Tax Allocation in Partnerships and LLCs

Transcription

1 Presenting a 90-Minute Encore Presentation of the Teleconference with Live, Interactive Q&A Tax Allocation in Partnerships and LLCs Minimizing Tax Impact Through Strategic Allocation of Income, Gains, Losses and Liabilities WEDNESDAY, APRIL 3, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Saba Ashraf, Partner, McKenna Long & Aldridge, Atlanta Jed A. Roher, Attorney, Godfrey & Kahn, Madison, Wis. Lynn Fowler, Partner, Kilpatrick Townsend & Stockton, Atlanta Attendees seeking CPE credit must listen to the audio over the telephone. Please refer to the instructions ed to registrants for dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 Tax Allocation in Partnerships and LLCs Saba Ashraf McKenna Long & Aldridge LLP Atlanta, Georgia February 6, 2013

6 Basic Concept 1: Difference Between LLC Unit/Interest & Share of Stock of Corporation Each share of a corporation within a particular class entitles its owner to a horizontal slice of: (i) the corporation s current value (the capital interest ); and (ii) the corporation s future value which includes (a) future appreciation beyond the date of the acquisition of the interest, and (b) future income (the profits interest ) A share, when 100 are outstanding entitles an owner of 1 share to: 1. 1/100 of the future income (i.e. dividends) of the corporation; 2. 1/100 of the current value of the corporation (if corporation were sold now, such owner would get 1/100 th of value) 3. 1/100 of the future value or proceeds on liquidation of the corporation 6

7 Basic Concept 1: Difference Between LLC Unit/Interest & Stock of Corporation A unit or interest in an LLC does not entitle its owner to a horizontal slice of everything. An LLC Operating Agreement is basically a contract between the members as to how they are going to share all these things (income of the business, current value and future value). If you provide for a unit mechanism in your Operating Agreement, that doesn t mean that your unit is entitling its holder to a pro rata portion of these things. You have to think about how these things are to be shared among the members, and you have to build your operating agreement to reflect this sharing. It won t happen simply by virtue of owning a unit if you don t explicitly provide what your unit entitles your holder to. You can set up a unit mechanism and give each unit a horizontal slice of all these things, but they don t have to. 7

8 Basic Concept 2: Distributions Versus Allocations Separate Distribution and Allocation Sections. An LLC Operating Agreement generally has, on the one hand, a Distributions section, and on the other hand the Allocations section. Distributions Section. The distribution section sets forth the timing and order in which the distributable cash of the LLC will be distributed to the members (also called the Waterfall ). This reflects the economic sharing the members have agreed to. Allocations Section. The allocations section sets forth how the book items of income, gain, loss, deduction (which includes the taxable income and loss) of the LLC will be shared among the members of the LLC. 8

9 Basic Concept 2: Distributions Versus Allocations Allocations. Members can decide how they will share the items of taxable income or loss of the LLC. Members have a good bit of control over how to share. People/companies generally are very excited upon learning that the taxable income and losses of LLCs may be shared among its members in accordance with their agreement and have immediate visions of having all the taxable income allocated to members that can bear it (i.e. tax exempt members or members that have unused losses), and having all the tax losses go to them. However, as you might guess, this is not so easy. In order to be respected by the IRS, the allocations the members agree to must have substantial economic effect. 9

10 Example of Distributions Section Distributions Net Cash Flow. Except as otherwise provided in this Agreement, in the discretion of the Managers Net Cash Flow shall be distributed annually, or at such other times as determined by the Managers, to the Members in the following order and priority: (a) First, 100% to Investor until the cumulative distributions under this Section 4.1.1(a) equal Investor's initial Capital Contribution. (b) Second, twenty percent (20%) to Developer and eighty percent (80%) to Investor. 10

11 Example of Allocations Section Profits and Losses. Except as otherwise provided in Section 4.2.2, any Profits or Losses of the Company for any Allocation Year shall be allocated among the Members in the following order and priority. (a) Profits. (i) First, Profits shall be allocated one hundred percent (100%) to Investor in an amount equal to the excess, if any, of the cumulative Losses allocated to Investor pursuant to Section 4.2.1(b)(ii) for all prior Allocation Years over the cumulative Profits allocated pursuant to this Section 4.2.1(a)(i) for all prior Allocation Years. (ii) Second, after giving effect to the allocations made pursuant to Section 4.2.1(a)(i), Profits shall be allocated twenty percent (20%) to Developer and eighty percent (80%) to Investor. (b) Losses. (i) First, Losses shall be allocated twenty percent (20%) to Developer and eighty percent (80%) to Investor in an amount equal to the excess, if any, of the cumulative Profits allocated pursuant to 4.2.1(a)(ii) for all prior Allocation Years over the cumulative Losses allocated pursuant to this Section 4.2.1(b)(i) for all prior Allocation Years. (ii) Second, after giving effect to the allocations made pursuant to Section 4.2.1(b)(i), Losses shall be allocated one hundred percent (100%) to Investor. 11

12 Substantial Economic Effect SEE generally requires that the income and losses be allocated to the members that actually bear the economic impact of the losses. Super Simple Example: A& B form LLC, A contributing $0, and B contributing $100. A B $0 $100 12

13 Allocation Provisions Substantial Economic Effect LLC has $100 of taxable LLC decides to hang on to the cash, but it still has to allocate all the taxable income to the members. It has to allocate it to somebody. So, the LLC allocates it all to B. If that happens, then, generally, for that allocation to have SEE, B has to actually get that $100 at some point. You can t allocate $100 of taxable income to B and then give that cash to A instead. Similarly, if the LLC loses the $100 of money that B contributed, you have to allocate that $100 loss to B. You can t allocate the $100 loss to A, and then have B be the one that is actually out of pocket $

14 Substantial Economic Effect - Requirements Key Requirements of SSE. (Again, these are based on the theory that the real economics should determine the tax consequences.): 1. Capital Account be kept for each member. A Capital Account is analogous to a person s bank account balance. At any point in time, the balance shows you how much the bank has to give you if you decide to close down your account with the bank. One of the key premises that the partnership tax regulations are based on is that the Capital Account balance effectively represents the value of a member s interest in the LLC. 2. The Capital Account balance must be increased or decreased in accordance with certain rules. You bank account balance is (i) increased by the amount of money you deposited, (ii) increased by the interest you earn on the deposit, (iii) decreased by withdrawals you make. Analogously, a Capital Account balance of a member is: -increased by contributions of money or other property -increased by income allocations to the members -decreased by loss allocations -decreased by distributions to the member 3. On liquidation, the amount a member gets is equal to his/her Capital Account balance. Using the bank account balance as an analogy, when you close an account, you get what is equal to your bank account balance. Similarly, an LLC has to distribute an amount equal to the bank account balance when a member leaves the LLC. This has to be the rule in order for the rules described above for computing the Capital Account balance to have any meaning. It wouldn t make sense that you had all these rules for computing your bank account or Capital Account balance, if on closing an account or on liquidation, the LLC/bank had to give you an amount completely unrelated to your balance. 14

15 Substantial Economic Effect Simple Examples A $100 $100 B Ex. 1 A & B form an LLC; each contributes $100. The operating agreement ( OA ) says profits and losses will be allocated 60% to A and 40% to B. It also says CA will be kept for A and B and they will be increased by income allocation, contributions made and decreased by distributions and losses allocated + it says on liquidation A and B will get their capital account balance. Operating Agreement says: Profits and Losses to be allocated 60% to A and 40% to B Capital accounts to be kept for A and B that are increased by income allocation, contributions, and decreased by distributions and losses allocated. On liquidation A and B will get their capital account balances returned to them. 15

16 Substantial Economic Effect Simple Examples So, the LLC has $200 of taxable income. Under OA, $120 (60%)of this is allocated to A (bringing A s Capital Account balance to $220),and $80 is allocated to B (bringing his CA to $180). Suppose at the end of the year, the LLC sells all its assets and liquidates. It has $400 of assets, so A gets $220 and B gets $180 Beginning Capital Account A $100 $100 $200 taxable income $120 (60%) $80 (40%) B Capital Account at Year End $220 $180 Because CA are properly kept and liquidating distributions are in accordance with CA balances, this LLC s allocations will be respected by the IRS. 16

17 Substantial Economic Effect Simple Examples Ex. 2 Same as before, except that when the nontax lawyer looked at the section of the Operating Agreement that says how distributions will be made on liquidation, the lawyer thought no way am I going to say liquidations will be made in accordance with capital account balances when neither I nor my client really understand what that ll mean. I can t take the chance that my clients gets out of the deal anything different from what they expect to get out. I don t have the time or the patience to go talk to our tax person. So, he changes the Operating Agreement to say that on liquidation A will receive 60% of the proceeds, and B will be entitled to receive 40% of the proceeds. So, now if the LLC liquidates when it has $400 of assets, everyone ignores Capital Account balances, and A gets $240 on liquidation (60% of $400) and B gets $160 (40% of 400). Because the allocated income provided for in the Operating Agreement does not match the economic gain that would be realized by each member on liquidation, the contractually agreed upon allocations do not have SEE and will not be respected. 17

18 Substantial Economic Effect Simple Examples Ex. 3 A&B form an LLC and contribute $100 each; they decide that on ultimate liquidation, A will receive 60% of the proceeds and B will receive 40% of the proceeds. A B Operating Agreement says: -share distributions 60/40 -but liquidating distributions made in accordance with positive capital account balances. $100 $100 The nontax lawyers uses the form used for the LLC in Ex. 2 as a starting point for drafting. If you ll recall, that didn t have liquidation in accordance with Capital Account balances. They give it to their tax lawyer to review. The tax lawyer and the nontax lawyer do not coordinate or communicate with each other at all as to what the business deal is. The tax lawyer fixes the OA to provide for liquidation in accordance with capital account balances (because s/he wants the OA to have allocations that the IRS will respect). But now, without realizing it, the tax lawyer has completely altered the business deal of the parties. 18

19 Substantial Economic Effect Substantiality The substantiality aspect of SEE comes up a bit less frequently. This test is more subjective. In general, for an allocation to be substantial, there must be reasonable possibility that the allocation will affect substantially the dollar amounts received by the partners independent of tax considerations. An example of a potential substantiality problem is when a partnership contains both a tax-exempt partner and a taxable partner and the partnership specially allocates disproportionate taxable income to the tax-exempt partner and then allocates disproportionate tax-exempt income to the taxable partner to have the 2 special allocations generally offset economically but lower the overall taxes paid by the partner in the aggregate. 19

20 Getting Distribution/Allocation Provisions Right 2 Goals: (1) Get economic/business deal right, and (2) Ensure that allocations have SEE, so that no risk of IRS setting them aside. The Distribution provisions and the Allocation provisions of the OA have to work together to get these right. The Distribution provisions set out what the parties economically get from the LLC. They are the most important. The Allocation provisions allocate the income and loss to members. But since allocations also affect capital accounts, they can indirectly affect the business deal of the parties particularly true where you are liquidating in accordance with capital account balances. 20

21 Allocation Provisions Ways They Can Be Wrong With that it is important to understand that there are 2 ways in which allocations may be wrong. 1. If they don t have SEE, the IRS can come along and reallocate them in accordance with the partner s interest in the partnership. In a simple case, such as one where the current and liquidating distributions are supposed to be shared by everyone pro-rata, it is pretty easy to figure out what in accordance with the partner s interest in the partnership means. However, where the distribution scheme is more complicated, it is pretty hard to figure it out: Example: A & B form an LLC. A contributes $100, and B contributes $20. Economic deal between the parties is: 1. First, A gets his capital back, with a 5% rate of return 2. Then B gets his capital back 3. The next $100 of distributions is shared 75% by B and 25% by A; 4. The next $250 of distributions is shared 50% by A and B 5. Any additional distributions are shared 67% by A and 33% by B If the allocations in the operating agreement do not have SEE, it may not be possible to predict with any degree of confidence who will be taxed on the LLC s income. This could result in some very unpleasant surprises to the members, who entered into the deal believing that each member would be taxed in accordance with the allocations set forth in the operating agreement. 21

22 Allocation Provisions Ways They Can Be Wrong The IRS cannot invalidate provisions that call for contributions or distributions; these provisions are matters of agreement among the parties. What the IRS can do is invalidate allocations, reallocate, and assess interest and penalties. 22

23 Allocation Provisions Ways They Can Be Wrong 2. The second way that the allocation provisions can be wrong is by not properly reflecting the economic deal of the members. A common example: In an effort to comply with the SEE regulations, the operating agreement contains provisions under which (1) all income or loss allocated to a member is reflected in a member s capital account, and (2) upon liquidation of the LLC, the members will be entitled to distributions in proportion to their positive capital account balances. This means the effect of income allocations is not merely on the amount of tax that each members will be required to pay, but also on the number of real dollars that the member will get when the LLC ultimately liquidates. So if the allocations are wrong (not because they fail to comply with the SEE rules, but because they don t properly reflect the economic deal) the effect can be that the actual cash received by each member, regardless of tax consequences, may not be in accordance with the intention of the parties. 23

24 Drafting Allocation/Distribution Provisions There are many ways to draft an allocation provision. Very broadly, they can be placed in 2 categories: 1. Layered approach 2. Targeted/Forced approach 24

25 2 Allocation Provision Approaches 1. Layered Approach The tax lawyer carefully goes through the ordering rules in the Distribution Section (the Waterfall ) and thinks through how allocations should be made so as to (i) not alter the business deal of the members, and (ii) so that the regulations have SEE. 25

26 1 st Approach: Layered Allocation Simple Example: A & B form an LLC. A puts in $100, and B puts in $50. Distributions: Distributions of available cash shall be made each year at he discretion of the Manager and shall be in the following order of priority: (i) First, to A, until the Unpaid Preferred Amount has been reduced to zero; (ii) Then to return A s capital contributions; and (iii) Then to return B s capital contribution; and (iv) Thereafter, equally to A and B. Allocations: -Profits shall be allocated each year as follows: (i) First, if A s capital account balance is less than the Unpaid Preferred Amount to A, until A s Unpaid Preferred Amount has been reduced to zero; and (ii) Thereafter, equally to A & B. 26

27 1 st Approach: Layered Allocation Pros: There is a greater emphasis placed on making sure the Capital Account balances get to the right place, which necessarily means there is a greater emphasis on making sure the client him/herself has thought through precisely what their business deal is. Once you start to ask business people some questions about their business deal, you often realize they haven t fully thought it through. Cons: Time consuming. You will actually have to talk with tax lawyers. Hard to explain to your client. Even with all the discussion, there can be no guarantee that the allocations are correct. The consequence of an error is that the business deal itself might be changed. So, there is a lot riding on making sure these are correct. 27

28 2 nd Approach: Targeted/Forced Allocations Generally, this type of allocation provision says something along the lines of profits and losses will be allocated in such a way so as to cause each member s capital account balance to be equal to the amount that the member is entitled to receive if the LLC were to liquidate at the end of the year. In other words, the distributions should be very clear. If they are clear, then the LLC will allocate the income/losses to the members to force each member s Capital Account balance to equal precisely what the member is supposed to receive on liquidation. 28

29 2 nd Approach: Targeted/Forced Allocation Increasingly Popular. There are many different ways to draft such a provision. One example: Net Profits and Net Losses for the year shall be allocated among the partners in a manner such that, to the extent possible, the capital account balance of each partner at the end of such year shall be equal to the excess of: (1)The amount that would be distributed to such partner if (a) the company were to sell the assets of the company for their Gross Asset Values, (b) all Company liabilities were settled in cash according to their terms (limited, with respect to each nonrecourse liability, to the book values of the assets securing such liability), and (c) the net proceeds thereof were distributed in full pursuant to the distribution provisions, over (2)The sum of (a) the amount, if any, without duplication, that such Partner would be obligated to contribute to the capital of the Company, (b) such Partner s share of Partnership Minimum Gain determined pursuant to Treas. Reg. Section (g) and (c) such Partner s share of Partner Nonrecourse Debt Minimum Gain determined pursuant to Treas. Reg. Section (i)(5), all computed as of the date of the hypothetical sale described in (1) above. 29

30 2 nd Approach: Targeted/Forced Allocation Way this practically works: (1) Each member s Capital Account is adjusted based on the year s contributions, distributions and book-ups (i.e. everything other than the income/loss tax allocations). (2) Everyone pretends the LLC sells all its assets for cash at the end of the year at their fair market value, and that it took the proceeds and will distribute to the members pursuant to the waterfall. (3) The income/loss the LLC has is allocated among the members so that each member s balance equals the amount the member would be entitled to receive as described in Step (2). 30

31 2 nd Approach: Targeted/Forced Allocations Ex: A and B form an LLC. A contributes $90. B contributes $10. Distributions: Cash is paid first to return contributed capital + a 10% annual preferred return, and then is paid 80/20 to A and B respectively. The LLC earns $20 of income in year 1. A B $90 $10 Operating Agreement Distributions 1. First to return contributed capital+ preferred return of 10% 2. Then 80/20 to A and B. 31

32 2 nd Approach: Targeted/Forced Allocations Step 1: Our example is really simple and we re pretending there were no other contributions/distributions. So, A s capital account is $90 and B s is $10 Step 2: All the LLC s assets at the end of the year are worth $120 ($100 contributions + $20 income). If the LLC liquidated at the end of the year, then under our distribution waterfall, A and B would get $107 and $13 respectively: A B Total Return of capital $90 $10 $100 Preferred returns $9 $1 $10 Residual return $8 $2 $10 Total Distribution if LLC sold all assets and liquidated $107 $13 $120 Step 3: Allocate income to that A s capital account balance equals $107. -For A: to get from $90 (beginning capital account) to $107 (ending capital account), we have to add $17 to it. A gets allocated $17 of the taxable income. -For B: to get from $10 to $13, we allocate $3 of taxable income to him or her. 32

33 2 nd Approach: Targeted/Forced Allocation Pros: 1. Can t alter the business arrangement. There is economic certainty. 2. You technically have SEE because liquidating distributions equal the amount of the capital account balance. Some people take position that it is unclear whether targeted/forced allocations have SEE because technically you are still liquidating in accordance with distributions scheme. However, most take the view that where the capital account balance must equal that amount to be received in the waterfall, it doesn t matter that the liquidation section doesn t precisely say liquidate in accordance with capital account balances. 33

34 2 nd Approach: Targeted/Forced Allocation Cons: 1. They are the easy way out, so often no one (including the tax lawyers and the members of the LLC) stops to think through how income/losses will really be allocated. 2. The work and the risk is shifted from the lawyer during the drafting of the OA to the accountant who will prepare the K-1s. (In all honesty, even in perfectly drafted allocation provisions, there are usually situations that come up that the accountant has to think through that the drafters didn t anticipate or address.) 3. Practically, there is really no telling how the person actually doing the allocations is doing them and whether s/he really understands how the targeted allocation provision works. (Same is true, however, for layered allocations.) 34

35 Allocations with Respect to Built-In Gain or Loss Property If a member contributes assets with built-in appreciation or depreciation, special rules require that the built-in tax gain or loss (when it is eventually recognized by the LLC) be allocated back to the contributing partner. Again, keep in mind that this only relates to the allocations of gain and loss. The distributions of the proceeds from the sale of the property can be shared by the members in whatever manner they choose. 35

36 Allocations with Respect to Built-in Gain or Loss Property - Section 704(c) A B $100 cash Property with value of $100 and basis of $20 When the partnership eventually sells the property, the $80 of taxable gain must be allocated to B. Unlike with a corporation, B can t escape taxation on that just by contributing it to the LLC. If the property is sold for more than $100, then while the first $80 of gain must be allocated to B, the remainder of the economic gain (i.e., the post contribution gain) can be allocated in accordance with the parties agreement. 36

37 Allocations with Respect to Built-in Gain or Loss Property - Section 704(c) Another way to look at this is that the tax-basis shortfall (i.e., to the extent that the tax basis is less than the value upon contribution) must be borne by the contributing partner. The tax basis shortfall can be borne by the contributing partner either by having (i) the taxable gain on the sale being allocated to the contributing partner, (ii) the tax depreciation deductions being allocated away from the contributing partner to the noncontributing partner. 37

38 Nonrecourse Deductions & Minimum Gain Chargeback Provisions A special set of rules govern allocation of partnership deductions funded by nonrecourse debt. Without the special rule, these allocations could not have SEE because no members bears the economic burden of the losses associated with these since the lender is really the one whose capital is at stake (and not a member s). Example: A and B each contribute $100 to a LLC. LLC borrows $800 on a nonrecourse basis to buy a building for $1 million. Once the building was depreciated from $1000 to $800, A s and B s capital accounts would be zero. Any further allocations of depreciation would drive their capital accounts impermissibly negative but for the special nonrecourse deduction rules. 38

39 Nonrecourse Deductions & Minimum Gain Chargeback Provisions To address this situation, the regulations create the concept called partnership minimum gain to track deductions where a nonpartner lender is at risk for a partnership liability. Minimum gain is the amount by which the nonrecourse debt exceeds the basis in the property secured by the debt. (The debt will probably not start out as exceeding basis, but will get to that point when depreciation deductions are taken on the property, and eventually, the basis is below the debt encumbering the property.) The concept is that a nonrecourse deduction can be allocated to a partner to cause its capital account to be negative, even without a partner obligation to restore such negative capital account. The IRS allows this so long as there is a minimum gain chargeback. The idea is that when the property secured by the nonrecourse debt is disposed of, an amount of gain equal to the nonrecourse debt minus the basis will be charged back to those members that took the nonrecourse deductions. So, the IRS is protected overall. 39

40 Nonrecourse Deductions & Minimum Gain Chargeback Provisions Example: A and B each contribute $50k to an LLC LLC borrows an additional $900k on a non-recourse basis to acquire a $1 million building. Over the years, A and B take depreciation deductions of $500k ($250k each). Their capital accounts are decreased from $50k to negative $200. Of the $500k in deductions ($250k each), the first $100k ($50k each) are attributed to A s and B s contributed capital. The remaining $200k each of deductions is attributed to the nonrecourse debt. It is okay to allocate these deductions to A and B so long as the $400k of partnership minimum gain ($900k liability less $500k basis) is allocated also to A and B. The minimum gain will be triggered on the sale by the LLC of the building or if the lender forgives the loan. 40

41 Nonrecourse Deductions & Minimum Gain Chargeback Provisions A B Initial Capital Nonrecourse Deductions (250) (250) Net Capital (200) (200) Only the first $50 of the depreciation deductions can have substantial economic effect, since neither of the parties contributed money greater than that. However, since the partnership agreement contains a minimum gain chargeback provision, this means the partnership will keep track of its minimum gain ($900 nonrecourse debt less $500 book basis will mean $400 of minimum gain). And when the partnership minimum gain of $400 is recognized, each of A and B has agreed to recognize their share of $200 each. This minimum gain will support their negative capital account of $200, and prevent them from having Adjusted Capital Account Deficits. 41

42 Nonrecourse Deductions & Minimum Gain Chargeback Provisions If the partnership sells or otherwise disposes of the building, or if the creditor of the nonrecourse loan forgives all or a portion of the loan the minimum gain will be recognized and the chargeback will kick in. 42

43 Nonrecourse Deductions & Minimum Gain Chargeback Provisions The regulations create a parallel concept for nonrecourse debt loaned or guaranteed by a partner (i.e., partner nonrecourse debt ) except that those deductions and the related chargeback must be allocated to the lender/guarantor partner because that partner is indirectly at risk due to also being the lender/guarantor. In that case, the regulations use the terms partner minimum gain and partner minimum gain chargeback to have similar meanings to partnership minimum gain and partnership minimum gain chargeback. 43

44 Capital Shifts Why is it important? The IRS has historically successfully asserted that a shift in capital among partners produces a taxable event for the receiving partner (and in some cases, for the transferring partners too). See Lehman v. Commissioner, 19 T.C What is it? Capital shifts can take many forms, but a capital shift generally occurs when a member with a capital interest agrees to forgo part or all of its right to proceeds on liquidation of the LLC. As earlier discussed, one of the key concepts underlying partnership taxation is that the capital account balance represents what each partner is entitled to receive on the liquidation of a partnership, and thus, the capital account balance must represent the value of the partnership interest. 44

45 Capital shift simplest example A and B form a partnership. A contributes $0 and B contributes $100. The operating agreement says split the proceeds 50/50 on liquidation. There is a capital shift of $50 from B to A. This shift is immediate because the operating agreement says that on an immediate liquidation, A and B would share equally. (In other words, it isn t as if a hurdle has to be reached before this shift kicks in.) A B $100 On liquidation: A gets $50 B gets $50 45

46 Capital Shift Targeted/Forced Allocation With Preferred Return Ex: A & B form an LLC. A puts in $100, and B puts in $50. Distributions: (i) First, to A, until A gets preferred return ($10 for year 1); (ii) Then to return A s capital contributions; and (iii) Then to return B s capital contribution; and (iv) Thereafter, equally to A and B. A B $100 $50 The LLC earns $7 for year 1. If the LLC allocated in accordance with a layered approach, allocations would go something like this (1 st to A in an amount equal to A s preferred return; then, equally to A & B): A B Total Beginning Capital Account $100 $50 $150 Allocation of income $7 $0 $7 Ending Capital Account $107 $50 $157 So, on liquidation, this is the amount A and B would get. 46

47 Capital Shift Targeted/Forced Allocation With Preferred Return If on the other hand, there was a targeted allocation provision: Step 1: Starting capital account balances: A=$100 and B = $50 Step 2: Distributions on hypothetical liquidation - LLC has total of $157: A B Total Preferred Return $10 - $10 Return of A s Capital $100 - $100 Residual Returns B s Capital $47 $47 Total to be Distributed $110 $47 $147 So, on liquidation, this is the amount A and B would get. $3 of B s capital got shifted to A. 47

48 Capital Shift Targeted/Forced Allocation With Preferred Return So, the key difference is that in the case where there is not enough money to satisfy the preferred return priority, some of the capital will shift from B to A. What the parties probably really intended was that A gets a preferred return only if there is enough money in the LLC to satisfy the preferred return after the capital contributions of A and B are satisfied. The potential taxable income occurs when the shift occurs. So, if for years, there was enough to give the preferred return, and only at a certain point there was insufficient income, then that is when the capital shifted, and that is when the taxable income event would occur. The allocation is technically correct. But the distributions may not be what the parties intended. Maybe one way around this is to specify that the preferred return is to be paid to the extent there were sufficient net profits. 48

49 Capital Shift When Service Providers Receives a Capital Interest Another typical example: LLC with A and B as members wants to give C, an employee, an interest in the LLC. Suppose A and B formed it on 1/1/12 by contributing $10 each. On 1/1/13, the LLC is worth $150, and they want to bring in C, and give him a 1/3 interest. At this point, the capital acccounts of A and B should reflect a booked up balance of $75 each. If C gets a right to 1/3 or $50 upon entering, then $50 of capital shifted from A and B to C. A B -C s interest would have been tax-free if it had been a profits interest instead of this. -How do get it to be a profits interest? -Say distribution/liquidation section provides that after first $10 is returned to each of A and B, then everything is shared? 49

50 Capital Shift Forfeit Interest on Failure to Meet Capital Call A The members of this LLC have agreed that there will be regular capital calls; and that upon the failure of a member to meet a capital call, the member will forfeit a portion of his interest, and it will revert to the other members. Example: A has contributed $1,000. The LLC is worth $100,000. There is a capital call that A fails to meet. Let s assume A s capital account balance at that time is $1,000. Under the terms of the operating agreement, A is to forfeit all of this (typically, it ll probably be a portion). Upon the forfeiture, $1,000 of capital has shifted from A to the other members. 50

51 Capital shift Common examples When a service provider receives anything other than a pure profits interest in an LLC. When a non-compensatory option is exercise to acquire an interest in an LLC. When a preferred interest in an LLC converts to a common interest in an LLC at a point in time when the common was already entitled to some value. When someone a member forfeits his/her/its interest (perhaps because s/he or it couldn t meet a capital call) and their capital shifts to the account of other members. 51

52 Tax Consequences of Capital Shift In the context of compensatory capital shifts, it is pretty clear that the IRS will tax the capital shift to the recipient. In the case of the exercise of noncompensatory options, the IRS has issued proposed regulations that take the position there is no capital shift or resulting income. Outside these 2 contexts, however, there is relatively little law on the tax consequences of capital shifts. 52

53 Tax Consequences of Capital Shift Based on the limited case-law, the partnership tax regulations and the commentary, below is a summary of the approaches that may be taken: 1. There is current taxable income to the remaining partners in the amount of the capital that has shifted from the defaulting partners to them. 2. There is current taxable income to the remaining partners; however, the value of the current income should equal the fair market value of the forfeited interest of the defaulting partners; this may not necessarily be equal to the capital being shifted. Perhaps minority discounts and lack of marketability would make this lower. 3. Instead of accounting for the capital shift by reporting current income to the remaining partners, the partnership should do "catch-up" allocations of future losses of the partnership (gross, not net) to the defaulting partners and income to the remaining partners until such time as enough income has been allocated to the remaining partners. This approach seems like a reasonable one; though there isn't certainty that the IRS would agree with it. 4. Finally, some take the position that the IRS would be wrong in asserting that there should be current taxable income. Though not all the commentators supporting this view are able to clearly articulate the rationale for this, it appears to be based on either a bargain purchase theory, or along the lines of: When a partnership redeems the interest of a partner for less than his capital account balance, there isn't considered to be a capital shift or taxable income to the remaining partner. It should be noted that this position carries a good bit of risk with it, and it is not at all clear that the IRS would agree with this. 53

54 Additional Authorities/Sources Jonathan R. Flora, Venture Capital, Meet Capital Shift, The M&A Tax Report, February Kevin Thomason, The Myth of the Capital Shift, Journal of Passthrough Entities, September-October Robert P. Rothman, Translating Corporate Concepts into LLCs, 61 The Tax Lawyer 161 (2007). Linda Z. Swartz, A Layman s Guide to LLC Incentive Compensation, PLI s Tax planning for domestic & foreign partnerships, LLCs, joint ventures & other strategic alliances, Steven R. Schneider & Brian J. O Connor, Partnership and LLC Agreements Learning to Read and Write Again, Tax Notes, December 21, William G. Cavanagh, Targeted Allocations Hit the Spot, Tax Notes, October 4, L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, Journal of Business Entities, July/August

55 Tax Allocations in Partnerships and LLCs Strafford Publications April 3, 2013 JED A. ROHER One East Main Street Suite 500 Madison, WI

56 Agenda II. III. IV. Allocation of Contributed Property Allocation of Liabilities Distribution Rules 56

57 Allocations: Contributed Property Capital accounts are economic / book concepts - So, capital accounts are increased by fair market value of contributed property - And fair market value of property is reflected on the partnership s books But, basis is a tax concept - So, contributor s basis in partnership interest derived from basis in property - And partnership takes a basis in contributed property equal to contributor s basis 57

58 Allocations: Contributed Property Can create book / tax disparities A contributes property with a basis of $5,000, FMV of $25,000; B contributes $75,000 cash - Assume 5-year, straight line depreciation A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 58

59 Allocations: Contributed Property The Code s answer: 704(c)(1)(A) - income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of the contribution - The purpose of section 704(c) is to prevent the shifting of tax consequences among partners with respect to precontribution gain or loss. Treas. Reg (a)(1) 59

60 Allocations: Contributed Property Goal is to bring book and tax into harmony using a reasonable method that is consistent with the purpose of section 704(c). Treas. Reg (a)(1). 704(c) allocation rules apply on a property-byproperty basis. Can choose different methods for different properties. Treas. Reg (a)(2). Subject to an anti-abuse rule if allocations aimed at reducing aggregate tax liability 60

61 Allocations: Contributed Property Regulations detail three methods: - traditional (Treas. Reg (b)); - traditional with curative allocations (Treas. Reg (c)); - remedial ((Treas. Reg (d)) 61

62 Allocations: Contributed Property Traditional method: - Tax allocations follow book allocations - But total income, gain, loss or deduction allocated to the partners in a taxable year with respect to a property cannot exceed the total partnership income, gain, loss or deduction with respect to that property in that year This is the ceiling rule 62

63 Allocations: Contributed Property Traditional method: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 Y1 Depreciation 0 (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 63

64 Allocations: Contributed Property Traditional method with curative allocations: - Goal is to correct distortions caused by ceiling rule - Tax allocations follow book allocations, but partnership can use tax allocations from other property to mitigate effect of ceiling rule - Tax allocations from other property must be expected to have same effect on partners tax liability as tax item limited by ceiling rule 64

65 Allocations: Contributed Property Traditional method with curative allocations: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 Y1 Depreciation (A asset) 0 (1,250) (1,000) (3,750) (1,000) (5,000) Y1 Depreciation (bought asset) (1,000) (3,750) (14,000) (11,250) (15,000) (15,000) Capital Accounts After Y1 4,000 20,000 60,000 60,000 64,000 80,000 65

66 Allocations: Contributed Property Remedial method: - Goal is to eliminate distortions caused by ceiling rule - Partnership creates phantom tax items to allocate among the partners 66

67 Allocations: Contributed Property Remedial method: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 Y1 Depreciation 0 (1,250) (1,000) (3,750) (1,000) (5,000) Y1 Remedial Allocations 2,750 0 (2,750) Capital Accounts After Y1 7,750 23,750 71,250 71,250 79,000 95,000 67

68 Allocations: Contributed Property We have been talking about operating allocations with respect to property On the sale of property, the basic rule is that built-in gain or loss remaining in property on sale is allocated to contributing partner 68

69 Allocations: Contributed Property Sale of property: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 Sale for $25,000 20, ,000 0 Capital Accounts After Sale 25,000 25,000 75,000 75, , ,000 69

70 Allocations: Contributed Property Sale of property after 1 year: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 Y1 Depreciation 0 (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 Sale for $20,000 16, ,000 0 Capital Accounts After Sale 21,000 23,750 74,000 71,250 95,000 95,000 70

71 Allocations: Contributed Property Sale of property after 1 year: A (25 Units) B (75 Units) Total Tax Book Tax Book Tax Book Capital Contribution 5,000 25,000 75,000 75,000 80, ,000 Y1 Depreciation 0 (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 Sale for $25,000 16, , ,250 1,250 3,750 3,750 5,000 5,000 Capital Accounts After Sale 22,250 25,000 77,750 75, , ,000 71

72 Allocations: Contributed Property Mixing Bowl rules: Section 704(c)(1)(B) / Treas. Reg If property contributed by 1 partner is distributed to a different partner within 7 years of contribution, built-in gain or loss is allocated to contributing partner 72

73 Allocations: Contributed Property Partner 1 3. Allocation of built-in gain to Partner 1 Partner 2 1. Contribution of appreciated property 2. Distribution of property w/in 7 years 704(c)(1)(B) 73

74 Allocations: Contributed Property Reverse Mixing Bowl rules: Section 737(a) / Treas. Reg If partner contributes property with built-in gain, and receives a distribution of other property within 7 years of contribution, contributing partner recognizes lesser of (i) excess of value of distributed property over partner s outside basis, or (ii) amount that would have been recognized by partner under the mixing bowl rules w/r/t all property contributed by partner 74

75 Allocations: Contributed Property Partner 1 1. Contribution of appreciated property 2. Distribution of other property w/in 7 years 3. Allocation of built-in gain in properties contributed by Partner 1 to Partner 1 737(a) 75

76 Allocations: Contributed Property And watch out for the disguised sale rules of 707(a)(2)(B)! If: - direct or indirect transfer of money or other property by a partner to a partnership, - related direct or indirect transfer of money or other property by partnership to contributing partner or another partner, and - transfers properly characterized as a sale, Then transaction treated as sale of property 76

77 Agenda II. III. IV. Allocation of Contributed Property Allocation of Liabilities Distribution Rules 77

78 Allocation of Liabilities Increase in share of partner s liabilities treated as a contribution of money by the partner to the partnership. Decrease in share of partner s liabilities treated as a distribution of money by the partnership to the partner. - Any decrease in partner s liabilities as a result of a sale or exchange of the partner s interest in the partnership treated as an amount realized under

79 Allocation of Liabilities Two types of liabilities: - Recourse: liabilities for which a partner bears the economic risk of loss under Treas. Reg Nonrecourse: liabilities for which no partner bears the economic risk of loss 79

80 Allocation of Liabilities Economic risk of loss : - Driven by obligation of a partner to make a payment to any person if the partnership constructively liquidates - Paying partner must not have any right of reimbursement from any other partner Obligation can be derived from contractual obligations outside of partnership (guarantees, etc.) or from partnership agreement (capital contribution obligation, DRO) 80

81 Allocation of Liabilities Recourse liabilities are allocated among the partners that bear the economic risk of loss for those liabilities, to extent of economic risk. Nonrecourse liabilities are allocated among all of the partners. Each partner is allocated: - Partner s share of partnership minimum gain, + - Partner s share of 704(c) gain for property subject to nonrecourse liabilities, + - Partner s allocable share of any remaining nonrecourse liabilities, based on share of profits 81

82 Agenda II. III. IV. Allocation of Contributed Property Allocation of Liabilities Distribution Rules 82

83 Distribution Rules Distributions by a partnership to a partner generally trigger gain only if any money distributed exceeds the partner s adjusted basis in the partner s interest in the partnership. 737(a)(1) Any gain on distribution is treated as gain from the sale or exchange of the distributee partner s partnership interest 83

84 Distribution Rules First, partner s basis in partnership interest is reduced (but not below zero) by amount of cash distributed. - If basis is insufficient to soak up cash, gain to extent of excess Second, partner s remaining basis becomes the basis of any non-cash property distributed to the partner 84

85 Distribution Rules If more than one property / type of property is distributed, remaining basis goes: - first to any distributed unrealized receivables and inventory items, to the extent of the partnership s basis in those items; - second to any other property distributed (first to depreciated property, then to all property in proportion to inside basis) 85

86 Distribution Rules If distribution operates to increase or decrease a partner s share of partnership hot assets (unrealized receivables or substantially appreciated inventory) in exchange for a decrease or increase in the partner s share of other partnership property, distribution is treated as a sale or exchange. 751(b). - Trap for the unwary: admission of new partner reduces existing partners share of nonrecourse liabilities; deemed cash distribution / reduction in hot assets; 751(b) applies. Rev. Rul

87 Lynn E Fowler Kilpatrick, Townsend & Stockton LLP 1100 Peachtree Street, Suite 2800 Atlanta, Georgia Lfowler@kilpatricktownsend.com V. ADJUSTMENTS TO BASIS OF PARTNERSHIP/LLC ASSETS

88 Base Case ASSETS LIABILITIES/ CAPITAL TAX/BOOK FMV TAX/BOOK FMV Cash Liabilities Blackacre A Capital B Capital C Capital Total Total P allocates profits and losses 1/3 to each of A, B and C 88