of nonrecourse liabilities based upon Section 704(c) gain inherent in the property. Page 10

11 Springing liability trap base facts Loan by TP to LLC = $40 TP Loan to disregarded entity 1. TP is the sole member of an LLC that is disregarded for tax purposes. 2. TP has advanced cash to LLC to fund operations, for state or international tax planning purposes, etc. LLC Asset FMV = $100 Debt = $40 ATB = $0 Page 11

12 Springing liability trap LLC treated as issuing $40 note and $60 of equity to TP TP LLC Asset FMV = $100 Debt = $40 ATB = $0 $10 Third party Conversion to tax partnership 1. Third party contributes $10 to LLC for an interest therein. 2. Under Rev. Rul. 99-5, LLC springs into existence as a partnership for tax purposes. 3. TP and third party are treated as contributing asset and $10, respectively, to LLC. 4. LLC is treated as having agreed to pay $40 to TP in connection with its formation (i.e., loan likewise springs into existence). 5. TP is treated as having contributed $60 of asset to LLC for units and as having sold $40 of asset to LLC. 6. TP recognizes gain of $40. Related-party rules may make matters worse (Sections 197, 267, 707, 1239, etc.). 7. What if an affiliate of TP had made the loan to LLC? Page 12

13 Disguised sale reporting obligations Taxpayers must disclose: Any distribution within two years of a property contribution that the parties do not treat as part of a disguised sale Exceptions for certain preferred returns, guaranteed payments and operating cash flow distributions Any liability treated as a qualified liability under the not in anticipation rule Page 13

14 Disguised sales of partnership interests A contribution by a partner to a partnership that occurs in connection with a distribution to another partner may be treated as a sale of an interest between the partners (rather than as a contribution and a separate distribution). What about normal redemptions and admissions of doctors? Page 14

15 Section 704(c)(1)(C) trap A built-in loss with respect to property contributed to a partnership may be taken into account only with respect to the contributing partner. With respect to the non-contributing partner(s), the basis of the property in the hands of the partnership shall be treated as its fair market value. Page 15

16 Section 704(c)(1)(C) trap (cont.) Assume taxpayer contributes asset with a fair market value of $100 and an adjusted tax basis of $300 to partnership: Partnership later sells asset for $300 Is it possible the non-contributing partners recognize a gain and the contributing partner is not entitled to recognize its $200 loss with respect to the property? Taxpayer subsequently transfers its interest to another partnership or a wholly owned corporate subsidiary and the asset is later sold for $100 Is it possible the loss inherent in the asset goes poof? Page 16

17 Allocation issues the basics Basic rules Types of partnership agreements Correcting prior-year errors Impact of debt on allocations (and tax basis) Page 17

18 Section 704(b) a refresher To be respected, partnership allocations must be set forth in the partnership agreement and: Have substantial economic effect (i.e., satisfy the economic effect test and substantiality test set forth in the regulations) Be in accordance with the partners interests in the partnership Or Be deemed to be in accordance with the partners interests in the partnership (e.g., non-recourse deductions, tax credits) Otherwise, items will be allocated in accordance with the partners interests in the partnership (PIP). Page 18

19 Substantial economic effect To have substantial economic effect, an allocation must have economic effect and be substantial. Substantiality: An allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Three general rules: Intra-year shifting rule Inter-year transitory allocation rule Overall tax effect rule Page 19

20 Three tests for economic effect Economic effect test Capital account maintenance Liquidation in accordance with positive capital accounts Deficit restoration obligation (DRO) Alternate test for economic effect Same as above, but in lieu of DRO Loss allocation may not cause or increase adjusted capital account deficit Agreement must contain a qualified income offset (QIO) Economic equivalence test The allocations must, in all situations, result in the exact same consequences to each of the partners as would have been the case had the agreement complied with the economic effect test. Page 20

21 Partner s interest in partnership (PIP) Facts-and-circumstances test Factors to be considered include: Relative contributions of partners Relative interests in distributions upon liquidation Relative interests in cash flow Relative interests in economic profit and loss sharing ratios Page 21

22 Types of partnership agreements Generally, three primary types of agreements: Safe harbor agreements Agreements that comply with the economic effect test or, more commonly, the alternate economic effect test (i.e., maintain capital accounts, liquidate in accordance with positive capital accounts, provide for a QIO, no loss allocation that causes an impermissible deficit in a partner s capital account) Waterfall agreements The waterfall provision in the agreement provides the mechanism for making operating and liquidating distributions (i.e., capital accounts do NOT control distribution rights on liquidation). These agreements do not satisfy the economic effect test or the alternative economic effect test (and may or may not satisfy the economic effect equivalence test). Hybrid agreements Page 22

23 Types of partnership agreements (cont.) When do parties use a safe harbor agreement? A waterfall agreement? Which type of partnership agreement do you have? Are you maintaining capital accounts? If so, on what basis? GAAP? Tax? Section 704(b)? What type of capital account does the agreement require you to maintain? Should you maintain capital accounts if you have a waterfall agreement? What if you discover you have not been maintaining capital accounts to date? Page 23

24 Correcting prior-year errors in allocations and capital accounting Economic perspective Duty to maintain accurate capital accounts Duty where capital accounts really matter (i.e., where capital accounts control distribution rights upon liquidation) Tax perspective Duty to amend prior-year returns Amending returns versus corrective allocations Failure to correct impact on future allocations Page 24

25 Impact of debt on allocations (and tax basis) Non-recourse debt Recourse debt Partner non-recourse debt Partner is the lender Partner (or partners) are related to the lender Potential impact of recourse or partner non-recourse debt on tax-exempt partner in an ACO Page 25

26 Example 1: allocation of recourse deductions A C/A = $0 O/B = $100 B C/A - $0 O/B = $0 60% GP 40% LP LP $100 Recourse Debt Lender Asset FMV: $ (b) Basis: $100 Debt: $100 ATB: $100 A and B have been previously allocated Section 704(b) book and tax losses equal to their contributed capital (both have 704(b) and tax basis capital accounts of $0). A is the general partner and B is the limited partner. How will the next $100 of losses be allocated? What if A doesn t have any assets other than its interest in the partnership? What will A and B s respective Section 704(b) and tax basis capital accounts be after the $100 in losses are allocated? When will the negative capital account(s) be restored? What is the potential impact on B if it is tax-exempt and partnership is an ACO? What impact on cost recovery under Section 168(h)(6) if B is tax exempt? Page 26

27 Example 2: allocation of nonrecourse deductions A C/A = $0 O/B = $60 B C/A - $0 O/B = $40 60% GP 40% LP LP $100 NR Debt Lender Asset FMV: $ (b) Basis: $100 Debt: $100 ATB: $100 Same facts as Example 1, but debt is non-recourse (rather than recourse). How will the next $100 of losses be allocated? What will A and B s respective Section 704(b) and tax basis capital accounts be after the $100 in losses are allocated? When and how will the negative capital accounts be restored? Page 27

28 Example 3: allocation of partner non-recourse deductions A C/A = $0 O/B = $100 B C/A - $0 O/B = $0 60% GP 40% LP $100 NR Debt LP Asset FMV: $ (b) Basis: $100 Debt: $100 ATB: $100 Same facts as Example 2 (i.e., debt is non-recourse), but A is the lender. A lends $100 to LP on a non-recourse basis (or is related to the lender). How will the next $100 of losses be allocated? What will A and B s respective Section 704(b) and tax basis capital accounts be after the $100 in losses are allocated? When will the negative capital accounts be restored? What is the potential impact on B if it is tax-exempt and partnership is an ACO? What impact on cost recovery under Section 168(h)(6) if B is tax-exempt? Page 28

29 Example 4: partner non-recourse deductions related party lender A C/A = $0 O/B = $50 B C/A - $0 O/B = $50 60% GP 40% LP LP $100 NR Debt Lender Asset FMV: $ (b) Basis: $100 Debt: $100 ATB: $100 Same facts as Example 3, but lender owns 100% of both A and B (i.e., lender is the parent corporation of both A and B) How will the next $100 of losses be allocated? What if the debt is recourse, rather than non-recourse? What if the debt is recourse, but the LP is instead a limited liability company? Page 29

30 Acquisition of a partnership interest due diligence issues Entity-level taxes (withholding, employment, state, etc.) Tax protection agreements Section 754 election Mechanics of Section 743 adjustment/interaction with Section 704(c) Built-in loss and mandatory adjustments Section 706 Intra-year allocations and permissible methods Inheriting your predecessor s economic and tax attributes Capital account, operating and liquidating distribution waterfall Tax allocations catch-up allocations, minimum gain, Section 704(c) built-in gain (and method) Page 30

31 Corporate real estate spin-offs, REITs and monetization Page 31

32 Context Corporate America is going through a period of refocusing on core competencies. Two manifestations: Spin-offs of non-core businesses Monetization of owned real estate to recycle capital into core activities Objective of presentation provide an overview of issues, approaches and key drivers Page 32

33 Context (cont.) In health sciences, we have seen significant real estaterelated restructuring in the senior living sector. There may be opportunities to achieve similar results and benefits in other health sciences sectors: Hospital owner-operators Other real estate-intensive health care companies Page 33

34 Real estate financing options Unsecured borrowing Mortgage financing Sale/leaseback or sale/manageback Partnership financing vehicle REIT or master limited partnership (MLP) equity offering Complete separation/spin-off (i.e., OpCo/PropCo ) Page 34

35 Key drivers of real estate financing structure for issuers Cost of funds Financing term Collateral/recourse requirements Accessing new sources of capital Ratings treatment Financial reporting treatment Tax treatment Degree of control over real estate Strategic considerations (e.g., desire to become asset light, potential multiple expansion) Operations and management accounting considerations Page 35

36 Partnership and REIT approaches Partnership financing vehicles Development Acquisition Monetization (e.g., transfer/leaseback; transfer/manageback; leveraged partnership distribution) REIT financing vehicles REIT Industry Diversification and Empowerment Act (RIDEA) structure (could be the result of an OpCo/PropCo complete separation) Merrill Gardens structure Page 36

37 Summary illustration of development partnership Health care operator Investor(s)* LLC interest and management contract, license or leaseback Cash Cash LLC interest LLC * The manner in which the investor(s) invest in the LLC vehicle depends on both the type of development and the types of investors. Page 37

38 Summary illustration of acquisition partnership Health care operator Investor(s)* LLC interest and management/ franchise contract or license Cash Cash (1) (1) LLC interest LLC Cash** (2) Assets Seller * The manner in which the investor(s) invest in the LLC depends on both the assets acquired and the types of investors. ** The LLC may also borrow funds to finance the purchase. Page 38

39 Joint venture transfer/leaseback Health care operator Investor(s)** LLC interest, debt assumption and/or cash with leaseback* Assets Cash LLC interest LLC * Debt assumption or cash distribution must comply with exceptions to the disguised sale rules set forth in Section 707 to avoid current gain. ** The manner in which the investor(s) invest in the LLC depends on both the assets transferred and the types of investors. Page 39

40 Joint venture transfer/manageback Health care operator Investor(s)** LLC interest, debt assumption and/or cash with management contract or license* Assets Cash LLC interest LLC * Debt assumption or cash distribution must comply with exceptions to the disguised sale rules set forth in Section 707 to avoid current gain. ** The manner in which the investor(s) invest in the LLC depends on both the assets transferred and the types of investors. Page 40

41 Leveraged partnership distribution Health care operator Investor(s)* LLC interest and leaseback, license or management contract (1) and cash (3) Assets (1) Cash (1) LLC interest LLC Cash (2) Notes Banks * The manner in which the investor(s) invest in the LLC depends on both the assets transferred and the types of investors. Page 41

42 Summary illustration of the RIDEA structure Public Existing OP unit holders OP units (exchangeable into listed REIT shares) Operating partnership Senior living REIT Managing member interest Lease of health care real estate by TRS (3) Customers Taxable REIT subsidiary (1) (2) Fees for services Management/ franchise agreement Third-party senior living operator Page 42

43 Merrill Gardens structure (simplified) Senior living REIT Senior living operator 100% Taxable REIT subsidiary 80% 80% Lessor/ real estate owner Real estate lease (3) 20% 20% Management/franchise agreement (2) Lessee/ license owner (1) Fees for services Customers Page 43

44 Key takeaways Partnership tax planning provides significant flexibility to achieve partner objectives, including tax deferral and a desired level of retained influence/control and upside. A healthy public REIT sector provides a potential home for health care real estate. The Merrill Gardens structure combines the above benefits, enabling the operator and the owner to each focus on their core competencies while retaining some level of influence on each other s activities. Page 44