25th Annual Health Sciences Tax Conference

Transcription

1 25th Annual Health Sciences Tax Conference Partnerships and joint ventures (JVs): Mergers and acquisitions (M&A), current developments, and JVs with exempt organizations December 9, 2015

2 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. This presentation is 2015 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP. This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Page 2

3 Presenters Dan Jensen HCA Nashville, TN Dave Courtney Ardent Health Services Nashville, TN David Miller Ernst & Young LLP Dallas, TX Eric J. Matuszak Ernst & Young LLP Los Angeles, CA Page 3

4 Agenda M&A topics Mixing bowl trap Disregarded entities disappearing liability trap Preferred returns and guaranteed payments Unlocking value Up-C structure Unlocking real estate value real estate investment trust (REIT) conversions Current developments Notice New partnership audit and adjustment rules JVs with exempt organizations Page 4

5 M&A topics Page 5

6 Mixing bowl trap Page 6

7 Mixing bowl rules General rule The mixing bowl rules generally require a partner that contributes built-in gain property to a partnership to recognize gain if, within seven years of the contribution, either: Section 704(c)(1)(B) the contributed property is distributed to another partner, Or Section 737 other property is distributed to the contributing partner Amount of gain Section 704(c)(1)(B) the remaining unrecognized Section 704(c) gain in the contributed property i.e., gain that would have been allocated to the contributor pursuant to Section 704(c) if the contributed property had been sold for its fair market value as of the time of the distribution Section 737 the lesser of (1) the remaining unrecognized Section 704(c) gain in the contributed property or (2) the excess of the fair market value of the distributed property over the adjusted basis of the contributing partner s partnership interest In both cases, the gain recognized burns off over time in the case of depreciable Section 704(c) property (as the Section 704(c) gain burns off) Page 7

8 Mixing bowl transactions Section 704(c)(1)(B) Section 737 TP Partner TP Partner LLC LLC Page 8

9 Mixing bowl exceptions Section 704(c)(1)(B) exceptions Certain liquidations Section 704(c) property is distributed to the non-contributor in liquidation of the partnership and (1) in the liquidation, the contributing partner receives an interest in the contributed Section 704(c) property and no other property; and (2) the built-in gain or loss in the property after the distribution is at least equal to the built-in gain or loss that would have been allocated to the contributing partner on a sale of the property immediately before the distribution Page 9

10 Mixing bowl exceptions Section 737 exception Certain divisions Transfer by a partnership (transferor partnership) of all of the contributing partner s Section 704(c) property to a second partnership (transferee partnership) in a Section 721 transaction, followed by a distribution of an interest in the transferee partnership (and no other property) in complete liquidation of the interest of the contributing partner Previously contributed property Property distributed to the contributing partner consists of previously contributed property Certain exceptions to the exception for distributions of interests in previously contributed entities Page 10

11 Mixing bowl exceptions Dual exceptions Technical terminations Complete transfers to another partnership A transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in Section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement Incorporation of a partnership Like-kind property Undivided interest A distribution of an undivided interest in property that does not exceed the undivided interest contributed by the distributee partner Page 11

12 Mixing bowl trap example 1 TP Partner Taxpayer (TP) and Partner each contributed an operating business to LLC on Day 1 The venture has not worked out well and TP and Partner would like to liquidate LLC (with each taking back the business it contributed) Operating assets LLC Operating assets Do any of the mixing bowl exceptions apply? What if LLC has new furniture, fixtures and equipment (FF&E), other purchased assets, etc.? Are the existing intangibles associated with the businesses the same intangibles each partner originally contributed? Page 12

13 Mixing bowl trap example 2 TP Partner Asset 1 $ LLC TP contributes Asset 1 (land) and Partner contributes cash to LLC on Day 1 The plan to develop the land falls apart, and TP and Partner would like to unwind LLC LLC is liquidated; TP receives an undivided interest in the land it contributed, and Partner receives an undivided interest in the land plus all other assets of LLC Do any mixing bowl exceptions apply to the distribution of an undivided interest in the land to Partner? Page 13

14 Mixing bowl trap example 3 TP Partner TP and Partner each contribute units in existing partnership (PS) to LLC on Day 1 The partners disagree as to whether to later sell the interests in PS Third Party Asset 1 $ PS LLC PS units Can the partners agree to have LLC sell PS units on behalf of one partner and allocate the gain solely to that partner? If not, can LLC distribute PS units back to the partners without triggering gain under the mixing bowl rules? Is whether LLC made subsequent contributions to PS relevant? Page 14

15 Disregarded entities disappearing liability trap Page 15

16 Disappearing liability trap TP LLC units $ Investor Deemed liquidation of a partnership TP has an outstanding loan to LLC and purchases Investor s interests in LLC for cash Loan by TP to LLC = $40 LLC Under Rev. Rul. 99-6, LLC is deemed to liquidate with TP deemed to receive a portion of LLC s assets in a liquidating distribution Even though the loan remains in existence for state law purposes, it disappears for federal tax purposes when the borrower (LLC) becomes a disregarded entity of the lender (TP) Assets Is LLC deemed to distribute a portion of its assets in satisfaction of the loan in a taxable transaction? If so, what if some assets trigger gains and others trigger losses? Is the loan deemed discharged in a manner that triggers cancellation of debt income (CODI)? Is the loan deemed discharged without any tax consequences? Page 16

17 Preferred returns and guaranteed payments Page 17

18 Overview In a typical fund structure (real estate, private equity, etc.) investors contribute capital in exchange for an interest that entitles such investor to both a common and a preferred return. In a given year, the character of the preferred return income can vary depending on whether the payment is considered to be a distributive share of partnership income or a guaranteed payment under Section 707(c). Page 18

19 Section 707(c) Section 707(c) states: To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for purposes of Section 61(a) (relating to gross income) and, subject to Section 263, for purposes of Section 162(a) (relating to trade or business expenses). Page 19

20 Section 707(c) regulation example Under an existing regulation example, a partner entitled to receive the greater of a percentage of partnership income or a specified amount is treated as receiving a guaranteed payment only to the extent the allocated share is less than the minimum amount. For example, if a partner is to receive the greater of $10,000 or 20% of partnership income (determined without regard to the payment) and the partnership reports $20,000 of income for the year, the partner would be entitled to $10,000. Under the existing regulations, $4,000 of the payment (20% of $20,000) would be characterized as an allocable share of income and $6,000 would be treated as a guaranteed payment under Section 707(c). Page 20

21 Section 707(c) regulation example A proposed regulation package would modify the current regulation example to state that the entire minimum amount ($10,000) is to be treated as a guaranteed payment in light of the fact that the minimum amount is not subject to significant entrepreneurial risk. Page 21

22 Example A B A contributes $20 of cash in exchange for a 20% common interest and B contributes $80 of cash in exchange for a 10% preferred return and an 80% common interest 20% 80% Is any of B s $8 preferred return a guaranteed payment if PRS: $20 PRS $80 Earns $0 of net and gross income in Year 1 (i.e., PRS owns as its sole asset stock of a subsidiary corporation that doesn t pay a dividend)? Loses $100 of net income in Year 1 (made up of $100 of gross income and $200 of expenses)? If not, must PRS allocate $100 of gross income to B under Section 704(b)? Page 22

23 Unlocking value Up-C structure Page 23

24 Representative traditional IPO transaction steps Step 1: Legacy Owners contribute property to newly formed C corporation (PubCo) Legacy Owners Public Step 2: PubCo issues common stock to the Public in an initial public offering (IPO) for cash PubCo Result: PubCo takes a carryover basis in the assets contributed by the Legacy Owners Page 24

25 Representative formation transaction steps Legacy Owners Public Step 1: Legacy Owners acquire high vote stock (golden shares) in a newly formed C corporation (PubCo) Class B Class A Step 2: PubCo issues regular common stock to the Public in an IPO for cash PubCo LP GP OpCo Business Step 3: Legacy Owners contribute Business and PubCo contributes cash to partnership (OpCo) PubCo holds the managing interest in OpCo Legacy Owners units in OpCo are exchangeable for stock in PubCo on a one-for-one basis PubCo will take a fair market value basis in those units upon a later exchange resulting in a step-up in tax basis Page 25

26 Benefits of the Up-C structure Raise equity capital through a well-accepted public vehicle Take advantage of public multiples Preserves single level of tax for legacy owners Potential for tax-efficient monetization for legacy owners Exchange rights provide liquidity to legacy owners Creates two types of acquisition currency Tax-efficient management incentives through profits interests Tax receivable agreement (TRA) increases return to legacy owners as compared to traditional IPO structures Page 26

27 Tax receivable agreement Up-C structure provides PubCo with a step-up in the tax basis of its share of the partnership s assets upon legacy owners exchange of units (in contrast to a traditional IPO) PubCo and legacy owners share the benefit of the step-up (generally 85% to the legacy owners and 15% to PubCo) TRA payments typically made in cash and are treated as additional purchase price paid by PubCo for units in OpCo (and interest) TRA provides legacy owners with additional cash payments as compared to a traditional IPO Market does not appear to view presence of the TRA negatively Different types of basis adjustments may or may not be covered under the TRA Anti-churning considerations Page 27

28 TRA simple example Year PubCo amortization PubCo cash tax savings TRA payment to legacy owners Net cash savings to PubCo 1 $ 6.67 $ 2.67 $ 2.27 $ Total $ $ $ $ 6.00 Nominal value to legacy owners $34.00 Net present value to legacy owners $19.40 Assumptions Step-up delivered to PubCo: $100 PubCo effective tax rate: 40% TRA payment ratio: 85% to legacy owners Discount rate for net present value: 8% Step-up allocated entirely to intangible assets amortizable over 15 years PubCo has sufficient taxable income to utilize amortization as generated Iterative effect of TRA payments on basis step-up and interest payments are ignored for this calculation Page 28

29 Unlocking real estate value REIT conversions Page 29

30 REIT introduction REITs generally provide greater access to capital for real estate oriented businesses than other structures. The listed REIT sector is well established. REITs (particularly umbrella partnership real estate investment trusts (UPREITs)) have significant advantages in structuring future property acquisitions because they generally can offer a mix of consideration (i.e., cash, REIT stock and/or operating partnership (OP) units) tailored to each particular seller s business needs. REITs minimize their corporate tax expense (relative to a C corporation) via dividends paid deductions (DPDs). To qualify for REIT tax treatment, among other requirements, the REIT s assets must primarily consist of real estate and its income must primarily consist of rents or interest on loans secured by real estate. Page 30

31 OpCo-PropCo REIT conversions A handful of high-profile businesses in a variety of industries have recently separated or announced plans to separate their real estate assets into a REIT that leases (or will lease) the real estate to the operating business. Penn National Gaming (Gaming and Leisure Properties, Inc.) Windstream (Communications Sales & Leasing, Inc.) Ensign Group (CareTrust) Darden (Four Corners Property Trust) Energy Future Holdings Many of these transactions were structured as tax-free spin-offs under Section 355 and were completed after receiving a private letter ruling from the Internal Revenue Service (IRS). The IRS has recently announced that it generally will no longer entertain private letter ruling requests involving spin-off transactions in which the distributing or controlled corporation elects to be a REIT. Page 31

32 Activity in the health care space The long-term trend of separating health care real estate (e.g., medical office, lab space, senior housing, skilled nursing) is broadening to the hospital sector examples include Medical Properties Trust/Capella Healthcare and Ventas/Ardent Health Services. Although the capital advantages of major players (e.g., Ventas, HCP, Welltower, Omega) have moderated in recent months, we continue to see significant appetite among the listed REITs and private equity players for health care assets. Notwithstanding the activity in the area, many providers in the hospital sector are concerned about the impact of a transaction with a REIT on their ability to control the real estate. Page 32

33 UPREIT IPO alternative to Section 355 spin-off Public 1 $ Instead of spinning off its real estate into a REIT in a Section 355 transaction, OpCo transfers its real estate using a partnership structure: Step (1): Newly formed REIT issues stock in an IPO OpCo Operating assets Real estate Real estate 2B 3 Lease REIT OP 2A $ Step (2A): REIT contributes its IPO proceeds to OP, a partnership, in exchange for OP units Step (2B): OpCo contributes its real estate to OP in exchange for OP units OP units are generally exchangeable for REIT stock OpCo s contribution can be combined with certain disguised sale planning techniques e.g., assumption of OpCo liabilities, reimbursement of capital expenditures Step (3): OP leases real estate to OpCo See, for example, MGM and CyrusOne Page 33

34 UPREIT IPO alternative to Section 355 spin-off Public OpCo REIT Operating assets Lease OP Real estate Page 34

35 Current developments Page 35

36 Notice Page 36

37 Notice overview Treasury and the IRS announced the intent to issue regulations under: Section 721(c) providing that Section 721(a) will not apply when a US transferor contributes Section 721(c) Property to a Section 721(c) Partnership, unless the Gain Deferral Method is applied with respect to such Section 721(c) Property Sections 482 and 6662 are applicable to controlled transactions involving partnerships to ensure the appropriate valuation of such transactions Regulations under Section 721(c) will apply to transfers occurring on or after August 6, 2015 Section 721(c) Property Built-in gain (BIG) property, subject to certain exclusions Section 721(c) Partnership Domestic or foreign partnership if: (1) one or more foreign persons related to the US transferor is a direct or indirect partner in the partnership; and (2) the US transferor and related persons own more than 50% of the interests in partnership capital, profits, deductions or losses Page 37

38 Notice Gain Deferral Method Remedial allocation method Partnership adopts the remedial allocation method with respect to all Section 721(c) Property contributed by US transferors Proportionate allocation In each taxable year in which there is remaining BIG on the Section 721(c) Property, all items of Section 704(b) income, gain, loss and deduction with respect to such property are allocated in the same proportion Reporting requirements The reporting requirements under Sections 6038, 6038B and 6046A are satisfied Page 38

39 Notice Gain Deferral Method Acceleration event US transferor recognizes BIG with respect to any item of Section 721(c) Property upon an Acceleration Event An Acceleration Event is any transaction that either would reduce the amount of remaining BIG that a US transferor would recognize under the Gain Deferral Method, or could defer the recognition of BIG. Subsequent contributions The Gain Deferral Method is applied to all subsequent contributions until the earlier of: (i) when no BIG remains on any Section 721(c) Property to which the Gain Deferral Method first applied; or (ii) 60 months after the initial contribution to which the Gain Deferral Method applied Page 39

40 New partnership audit and adjustment rules Page 40

41 Bipartisan Budget Act of 2015 As part of the Bipartisan Budget Act of 2015, Congress made significant changes to the partnership audit and adjustment rules. The legislation replaces the Tax Equity and Fiscal Responsibility Act of 1982 partnership audit rules (Sections 6221 through 6234). The legislation repeals the special rules for electing large partnerships (Sections 771 through 777 and Sections 6240 through 6255). The new rules are designed to collect adjustments from the partnership rather than from the partners. The new rules would apply to partnership returns filed for tax years beginning after December 31, Page 41

42 New Section 6221 New Section 6221 provides that: Any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership taxable year (and any partner s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax or additional amount that relates to an adjustment to any such item or share shall be determined at the partnership level. Certain partnerships with 100 or fewer partners can elect out of new Section Page 42

43 Other changes Underpayments collected from partnerships: For adjustments that result in tax underpayments, new Section 6225 allows the IRS to collect the additional tax directly from the partnership in the year of an adjustment. The tax can be collected at the highest individual tax rate. If the partnership elects, any imputed underpayment of tax by the partnership can be taken into account and paid by the partners if certain conditions and procedures are satisfied. Page 43

44 Other changes Partnership representative New Section 6223 requires partnerships to designate a partnership representative who shall have the sole authority to act on behalf of the partnership in this subchapter. The partnerships and all partners will be bound by the actions of the partnership and by any final decision in a proceeding with respect to the partnership. Page 44

45 JVs with exempt organizations Page 45

46 Impact on exempt organization status Participation in a JV may cause an exempt organization to lose its exempt status. See Redlands Surgical Services v. Comm r, 113 T.C. 47 (1999) Exempt organizations may participate in a JV without losing their exempt status in certain situations. Rev. Rul An exempt organization may form and participate in a partnership or LLC provided: 1. The participation furthers a charitable purpose. 2. The arrangement permits the exempt organization to act exclusively in furtherance of its exempt purpose and only incidentally for the benefit of the for-profit partners or LLC members. 3. If a management contract is entered into, the exempt organization retains ultimate authority over the assets and activities being managed and the terms and conditions of the contract are reasonable. Page 46

47 Impact on exempt organization unrelated business taxable income (UBTI) When an exempt organization is a partner in a JV, that exempt partner may recognize and pay tax on UBTI. UBTI may result from many sources, including: Dealer sales by the JV (e.g., home or condo sales) Active business income of the JV (e.g., service income) Acquisition indebtedness However, Section 514(c)(9) provides limited exceptions for qualified organizations provided that the fractions rule is met. Page 47

48 Impacts on JV and other taxable partners A partner s tax exempt status impacts the JV, including: Whether allocations have substantial economic effect Effective savings clause that ensures proper capital accounts at liquidation is generally required The application of the Section 704(c) anti-abuse rule Absent the anti-abuse rule, the traditional method may shift income to a tax-exempt partner in certain instances The application of Section 706 Recovery period and method of depreciable property See Section 168(h)(6) The application of Section 163(j) s interest stripping rules Applicable when blocker corporation is used and is capitalized with debt Page 48

49 Questions? Page 49

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