Basic Concepts. Basic Concepts. Basic Steps Layer Cake Allocations. Drafting Partnership & LLC Agreements

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1 asic Concepts Drafting Partnership & LLC greements Layer Cake llocation asic concept is to allocate 704(b) book profit/loss first and use this allocation to determine the cash distributions. Targeted llocations asic concept is to allocate profit/loss so that, at the end of the taxable year, each partner s capital account is equal to: the amount that would be distributed to that partner in liquidation if all partnership assets were sold at their 704(b) book value, less the partner s share of minimum gain. 2 asic Concepts Layer Cake vs. Target & 704(b) Safe Harbors s a technical matter, liquidation with 704(b) capital accounts (often referred to as a safe harbor agreement) can occur with either a Layer Cake or a Target allocation. s a matter of practice, most Target allocations instead liquidate with the cash waterfall in which they target the income and most layer cake liquidate with positive 704(b) capital accounts. It is possible to use Target allocations to target capital accounts to equal the cash waterfall, but instead liquidate with capital accounts. The risk is that if the capital accounts do not equal the waterfall, the capital accounts govern the economics. asic Steps Layer Cake llocations Profit allocations Reverse prior losses Preferred return Residual sharing ratio Loss allocations Reverse prior profits (in reverse order) Residual sharing ratio djust capital accounts for contributions, distributions, and allocations Liquidate with positive capital accounts 3 4 1

2 asic Steps Targeted llocations Calculate Cash Waterfall Target Preferred return Preferred capital Common capital Profit/Loss allocations to bring adjusted capital account to equal Target djust the capital accounts for distributions Generally liquidate with cash waterfall, but can liquidate with positive capital accounts 3 Steps to Target llocations Step 1 Determine Partially djusted Capital ccount (adjust beginning of year capital for current year contributions and distributions) Step 2 Determine Target Capital ccount (based on distribution waterfall at book value) (a) Net value in partnership up on deemed liquidation: (b) Run value through distribution waterfall Step 3 llocate Profit for Loss to bring Partially djusted Capital ccounts to Target Capital ccount. 5 6 Example 1 Net Income in Excess of Preference LLC Year 1 Income = $50,000 10% preferred to, residual =40%, =60% eginning alance Sheet ssets Liabilities Cash: $200,000 Capital : : Total $200,000 Total: $200,000 7 Capital-ccount ased Liquidation Layer Cake llocations (cont d) 2. 40:60 and Total Income Ending Capital Section 704(b) Income llocations Opening Capital $50,000 Income 1. 10% pref to. $10,000 $16,000 $26,000 $126,000 $24,000 $24,000 $124,

3 Capital-ccount ased Liquidation Targeted llocations (cont d) Opening Capital djustments during year Partially adjusted cap acct Section 704(b) Income llocations 0 0 Example 2 Net Income Less than Preference eginning alance Sheet ssets Liabilities Cash: $200,000 Determine Cash Waterfall $250,000 Cash 1. 10% pref to. 2. Return original capital 3. 40:60 and $10,000 $16,000 $24,000 LLC Capital : : Total $200,000 Total: $200,000 Ending Target Capital $126,000 $124,000 Year 1 Income = $8,000 Income llocation $26,000 $24,000 10% preferred to, residual =40%, =60% 9 10 Capital-ccount ased Liquidation Targeted llocations (cont d) Section 704(b) Income llocations Opening Capital djustments during year 0 0 Partially adjusted cap acct Determine Cash Waterfall $208,000 Cash 1. 10% pref to. $10, Return original capital $99,000 $99, :60 and $ $ Ending Target Capital $109,000 $99,000 Target Income llocation $9,000 ($1,000) Net Income llocation $8, Shortfall (Gpmt?) $1,000 ($1,000) Capital-ccount ased Liquidation Layer Cake llocations (cont d) $8,000 Income 2. 40:60 and Total Income Ending Capital Section 704(b) Income llocations Opening Capital 1. 10% pref to. $8,000 $ $8,000 $108,000 $ 12 3

4 Comparison of Examples 1 and 2 Example 1 Target/waterfall Example 2 Target/waterfall Ending Cash Received by and Layer Cake/cap acct Layer Cake/cap acct $126,000 $126,000 $109,000 $108,000 $124,000 $124,000 $99,000 Maryland ssociation of CPs, Inc dvanced Tax Institute / Target llocations November 1-5, 2010 Substantial Economic Effect / Partner s Interest in the Partnership 13 llocation Provision 1 Not So Great llocation Provision 2 Not So Great ut etter Than llocation Provision 1 t the end of each Fiscal Year, the Company shall allocate all of its taxable income or loss for such Fiscal Year in a manner such that, after such allocations have been made, the balance of each Member s Capital ccount shall, to the extent possible, be equal to an amount that would be distributed to such Member if the Company were to sell all of its assets and distribute the proceeds of such sale in accordance with [THE DISTRIUTION PROVISION] of this greement. t the end of each Fiscal Year, the Company shall allocate all of its Net Profit and Net Loss for such Fiscal Year in a manner such that, after such allocations have been made, the balance of each Member s Capital ccount shall, to the extent possible, be equal to an amount that would be distributed to such Member if the Company were to sell all of its assets and distribute the proceeds of such sale in accordance with [THE DISTRIUTION PROVISION] of this greement. Definition: Net Profit and Net Loss is defined as book income or loss as determined under Treas. Reg (b)(2)(iv)

5 llocation Provision 3 - etter llocation Provision 3 etter (cont d.) t the end of each Fiscal Year, the Company shall allocate all of its Net Profit and Net Loss for such Fiscal Year in a manner such that, after such allocations have been made, the balance of each Member s Capital ccount shall, to the extent possible, be equal to an amount that would be distributed to such Member if (a) the Company were to sell the assets of the Company for their Gross sset Values, (b) all Company liabilities were satisfied (limited with respect to each nonrecourse liability to the Gross sset Values of the assets securing such liability), (c) the Company were to distribute the proceeds of sale pursuant to [THE DISTRIUTION PROVISION] nd (d) the Company were to dissolve pursuant to [THE LIQUIDTION PROVISION], minus such Member s share of Company Minimum Gain or Member Minimum Gain, computed immediately prior to the hypothetical sale of assets. Definitions: Gross sset Value, Company Minimum Gain and Member Minimum Gain follow the Treasury Regulations definitions llocation Provision 4 etter Than the Rest, ut Not For Everyone Except as otherwise provided in [THE REGULTORY LLOCTIONS PROVISION], and after adjusting for all Capital Contributions and Distributions made during such Fiscal Year, Net Income and Net Loss (and, if necessary, individual items of gross income or loss) shall be allocated annually (and at such other times as the Management Committee determines), the Company shall allocate all of its Net Profit and Net Loss for such Fiscal Year in a manner such that, after such allocations have been made, the balance of each Member s Capital ccount shall, to the extent possible, be equal to an amount that would be distributed to such Member if (a) the Company were to sell the assets of the Company for their Gross sset Values, (b) 19 llocation Provision 4 etter Than the Rest, ut Not For Everyone (cont d.) all Company liabilities were satisfied (limited with respect to each nonrecourse liability to the Gross sset Values of the assets securing such liability), (c) the Company were to distribute the proceeds of sale pursuant to [THE DISTRIUTION PROVISION] and (d) the Company were to dissolve pursuant to [THE LIQUIDTION PROVISION], minus the sum of (1) such Member s share of Company Minimum Gain or Member Minimum Gain, and (2) the amount, if any, that such Member is obligated (or deemed obligated) to contribute, in its capacity as a Member, to the Company; computed immediately prior to the hypothetical sale of assets. 20 5

6 * * * Pursuant to requirements relating to practice before the Internal Revenue Service, any tax advice in this communication (including any attachments) is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related matter. Speakers: Todd D. Golub aker & McKenzie LLP One Prudential Plaza 130 East Randolph Drive Chicago, Illinois tel: (312) todd.golub@bakermckenzie.com rian J. O Connor Venable LLP 750 East Pratt Street Suite 900 altimore, Maryland tel: (410) bjoconnor@venable.com Section 704(c) vailable Methods Contributed Property Section 704(c) Traditional method. Traditional method with curative allocations. Remedial method. Other reasonable methods. 24 6

7 Traditional Method Operative Rule Tax follows book Noncontributing partner receives tax allocations equal to its share of book items Contributing partner receives residual tax allocations. Ceiling limitation If insufficient tax items, noncontributing partners may not receive tax allocations equal to their share of book items. pplies to gain or loss from sale of property and to depreciation and/or amortization; generally, does not apply to income from the Section 704(c) property. Five Step pproach Ste One: Compute tax item Step Two: Compute book item Step Three: llocate book item Step Four: llocate tax to noncontributing partner to the extent of its share of the book item Step Five: llocate residual tax, if any, to contributing/section 704(c) partner ase Example! Traditional Method Cash $200 Equipment Land FMV $ T $50 80 Operative Rule Tax follows book. Noncontributing partner receives tax allocations equal to its share of book items. Contributing partner receives residual tax allocations. Ceiling limitation. If insufficient tax items, noncontributing partners may not receive tax allocations equal to their share of book items. pplies to gain or loss from sale of property and to depreciation and/or amortization; generally, does not apply to income from the Section 704(c) property. Total $200 $130 Land and Equipment are both Section 704(c) property. Land (non-depreciable) book/tax difference accounted for upon disposition. Equipment book/tax difference accounted for through tax allocations of depreciation and gain/loss on disposition. is contributing partner and is noncontributing partner. ook depreciation allocated

8 Example 2. Traditional Method llocating Depreciation Step One: Compute annual tax depreciation $50/4 - $12.5 Step Two: Compute annual book depreciation $12.5/$50 x $100 - $25 Step Three: llocate book depreciation (50/50) Step Four: llocate tax depreciation to (noncontributing partner) to extent of book Step Five: llocate residual tax depreciation (if any) to as contributing partner Remaining tax life on Equipment: 4 years Equipment FMV=100 T=50 50% 50% Cash FMV=200 T=200 Land FMV=100 T=80 Example 2. Traditional Method llocating Gain on Sale Step One: Compute tax gain $100- $50 = $50 Step Two: Compute book gain $100 - $100 = Step Three: llocate book gain (50/50) Step Four: llocate tax gain to (noncontributing partner) to extent of book Step Five: llocate residual tax gain (if any) to as contributing partner Equipment FMV=100 T=50 50% 50% Cash FMV=200 T=200 Land FMV=100 T=80 Partnership ook Tax (50%) ook Tax (50%) ook Tax Partnership ook Tax (50%) ook Tax Sells Equipment for $100 (50%) ook Tax $25.0 $12.5 $12.5 $12.5 $ $ $ Ceiling Rule The Rule: Total income, gain, loss or deduction allocated to noncontributing partners with respect to contributed property may not exceed total partnership income, gain, loss or deduction recognized by partnership with respect to that property for the taxable year (the ceiling rule). Impact: To the extent that tax items allocated to a noncontributing partner fall short of matching book items allocated to it, a portion of the built-in gain or loss is shifted to such partner. General Rules for Planning Which Method est for You Generally, methods will only differ if ceiling rule will apply otherwise reach same result using traditional method. Note that the remedial method is available even if there is not a current ceiling limitation as a protective measure for ceiling limited sale. If you are property contributor Negotiate for traditional method (with potential for shifting tax consequences to money partner). Don t want curatives - too fast burn-off of built-in gain with phantom income allocated to property contributor. Compromise on remedials. Especially if big book-up and long lives. Stretches out realization of built-in gain. 31 (continued on next slide) 32 8

9 General Rules for Planning (cont d) Which Method est for you If you are cash contributor Negotiate for curatives (if adequate items) - Fastest expensing of investment. Especially if short remaining recovery cycle. Don t want traditional method with exposure for shifting tax consequences. Compromise on remedials. Special considerations if section 197 anti-churning applies. How to dopt a Method Except for two provisions, neither the Code nor the Treasury Regulations specify how to adopt a Section 704(c) method. Treas. Reg (c)(3)(iii)() states that the general limitation on character applied to curatives does not apply to the disposition of property subject to the ceiling rule if provided for in the partnership agreement. Treas. Reg (c)(3)(ii) states that the partnership agreement in effect for the year of contribution must provide for curative allocations in a taxable year to offset the effect of the ceiling rule for a prior taxable year. Remember mix and match rules (e.g., different methods allowed for different property and Section 704(c) layers, consistency required)