Top Tax Issues for Partnerships and LLCs TTI

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1 Top Tax Issues for Partnerships and LLCs TTI

2 TOP TAX ISSUES FOR PARTNERSHIPS AND LLCs C. CLINTON DAVIS, JR. Krage & Janvey, L.L.P Ross Avenue, Suite 2600 Dallas, Texas

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4 Rep. Camp s (R-MI) 2014 Tax Reform Act Proposals 1. Repeal guaranteed payment rules everything goes to 707(a) 2. Repeal Required 743 and 734 basis adjustments no more electivity 4. Mandatory basis adjustments in lower tier (subsidiary) partnerships if there is a basis adjustment from a distribution by an upper tier partnership

5 Rep. Camp s 2014 Tax Reform Act Proposals 5. Requiring A/B of property in 702(a)(4) charitable transfer and 702(a)(6) taxes to be taken into account for loss limits in 704(d) 6. Expanded hot asset rules: No substantial appreciation requirement on inventory Apply 751(b) on basis of income and gain shares, not asset shares Treat as unrealized receivable ANY items producing OI on hypothetical sale

6 Rep. Camp s 2014 Tax Reform Act Proposals 7. No more 7 year limit on mixing bowl transactions new rule unlimited time period 8. Eliminate 704(e) protection for respecting who is a partner and go to general tax principles 9. No more technical terminations 10. Expand PTP rules to treat entities as corporations Mining and natural resources income still OK; NO LONGER -- real estate and commodities income 11. Tax carried interests as OI 12. Modify TEFRA audit rules

7 NEW PROPOSED BASIS REGULATIONS TO ADDRESS LEVERAGED PARTNERSHIP TRANSACTIONS LIKE CANAL V. COMMISSIONER

8 Background: Existing Basis Regulations Allocating Recourse Liabilities Economic risk of loss Constructive Liquidation. Who ends up paying the liabilities when all the assets are gone? A mechanical test that does not always follow reality? Atom Bomb Test

9 Does a guarantee change BASIS division? What is a guarantee? Regulations do not distinguish between types of guarantees. Regulations do not tell us whether remoteness of risk on the guarantee is relevant?

10 Under current Regulations, you generally ASS-U-ME payment of obligations without regard to ability to actually pay subject to an antiabuse rule.

11 CANAL CORP. v. COMM R: CHESAPEAKE GEORGIA PACIFIC $755.2MM DEBT FINANCED DISTRIB. WISCONSIN TISSUE MILLS $157 MM NET WORTH POST DISTRIBUTION (excluding Fox River liability) 100% $377 MM TISSUE BUSINESS CONTRIBUTION $775MM TISSUE BUSINESS CONTRIBUTION LENDER: $755.2 LOAN; GA PAC GUARANTEE; WTM INDEMNITY $$$ $755.2MM DEBT FINANCED DISTRIB. 5% 95% GEORGIA PACIFIC TISSUE, LLC

12 2014 PROPOSED BASIS REGS A payment obligation such as a guarantee or indemnity must satisfy the following 6 requirements to be taken into account: 1. The obligor must maintain a commercially reasonable net worth throughout the term of the payment obligation, or be subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration. 2. The obligor must be required to periodically provide commercially reasonable documentation regarding the obligor s financial condition.

13 2014 PROPOSED BASIS REGS. 3. The term of the obligation must not end prior to the term of the partnership liability. 4. The payment obligation must not require that the primary obligor or any other obligor with respect to the partnership liability directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor.

14 2014 PROPOSED BASIS REGS. 5. The obligor must receive arm s length consideration for assuming the payment obligation. 6. In the case of a guarantee or similar arrangement, the obligor must be liable up to the full amount of such obligor s payment obligation if, and to the extent that, any amount of the partnership liability is not otherwise satisfied.

15 2014 PROPOSED REGS. The sixth factor would prevent any obligation that is not a top guarantee or similar arrangement from being taken into account. As a result, a bottom guarantee, including a guarantee of the bottom 99% of a partnership liability, would be disregarded under the Proposed Regulations. A vertical slice guarantee (i.e., 50% of every dollar of shortfall) would also not be recognized.

16 PROBLEMS FOR TOP GUARANTEES The Proposed Regulations provide that, if there is more than one obligor, even a top guarantee or similar obligation would be disregarded unless the obligors are jointly and severally liable. The Proposed Regulations also provide that a top guarantee must be disregarded if the obligor has any right of indemnification from any person with respect to the guarantee. This would presumably preclude an obligor from insuring an obligation. Although the status of deficit restoration obligations is not specifically addressed in the Proposed Regulations, they may also be adversely affected.

17 Net Value Limitation To the extent that an obligation is taken into account under the six-factor test described above, the allocation of a partnership liability on account of the obligation entered into by such a partner or related person will be limited to such obligor s net value. In addition, the Proposed Regulations require that an obligor subject to the net value requirement must provide information to the partnership as to the obligor s net value that is appropriately allocable to the partnership s liabilities on a timely basis.

18 7-Year Phase In For a seven-year transition period, a partnership may choose not to apply the new partnership recourse debt allocation rules to an amount of partnership liabilities equal to an obligor partner s negative tax basis capital account. The amount of partnership liabilities to which the transition rule applies is reduced to the extent the built-in gain attributable to the obligor partner s negative tax basis capital account is recognized. In addition, if the obligor partner is a partnership, S corporation or disregarded entity, a 50% or more change in ownership of the obligor partner will terminate the transition period. Because the seven-year transition rule applies only if elected by the partnership, partners that have entered into or will enter into guarantees and similar obligations with respect to partnership liabilities should consider steps now to require that the partnership elect to apply the seven-year transaction rule if the Proposed Regulations are finalized and the partner so requests.

19 Proposed Changes to Nonrecourse Debt Rules Proposed Regulations would only permit excess nonrecourse liabilities to be allocated under: the Excess Section 704(c) Method under which the partnership may first allocate excess nonrecourse liabilities to a partner up to the amount of built-in gain that is allocable to the partner on Section 704(c) property or property for which reverse Section 704(c) allocations are applicable by virtue of a book-up (as described in Treas. Reg (a)(6)(i)) where such property is subject to the nonrecourse liability to the extent that such built-in gain exceeds the amount of gain taken into account under the second tier with respect to such property; or based on the partners liquidation value percentages. A partner s initial liquidation value percentage would be equal to the partner s percentage of partnership capital. A partner s liquidation value percentage would be required to be re-determined whenever a Section 704(b) revaluation event occurs (i.e., a disproportionate capital contribution or distribution), regardless of whether the partnership actually revalues its assets. In addition, the Proposed Regulations impose an administrative burden on partnerships that must value all of the partnership s assets any time a recalculation of the partners liquidation value percentages is required.

20 Proposed Changes to Nonrecourse Debt Rules The following methods would be eliminated: the Significant Item Method: The current regulations provide that the partnership agreement may specify the partner s interest in partnership profits for purposes of allocating excess nonrecourse liabilities provided the interest so specified is reasonably consistent with allocations (that have substantial economic effect under the Section 704(b) regulations) of some significant item of partnership income or gain. the Alternative Method: the current regulations provide that excess nonrecourse liabilities may be allocated among the partners in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated.

21 Changes to Exception From Disguised Sale Treatment For Certain Reimbursements Of Pre-formation Capital Expenditures Set Forth In Treas. Reg (d) CURRENTLY: Exception for reimbursement during 2 years after formation only to the extent the reimbursed capital expenditures do not exceed 20% of the fair market value of such property at the time of contribution. The 20% of fair market value limitation does not apply, however, if the fair market value of the contributed property does not exceed 120% of the partner s adjusted basis in the contributed property at the time of contribution.

22 Changes to Exception From Disguised Sale Treatment For Certain Reimbursements Of Pre-formation Capital Expenditures Set Forth In Treas. Reg (d) PROPOSED CHANGES: The 20% and 120% tests must be applied on a property-byproperty basis and not on an aggregate basis. To the extent a partner has funded a capital expenditure through a borrowing, the reimbursement of pre-formation expenditures exception to the disguised sale rules only applies to the extent the transfer of money or other consideration to the partner does not exceed the partner s allocable share of the liability.

23 Chief Counsel Advice (CCA) A 1065 filed on behalf of an LLC taxed as a partnership was not validly filed as it was not signed by a member manager of the LLC. Someone wrote in the name of the entity that was a member as opposed to the name of someone signing on behalf of the entity. QUESTION Is the IRS signature block really to blame in this situation?

24 Chief Counsel Advice (CCA) A 1065 filed on behalf of an LLC taxed as a partnership was not validly filed as it was not signed by a member manager of the LLC. Someone wrote in the name of the entity that was a member as opposed to the name of someone signing on behalf of the entity. NOT ADEQUATE FOR AN OFFICER OR EMPLOYEE OF THE LLC TO SIGN THE RETURN

25 CCA State law controls who can act as the tax matters member of an LLC. But manager must also be a member to act as the tax matters member.

26 CCA For a non-community property state, joint venture operated by H & W is presumed to be a partnership unless they affirmatively elect out. Chief Counsel cites 761(a) and (f). Community property state protected by Rev. Proc BOTH spouses subjected to SE tax.

27 CCA Bankruptcy of Tax Matters Partner terminates his authority to act.

28 CCA In determining the beginning of a partnership proceeding, IRS must issue a notice of the beginning of the proceeding at least 120 days before issuing a final partnership administrative adjustment (FPAA).

29 CCA Each year is a separate cause of action in an administrative proceeding. IRS can issue an FPAA in a closed year for purposes of preventing partners to carry forward loss to an open year.

30 CCA If any partner has an open limitations period, IRS can issue an FPAA that is binding on that partner. So filing of the partner s return is key extends but does not shorten a partner s 6501 limitations period.

31 McLauchlan v. Comm r, 113 AFTR 2d (5 th Cir. 2014) (per curiam) Law firm partner not allowed to convert reimbursable expenses into Schedule C items by failing to seek reimbursement. Expenses only deductible if partnership agreement requires individual payment.

32 Crescent Holdings, LLC v. Comm r, 141 T.C. No. 15 (2013) An unvested, forfeitable and nontransferable interest in an LLC granted to an employee of a subsidiary of the LLC was a capital interest for tax purposes as the employee would receive a distribution in a hypothetical distribution. No 83(b) election was made so allocations to the employee were improper and had to be reallocated to the members. Holder of this interest was not a member for tax purposes in the absence of the 83(b) election.

33 WOOD v. U.S. (U.S. S.Ct. 12/3/13) District Court has jurisdiction to impose a 40% valuation misstatement penalty in a TEFRA proceeding at the partnership level. Defenses by an individual partner are raised in a later partner level proceeding. Goodbye Petaluma. 9-0 unanimous decision by the Supreme Court.

34 Cahill v. Comm r, T.C. Memo Cahill was determined to be a partner even though he did not sign the partnership agreement. Cahill acted as though he was a partner, pooled resources to develop business and entered into a revenue sharing arrangement. Cahill received a K-1 reporting payments as guaranteed payments. Cahill s attempt to recast as loans rejected.

35 M ing o v. Comm r, T.C. Memo Proceeds from the sale of a partnership interest may not be reported as an installment sale to the extent that the proceeds would have constituted compensation. Taxpayer received a note. IRS changed petitioners method of accounting with respect to partnership unrealized receivables from the installment method under section 453 to the cash receipts and disbursements method.

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37 Tax Extenders Act of 2009 SEC PARTNERSHIP INTERESTS TRANSFERRED IN CONNECTION WITH PERFORMANCE OF SERVICES. (a) MODIFICATION TO ELECTION TO INCLUDE PARTNERSHIP INTEREST IN GROSS INCOME IN YEAR OF TRANSFER. Subsection (c) of section 83 is amended by redesignating paragraph (4) as paragraph (5) and by inserting after paragraph (3) the following new paragraph:

38 (4) PARTNERSHIP INTERESTS. Except as provided by the Secretary, in the case of any transfer of an interest in a partnership in connection with the provision of services to (or for the benefit of) such partnership (A) the fair market value of such interest shall be treated for purposes of this section as being equal to the amount of the distribution which the partner would receive if the partnership sold (at the time of the transfer) all of its assets at fair market value and distributed the proceeds of such sale (reduced by the liabilities of the partnership) to its partners in liquidation of the partnership, and (B) the person receiving such interest shall be treated as having made the election under subsection (b)(1) unless such person makes an election under this paragraph to have such subsection not apply. (b) CONFORMING AMENDMENT. Paragraph (2) of section 83(b) is amended by inserting or subsection (c)(4)(b) after paragraph (1). (c) EFFECTIVE DATE. The amendments made by this section shall apply to interests in partnerships transferred after the date of the enactment of this Act.

39 Change is in the Air (Will Congress act first?) On May 20, 2005, Proposed Regulations and IRS Notice were issued. Proposed Regulations would apply Section 83 to BOTH capital interests and profits interests. 38

40 Compensatory Partnership Interests Will Be Subject to 83 Section 83(a) Include in income the excess of the FMV of the partnership interest over the amount paid for it. Determine FMV (and taxation) at earlier of Date interest is transferable or Date not subject to a substantial risk of forfeiture 39

41 NOTE: Under proposed rules, even if a service partner must surrender a profits interest upon termination of service, it is treated as substantially vested if he does not forfeit profits accumulated through the end of the prior year. 40

42 83(b) and its Consequences Section 83(b) election is available to treat issuance of nontransferable interests subject to a substantial risk of forfeiture as currently taxable. Only 30 days from transfer to make election If no election, future appreciation is compensation, i.e., ordinary income. 41

43 83(b) Election Without Bargain Element in Price The fact that the transferee has paid full value for the property transferred, realizing no bargain element in the transaction, does not preclude the use of the election.... Treasury Regulation Important to make the election to cut off the compensation character. 42

44 Without the 83(b) election May be a partner for state law purposes, but not for federal income tax purposes No Form 1065, Sch. K-1 for service provider Others report the income Like an S corporation stock option And, no federal income tax consequences on forfeiture of nonvested interest 43

45 With the 83(b) election Service partner is a partner for federal income tax purposes and is allocated his distributable share (prior to forfeiture) But, service partner who makes the 83(b) election and later forfeits the interest is allowed no deduction in respect of forfeiture 44

46 Section 83(h): Treatment of the Issuing Partnership Issuing partnership gets deduction equal to amount included in income by service partner. Deduction can still be capitalized by other rules like 263. Deduction is in partnership s tax year in which or with which ends the tax year of income inclusion of the service partner 45

47 The Hard Question: What is the FMV of the Partnership Interest? Proposed Regulations and Notice establish a safe harbor election Recall Section 83(a) Include in income the excess of the FMV of the partnership interest over the amount paid for it. In most tax matters, FMV is an unrelated willing buyer, willing seller standard 46

48 Valuation under the Safe Harbor If conditions are met, service partner and partnership can use Liquidation Value. Liquidation Value is the amount of cash that the service partner would receive if the partnership sold all of its assets for FMV (not book value) and liquidated immediately after the transfer of the partnership interest. 47

49 Conditions for Liquidation Value First Requirement: Written election Executed by partner with responsibility for federal income tax reporting Must be an election on behalf of partnership and each partner to have safe harbor apply irrevocably with respect to all partnership interests transferred for services while election in effect Attached to partnership tax return for tax year including effective date of election 48

50 Second Requirement: Legally binding provisions in Partnership Agreement Partnership authorized and directed to elect safe harbor Partnership and each partner must agree to comply with all safe harbor requirements 49

51 Alternatively: If agreement requirement is not satisfied or if provisions are not legally binding, the safe harbor valuation can still be elected if Each partner in the partnership transferring an interest for services executes a document legally binding on that partner The document must state that the partnership is authorized and directed to elect the safe harbor The document must state that each partner agrees to comply with all of the requirements of the safe harbor 50

52 Other Safe Harbor Rules Third Requirement: Specified effective date cannot be prior to the date that the safe harbor election is executed Election only applies to interests issued while election in effect Election precedes issuance of interest for services NO as of dating 51

53 Fourth Requirement: Partnership is required to retain records proving the election was made Otherwise, the election is treated as terminated Safe harbor election is revocable Prepare revocation document and attach to tax return 52

54 Fifth Requirement: Safe Harbor Election only applies to safe harbor partnership interests Transferred by partnership to service provider in connection with services to partnership NOT related to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease NOT an interest in a publicly traded partnership 53

55 NOT transferred in anticipation of subsequent disposition Rebuttable presumption of anticipation of subsequent disposition if sale or disposition of interest is within 2 years of receipt (except for death or disability of service provider) OR if partnership interest is subject at any time within 2 years of receipt to a right to buy or sell regardless of when the right is exercisable (except in the case of death or disability) Rebutting requires clear and convincing evidence 54

56 CHAPTER 2 RELATIVELY NEW RULES ON AT-RISK FOR LLCs CCA

57 A guarantor of debt of an LLC treated as either a partnership or a disregarded entity for federal tax purposes may be at risk, for purposes of 465, with respect to the guaranteed debt even if the guarantor does not completely waive his rights of subrogation and reimbursement from the LLC with respect to the guaranty, as long as the guaranty is bona fide and enforceable by the creditor against the guarantor under local law and the guarantor is not otherwise protected against loss within the meaning of Section 465(b)(4). 56

58 A guaranty by a limited partner is generally not sufficient to cause the limited partner to be at risk for the amount of the guaranty until such time that the limited partner has no remaining rights against the partnership or the general partner. Given that an LLC that is treated as a partnership or disregarded entity for federal tax purposes has no members with unlimited liability with respect to the debts of the LLC, an LLC member that guarantees the debt of an LLC (in cases where no other persons co-guarantee the debt) is in a position similar to a sole general partner with respect to the guaranteed debt (i.e., the guaranteeing member s only recourse with respect to repayment of guaranteed debt is against the assets of the entity, if any remain). 57

59 Under the worst case scenario test, we assume that the primary obligor cannot and will not pay on the liability, thus putting the guaranteeing member at risk for ultimate payment. We believe it would be inappropriate to apply the economic realities test of 465(b)(4) to then assume that the guaranteeing member will nevertheless be able to successfully seek subrogation, reimbursement, or indemnification from the primary obligor after a default because the member has not waived his rights for such actions against the primary obligor. 58

60 It should be noted that the conclusions contained within this advice may be viewed as contrary to Prop. Treas. Reg (d) (1979), which provides that if a taxpayer guarantees repayment of an amount borrowed by another person (primary obligor) for use in an activity, the guaranty shall not increase the taxpayer s amount at risk. 59

61 Prop (d) further provides that if the taxpayer repays to the creditor the amount borrowed by the primary obligor, the taxpayer s amount at risk shall be increased at such time as the taxpayer has no remaining legal rights against the primary obligor. However, Prop (d) was promulgated before the development of LLCs under various state laws, and at a time when entities treated as partnerships for federal tax purposes were usually state law general partnerships and limited partnerships. 60

62 Therefore, the CCA concludes that Prop (d) is generally not applicable to situations involving bona fide guarantees of LLC debt by one or more members of the LLC that is enforceable by creditors of the LLC under local law, where the LLC is treated as either a partnership or a disregarded entity for federal tax purposes. 61

63 Rights of contribution and the presence of co-guarantors may be an arrangement described in Code Sec. 465(b)(4) that protects the taxpayer from loss and denies an at risk amount for the guarantee. 62

64 REMEMBER: BASIS AND AT-RISK HAVE DIFFERENT RULES DON T TRICK YOURSELF BY USING THE TERM AT-RISK BASIS

65 GUARANTEE GUARANTEE BAD IDEA LOAN LLC

66 A reminder and warning from the June 2002 Journal of Accountancy discussion of the Vons case: In recent years there has been an apparent increase in reliance on LTRs, TAMs and GCMs. This case reminds taxpayers and their CPAs that these documents are not precedent. A taxpayer that treats them as such does so at his or her own risk. 65

67 CHAPTER 3: THE NET INVESTMENT INCOME SURTAX WHAT SHOULD PARTNERSHIPS BE DOING NOW TO MINIMIZE THE TAX?

68 For 2013, individuals, estates and some trusts* woke up to new taxes A 3.8% NET investment income tax [NIIT] on high income taxpayers; Not yet understood by your clients; AND NOT INDEXED FOR INFLATION IN FUTURE YEARS It s a SURTAX not deductible from the income tax * Exemptions apply to nonresident individuals, foreign estates and some types of trusts.

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70 COMPUTATION The 3.8% NIIT is levied on the LESSER of: 1. Net Investment Income [NII]; or 2. Excess of: a. MAGI [MAGI = AGI unless you have foreign earned income; then add back 911 excluded income and expenses] OVER b. the Taxpayer s Threshold Amount: ($250,000 joint; $200,000 single; $125,000 married filing separately) About 6% of the population has MAGI above those thresholds. NIIT N/A WHERE THE SE TAX APPLIES.

71 So high income is? INCOME MARRIED JOINT SINGLE TRUSTS 39.6% RATE ABOVE (INDEXED) $450,000 (2013); $457,600 (2014) $400,000 (2013); $406,750 (2014) $11,950 (2013); $12,150 (2014) PEASE LIMITATION (INDEXED) $300,000 (2013); $305,050 (2014) $250,000 (2013); $254,200 (2014) N/A 3.8% NIIT OVER (NOT INDEXED FOR INDIVIDUALS) $250,000 $200,000 $11,950 (2013); $12,150 (2014)

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73 WHAT IS INCLUDED UNDER INVESTMENT INCOME FOR THE NIIT? 3 BROAD AREAS 1. Interest, Rents, Dividends, Annuities, Royalties; 2. (A) All Income from a Passive Activity; AND (B) All Income from a Trade or Business of Trading in Financial Instruments or Commodities; 3. Gains from Sale of Property. EACH HAS EXCEPTIONS.

74 SPECIAL RULES MAY APPLY For example, drilling funds are initially set up as joint ventures to qualify for the working interest exception to the PAL rules so the IDCs are deductible [from an active activity]. But taxpayers are prevented from placing oil and gas properties into limited liability holdings in order to convert this income to passive income in subsequent tax years. IRC 469(c)(3)(a). SO SE TAXES APPLY

75 Common items NOT subject to NIIT [notwithstanding political ads]: Alimony; Unemployment compensation; Sickness and injury benefits from workmen s compensation; Payments on account of personal injury (including related emotional distress); Tax-Exempt Interest;

76 Common items NOT subject to NIIT [notwithstanding political ads]: Veteran s and social security benefits; Income or gain that is not recognized-- e.g., excluded portion of gain on sale of a principal residence; Loans from a whole life insurance contract s cash value; C corporation distributions that return basis;

77 Common items NOT subject to NIIT [notwithstanding political ads]: Distributions from a Roth IRA; Distributions from a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b); Dividends on employer securities held by an employee stock ownership plan deductible under section 404(k) and paid in cash directly to a plan participant or beneficiary; For ESOPs: net unrealized appreciation in employer securities that is realized in a disposition of those employer securities; ANYTHING TAXED UNDER THE SE TAX.

78 A few taxpayers can exclude investment-type income (interest, dividends): 4-part test to be met: 1. Income is earned in a TRADE OR BUSINESS; 2. Income is earned in the ordinary course of the trade or business; 3. Trade or business is not trading financial instruments or commodities; and 4. Taxpayer is NOT PASSIVE with respect to the activity [e.g., real estate professionals with respect to rents]. SE taxes may apply to the trade or business income! E.g., holders of working interests.

79 KEY INQUIRIES Does this activity constitute a trade or business? Is this income earned in the ordinary course of the trade or business? Does the taxpayer materially participate? All questions need yes answers to escape the NIIT but yes answers (depending on structure) can expose the taxpayer to SE Taxes.

80 TRUSTS HAVE SPECIAL ISSUES: HOW DOES A TRUST MATERIALLY PARTICIPATE? IRS takes the position that the trust can only materially participate if the trustee participates in the activity on a regular, continuous and substantial basis in its fiduciary capacity. Cases takes a different approach.

81 FRANK ARAGONA TRUST, 142 T.C. NO. 9 (2014) [U.S. TAX COURT DOCKET ] Activities of Trustees who were also employees of an LLC owned by the trust could not be disregarded as argued by the IRS. IRS POSITION REJECTED.

82 MATTIE K. CARTER TRUST V. U.S., 256 F. SUPP. 2D 536 (N.D. TX 2003) The Trust was the taxpayer, and material participation was determined by assessing the Trust s activities through its fiduciaries, employees and agents. QUERY: Planning opportunities using trusts to incorporate the activities of employees into the material participation calculation?

83 TRUSTS HAVE SPECIAL ISSUES 43.4% TAX RATE ON UNDISTRIBUTED INCOME KICKS IN ABOVE ONLY $11,950 FOR 2013 DISTRIBUTE INCOME TO BENEFICIARY AND SAVE TAX? POTENTIAL SAVINGS IF THE KIDDIE FILES HIS OWN RETURN AND HAS HIS OWN $200,000 EXEMPTION: $200,000 X 3.8% = $7,600 PER YEAR

84 TRUSTS HAVE SPECIAL ISSUES BUT: MAY BE A DIFFERENT BENEFICIARY THAN REMAINDER BENEFICIARY; FIDUCIARY DUTY ISSUES; LOSS OF SPENDTHRIFT PROTECTION FROM CREDITORS AND/OR DIVORCING SPOUSES; REMEMBER 65-DAY PERIOD TO DISTRIBUTE PRIOR YEAR INCOME AND TREAT AS PRIOR YEAR DISTRIBUTION.

85 Deductions For passive trade or business, deduct 62(a)(1) expenses not taken into account in determining SE income. For rents and royalties, deduct 62(a)(4) expenses. Deduct investment losses NOL (discussed below). Deduct penalties on early withdrawal of savings.

86 Deductions Investment interest expense allowed under 163(d)(1) [so the limitation to investment income applies]. Investment advisory expense. But limitations on miscellaneous itemized deductions apply and PEASE limitations apply. State and local taxes attributable to investment income. Items described in 72(b)(3) for the annuitant s last taxable year if income would have been in NII.

87 Deductions Deductions for estate and GST allowed under 691(c) allocable to NII. Amounts described in 212(3) and (l) to extent allocable to NII. Deductions allowed under 171(a)(1) for the amortizable bond premium on a taxable bond. Fiduciary expenses allocable to NII.

88 Capital Loss Carryovers Except for certain excluded capital losses, capital losses GENERALLY may be taken into account in the computation of section 1411(c)(1)(A)(iii) net gain by reason of the mechanics of section 1212(b)(1). Proposed (d)(4)(iii) creates an annual adjustment to capital loss carryforwards to prevent capital losses excluded from the net investment income calculation in the year of recognition from becoming deductible losses in future years.

89 WHAT ABOUT NOLs? New concepts to understand (h)(2) APPLICABLE PORTION OF AN NOL For any year when the taxpayer incurs an NOL, the applicable portion is the LESSER of: The NOL that TP would incur if only NII gross income and only properly allocable deductions are considered; OR The NOL for the year.

90 WHAT ABOUT NOLs? New concepts to understand (h)(3): SECTION 1411 NOL AMOUNT OF AN NOL CARRIED TO AND DEDUCTED IN THE YEAR The total NOL amount carried from a loss year and allowed under 172(a) MULTIPLIED BY A Fraction: Applicable Portion for the Loss Year Total Amount of NOL for Same Year

91 WHAT ABOUT NOLs? STEPS: 1. First, determine the APPLICABLE PORTION of TP s NOL for each loss year; 2. Determine the amount carried from a loss year and deducted in the tax year; 3. Add together the 1411 NOL amounts of each NOL carried from a loss year and deducted in a tax year. 4. Sum is the allowed NOL deduction. LENGTHY EXAMPLES IN REGULATIONS.

92 WHAT ABOUT SUSPENDED PALS? A taxpayer can use suspended PALs to offset NII but only to the extent of income that is included in NII. Assume $50,000 of suspended loss from an activity that was passive in Assume $25,000 of income from the same activity but that it was active in Also assume $5,000 of passive income from other sources in $25,000 of suspended loss first offsets income from the formerly passive activity but that income was excluded from NII. The remaining $5,000 would be in NII for 2014 but is offset by suspended PALs. $20,000 in PAL remains suspended.

93 TRADER FUNDS Trader funds segregate income into three components: 1. Gross gains from the disposition of financial instruments and commodities, 2. Gross losses from the disposition of financial instruments and commodities, and 3. Deductions allocable to trading activities. Taxpayers can net all gains and losses from both investor and trader funds, including those with 475(f) elections. Any excess losses that result from this netting can be used to reduce other categories of NII to the extent allowed for regular income tax purposes.

94 TRADER FUNDS NEW ELECTION IN FINAL REGS: Investor funds MAY elect, at the partnership level, to include income from CFCs and PFICs as part of NII at the same time as they would for regular income tax purposes (i.e., in the same manner as trader funds). Funds may make this election on an entity-byentity basis beginning with the 2014 tax year. The election may also be made for the 2013 tax year, but only if funds have received consent from all partners.

95 TRADER FUNDS For both trader and investor funds, periodic, non-periodic and mark-to-market income from swaps should be included in NII. Under new proposed regulations, swap income is only subject to NII if the underlying property to which the swap references produces (or would produce if the property were to produce income) interest, dividends, royalties or rents if the property were directly held by the taxpayer.

96 SPECIAL RULES: SELF-CHARGED INTEREST UNDER REG In the case of self-charged interest received from a non-passive entity, the amount of interest income excluded from net investment income will be the taxpayer s allocable share of the non-passive deduction. Exception: The special rule does not apply to a situation where the interest deduction is taken into account in determining self-employment income tax.

97 SPECIAL RULES: SELF-CHARGED INTEREST UNDER REG EXAMPLE: TP owns 25% of an S corporation in which he materially participates. He loans $200,000 to the S corporation at 10% interest and collects interest income of $20,000 per year. The S corporation has a $20,000 deduction. RESULT: Of the $20,000 in annual interest income, 25% [$5,000] is excluded from investment income. The remaining 75% [$15,000] is subject to taxation under the NIIT.

98 If rental income is treated as non-passive: (A) (B) by reason of Reg (f)(6) when the taxpayer rents the property for use in an activity in which the taxpayer materially participates, or because the rental activity is properly grouped with a trade or business activity under Reg (d)(1) and the grouped activity is a non-passive activity, then, the gross rental income is deemed to be derived in the ordinary course of a trade or business.

99 Furthermore, in both of these instances, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as non-passive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a non-passive trade or business.

100 So, self-charged rental income gets excluded from NII when the taxpayer materially participates. Self-charged rental loss stays passive and, in the absence of other passive income, cannot reduce portfolio interest and dividends included in NII because the passive loss is currently suspended. You need other passive income to use the suspended selfcharged passive losses for purposes of the NIIT.

101 Assume a self-charged rental that produces a loss. Assume also that the rental activity is grouped with a business in which the taxpayer materially participates. Result the loss which would have been passive is now out of the NII computation altogether because it is now part of a non-passive activity. So, because of this grouping election, the otherwise passive loss that might have eventually reduced NII from another source will never do so. 100

102 SPECIAL RULES: WHAT IS A REAL ESTATE PROFESSIONAL? 2-PART TEST: 1. More than 50% of services performed during the year are in real estate trades or businesses where taxpayer materially participates; 2. More than 750 hours of services in those.

103 Real property trades or businesses A real property trade or business is a trade or business that does any of the following with real property: Develops or redevelops it; Constructs or reconstructs it; Acquires it; Converts it; Rents or leases it; Operates or manages it; Brokers it.

104 IRS INSTRUCTIONS Safe Harbor for Real Estate Professionals You qualify for the safe harbor if you are a real estate professional for purposes of section 469 and you: Participate in each rental real estate activity for more than 500 hours during the tax year, or Participated in a rental real estate activity for more than 500 hours in any 5 tax years (whether or not consecutive) during the 10 tax years immediately prior to this tax year.

105 500 hours on EACH rental

106 IRS INSTRUCTIONS Safe Harbor for Real Estate Professionals For real estate professionals with a Regulations section (g) election [election to treat all interests in rental real estate as a single rental real estate activity] in effect, all rental real estate activities constitute a single activity for purposes of applying the 500-hour test.

107 REAL ESTATE PROFESSIONALS 500-hour safe harbor is not the only option. Final 1411 regulations provide that failure to meet the 500-hour safe harbor will not preclude a taxpayer from establishing that such gross rental income and gain or loss from the disposition of real property, as applicable, is not included in net investment income.

108 THE 1-TIME REGROUPING ELECTION (originally allowed under -11 of the 1411 Regs.) An individual, trust, or estate that meets the eligibility criteria may regroup its activities, regardless of how they were grouped in the preceding tax year: for any tax year that begins during 2013, if the taxpayer meets the eligibility criteria for that year, or in the first tax year beginning after 12/31/13, in which the NIIT would apply.

109 THE 1-TIME REGROUPING ELECTION ELIGIBILITY: For an individual: (1) NII and (2) the individual's MAGI exceeds the applicable threshold. For a trust: (1) NII and (2) the trust's adjusted gross income (AGI) exceeds the dollar amount at which the highest tax bracket in Code 1(e) begins for that tax year [For 2014, it s $12,150]. For an estate: (1) NII and (2) the estate's AGI exceeds the dollar amount at which the highest tax bracket in Code 1(e) begins for that tax year.

110 SAMPLE USES OF THE 1-TIME REGROUPING ELECTION For real estate professionals, so that multiple rentals will be tested with a single 500 hour requirement; For previously ungrouped activities so that the taxpayer will be deemed to materially participate with respect to all: E.g., combining multiple non-rental activities.

111 REGROUPING RULES PARTNERSHIPS AND S CORPS ARE NOT ALLOWED TO REGROUP under the 1-time 1411 permission. The final regulations now allow a taxpayer to regroup under (b)(3)(iv) on an amended return, but only if the taxpayer was not subject to section 1411 on his or her original return (or previously amended return), and if, because of a change to the original return, the taxpayer owed tax under section 1411 for that taxable year.

112 REGROUPING REFRESHER You can treat one or more trade or business activities, or rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain or loss under the passive activity rules.

113 REGROUPING REFRESHER The factors that you should consider are: The similarities and differences in the types of trades or businesses, The extent of common control, The extent of common ownership, The geographical location,

114 REGROUPING REFRESHER The interdependencies between or among activities, which may include the extent to which the activities: Buy or sell goods between or among themselves, Involve products or services that are generally provided together, Have the same customers, Have the same employees, or Use a single set of books and records.

115 REGROUPING Rental activities. In general, you CANNOT group a rental activity with a trade or business activity. However, you CAN group them together if the activities form an appropriate economic unit and:

116 REGROUPING The rental activity is insubstantial in relation to the trade or business activity, The trade or business activity is insubstantial in relation to the rental activity, or Each owner of the trade or business activity has the same ownership interest in the rental activity, in which case the part of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

117 REGROUPING EXAMPLE: John owns a bakery and a movie theater at a shopping mall in Baltimore and a bakery and movie theater in Philadelphia. John may be able to group the movie theaters and the bakeries into: One activity, A movie theater activity and a bakery activity, A Baltimore activity and a Philadelphia activity, or Four separate activities.

118 117

119 118

120 HOW?--Taxpayers Need to MATERIALLY PARTICIPATE & DON T TRIGGER SE TAX

121 120

122 *NIIT applies to allocable portfolio income from working capital even if the partner is active. 121

123 Iversen v. Commissioner, T.C. Memo Taxpayer failed to prove that he worked 500+ hours for material participation on his ranch. 11 trips with the kids + on a private jet + to stay in the 20,000 square foot lodge at the Rocky Mountain cattle ranch + talking to the ranch manager while there DOES NOT EQUAL material participation. 122

124 Sometimes Pay reasonable compensation and take distributions that escape SE tax and NIIT for active shareholders S corporation a better fit for service business The Newt Gingrich/John Edwards loophole Subject to challenge by IRS Need to pay reasonable compensation EVERYBODY S NOW TALKING ABOUT THIS That could mean possible future legislation [a/k/a CLOSING LOOPHOLES] Senate Democrats had targeted S corps with 3 or fewer shareholders 123

125 AVOIDING NII The answer is: Philandering Presidential Candidates Saving Taxes

126 WHAT IS THE NEWT GINGRICH/JOHN EDWARDS LOOPHOLE? SENATE DEMOCRATS HAVE UNSUCCESSFULLY TARGETED S CORPS WITH 3 OR FEWER SHAREHOLDERS

127 THE NEWT GINGRICH/JOHN EDWARDS LOOPHOLE SHAREHOLDERS Reasonable Comp/ Subject to Emloyment Taxes (IRS can challenge) Distributions Not SE Taxable Not NII to Active SH BUT NII to Passive SH S CORPORATION

128 S Corp SE tax risks: Examples of existing cases: The best evidence of value of services provided in a professional personal service corporation is the profit made by the corporation. Thomas A. Curtis, M.D., Inc. v. Commissioner, 67 T.C.M. (CCH) 1958, 1963 (1994) [T.C. Memo ].

129 S corp SE tax risks: Examples of existing cases: LaMastro v. Commissioner, 72 T.C. 377, 384 (1979). The Tax Court in LaMastro, relying on Bianchi v. Commissioner, 66 T.C. 324 (1976), aff d per curiam, 553 F.2d 93 (2nd Cir. 1977), held that the best evidence of the value of a dentist s personal services is the profit derived from the practice.

130 What about a Partnership? Limited partner exception in self-employment tax statute not intended to apply to service business

131 The intent of Section 1402(a)(13) was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership's business operations would not receive credits toward Social Security coverage. The legislative history of Section 1402(a)(13) did not support a holding that Congress wanted to exclude partners who performed services for a partnership in their capacity as partners (i.e., acting as self-employed persons) from liability for selfemployment taxes.

132 Is it possible to have an LLC interest that is all active under the PAL rules but bifurcated into general and limited for SE Tax purposes? We hope so! 131

133 132

134 WHAT CAN BE ATTEMPTED USING LLCs OR LPs? Old proposed 1402 regulations never finalized: Exception for holders of more than one class of interest. An individual holding more than one class of interest in the partnership who is not treated as a limited partner under paragraph (h)(2) of this section is treated as a limited partner under this paragraph (h)(3) with respect to a specific class of partnership interests held by such individual if, immediately after the individual acquires that class of interest

135 WHAT CAN BE ATTEMPTED USING LLCs OR LPs? Limited partners own a substantial, continuing interest in that specific class of partnership interest; and The individual s rights and obligations with respect to that specific class of interests are identical to the rights and obligations of that specific class of partnership interest held by the [above] limited partners.

136 Will We See This Variation? John, Member / Manager Mary, Member CLASS A CLASS B INTERESTS INTERESTS* 20% overall LLC *All Class B interests have the same rights and obligations

137 Problematic for a Services Entity John 100% 99% LP INTEREST S CORPORATION 1% GP INTEREST LIMITED PARTNERSHIP RENKEMEYER SAYS TO TREAT THE LP INTEREST AS PRODUCING SE TAX

138 Will We See Someone Attempt This [Problematic?] Variation? John, Member / Manager Mary, Member S CORPORATION CLEANSER S CORPORATION CLEANSER LLC

139 BACKGROUND SALES OF INTERESTS IN PASSTHROUGH ENTITIES Code section 1411(c)(4) provides that gain or loss from such disposition is taken into account for purposes of section 1411(c)(1)(A)(iii) only to the extent of the net gain or net loss that would be so taken into account by the transferor if all property of the partnership or S corporation were sold at fair market value immediately before the disposition of such interest.

140 Prop. Reg NEW Prop. Reg Exception for Dispositions of Certain Active Interests in Partnerships and S Corporations:

141 Prop. Reg Newly proposed regs. provide for calculation of gain or loss by a materially participating transferor by activity rather than property by property consistent with the PAL rules. Newly proposed simplified method if you qualify uses the same percentage of NII to all income that is reported on applicable K-1s.

142 GENERAL RULE GAIN ON DISPOSITION Net gain in (a)(1)(iii) is LESSER OF: the transferor s gain on the disposition of the interest in the Passthrough Entity for income tax purposes; or

143 GENERAL RULE GAIN ON DISPOSITION Net gain in (a)(1)(iii) is LESSER OF: the transferor s allocable share of the chapter 1 net gain from a deemed sale of the Passthrough Entity s Section 1411 Property as determined using the principles of T(e)(3) (allocation of gain or loss to activities of the Passthrough Entity) where the net gain is the sum of the amounts of net gain and net loss allocable to the transferor as determined under T(e)(3)(ii)(B)(1)(i) and T(e)(3)(ii)(B)(2)(i) that would constitute income to the transferor for purposes of section 1411 if sold by the Passthrough Entity.

144 Prop. Reg OPTIONAL SIMPLIFIED METHOD--EITHER: #1 2 parts: Transferor s distributive share during disposition year + 2 preceding years of NII items is 5% or less of distributive share in that period (with separately stated loss and deduction items included as positive numbers); AND Transferor s share of gain on disposition is $5 million or less.

145 Prop. Reg OPTIONAL SIMPLIFIED METHOD QUALIFICATION [unless excluded]--either: #2--Transferor s share of gain on disposition is $250,000 or less.

146 CANNOT use simplified method--5 exclusions Transferor held the interest for 12 months or less preceding the Disposition. Transferor transferred 1411 property to the entity or received a distribution of other than 1411 property from the entity during the 1411 Holding Period [generally, the current year and the 2 preceding years] as part of a plan that includes the transfer of the interest. Contributions within 120 days presumed to be part of a plan.

147 CANNOT use simplified method--5 exclusions Passthrough Entity is a partnership and the transferor transfers a partial interest that is not a proportionate share. Transferor knows or has reason to know that the % of the Passthrough Entity s gross assets consisting of 1411 property has increased or decreased by 25% or more during the Transferor s 1411 holding period. S corps that converted from C during the 1411 Holding Period.

148 Proposed Regs. under the NIIT applicable to partnerships: New guidance on applying the NIIT to guaranteed payments under 707; New guidance on applying the NIIT to payments to a retiring partner under 736.

149 GUARANTEED PAYMENTS PARTNER OPTION #1: GUARANTEED PAYMENT FOR SERVICES OOPS! NOT SUBJECT TO THE NIIT; BUT SUBJECT TO SE TAX Partnership wants to get $$$ out to the Partners

150 GUARANTEED PAYMENTS PARTNER OPTION #2: GUARANTEED PAYMENT FOR CAPITAL Partnership wants to get $$$ out to the Partners OOPS! SUBJECT TO THE NIIT; AKIN TO INTEREST RECALL THE SELF CHARGED INTEREST RULE

151 WHAT ABOUT A PREFERRED RETURN? PARTNER IF YOU MATERIALLY PARTICIPATE, A DISTRIBUTIVE SHARE OF INCOME IS NOT NECESSARILLY NII BUT BEWARE THE SE TAX Partnership wants to get $$$ out to the Partners 150

152 DEPENDS ON WHAT? For purposes of Code Sec. 1411, the items of income, gain, loss, and deduction attributable to the distributive share are taken into account in computing NII in a manner consistent with the item's chapter 1 character and treatment.

153 Thus, if the partner's distributive share includes income from a trade or business not described in Code Sec. 1411(c)(2), that income will be excluded from NII. However, if the distributive share includes interest income from working capital, then that income is NII.

154 Gain or loss relating to Code Sec. 736(b) payments is included in NII under Code Sec. 1411(c)(1)(A)(iii) regardless of whether the payments are classified as capital gain or ordinary income (for example, by reason of Code Sec. 751).

155 Code Sec. 736(a)(1) provides that if the amount of a liquidating distribution (other than a payment for partnership property described in Code Sec. 736(b)) is determined with regard to the partnership's income, then the payment is treated as a distributive share of income to the retiring partner. For purposes of Code Sec. 1411, the items of income, gain, loss, and deduction attributable to the distributive share are taken into account in computing NII in a manner consistent with the item's chapter 1 character and treatment.

156 Code Sec. 736(a)(2) provides that if the amount of a liquidating distribution (other than a payment for partnership property described in Code Sec. 736(b)) is determined without regard to the partnership's income, then the payment is treated as a guaranteed payment as described in Code Sec. 707(c). Such payments under Code Sec. 736(a)(2) might be in exchange for services, use of capital, or Code Sec. 736(a) Property.

157 The treatment of guaranteed payments for services or the use of capital follows the general rules for guaranteed payments.

158 Code Sec. 736(a)(2) payments in exchange for Code Sec. 736 Property are treated as gain or loss from the disposition of a partnership interest, which is generally included in NII under Code Sec. 1411(c)(1)(A)(iii). If the retiring partner materially participates in a partnership trade or business, then the retiring partner must also apply Prop Reg to reduce appropriately the NII under Code Sec. 1411(c)(4).

159 To the extent that Code Sec. 736(a)(2) payments exceed the fair market value of Code Sec. 736(a) Property, the proposed regs provide that the excess will be treated as either interest income or as income in exchange for services.

160 FAQs on the Additional Medicare Tax Businesses-%26-Self-Employed/Questions-and- Answers-for-the-Additional-Medicare-Tax

161 NEW FORMS 8959 FOR THE ADDITIONAL MEDICARE TAX & 8960 FOR THE NIIT

162

163

164 Form 8960 Instructions A Few Key Points Heavy lifting in computations is done off-form in worksheets provided by the instructions. Forms track the Regulations. Regulations expanded the definition of properly allocable deductions to include any net losses from the sale of property to the extent those losses are used in the current year to reduce the taxpayer s taxable income.

165 Form 8960 A Few Key Points Those amounts do not appear in Part II of the form alongside other allocable deductions like investment interest expense or state and local taxes. Instead, the Form 8960 simply allows Line 5d the total of gains or losses included in net investment income to be negative.

166 Highlights of the Form 8960 Instructions for Sales of Interests If you disposed of a partnership interest or S corporation stock in an installment sale transaction to which section 453 applies, you need to calculate your adjustment to net gain in the year of the disposition, even if the disposition occurred prior to The difference between the amount reported for regular tax and NIIT will be taken into account when each payment is received.

167 Highlights of the Form 8960 Instructions for Sales of Interests If an interest was sold prior to 2013, in the first year the taxpayer is subject to the net investment income tax, he must attach to his return a statement explaining his computation of the excluded amount under the Regulations, as well as other required disclosures. The worksheet on page 9 causes you to first include in net investment income the current year gain recognized under the installment method for income tax purposes before backing out the amount excluded from net investment income under the Regulations.

168 FAQs on the Net Investment Income Tax Net-Investment-Income-Tax-FAQs

169 CHAPTER 4: REVIEW OF STRUCTURING TIPS FOR FAMILY LIMITED PARTNERSHIPS ADDENDUM AT END OF MATERIALS CONTAINS CODE SECTION 2036 MATERIALS THAT WILL NOT BE COVERED IN TODAY S CLASS

170 FAMILY LP STRUCTURE PRIOR TO GIFTING

171 KIDS OR TRUSTS [W/ IND. TRUSTEES] BETTER FAMILY LP STRUCTURE: USE AN INDEPENDENT GENERAL PARTNER/ DON T HAVE TRANSFERORS WITH RETAINED CONTROLS

172 KIDS OR TRUSTS [W/ IND. TRUSTEES] 1ST ISSUE: REAL NON-TAX BUSINESS PURPOSES As opposed to a recitation of generic non-tax purposes; And hopefully, set up well before death is anticipated [makes the LP more supportable; deathbed LPs more problematic?]

173 KIDS OR TRUSTS [W/ IND. TRUSTEES] 2ND ISSUE: A NEGOTIATED DEAL? For example, Stone v. Commissioner

174 KIDS OR TRUSTS [W/ IND. TRUSTEES] Third Issue: Asset Selection: NO PERSONAL USE/RETAINED ENJOYMENT ASSETS SEE RESOURCE MATERIALS AT END OF SECTION Closely Held Businesses, Investment Real Estate, Securities, Cash BUT LEAVE ENOUGH ASSETS OUTSIDE THE PARTNERSHIP FOR NEEDS INCLUDING ESTATE TAXES Courts holding that a required redemption to pay estate taxes may be problematic Formal Needs Study

175 KIDS OR TRUSTS [W/ IND. TRUSTEES] Fourth Issue: Avoid Implied Agreement for Continued Enjoyment: Estate of Reichardt v. Commissioner, 114 T.C. 144, 152 (2000) (holding that implied agreement existed where decedent used partnership's checking account as his own, lived rent free in a home owned by the partnership, and maintained the same relationship with assets before and their transfer); Estate of Paxton v. Commissioner, 86 T.C. 785, 809 (1986) (holding that implied agreement existed where decedent transferred substantially all assets to trusts); Estate of Hendry v. Commissioner, 62 T.C. at 874 (holding that implied agreement existed where decedent received distributions when and if requested).

176 KIDS OR TRUSTS [W/ IND. TRUSTEES] Fifth Issue: Code Section 721 on Transfer of Assets Into FLP: More than 80% stock, securities & money; AND Diversification [look to Section 351 Regs.]

177 KIDS OR TRUSTS [W/ IND. TRUSTEES] Sixth Issue: Gifts of What? NOT Gifts of Limited Partnership Interests Per 5 th Circuit Adams Decision Gifts of Assignee Interests [but may require consent by nontransferor per Astleford]

178 KIDS OR TRUSTS [W/ IND. TRUSTEES] Seventh Issue: Gifts When? Avoid Shepherd and Senda decisions Advisable to delay between contributions and gifting because of IRS integrated transaction argument. How long a delay is needed? Holman v. Comm r, 130 T.C. No. 12 (2008). [Economic risk argument; 6 days was sufficient for underlying Dell stock ][Longer may be needed for real estate]

179 KIDS OR TRUSTS [W/ IND. TRUSTEES] TRUSTS Eighth Issue: Gifts to Whom? NOT Gifts to Minors, or Children or Grandchildren Consider Asset Protection Advantages of Gifts to Spendthrift Trusts f/b/o Children or Grandchildren

180 KIDS OR TRUSTS [W/ IND. TRUSTEES] TRUSTS Ninth Issue: 704(e) MANDATORY AS BETWEEN TRANSFEROR AND TRANSFEREE Allocations Based on Capital [fmv] from time to time Necessity to Revalue for 704(e) Capital Accounts Required Management Fees [Reasonableness + Consistency +Need + Documentation]

181 CHAPTER 5: PLANNING TO GET THE ANNUAL INTEREST EXCLUSION ON GIFTS OF PARTNERSHIP INTERESTS RECOGNIZING LANGUAGE THAT CAUSES THERE TO NOT BE A GIFT OF A PRESENT INTEREST

182 Hackl v. Commissioner, 118 T.C. 279 (2002) Key Issue: Qualification for annual gift tax exclusion Split gifts by H&W of voting and nonvoting Family LLC interests to 8 children and their spouses and a 2503(c) grandchildren s trust with 25 subtrusts for the 25 grandchildren = 82 total gifts [(8+8+25) X 2 = 82] per year

183 Hackl v. Commissioner, 118 T.C. 279 (2002) Parties stipulated to valid 2503(c) trust but agreed that gifts would qualify for annual exclusion only if they were gifts of present interest It s 1996 Why file gift tax returns? Because they were in a separate property jurisdiction and wanted to split gifts The LLC assets were timber land that did not yet have timber so no income stream now

184 No right to withdraw capital without the Manager s consent No right to withdraw from LLC must offer the LLC interest only to the LLC and the Manager could accept or reject and negotiate terms Sale or hypothecation required Manager s consent which could be withheld in Manager s sole discretion BUT A TRANSFER IN VIOLATION WOULD STILL HAVE EFFECTIVELY MADE THE BUYER AN ASSIGNEE WITH A RIGHT TO SHARE IN DISTRIBUTIONS

185 NO says the 7 th Circuit Court of Appeals: Possibility of sale in violation of agreement to a transferee who would have no membership or voting rights can hardly be called a substantial economic benefit Burden is on taxpayers to show that their transfers qualify for the gift tax exclusion 7 th Circuit took only 38 days from oral argument to issue its opinion

186 Gift giving is for 1996, 1997 and 1998: 82 exclusions per year X 3 years = 246 annual exclusions lost X $10,000 = $2,460,000 of taxable gifts A.J. Hackl may have been Tree Farmer of the Year in Putnam County, FL for 1999, but OUCH that s got to hurt Let s hope that the gifted LLC interests were worth less than $10,000 because of the lack of right to any present enjoyment[????]

187 2010 case: Price v. Comm r Distributions made annually; As to the income, (1) there was no steady flow of income, and (2) distribution of profits was in the discretion of the general partner and the partnership agreement specifically stated that distributions are secondary to the partnership's primary purpose of generating a long-term reasonable rate of return. No ability to withdraw capital;

188 Right of first refusal for transfers but no time limit for exercising the purchase option with respect to a voluntary transfer; Court says distributions not enough.

189 Estate of George H. Wimmer et al v. Commissioner, T.C. Memo For the Court to ascertain whether rights to income satisfy the criteria for a present interest under section 2503(b), the estate must prove, on the basis of the surrounding circumstances, that: (1) the partnership would generate income, (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.

190 3 Tests Satisfied: 1. Partnership was formed with dividend paying stocks; 2. Mandatory distributions and pro rata allocations; 3. Because the stock was publicly traded, the limited partners could estimate their allocation of quarterly dividends on the basis of the stock's dividend history and their percentage ownership in the partnership.

191 So what do we do? NO PERFECT SOLUTIONS TO PRICE

192 IDEAS A typical provision that prohibits transfer without the consent of the general partner (or Manager) or without the consent of all partners falls into the Hackl /Price trap Why not use a right of first refusal one that works and no restrictions at all?

193 IDEAS Require some distributions? Make sure contributed assets will produce income for distribution Not enough per Price for discretionary standard + actual distributions Mandatory distributions of net cash flow Mandatory tax distributions Distributions may be inadvisable due to 2036 issues

194 IDEAS Do NOT use the following language: annual or periodic distributions to the partners are secondary to the partnership s primary purpose of achieving a reasonable, compounded rate of return, on a long-term basis, with respect to its investments. Forego the discount on gift of a partnership interest when using the annual exclusion Use it only on lifetime exclusion gifts Give Cash AND Let Donees buy interests.

195 IDEAS Make donees substitute limited partners not mere assignees. Contrary to maximizing the discount Use Put rights?

196 CHAPTER 6: PRESERVING CAPITAL GAINS ON SALE TO A RELATED ENTITY BEWARE OF CODE SECTION 707(b)(2)

197 CODE SECTION 707(b)(2) In the case of a sale or exchange, directly or indirectly, of property, which in the hands of the transferee, is property other than a capital asset as defined in section 1221 (A) between a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or profits interest, in such partnership, or (B) between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interest or profits interests, any gain recognized shall be considered as ordinary income.

198 BRAMBLETT v. COMMISSIONER Sales based on appraisals PARTNERSHIP CORPORATION PARTNERSHIP SELLS TRACTS OF RAW LAND TO CORPORATION IN EXCHANGE FOR A NONRECOURSE PROMISSORY NOTE. CORPORATION DEVELOPS RAW LAND.

199 NATIONAL CARBIDE FACTORS Whether the corporation operates in the name and for the account of the principal, binds the principal by its actions, transmits money received to the principal, and whether receipt of income is attributable to services of employees of the principal and to assets belonging to the principal. If the corporation is a true agent, its relations with the principal must not be dependent upon the fact that it is owned by the principal, if that is the case. Its business purpose must be the carrying on of the normal duties of an agent.

200 PRIMARILY HELD FOR SALE IN THE ORDINARY COURSE OF BUSINESS Was the taxpayer engaged in a trade or business and, if so, what business? Was the taxpayer holding the property primarily for sale in that business? Were the sales contemplated ordinary in the course of that business

201 7 OBJECTIVE FACTORS The nature and purpose of the acquisition of the property and the duration of ownership; The extent and nature of efforts to sell the property; The number, extent, continuity and substantiality of sales;

202 The extent of subdividing, developing and advertising; The use of a business office for sale of the property; The character and degree of supervision or control exercised by the taxpayer over any representative selling the property; The time and effort habitually devoted to the sales.

203 Admissions Against Interest Description of an activity as real estate has been held sufficient to preclude the taxpayer from claiming investment character. See Thomas v. Commissioner, 254 F.2d 233 (5th Cir. 1958); White v. Commissioner, 172 F.2d 629 (5th Cir. 1949).

204 Section 1237: Statutory Nondealer Status for Subdivided Real Estate. Applicable to sales, not exchanges, as a relief valve for capital gains treatment General Rules (1) such tract, or any lot or parcel thereof, has not previously been held by such taxpayer primarily for sale to customers in the ordinary course of trade or business (unless such tract at such previous time would have been covered by this section) and, in the same taxable year in which the sale occurs, such taxpayer does not so hold any other real property; and

205 (2) no substantial improvement that substantially enhances the value of the lot or parcel sold is made by the taxpayer on such tract while held by the taxpayer or is made pursuant to a contract of sale entered into between the taxpayer and the buyer. For purposes of this paragraph, an improvement shall be deemed to be made by the taxpayer if such improvement was made by -- (A) the taxpayer or members of his family [as defined in Section 267(c)(4)], by a corporation controlled by the taxpayer, or by a partnership which included the taxpayer as a partner; or (B) a lessee, but only if the improvement constitutes income to the taxpayer; or (C) Federal, State, or local government, or political subdivision thereof, but only if the improvement constitutes an addition to basis for the taxpayer; and (3) such lot or parcel, except in the case of real property acquired by inheritance or devise, is held by the taxpayer for a period of 5 years.

206 Note: Special exception for necessary improvements, but the taxpayer must have held the property for 10 years and obtain the consent of the Commissioner. Cost is no adjustment to lot basis for the necessary improvements.

207 HOW NOT TO DO IT: POOL v. COMMISSIONER, T.C. MEMO POOL BUCHANAN KALLENBACH JOSEPHS CONCINNITY, LLC [taxable as a partnership] SALE POOL BUCHANAN KALLENBACH JOSEPHS ELK GROVE DEVELOPMENT CO. [taxable as a CORPORATION]

208 LOTS OF BAD FACTS [POOL] An agreement with Gallatin County, Montana, by Concinnity wherein Concinnity agreed that it, as subdivider, shall, at its sole cost and expense, pay for the improvements to the land in phase 1(improvements agreement). Concinnity filed an affidavit, in response to a Gallatin County Subdivision Regulation that required Concinnity to bond 150% of the total improvement costs, that stated in part: (1) Concinnity is the developer of proposed subdivision Elk Grove * * * [PUD] in Gallatin County, Montana and (2) As of June 13, 2001, Concinnity has entered into buy-sell agreements for the sale of 81 lots within * * * [phase 1] of Elk Grove PUD for an average fair market value of $41, per lot.

209 LOTS OF BAD FACTS [POOL] Concinnity s 2000 Form 1065 identifies its principal business activity as development and its principal product or service as real estate. Court record did not establish whether the buy-sell agreements in the affidavit were to 81 different buyers or to Elk Grove Development Co. alone. $41,000 per lot inconsistent with agreements for sale to Elk Grove Development Co. alone.

210 LOTS OF BAD FACTS [POOL] Concinnity developed the water and wastewater system as it agreed to do in the land exclusive option agreement. Concinnity mortgaged property after it had allegedly been sold to Elk Grove. There was no need for Concinnity to construct the water and wastewater systems as a means of promoting sales and attracting buyers because petitioners owned the very company that was granted the exclusive right to purchase the land. NO evidence of how sales prices were set.

211 Taxpayer Loses in Pool Having a Bramblett type structure is not enough. Taxpayer bears burden of producing evidence to support its position. Taxpayer s actions must be consistent with the seller being an investment only entity. Development costs cannot be paid by the investment entity. The investment entity must not hold itself out as a developer.

212 Where Appreciated Property is Contributed

213 Property s Capital Accounts: 704(b) Tax Basis 10,000 4,000 (500) -0-9,500 4,000 Cash s Capital Accounts: 704(b) Tax Basis 10,000 10,000 (500) (400) - CEILING 9,500 9,600 RULE DISTORTION 212

214 Property s Capital Accounts: 704(b) Tax Basis 10,000 4,000 (500) -0-9,500 4, ,850 4,450 Cash s Capital Accounts: 704(b) Tax Basis 10,000 10,000 (500) (400) 9,500 9, ,850 9,850 CEILING RULE DISTORTION ELIMINATED 213

215 Property s Capital Accounts: 704(b) Tax Basis 10,000 4,000 (500) -0-9,500 4, ,500 4,100 Cash s Capital Accounts: 704(b) Tax Basis 10,000 10,000 (500) (400) 9,500 9,600 (100) 9,500 9,500 CEILING RULE DISTORTION ELIMINATED 214

216 Existing A Existing B Admit New C 704(b) Tax 704(b) Tax 704(b) Tax 12,000 6,000 (400) (100) 12,000 6,000 (400) (100) 12,000 12,000 (400) (400) 11,600 5,900 11,600 5,900 11,600 11,

217 i. In connection with a contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership, or ii. In connection with the liquidation of the partnership or a distribution of money or other property (other than a de minimis amount) by the partnership to a retiring or continuing partner as consideration for an interest in the partnership, or

218 iii. iv. In connection with the grant of an interest in the partnership (other than a de minimis interest) on or after May 6, 2004, as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner. Under generally accepted industry accounting practices, provided substantially all of the partnership s property (excluding money) consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market.

219 Remedial & corrective reverse 704(c) allocations can cause additional income or lost deductions for the pre-existing partners under 704(c) principles

220 Build in safeguards: E.g., all additional contributions and distributions to be pro rata Negotiate the method to be applied in advance and make that part of the partnership agreement [* If you thought tax terminology was complex: The Lost in Space robot was a Model B-9, Class M-3 General Utility Non-Theorizing Environmental Control Robot ]

221 CHAPTER 8: HIGHLIGHTS OF PROPOSED REGULATIONS ON CONTRIBUTED BUILT-IN LOSS PROPERTY UNDER CODE SECTION 704(c)(1)(C)

222 CODE SECTION 704(c)(1)(C) Section 704(c)(1)(C) provides that if property contributed to a partnership has a built-in loss: (1) such built-in loss is to be taken into account only in determining the amount of items allocated to the contributing partner; and (2) except as provided by regulations, in determining the amount of items allocated to other partners, the basis of the contributed property in the hands of the partnership is equal to its fair market value at the time of the contribution.

223 TOPICS IN PROPOSED REGULATIONS The scope of section 704(c)(1)(C) The effect of the built-in loss Distributions by partnerships holding section 704(c)(1)(C) property Transfers of a section 704(c)(1)(C) partner s partnership interest Transfers of section 704(c)(1)(C) property Reporting requirements

224 PROPOSED REGULATIONS NOT APPLICABLE TO: Reverse section 704(c) allocations; Section 704(c)(1)(C) property does not include Reg. Sec liabilities.

225 NEW CONCEPT The proposed regulations create the concept of a section 704(c)(1)(C) basis adjustment. The section 704(c)(1)(C) basis adjustment is initially equal to the built-in loss associated with the section704(c)(1)(c) property at the contribution and then is adjusted in accordance with the proposed regulations. For example, if A contributes, in a section 721 transaction, property with a fair market value of $6,000 and an adjusted basis of $11,000 to a partnership, the partnership s basis in the property is $6,000, A s basis in its partnership interest is $11,000, and A has a section 704(c)(1)(C) basis adjustment of $5,000.

226 NEW CONCEPT The section 704(c)(1)(C) basis adjustment does not affect the basis of partnership property or the partnership s computation of any item under section 703. Recovery of the section 704(c)(1)(C) basis adjustment should be consistent with the rule regarding recovery of the adjusted tax basis in the property that is not subject to section 704(c)(1)(C).

227 NEW CONCEPT The amount of any section 704(c)(1)(C) basis adjustment that is recovered by the section 704(c)(1)(C) partner in any year is added to the section 704(c)(1)(C) partner s distributive share of the partnership s depreciation or amortization deductions for the year. The section 704(c)(1)(C) basis adjustment is adjusted under section 1016(a)(2) to reflect the recovery of the section 704(c)(1)(C) basis adjustment. SO, LIKE 743 ADJUSTMENTS, THESE ARE NOT ON THE PARTNERSHIP BOOKS. THEY ARE AT THE PARTNER LEVEL.

228 GUIDANCE ON DISTRIBUTIONS BY PARTNERSHIP HOLDING SECTION 704(c)(1)(C) PROPERTY AREAS: current distributions of section 704(c)(1)(C) property to the section 704(c)(1)(C) partner; distributions of section 704(c)(1)(C) property to another partner; and liquidating distributions to a section 704(c)(1)(C) partner. PRINCIPLES FROM 743(b) ADJUSTMENTS

229 Current distributions of section 704(c)(1)(C) property to the section 704(c)(1)(C) partner Adjusted partnership basis of section 704(c)(1)(C) property distributed to the section 704(c)(1)(C) partner includes the section 704(c)(1)(C) basis adjustment for purposes of determining the amount of any adjustment under section 734. However, the proposed regulations provide that section 704(c)(1)(C) basis adjustments are not taken into account in making allocations under (c).

230 Distribution of Section 704(c)(1)(C) Property to Another Partner If a partner receives a distribution of property in which another partner has a 704(c)(1)(C) basis adjustment, the distributee partner does not take the 704(c)(1)(C) basis adjustment into account under 732. The 704(c)(1)(C) partner reallocates its 704(c)(1)(C) basis adjustment relating to the distributed property among the remaining items of partnership property under (c), which is similar to the rule in (g)(2)(ii) for reallocating section 743(b) adjustments. This rule allocates the basis adjustment to partnership property without regard to the section 704(c)(1)(C) partner s allocable share of income, gain, or loss in each partnership asset.

231 Distribution of Section 704(c)(1)(C) Property to Another Partner If section 704(c)(1)(B) applies to treat the section 704(c)(1)(C) partner as recognizing loss on the sale of the distributed property, the section 704(c)(1)(C) basis adjustment is taken into account in determining the amount of loss. Accordingly, when the section 704(c)(1)(C) property is distributed to a partner other than the contributing partner within seven years of its contribution to the partnership, the loss will be taken into account by the contributing partner.

232 Distribution in Complete Liquidation of a 704(c)(1)(C) Partner s Interest If a 704(c)(1)(C) partner receives a distribution of property (whether or not the property is 704(c)(1)(C) property) in liquidation of its interest in the partnership, the adjusted basis to the partnership of the distributed property immediately before the distribution includes the 704(c)(1)(C) partner s 704(c)(1)(C) basis adjustment for the property in which the 704(c)(1)(C) partner relinquished an interest (if any) by reason of the liquidation.

233 Distribution in Complete Liquidation of a 704(c)(1)(C) Partner s Interest For purposes of determining the redeemed 704(c)(1)(C) partner s basis in distributed property under section 732, the partnership reallocates any 704(c)(1)(C) basis adjustment from 704(c)(1)(C) property retained by the partnership to distributed properties of like character under the principles of (c)(i), after applying sections 704(c)(1)(B) and 737. If section 704(c)(1)(C) property is retained by the partnership, and no property of like character is distributed, then that property s section 704(c)(1)(C) basis adjustment is not reallocated to the distributed property for purposes of 732.

234 Distribution in Complete Liquidation of a 704(c)(1)(C) Partner s Interest If any section 704(c)(1)(C) basis adjustment is not reallocated to the distributed property in connection with the distribution, then that remaining section 704(c)(1)(C) basis adjustment is a positive section 734(b) adjustment. If the distribution also gives rise to a negative section 734(b) adjustment, then the negative section 734(b) adjustment and the section 704(c)(1)(C) basis adjustment reallocation are netted together, and the net amount is allocated under (c).

235 Distribution in Complete Liquidation of a 704(c)(1)(C) Partner s Interest Partnerships without a 754 election in effect at the time of the distribution ARE TREATED AS HAVING MADE A 754 ELECTION solely for purposes of computing the negative 734 adjustment from the distribution.

236 Transfer of Section 704(c)(1)(C) Partner s Partnership Interest The transferee of a section 704(c)(1)(C) partner s partnership interest generally does not succeed to the section 704(c)(1)(C) partner s section 704(c)(1)(C) basis adjustment. Instead, the share of the section 704(c)(1)(C) basis adjustment attributable to the interest transferred is ELIMINATED.

237 EXAMPLE: Transfer of Section 704(c)(1)(C) Partner s Partnership Interest If a section 704(c)(1)(C) partner sells 20 percent of its interest in a partnership, the partner recognizes its outside loss with respect to that 20 percent but 20 percent of the partner s section 704(c)(1)(C) basis adjustment for each section 704(c)(1)(C) property contributed by the partner is eliminated. The transferor remains a section 704(c)(1)(C) partner with respect to any remaining section 704(c)(1)(C) basis adjustments.

238 Nonrecognition Exceptions The general rule that a section 704(c)(1)(C) basis adjustment is not transferred with the related partnership interest does not apply to the extent a section 704(c)(1)(C) partner transfers its partnership interest in a nonrecognition transaction, with certain exceptions.

239 Transfers of Section 704(c)(1)(C) Property by the Partnership Consistent with the rules under section 743, a section 704(c)(1)(C) partner s section 704(c)(1)(C) basis adjustment is generally taken into account in determining the section 704(c)(1)(C) partner s income, gain, loss, or deduction from the sale or exchange of section 704(c)(1)(C) property.

240 UPPER TIER/LOWER TIER PARTNERSHIP ISSUES 704(c)(1)(C) partner contributes to UTP who then contributes to LTP. Proposed regulations ensure that the section 704(c)(1)(C) adjustment amount is ultimately tracked back to the initial contributing partner, similar to the rules for section 721 contributions of property in which a partner has a section 743(b) adjustment.

241 UPPER TIER/LOWER TIER PARTNERSHIP ISSUES Interest in the LTP received by the UTP is treated as the 704(c)(1)(C) property with the same 704(c)(1)(C) basis adjustment as the contributed property. The LTP determines its basis in the contributed property by excluding the existing section 704(c)(1)(C) basis adjustment. However, the LTP also succeeds to the UTP s 704(c)(1)(C) basis adjustment. The portion of the UTP s basis in its interest in the LTP attributable to the 704(c)(1)(C) basis adjustment must be segregated and allocated solely to the 704(c)(1)(C) partner for whom the initial 704(c)(1)(C) basis adjustment was made.

242 UPPER TIER/LOWER TIER PARTNERSHIP ISSUES 704(c)(1)(C) basis adjustment to which the LTP succeeds must be segregated and allocated solely to the UTP, and the 704(c)(1)(C) partner for whom the initial 704(c)(1)(C) basis adjustment was made. If gain or loss is recognized on the transaction, appropriate adjustments must be made to the section 704(c)(1)(C) basis adjustment.

243 UPPER TIER/LOWER TIER PARTNERSHIP ISSUES Contribution from the UTP to the LTP will give rise to an additional section 704(c)(1)(C) basis adjustment if the value of the property has fallen below its common basis to the UTP; This additional 704(c)(1)(C) adjustment will be allocated among the partners of the UTP in a manner that reflects their relative shares of that loss.

244 REPORTING A partnership that owns property for which there is a section 704(c)(1)(C) basis adjustment must attach a statement to the partnership return for the year of the contribution of the section 704(c)(1)(C) property setting forth the name and taxpayer identification number of the section 704(c)(1)(C) partner as well as the section 704(c)(1)(C) basis adjustment and the section 704(c)(1)(C) property to which the adjustment relates.

245 WHAT ELSE IS IN THESE 110 PAGES OF PROPOSED REGULATIONS? Guidance on application of required 743(b) where the partnership has a substantial built-in loss. Determining fair market value in an LTP for 743(b). Guidance on the application of section 743(b) adjustments in tiered partnership situations generally. Anti-abuse rules to prevent avoidance of rules on substantial built-in losses. Rules for Electing Investment Partnerships.

246 WHAT ELSE IS IN THESE 110 PAGES OF PROPOSED REGULATIONS? Section 704(c) layers. Required separate tracking of section 704(c) positive and negative layers and disallowing netting a downward bookdown to offset an original positive section 704(c) layer. However, to make things easier with section 704(c) layers, the regulations allow any reasonable method for allocating tax items (such as depreciation) between the section 704(c) layers. The proposed regulations provide that a section 743(b) basis adjustment is no longer re-computed in a carryover basis transaction, effective to transfers of partnership interests occurring on or after January 16, 2014.

247 CHAPTER 9: NEW IRS SAFE HARBOR FOR ALLOCATIONS OF 47 REHABILITATION CREDITS REV. PROC

248 HISTORIC BOARDWALK AND ALLOCATIONS FOR THE REHABILITATION CREDIT AFTER ITS VICTORY, IRS PROVIDES A SAFE HARBOR

249 Historic Boardwalk Hall LLC v. Commissioner, F.3d, 110 A.F.T.R. 2d (3d Cir. 8/27/12), reversing 136 T.C. 1 (2011): Pitney Bowes had no meaningful downside risk, was certain to recoup its contributions and would not share in upside potential; PB not a partner for tax purposes under substance over form; PB denied rehabilitation tax credits allocated to it. 248

250 [T]he sharp eyes of the law require more from the parties than just putting on the habiliments of a partnership whenever it advantages them to be treated as partners underneath.... Indeed, Culbertson requires that a partner really and truly intend to... share in the profits and losses of the enterprise. 249

251 WHAT S THE ISSUE? Section 47(a) provides that the rehabilitation credit for any taxable year is the sum of 10 percent of the qualified rehabilitation expenditures with respect to any qualified rehabilitated building other than a certified historic structure, and 20 percent of the qualified rehabilitation expenditures with respect to any certified historic structure. Section 47(b)(1) provides that qualified rehabilitation expenditures with respect to any qualified rehabilitated building shall be taken into account for the taxable year in which the qualified rehabilitated building is placed in service.

252 WHAT S THE ISSUE? In Historic Boardwalk Hall, LLC. v. Commissioner, 694 F.3d 425 (3d Cir. 2012), cert. denied, U.S., No , May 28, 2013, the Third Circuit held that an investor s interest in the success or failure of a partnership that incurred qualifying rehabilitation expenditures was insufficiently meaningful for the investor to qualify as a partner in that partnership and receive allocations of Section 47 credits.

253 REV. PROC. SAFE HARBOR TO RECOGNIZE THE INVESTOR PARTNER A Partnership can be structured as either a Developer Partnership or a Master Tenant Partnership. A Developer Partnership is a Partnership that owns and restores a qualified rehabilitation building or a certified historic structure (Building). A Master Tenant Partnership is a Partnership that leases a Building from a Developer Partnership (Head Lease) and for which an election is made pursuant to (a)(1) to treat the Master Tenant Partnership as having acquired the Building solely for purposes of the 47 rehabilitation credit.

254 If the Investor receives an allocation of 47 rehabilitation credits from a Master Tenant Partnership, the Investor cannot also invest in the Developer Partnership other than through an indirect interest in the Developer Partnership held through the Master Tenant Partnership. This prohibition does not apply to a separately negotiated, distinct economic arrangement (e.g., a separate arm s-length investment into the Developer Partnership to share in allocations of federal new markets tax credits or low income housing credits).

255 The Principal must have a minimum one percent interest in each material item of Partnership income, gain, loss, deduction, and credit at all times during the existence of the Partnership. The Investor must have, at all times during the period it owns an interest in the Partnership, a minimum interest in each material item of Partnership income, gain, loss, deduction, and credit equal to at least five percent of the Investor s percentage interest in each such item for the taxable year for which the Investor s percentage share of that item is the largest (as adjusted for sales, redemptions, or dilution of the Investor s interest). So, an Investor with a maximum 99% interest must maintain a 5% interest at all times it owns an interest.

256 Investor Interest Must Be A Bona Fide Equity Investment Present only if that reasonably anticipated value is contingent upon the Partnership s net income, gain, and loss, and is not substantially fixed in amount. The Investor must not be substantially protected from losses from the Partnership s activities. The Investor must participate in the profits from the Partnership s activities in a manner that is not limited to a preferred return that is in the nature of a payment for capital.

257 Investor Interest Must Be A Bona Fide Equity Investment The terms of a sublease agreement of the Building by the Master Tenant Partnership to any person will be deemed unreasonable unless the duration of the sublease is shorter than the duration of the Head Lease. The Master Tenant Partnership may not terminate its lease of the Building from the Developer Partnership during the period in which the Investor remains as a partner in the Master Tenant Partnership.

258 Investor Interest Must Be A Bona Fide Equity Investment The value of the Investor s Partnership interest may not be reduced through fees (including developer, management, and incentive fees), lease terms, or other arrangements that are unreasonable as compared to fees, lease terms, or other arrangements for a real estate development project that does not qualify for 47 rehabilitation credits, and may not be reduced by disproportionate rights to distributions or by issuances of interests in the Partnership (or rights to acquire interests in the Partnership) for less than fair market value consideration. A sublease agreement of the Building from the Master Tenant Partnership back to the Developer Partnership or to the Principal of either the Developer Partnership or Master Tenant Partnership will be deemed unreasonable unless the sublease is mandated by a third party unrelated to the Principal.

259 Required Investor Contributions The Investor Minimum Contribution equals 20 percent of the Investor s total expected capital contributions required under the agreements relating to the Partnership as of the date the Building is placed in service. The Investor must maintain the Investor Minimum Contribution throughout the duration of its ownership of its Partnership interest in the Partnership (and the Investor Minimum Contribution must not be protected against loss through any arrangement, directly or indirectly, by any person involved with the rehabilitation except as permitted under the revenue procedure). Contributions of promissory notes or other obligations for which the Investor is the maker are not included in determining whether the Investor satisfies the Investor Minimum Contribution. AND At least 75 percent of the Investor s total expected capital contributions must be fixed in amount before the date the Building is placed in service. The Investor must reasonably expect to meet its funding obligations as they arise.

260 Permissible Unfunded Guarantees Guarantees for the performance of any acts necessary to claim the 47 rehabilitation credits; Guarantees for the avoidance of any act (or omissions) that would cause the Partnership to fail to qualify for the 47 rehabilitation credits or that would result in a recapture of the 47 rehabilitation credits; and, Guarantees that are not described as impermissible guarantees. Examples: completion guarantees, operating deficit guarantees, environmental indemnities, and financial covenants.

261 Impermissible Guarantees By Persons in the Transaction Funded Guarantees; To guarantee or otherwise insure the Investor s ability to claim the 47 rehabilitation credits, the cash equivalent of the credits, or the repayment of any portion of the Investor s contribution due to inability to claim the 47 rehabilitation credits in the event the Service challenges all or a portion of the transactional structure of the Partnership. To guarantee that the Investor will receive Partnership distributions or consideration in exchange for its Partnership interest (except for a fair market value sale right) Investor may procure insurance from persons not involved with the rehabilitation or the Partnership. Paying the Investor s costs or indemnify the Investor for the Investor s costs if the Service challenges the Investor s claim of the 47 rehabilitation credits.

262 Loans A Developer Partnership, a Master Tenant Partnership, or the Principal of either the Developer Partnership or the Master Tenant Partnership may not lend any Investor the funds to acquire any part of the Investor's interest in the Partnership or guarantee or otherwise insure any indebtedness incurred or created in connection with the Investor s acquisition of its Partnership interest.

263 Purchase and Sale Provisions Neither the Principal nor the Partnership may have a call option or other contractual right or agreement to purchase or redeem the Investor s interest at a future date (other than a contractual right or agreement for a present sale). The Investor may not have a contractual right or other agreement to require any person involved in any part of the rehabilitation transaction to purchase or liquidate the Investor s interest in the Partnership at a future date at a price that is more than its fair market value determined at the time of exercise of the contractual right to sell. An Investor may not acquire its interest in the Partnership with the intent of abandoning the interest after the Partnership completes the qualified rehabilitation. If an Investor abandons its interest in the Partnership at any time, the Investor will be presumed to have acquired its interest with the intent of later abandoning it.

264 THE END

265 ADDENDUM: Resource Materials Not Covered in Class CODE SECTION 2036

266 Section 2036 Property includible where decedent retained: (a)(1) = the possession or enjoyment of or the right to income from the property or (a)(2) = the right... to designate the persons who shall possess or enjoy the property or the income therefrom.

267 Estate of Harper, T.C. Memo No timely application for an EIN 3 month delay in depositing funds to partnership account Partnership funds deposited in decedent s revocable trust s bank account [commingling] Post mortem attempt by CPA to straighten out the accounts w/no money moving

268 Delay in transferring assets to partnership Decedent continued to receive income from assets during period of delay in transfer Disproportionate distributions to trust Partnership assets liquidated to pay estate taxes Guaranteed payments not made according to partnership agreement Primary motivation was to place assets beyond reach of child s creditors AFTER death

269 Transfer was substantially all of the decedent s assets Formation unilateral = no negotiation between partners CONCLUSION: Partnership was an alternative testamentary device and decedent maintained enjoyment of the property throughout. Assets included in estate.

270 Estate of Thompson, T.C. Memo Fortress Financial Group FLP plan costing $32,000 Family wanted to make sure that decedent could access the money in the partnerships Distributions to allow decedent to make Christmas gifts in 1993 Distributions in 1995 to cover hot Christmas gift checks

271 THE IRS SHOULD AT LEAST SAY THANK YOU: Before formation of FLPs, daughter sought assurances from financial planners that decedent could withdraw cash from FLPs to make gifts to her and others Distributions to pay decedent s personal expenses Substantially all of decedent s assets transferred to FLPs Son transferred the ranch he was living on to the FLP but he continued to operate the ranch and take the income

272 Son s $12,000 annual rental traced back to him through management fee paid to GP and salary he took from GP Court held that there was an implied agreement that decedent would continue to have enjoyment of assets in the partnership Control over management and distributions by the children of little import

273 Kimbell v. U.S., Civ.Act. 7:01- CV-0218R, 2003 U.S. Dist. LEXIS 523 (N.D. Tex.) Summary Judgment for the Government Decedent s LP interest had the right to remove the GP LP selects new GP after removal GP has right to make distributions in sole discretion

274 Therefore, by retaining the right to remove the GP through the 99% LP interest, the decedent effectively controlled distributions says the Court Partnership Agreement says GP does not owe a fiduciary duty to the Partnership or any of the Partners No need here to look for an implied agreement here the Partnership Agreement on its face reflects the agreement for continued enjoyment

275 BUT is this a 2036(a)(1) or (a)(2) case? Reads like an enjoyment case but the reasoning is based on retained controls LESSONS????? Bad decision? Be careful of the percentages retained by the decedent If the decedent is to be given discretion over distributions, does this case s reasoning say that you ve automatically lost the 2036(a)(2) argument?

276 WAIT: THE FIFTH CIRCUIT REVERSED THE DISTRICT COURT

277 EXCEPTION TO 2036 BONA FIDE SALE FOR FULL AND ADEQUATE CONSIDERATION A 2-PART TEST

278 THE WINNING FORMULA DID NOT OVERFUND FORMALITIES SATISFIED ASSETS NEEDED ACTIVE MANAGEMENT VALID BUSINESS PURPOSES

279 THE PURPOSES FIRST DISCUSSED EARLY 1990s CREDITOR PROTECTION NOT PRESENT WITH LIVING TRUST DESIRE FOR OIL & GAS OPERATIONS TO CONTINUE PAST DEATH REDUCED ADMINISTRATIVE COSTS NO NEED TO RECORD TRANSFERS FROM ONE GENERATION TO NEXT

280 MAINTAIN SEPARATE PROPERTY CHARACTER FOR DESCENDANTS PREPARED FOR MANAGEMENT OF ASSETS IN CASE OF SON S ILLNESS MEDIATION REQUIRED DOCUMENTS CONSISTENT UNCONTROVERTED TESTIMONY KEY: CONTRIBUTED MANAGEMENT EXPERTISE

281 THOMPSON & PROGENY STILL AN ISSUE WHERE PARTNERS NOT INVOLVED IN ACTIVE CONDUCT OF BUSINESS HEIGHTENED SCRUTINY IN FAMILY SITUATION FOR DISGUISED GIFTS AND SHAMS MERE RECYCLING OF ASSETS PAPER TRANSACTION WITHOUT SUBSTANCE

282 Estate of Strangi v. Commissioner, T.C. Memo (May 20, 2003) [Strangi II] The Taxpayer originally won this case on the issues of respecting the partnership s existence, gift on formation and whether the partnership could be disregarded under 2703

283 But the 5 th Circuit said the Tax Court should have permitted the Commissioner to add a 2036 argument Previously Strangi I has been widely cited as why FLPs work Now Strangi II is a big win for the IRS! Another Fortress Financial FLP Decedent has 1 to 2 years to live dies in 2 months FLP formed by decedent s attorney in fact

284 Distributions in sole discretion of the GP Assets distributable in kind in GP s sole and absolute discretion $9,876,929 [98% of decedent s wealth] transferred to FLP for 99% LP interest Corporate GP signs onto management agreement employing the attorney in fact Later a 1% interest in the GP given to charity

285 FLP paid for the decedent s nurse s back injury, the funeral expenses, estate administration expenses, the decedent s debts, nursing expenses of the decedent and a $65,000 specific bequest to the decedent s sister Items initially recorded in bookkeeping entries as advances to or accounts receivable from partners [Sound familiar????]

286 DOUBLE OOPS!!! Mr. Gulig manages the corporate GP of the FLP. The corporate GP manages the FLP. Mr. Gulig is the attorney in fact of the decedent under a general power of attorney [today, this is a statutory durable power where no authority is withheld] SO SAYS THE COURT Mr. Gulig s power with respect to the partnership is essentially the same as under the POA SO DECEDENT S POSITION HAS NOT CHANGED RE: THE ASSETS

287 Crossing the T s and dotting the I s does not preclude 2036(a)(1) FLP robbed decedent of liquidity = Court concludes that kids expected FLP to be the source of liquidity [At decedent s death, he had $762 in the bank.] Decedent lived in home owned by the FLP; accrued rent didn t save the day 1% distribution to GP didn t curb decedent s continued enjoyment of his assets

288 Looks like one man s estate plan rather than an arm s-length, negotiated enterprise 2036(a)(1) LOSER 2036(a)(2)? IRS says that decedent had more than mere management powers The court says this FLP placed the decedent as the 99% LP and as a director and shareholder of the GP to act alone or with others through his attorney in fact to cause distributions

289 No independent person with fiduciary duties No fiduciary duty owed to unrelated persons Mr. Gulig had a fiduciary duty to decedent under the pre-existing POA Family directors of GP do not limit decedent s control in a meaningful way Duties are essentially owed to himself Forget the IRS s prior inconsistent PLRs and Tech Advices Court says that by statute they have no precedential value

290 SO THE TAXPAYER LOSES UNDER BOTH 2036(a)(1) and (a)(2)

291 OOPS NOW IT S THE FIFTH CIRCUIT AFFIRMING AND HOLDING AGAINST THE TAXPAYER

292 IRS ARGUMENTS TO 5 TH CIRCUIT IRS requires an active trade or business {since when???} The Tax Court rejected this in 2008 in the Mirowski decision

293 Taxpayers must leave sufficient liquid assets outside the FLP to cover the estate tax liability {where is that in the law???} But later Courts are moving in this direction even on redemptions particularly where death is anticipated Compare Mirowski where death was not anticipated and a post-death distribution to pay estate taxes was not determinative

294 Management distinguished from the Kimbell decision assets in Kimbell needed management {Taxpayer won in Kimbell due in part to management of royalty and nonoperator working interests???????} Insufficient assets outside the FLP for personal needs {BEST IRS ARGUMENT!!!}

295 5 th Circuit Analysis Express or implied agreement required Deference to Finder of Fact [Tax Court] possession or enjoyment requires a substantial economic benefit Possession of residence Lack of Liquid Assets Assurance that assets available to meet postdeath obligations DOES THAT INCLUDE ESTATE TAX???

296 Strangi on Kimbell Court says that you need a substantial non-tax business purpose Is it a substantial non-tax business purpose or a substantial non-tax purpose? Court uses both formulations IMPORTANT to Family Investment Limited Partnerships (FLIPs)

297 A de minimis contribution of minority partners is not, in itself, sufficient grounds for finding that a transfer of assets to a partnership is not bona fide; however, where a partnership has made no actual investments, the existence of minimal minority contributions may well be insufficient to overcome inference [of no joint investment purpose].

298 Setting up an FLP for an incapacitated person Compare Estate of Abraham v. Commissioner, T.C. Memo , aff d, 408 F.3d 26, amended by 429 F.3d 294 (1 st Cir. May 25, 2005), cert. denied, 126 S.Ct (2006) [a how NOT to] with Estate of Beatrice Kelly et al. v. Commissioner, T.C. Memo [the how to guide]

299 Mirowski v. Commissioner, T.C. Memo LLC formed 8/27/01 9/1/01 transfer of 51.09% of the rights under a patent license generating millions in revenues each year for 100% of LLC interests. 9/5/01 to 9/7/01 transfers of securities worth $62 million to LLC.

300 9/7/01 gifts of a 16% interest in LLC to trusts for three daughters. Transferor retained $7.5 million in assets including $3.3 million in cash. She had retained ability to pay gift taxes (cash and borrowing ability based on anticipated millions in future earnings). Decedent unexpectedly became ill on 9/10/01 after latest treatments on foot ulcer. Decedent dies on 9/11/01 from sepsis. Death unanticipated.

301 Estate taxes were not anticipated or discussed; insufficient assets outside LLC to pay them. Decedent sole LLC manager at date of death. Actual investments post-death by trusts pooling assets as decedent had intended. Agreement imposed fiduciary duties and provided for pro rata distributions although timing of operating distribution was determined by a majority of the members [not a general partner].

302 Court held for taxpayer. Legitimate and Significant Non-Tax Reasons: Joint management Pooling of assets Provision for equality of treatment of children Also, creditor protection [nonsignificant] Failure to retain assets to pay unanticipated estate taxes nondispositive per the Court.

303 Rejection of government contention that a business was required for the LLC. Rejection of government argument against a deathbed partnership because death was not anticipated. Lack of negotiation not dispositive. Post-death distribution to pay estate tax not dispositive.

304 IRS attempted to argue integrated transaction type of attack which court rejected treating steps as separate. IRS did argue there was a proscribed 2036(a)(2) power [but lost] and did not argue that merely being the sole manager triggers 2036(a)(2). CAVEAT: THIS RESULT WAS HIGHLY FACT DEPENDENT THE UNEXPECTED DEATH WAS KEY.

305 Keller v. United States, Civil Action No. V-02-62, United States District Court for the Southern District of Texas, Victoria Division, 2009 U.S. Dist. Lexis 73789; 2009 WL (S.D.Tex.), U.S. Tax Cas. (CCH) 60,579 (August 20, 2009) Partnership was not funded at the time of death! Decedent and partnership accountants from Victoria, Texas. Accountants thought that there would be no discount. Partnership agreement executed but properties not transferred and general partner not funded. Heard about the Church decision in the Western District of Texas (discussed previously) post death at a seminar. And only then contacted a tax litigator and completed the funding.

306 This Court relying on the Church decision: Because Plaintiffs have established that Mrs. Williams intended to transfer the Community Property Bonds to the Partnership at the time she signed the Partnership Agreement, and that the Partnership was a valid Texas limited partnership before Mrs. Williams' death, the assets are considered partnership property before her passing, and Mrs. Williams' estate may be able to obtain a refund for taxes paid. [$40,455,332 Estate Tax refund.] Note that this is a U. S. District Court (Southern District of Texas--Victoria Division).

307 Keller v. United States, 110 A.F.T.R.2d (5 th Cir. 9/25/12): Family partnership case; Under Texas law, decedent s intent to make an asset partnership property caused equitable title to pass to the partnership; Valuation discount allowed; $147 million estate tax refund. 306

308 Estate of Kelly v. Commissioner, T.C. Memo Bad Facts: FLP set up by guardians of the decedent [so was management really needed?]; Purpose of ensuring equal distribution at death [a testamentary purpose]; Decedent retained sole control of the corporate general partner which was to be paid a management fee [2036 issues]. Result? 307

309 Good Facts: Asset Protection and Risk Management were clearly legitimate non-tax purposes: Blasting at quarries on the property; Dump truck collision over which the decedent had been sued; Bullets in a campfire site on the property. TAXPAYER WINS 308

310 Estate of VA V. Kite, et al. v. Commissioner, TC Memo Decedent's transfer of partnership interests to children in exchange for annuity agreements were not disguised gifts. Taxpayers relied on IRS's actuarial tables to value annuities and establish that there was full and adequate consideration. IMPORTANT: A physician's letter attested to decedent's longevity and showed she wasn't suffering any terminal illness at the time of the transaction. Use of IRS tables was, therefore, appropriate. 309

311 Estate of Lois L. Lockett, et al. v. Commissioner, T.C. Memo Held: Decedent owned 100% of partnership interests at the time of death. NO PARTNERSHIP = NO DISCOUNT Children never made any contribution for their general partnership interests. They subsequently tried to argue that there was an implicit gift to them of a 1% interest, that they provided services and that a contribution that the decedent made in the amount of $125,000 was actually made on their behalf giving them an 11.68% interest. 310

312 Estate of Turner v. Commissioner, 138 T.C. No. 14 (2012), aff g on motion for reh. T.C. Memo

313 The following were found NOT to be legitimate and significant nontax reasons based on the record: (1) to consolidate their assets for management purposes and allow someone other than themselves or their children to maintain and manage the family s assets for future growth pursuant to a more active and formal investment management strategy, (2) to facilitate resolution of family disputes through equal sharing of information, and (3) to protect the family assets and the decedent s wife from Rory Crumley (Rory), the Turners grandson with addiction problems, and to protect Rory from himself. 312

314 Court: NO ACTUAL MANAGEMENT; FAMILY DISPUTES WORSENED; RORY NOT PROTECTED NOR ANYONE ELSE. Court: 2036 applied to pull assets back into the taxable estate. No increased marital deduction under these facts according to the Court. 313

315 Some dictum that where 2036 applies the inclusion is the UNDISCOUNTED value of the assets and the marital deduction is the DISCOUNTED value of the partnership interest. 314

316 From the Tax Court:... consolidated asset management generally is not a significant nontax purpose where a family limited partnership is just a vehicle for changing the form of the investment in the assets, a mere asset container. 315

317 You can t just drop assets into a state law partnership or LLC and get a discount. That entity has to do something to support the asserted nontax purposes. 316

318 SO WHAT HAVE WE LEARNED? Pigs may still get fat, but hogs still get slaughtered: DON T OVERFUND RUN THE PARTNERSHIP LIKE A BUSINESS ASSET SELECTION IS CRITICAL PROVING ACTUAL NON-TAX BUSINESS PURPOSE IS CRITICAL AVOID INTEGRATED TRANSACTION ON FORMATION DELAY + REAL ECONOMIC RISK IN DELAY

319 NO SIDE AGREEMENTS THAT THE GRANTOR CAN STILL GET TO THE MONEY DON T PUT PERSONAL ASSETS INTO THE FLP = THAT MEANS NEVER AN FLP IS ONE PART OF AN ESTATE PLAN, NOT THE ENTIRE ESTATE PLAN MAKE SURE THERE IS NO POWER IN THE FLP THAT THE GRANTOR CAN USE TO GET HIS MONEY BACK

320 THE CLIENT MUST OBSERVE THE FORMALITIES OR ALL MAY BE LOST Post-mortem fixes by the accountants don t work THE IRS ATTACKS DEATHBED FLPS Sometimes unsuccessfully WHO IS GOING TO MONITOR ONGOING COMPLIANCE WITH THE PARTNERSHIP AGREEMENT?

321 CONSIDER GP INDEPENDENCE BECOMING MORE IMPORTANT LIQUIDITY, LIQUIDITY, LIQUIDITY NEW IRS ATTACK: ASSETS SUFFICIENT TO PAY ESTATE TAXES OUTSIDE THE PARTNERSHIP FIDUCIARY DUTIES ARE CRITICAL

322 SOMETIMES THE BEST SOLUTION MAY BE TO DISSOLVE THE FLP AND START FROM SCRATCH... IF AT FIRST YOU DON T SUCCEED.... BUT BE CAREFUL THAT YOUR NEW ENTITY IS NOT THE SAME PARTNERSHIP FOR TAX PURPOSES STATE LAW TERMINATION TAX TERMINATION OF THE PARTNERSHIP