Tax Executives Institute Houston Chapter. Partnership Update. February 27, 2018

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1 Tax Executives Institute Houston Chapter Partnership Update February 27, 2018

2 Today s Presenters Todd McArthur Principal Washington National Tax Services Todd McArthur is a Principal in the Mergers & Acquisitions Group in the PricewaterhouseCoopers LLP Washington National Tax Services office. Todd has over twenty-five years of transactional and tax controversy experience involving domestic and cross-border partnerships, oil and gas joint ventures, strategic joint ventures and other partnership, acquisitions, dispositions, and financings. In recent years, he has represented fund sponsors and institutional investors in respect of the formation of and investment in a wide variety of alternative investment funds. todd.y.mcarthur@pwc.com Nancy Langdon Managing Director Washington National Tax Services Nancy Langdon is a Managing Director of the Partnership Analytics Group in the Mergers & Acquisitions Group in the PricewaterhouseCoopers LLP Washington National Tax Services office, which specializes in modeling and quantitative analysis for partnership transactions. Nancy oversees complex modeling projects for domestic and international partnerships that include analyzing the projected tax and economic implications for multi-billion dollar transactions to determine which solutions best fit the client's needs, such as post acquisition restructuring, strategic joint ventures, and recapitalization events. nancy.l.langdon@pwc.com 2

3 Agenda 1. Tax Reform Choice of Entity Section 163(j) Interest Expense Limitation Sections 864(c)(8) & 1446(f) Codification of Rev. Rul Selected International Issues (US Shareholder, Toll Charge, GILTI) Section 199A 20% Deduction for Domestic Qualified Business Income Other Partnership Issues 2. BBA (Partnership Audit and Adjustment Rules) 3. Oil & Gas Partnership Agreements 3

4 Tax Reform 1 4

5 Choice of Entity 5

6 Choice of Entity Traditional choice of business entity considerations remain relevant, but tax reform requires rebalancing based on all relevant facts and circumstances Change in rates (39.6% to 37% for individuals; 35% to 21% for corporations) - Section 199A individual deduction up to 20% of QBI, subject to wage and basis limitations and uncertain scope - Near complete loss of individual deduction for state and local taxes and full loss of deduction for miscellaneous itemized deductions - Corporate advantage for holding foreign corporations 100% dividends received deduction Offsets for GILTI (Section 250) and availability of deemed paid credits) - Corporate deduction on foreign derived intangible income (FDII) 6

7 Choice of Entity (continued) Distribution considerations - Double tax remains a consideration but lower corporate rate Timing and amount of expected distributions? Impact of accumulated earnings tax? Reasonable compensation and other disguised dividend risks - Partnership distributions remain flexible compared to corporate distributions Debt-financed distributions generally tax free Distributions of appreciated property generally tax free 7

8 Choice of Entity (continued) Planning for operating losses - Individual limitations - Sections 465, 469; new Section 461(l) ($250,000/$500,000) - Section 163(j) applicable to both individuals and corporations - BEAT base erosion payments of corporations subject to a 10% minimum tax Formation and exit considerations - Tax free formation of partnerships is more flexible and permits more flexible, tax free economic arrangements - Basis step up in assets held by a partnership only subject to one level of tax - Accumulated earnings provide step up in partnership interest - Liquidating distributions of partnerships v. corporations 8

9 Choice of Entity (continued) Other considerations - Cost and complexity of Schedule K-1 reporting v. Form 1099-DIV reporting - Specter of Section 1446(f) withholding - Impact of BBA audit rules - State tax reporting - Long-term viability of rate structure? - Other? 9

10 Interest Expense Limitation (Section 163(j)) 10

11 Interest Expense Limitation (Section 163(j)) -- Partnerships Interest Limitation Amount: A taxpayer s interest deduction may not exceed 30% of Adjusted Taxable Income (ATI) plus business interest income plus floor plan financing interest - ATI is roughly equivalent to EBITDA for tax years beginning before January 1, ATI is roughly equivalent to EBIT (i.e., the add back for depreciation, amortization, and depletion is removed) for tax years beginning after January 1, Impact of IDC and depletion partner level deductions under general principles Under the partnership provisions, the limitation applies at the partnership level. When computing ATI of the partner, K-1 information from the partnership is ignored, but if the partnership has unused limitation, new Section 163(j) provides for a mechanic for it to be used by the partner 11

12 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) Any deduction for business interest is taken into account in determining the nonseparately stated income or loss of the entity - The partnership determines its ATI - The partnership s interest limitation is equal to its business interest income plus 30% of its ATI - The partnership may deduct business interest against non-separately stated income - Disallowed interest expense is allocated to the partners - To the extent interest is not deductible at the partnership level, the carryforward ( excess business interest ) is at the partner level 12

13 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) At the partner level: A partner s ATI shall be determined without regard to such partner s distributive share of any items of income, gain, deduction, or loss of such partnership and shall be increased by such partner s share of such partnership s excess taxable income A partner s distributive share of excess taxable income (ETI) is equal to its share of non-separately stated income 13

14 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) ETI is a percentage of partnership ATI equal to unused limitation/total limitation - ATI x [((30% x Partnership ATI) net business interest expense))/(30% x Partnership ATI)] Example -- partnership has ATI of $100 and business interest expense of $10 - ETI = $100 x (($30 - $10)/$30)) = $ At the partner level, $66.67 gives the partners the ability to deduct another $20 of interest (i.e., $66.67 x 30%) 14

15 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) Excess business interest (EBI) is allocated to the partners in proportion to their distributive share of nonseparately stated items. An allocation of EBI immediately reduces a partner s basis in its partnership interest (but not below zero). 15

16 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) The partner treats the EBI as business interest paid or accrued by the partner in the next succeeding taxable year in which the partner is allocated excess taxable income from such partnership, but only to the extent of such excess taxable income. Unclear what this means -- if partner is allocated $100 of EBI in year 1 and $100 of ETI in year 2, is the partner treated as (a) having $100 of business interest paid or accrued in year 2 that is deductible to the extent provided in 163(j) or (b) permitted to deduct $30 of the carryforward? If partner disposes of its interest in a taxable or nonrecognition transaction the reduction to basis (as a result of an allocation of EBI) is reversed to the extent the allocation of EBI was not treated as business interest paid or accrued by the partner. 16

17 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) Issues for consideration: - Partnership has no trade or business but has interest income/expense Are individual partners treated differently than corporate partners? FN 688 of Conference Committee Explanation (describing the House Provision): Section 163(d) applies in the case of a taxpayer other than a corporation. Thus, a corporation has neither investment interest nor investment income within the meaning of section 163(d). Thus, interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision. 17

18 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) Issues for consideration: - Partnership has net business interest income -- how is it taken into account by a partner? - If a partnership has a trade or business, does it need to allocate between trade or business interest income/expense and investment interest income/expense if it also finances corporate subsidiaries? - If a partnership has no operations but receives effectively connected income from an investment that is separate and apart from its interest income/expense, is the ECI enough to cause the partnership and its partners to have business interest income/expense for purposes of Section 163(j)? 18

19 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) Application to tiered partnerships (1) LTP has business income UTP has net interest expense All of LTP s business income should flow through to UTP as excess taxable income Excess taxable income is included in UTP s ATI calculation If LTP has interest income, does that flow through as a separately stated item that UTP can net against its interest expense? UTP LTP LTP Interest Expense Business Income 19

20 Interest Expense Limitation (Section 163(j)) -- Partnerships (continued) Application to tiered partnerships (2) LTP has interest expense UTP has business income Assume no deduction at LTP Interest expense is treated as being incurred by UTP in next taxable year UTP reduces basis in LTP UTP may use the expense carried forward only against future excess taxable income of LTP UTP LTP LTP Business Income Interest Expense 20

21 Sections 864(c)(8) and 1446(f) Codification of Rev. Rul and withholding 21

22 Codification of Rev. Rul Non-US Person s Sale of a Partnership Engaged in US Trade or Business In response to the Grecian Magnesite case, Congress codified Rev. Rul as part of tax reform Other Partner 40% Foreign Seller 60% FPS FP interest Foreign Buyer Gain or loss from the sale or exchange of a partnership interest treated as income that is effectively connected with a US trade or business (ECI) to the extent that the transferor would have had ECI if the partnership sold all of its assets at fair market value on the date of the sale o Withholding requirement is effective for tax years beginning after December 31, 2017 But provision is otherwise applicable for sales or exchanges on or after November 27, 2017 USTB Notice suspends withholding for publicly traded partnerships until further guidance is issued - substantive tax still in effect o Partnership required to withhold from distributions to the new partner amounts (plus interest) not withheld by transferee 22

23 Selected International Issues - Expanded definition of US Shareholder - Toll charge - GILTI/FDII 23

24 US Shareholder -- Only a US person can be a US shareholder US Partnership Foreign Partnership A US partnership can qualify as a US shareholder if it owns: o o 10% or more of the total combined voting power of all classes of voting stock OR 10% or more of the total value of shares of all classes of stock Therefore, partners of a US partnership may be allocated their distributive share of partnership items as a result of the US partnership qualifying a US shareholder A foreign partnership does not qualify as a US shareholder. Therefore, partners of a foreign partnership are only treated as a US shareholder to the extent they own: o o 10% or more of the total combined voting power of all classes of voting stock OR 10% or more of the total value of shares of all classes of stock 24

25 Expanding the Definition of United States Shareholder -- Section 951(b) 100 Individuals FPS Foreign Corp USPS 20% Profits Interests, 0 Invested Capital Issue: How do you measure value for purposes of establishing whether a partner is a US Shareholder with respect to a CFC held through a foreign partnership? Analysis: Section 318(a)(2)(A): Stock owned, directly or indirectly, by or for a partnership or estate shall be considered as owned proportionately by its partners or beneficiaries However, there is little direct guidance on what proportionate means for this context. In general, existing analogous authority establishes a partner s ownership under one of two approaches: 1. Greater of capital or profits interest in the partnership 2. Hypothetical partnership liquidation Under this approach each partner s ownership of the partnership is determined by calculating the amount proceeds each partner would receive upon a hypothetical liquidation of the partnership Takeaway: Historically capital or profits interest has been more commonly used to establish ownership through partnerships. However, hypothetical liquidation value has been used recently in the section 956 regulations 25

26 Deemed Repatriation Toll Charge (Section 965) -- What s the New Law? The Act: Imposes a toll charge on a US shareholder s pro rata share of certain foreign subsidiaries previously untaxed foreign earnings Treats the US shareholder s toll charge inclusion amount as additional Subpart F income, which may be reduced by a pro rata share of the deficits of certain foreign subsidiaries Deduction is allowed to the extent necessary for the foreign E&P attributable to cash and other liquid assets to be taxed at an effective rate of 15.5% and all residual foreign E&P at an effective rate of 8% (based on the corporate tax rate in existence during the year of inclusion) Permits an election to pay the tax liability imposed over eight years Effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and, with respect to US shareholders, for the taxable years in which or with which such taxable years of the foreign corporation ends 26

27 Deemed Repatriation Toll Charge (Section 965) -- Application to Investors in Passthrough Entities The mechanics of the toll charge to US passthrough entities generally operate in a similar manner to US corporations However, the effective tax rate for individuals is higher as compared to US corporations This disparity in tax rate is a result of US individuals being taxed at higher rates as compared to corporations The mechanism of getting the desired effective rates of 15.5% and 8% is via a deduction based on the applicable corporate tax rate For example, to the extent the toll charge is due on December 31, 2017, the deduction is based on a corporate tax rate of 35%. Therefore the effective tax rate for individuals is higher as a result of the individual rate being 39% However, this disparity can dramatically increase to the extent the toll charge is due in 2018 (e.g., CFC tax year is November 30) 27

28 Toll Charge (Section 965) -- Partner s Tax Basis Issue: What is partner s tax basis increased for income under toll charge? Analysis: US Corp 1 US Corp 2 US Partner 3 US Partner 4 Section 965 is implemented through a US Shareholder level subpart F inclusion. USPS is the US Shareholder that includes the toll charge into income under section 965(a), and its partners are allocated a distributive share of the inclusion 45% 5% 45% USPS 100% CFC 5% The corresponding section 965(c) deduction is determined at the level of USPS (i.e., the US Shareholder with the section 965(a) inclusion) and allocated to its partners Section 965(f)(2) The portion which is included in the income of a United States shareholder under section 951(a)(1) by reason of subsection (a) which is equal to the deduction allowed under subsection (c) by reason of such inclusion (A) shall be treated as income exempt from tax for purposes of section 705(a)(1)(B) and 1367(a)(1)(A), and (B) shall not be treated as income exempt from tax for purposes of determining whether an adjustment shall be made to an accumulated adjustment account under section 1368(e)(1)(A) Takeaway: Although the language that attempts to create full basis for the partner is not clear or accurate, it appears that the intent is to allow the partner to get basis in its partnership interest for the full amount of the section 965(a) inclusion (not net of the deduction) 28

29 Toll Charge (Section 960) -- FTCs Issue: Which partners are entitled to use foreign tax credits ( FTCs ) to offset its toll charge inclusion? Analysis: US Corp 1 US Corp 2 US Partner 3 US Partner 4 Section 960 only applies to corporate US Shareholders. As a result, US Partner 3 and US Partner 4 are not eligible to claim deemed paid FTCs in connection with the toll charge unless a special rule applies 5% 45% Additionally US Corp 2 does not qualify as a US Shareholder and thus is not entitled to offset toll charge with foreign tax credits 45% USPS 100% CFC 5% US Partner 3 (but not US Partner 4) may consider electing (under section 962) to be treated as a US corporation for purposes of subpart F. US Partner 4 does not qualify as a US Shareholder Takeaway: An individual is not entitled to deemed paid FTCs under section 960, absent a section 962 election 29

30 Toll Charge (Section 965) -- Liability Deferral Election Issue: Who (i.e., partnership or partner) is entitled to make the election to defer toll charge tax liability? Analysis: US Corp 1 US Corp 2 US Partner 3 US Partner 4 Section 965(h) allows a US shareholder to elect to pay its tax liability in 8 installments 45% 5% 45% USPS 100% CFC 5% USPS is a US Shareholder that includes the toll charge into income, but does not pay the tax. It is unclear whether the partnership can make the election on behalf of its partners US Corp 1 and US Partner 3 are US Shareholders (i.e., as they indirectly own more than 10% of the CFC) so they can make the election under 965(h) to defer their tax liability - However, US Corp 2 and US Partner 4 both have a tax liability (i.e., distributive share of USPS s toll charge income) but as they are not US Shareholders, it is unclear whether they can make a section 965(h) election even though they have a tax liability on the distributive share of USPS s toll charge inclusion Takeaway: It is unclear who can make a section 965(h) election to defer tax liability. We expect this to be addressed in future guidance 30

31 Global Intangible Low-Taxed Income (GILTI) (Section 951A) -- What s the New Law? The Act: Subjects US shareholders of CFCs to current US taxation on global intangible lowtaxed income (GILTI) Provides that GILTI is computed annually as the excess of each US shareholder s net CFC tested income over the shareholder s net deemed tangible income return - Net deemed tangible return is 10% of tax basis in depreciable assets - Net deemed tangible return is reduced for interest deducted in the determination of a US shareholder s net CFC tested income Corporations are entitled to a deduction of 50% (reduced to 37.5% for tax years beginning after 2025) of GILTI Permits a FTC for 80% of foreign taxes deemed paid by the US corporate shareholder with respect to the GILTI inclusion 31

32 GILTI (Section 951A) -- Application to Investors in Passthrough Entities Individuals unexpectedly are subject to the new GILTI US partnerships and S corporations qualify as US shareholders of a CFC. Therefore the partners of US partnerships are subject to tax on their allocable share of the GILTI income However, the GILTI allocable to individual partners will be taxed at the US individual tax rates with no corresponding deductions or foreign tax credits that are otherwise available to corporations 32

33 GILTI (Section 951A) -- Application Issue: Who is subject to GILTI? Analysis: Section 951A(a) states: US Corp 1 US Corp 2 US Partner 3 Foreign Partner 4 a) In general. Each person who is a United States shareholder of any controlled foreign corporation for any taxable year of such United States shareholder shall include in gross income such shareholder s global intangible low-taxed income for such taxable year 45% 5% 45% 5% In the case of a US partnership that is a US shareholder with respect to a CFC, the US partnership must include in gross income its pro rata share of GILTI, similar to inclusions under Subpart F Takeaway: USPS USPS qualifies as US Shareholder that includes GILTI in income 100% CFC US Corp 1 and US Partner 3 also are US Shareholders, but they do not directly include the GILTI under section 951A (because they do not hold the CFC stock directly or indirectly through a foreign entity as described in section 958(a)). Instead, they should be allocated a distributive share of USPS s GILTI under section 702 US Corp 2 is not a US Shareholder, but it also should be allocated a distributive share of USPS s GILTI under section 702 Foreign Partner 4 may not be taxed on its allocable share of GILTI income. In informal guidance, the Service has stated that it is inappropriate to include subpart F income in the income of foreign persons not otherwise subject to U.S. tax 33

34 GILTI (Section 951A) -- Application Issue: Who can utilize section 250 deductions and foreign tax credits to offset the GILTI income inclusion? Analysis: US Corp 1 US Corp 2 45% 5% US Partner 3 45% 5% USPS 100% CFC Foreign Partner 4 The new section 250 GILTI deduction entitles a domestic corporation to a 50% deduction of GILTI included in income under section 951A(reduced to 37.5% for tax years beginning after 2025) Section 960 was amended to include subsection (d), which permits a FTC for 80% of foreign taxes deemed paid by the corporate US Shareholder with respect to the GILTI included under section 951A o o o Takeaway: GILTI is included under section 951A by USPS Footnote 1525 of the conference report could be read to imply that Congress intended some partners to be eligible for section 250(a)(1)(B) deductions with respect to GILTI inclusions at the partnership level Section 702(a)(5) provides that a section 250 deduction will be a separately stated item (by virtue of being part of Subchapter B, Part VIII) US Corp 1 may be eligible for both the section 250 GILTI deduction and a FTC under section 960(d)(1) US Corp 2 may be eligible for the section 250 GILTI deduction, but it is not clear whether it may utilize a FTC under section 960(d)(1) US Partner 3 may not be eligible for the section 250 GILTI deduction. It also cannot utilize FTCs under section 960(d), unless it makes a section 962 election (discussed more below) 34

35 GILTI (Section 951A) -- Aggregation Rules Issue: Whether USPS s QBAI is taken into account when determining US Sub s GILTI inclusion? US Corp Analysis: US Sub 40% Generally, a US Shareholder s GILTI equals its net CFC tested income, minus its net deemed tangible income return (i.e.,10% of QBAI, minus any interest expense taken into account in determining net CFC tested income) Foreign Corp 1 60% USPS Because each of US Sub and USPS are US Shareholders that directly own shares of a CFC, they should compute their GILTI inclusions separately - Even if future regulations treat US Shareholders that are members of an affiliated group as a single US Shareholder for purposes of determining GILTI, USPS is not a member of any affiliated group, so it likely would be excluded Foreign Corp 2 Tangible Assets Takeaway: US Sub s GILTI inclusion is determined without regard to QBAI held by Foreign Corp 2, even if Foreign Corp 2 has excess QBAI that prevents USPS from currently including any GILTI in income 35

36 Foreign-Derived Intangible Income (FDII) -- Section 250 Issue: How does the deduction for FDII apply to partners of a partnership? Analysis: US Corp 1 US Corp 2 US Partner 3 US Partner 4 The section 250 deduction for FDII is available only to C corporation that are not RICs or REITs. This does not include an individual making a section 962 election FDII = DII x FDDEI 45% 5% 45% 5% o DEI DEI: Deductible eligible income is all gross income other than subpart F, GILTI, foreign branch income o DII: Deemed intangible income is DEI less 10 percent of QBAI USPS o FDDEI only includes income derived in connection with Property sold by the taxpayer (including by way of lease, license, or other disposition) to a foreign person for foreign use, and Income Services provided by the taxpayer to any person, or with respect to property, located outside the United States 36

37 Foreign-Derived Intangible Income (FDII) -- Section 250 (continued) If a partnership earns sales or services income, is the corporate partner who otherwise would be eligible or the deduction treated as selling or providing services so that its income can qualify as FDDEI? US Corp 1 US Corp 2 US Partner 3 US Partner 4 5% 45% 45% 5% USPS Income o o Footnote 1525 of the conference report could be read to imply that Congress intended some partners to be eligible for section 250(a)(1)(A) deductions with respect to FDII at the partnership level: Due to the reduction in the effective U.S. tax rate resulting from the deduction for FDII and GILTI, the conferees expect the Secretary to provide, as appropriate, regulations or other guidance similar to that under amended section 965 with respect to the determination of basis adjustments under section 705(a)(1) and the determination of gain or loss under section 986(c) Separately stated items allocated to a partner generally have the same character as if the partner earned/incurred the item directly under section 702(b) 37

38 Tax on Base Erosion Payments (BEAT) (Section 59A) -- Payment by a Partnership Issue: Does BEAT apply to this payment? US Corp 1 US Corp 2 5% 45% - + US Partner 3 US Partner 4 45% 5% USPS 100% CFC Analysis: BEAT applies to all domestic corporations to the extent they receive a deduction attributable to payments made to a related foreign person (based on 25% of vote or value). No rules specifically address the application of BEAT to corporations that are partners in partnerships that make base erosion payments. o Takeaway: Therefore, the rules also do not explain how to test a corporate partner's gross receipts or determine a partner s base erosion percentage. We believe the better view is to test the relationship between the relevant corporate partner and the foreign person to determine if BEAT is applicable to that corporate partner. If the corporate partner is related to the foreign person (e.g., US Corp 1), we believe the better application of BEAT is that a base erosion payment by a partnership is treated as a payment from the partners. 38

39 Tax on Base Erosion Payments (BEAT) (Section 59A) -- Payment to a Partnership Issue: Does BEAT apply to this payment? 50% - US Corp (US) CFC 1 CFC 2 50% 50% 50% Analysis: BEAT applies to all domestic corporations to the extent they receive a deduction attributable to payments made to a related foreign person (based on 25% of vote or value). The rules do not address base erosion payments from a domestic corporation to a domestic partnership with CFC partners. Takeaway: There is risk an aggregate approach should be applied which would cause the payment to be subject to BEAT. + USPS 39

40 20% Deduction for Domestic Qualified Business Income (Section 199A) 40

41 20% Deduction for Domestic Qualified Business Income (Section 199A) -- What s the New Law? Non-corporate taxpayers generally may deduct 20% of combined qualified business income from a partnership, S corporation, or sole proprietorship In the case of a taxpayer who has qualified business income from a partnership or S corporation, the amount of the deduction is capped at the greater of: - 50% of the W-2 wages paid with respect to the qualified trade or business or - The sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. W-2 wage limit phases in for taxpayers with taxable income more than $157,500 (single)/$315,000 (married filing jointly). Limit is fully phased in at $207,500/$415,000, respectively 41

42 20% Deduction for Domestic Qualified Business Income (Section 199A) -- What s the New Law? (continued) Qualified business income - Effectively connected with a trade or business within the United States Qualified business income does not include: - Income from specified services trades or businesses (for taxpayers with income above the income thresholds) - Individuals share of S Corp. reasonable compensation and partnership guaranteed payment income - Investment-type income (e.g., capital gains and dividends) REIT dividends, cooperative dividends, and qualified publicly traded partnership income are qualified income not subject to the wage limitations and are limited to 20% of such income - Qualified PTP income includes Section 751(a) gain - Is Section 751(a) gain from the sale of non-ptp partnership interests included? 42

43 20% Deduction for Domestic Qualified Business Income (Section 199A) -- What is a Specified Service Trade or Business? Any trade or business involving the performance of services described in Section 1202(e)(3)(A), other than engineering and architecture, but including investing, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities Section 1202(e)(3)(A): any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees Significant uncertainty regarding scope of definition and the impact of comingled qualified and specified service activities 43

44 20% Deduction for Domestic Qualified Business Income (Section 199A) -- What are Specified Service Activities? (continued) The provision may provide a benefit to certain labor income (e.g., specified services below the income thresholds) No benefit for guaranteed payments -- structure into Reg. sec (c), Example 2? - Partner C in the CD partnership is to receive 30% of partnership income as determined before taking into account any guaranteed payments, but not less than $10,000. The income of the partnership is $60,000, and C is entitled to $18,000 (30% of $60,000) as his distributive share. No part of this amount is a guaranteed payment. However, if the partnership had income of $20,000 instead of $60,000, $6,000 (30% of $20,000) would be partner C's distributive share, and the remaining $4,000 payable to C would be a guaranteed payment 44

45 20% Deduction for Domestic Qualified Business Income (Section 199A) Partnerships Applied at the partner level Individual partners determine allocable shares of each qualified item of income, gain, deduction, and loss Individual partners take allocable share of W-2 wages and unadjusted basis immediately after the acquisition of qualified property - W-2 wages based on allocable share of wage expense - Unadjusted basis based on allocable share of depreciation 45

46 Other Partnership Issues 46

47 Carried Interest Issues (Section 1061) -- What s the New Law? The Act: Long-term capital gains (LTCGs) with respect to certain applicable partnership interests (APIs) get benefit of preferential 20% rate only if the capital asset was held for at least three years. Applicable partnership interest: a partnership interest that is transferred to a partner in connection with the performance of substantial services in connection with an applicable trade or business An applicable trade or business: raising and returning of capital in connection with either (i) investing in specified assets or (ii) developing specified assets Specified assets: securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership s proportionate interest in any of the foregoing. 47

48 Carried Interest Issues (Section 1061) -- What s the New Law? (continued) APIs do not include interests held by a corporation and certain capital interests. - Does corporation mean just C corporations? What about S corporations? - What about mixed profits and capital interests? - Purchased interests? Specified assets: regulations may exclude any asset not held for portfolio investment on behalf of third party investors (not self effecting). Does the provision apply to partnership interests, partnership assets, or both? Who s holding period -- partner s or partnership s -- is relevant? What is the effect of special long-term capital gain provisions (e.g., Section 1231 or Section 1256)? 48

49 Other Passthrough Considerations -- What s the New Law? The Act: Repeals the technical termination rules for partnership for tax years beginning after December 31, 2017 (Section 708) Modifies the definition of substantial built-in loss under Section 743(d) to provide that a substantial built-in loss also exists if the transferee partner would be allocated a net loss in excess of $250,000 upon a hypothetical sale and liquidation of the partnership (not an issue for partnerships making a Section 754 election) Modifies Section 704(d) to apply the outside basis limitation to a partner s distributive share of charitable contributions and foreign tax credits Section 168(k) allows businesses to expense immediately the cost of qualified property Section 743(b) possible direct expensing 49

50 BBA - Partnership Audit and Adjustment Rules) 2 50

51 BBA -- Partnership Audit and Adjustment Rules For returns filed for partnership taxable years beginning after December 31, 2017: 6221: Election out for partnerships with 100 or fewer partners 6222: Consistency requirement for partners returns 6223: Partnership must designate one representative to deal with IRS examinations 6225 (Default Rule): Tax on imputed underpayments is assessed and collected at the partnership level in the adjustment year and adjustment-year partners bear economic burden 6226 (Push-out Election): Election available to pass adjustment through to its partners by the partnership 51

52 BBA -- Default Rule vs. Push-Out Default Rule Push-out Tax on imputed underpayments is assessed and collected at the partnership level in the adjustment year Shift the economic burden to the current year partners (adjustment year) Prevent adjustment-year partners from bearing tax liability for reviewed years (unless they also were reviewed-year partners) Mitigates potential distortions caused by the default rule (requires the reviewedyear partners to bear the tax liability for the reviewed year) Higher interest than under default rule (+ 2%) Partnership furnishes statement 52

53 BBA -- Updated Guidance REG and REG specifies that partnership can pass the tax along to the ultimate partner in a tiered structure (December 19, 2017) REG aims to re-align partnership owners capital accounts after an audit if the partnership pays the tax liability (February 2, 2018) All passthrough partners making a push-out election must furnish push-out statements no later than the extended due date for the return for the adjustment year of the partnership that made the election (the audited partnership) 53

54 BBA -- Practical Considerations Q: Does the partnership need to amend the partnership agreement? A: No. Designation of PR and/or election out are made on partnership returns; there is no requirement to amend the partnership agreement Q: Is it a good idea to amend the partnership agreement to clarify who will serve as PR and to address conflicts that may arise among the partners with regard to the application of the BBA rules? A: Yes Q: What should the amendment say? A: It depends Q: The statute goes into effect at the end of the year, do the amendments to the partnership agreement need to be completed by January 1, 2018? A: No 54

55 Key Practical Considerations -- The Partnership Representative Choice of partnership representative Approval of partnership representative s decisions any limits need to be included in the partnership agreement Level of engagement/diligence expected from partnership representative does state law impose any duty of care? Does it matter whether the partnership representative is itself a partner? Indemnification of the partnership representative any limits? 55

56 Key Practical Considerations -- Pay or Push-out Consider inter-generational conflicts Consider whether the total adjustment amount plus interest is higher under section 6225 or 6226 If tax is paid at the partnership level, how is the allocation of the tax burden among the partners determined? If tax is paid at the partnership level, how is the tax payment funded? 56

57 Key Practical Considerations -- Actions of Partners to Reduce Imputed Underpayment Can the partnership representative require partners to file amended returns? Can the partnership representative require a partner to provide information that would reduce the partnership s tax? What if the partner is itself a partnership? Can an upper-tier partnership be required to provide information about its partners? If a partner s attribute (e.g., status as tax exempt) results in a reduction in the partnership s tax, should the benefit be allocated solely to the partner with the attribute or shared? 57

58 Retaining Flexibility: One Approach A. General designation of the partnership representative and scope of authority - General partner is designated as the partnership representative (PR) - PR has the right to take all actions/make all elections provided in BBA - Partners agree to cooperate with such actions/election (e.g., file amended returns and pay tax and provide any requested information required to reduce tax under section 6225) B. Provisions to address payment of tax by the partnership - If partnership pays the tax, GP may cause the partners (including former partners) to pay their share of the tax, as determined by the GP in its "sole [good faith] discretion - If the partner does not pay promptly, interest accrues on the amount due to the partnership - A payment of the tax is not treated as a capital contribution/does not reduce capital commitment - Partnership may reduce distributions by unpaid amount C. Some indemnification/hold harmless language that applies to the PR for actions taken in its capacity as PR 58

59 Oil & Gas Partnership Agreements 3 59

60 Oil and Gas Partnership Agreements The API model partnership agreement was last revised in 1997 Intended to meet the SEE safe harbor - Capital accounts maintained in a manner intended to comply with Treas. Reg (b) - Partners have full DROs and balancing cash obligations 60

61 Selected Changes in Partnership Tax Law and Other Guidance and Developments Since (c)(1)(B): substituted 7 years for 5 years in introductory provisions (1997) 704(c)(1)(C): built in loss property (2004) 737(b)(1): substituted 7 years for 5 years (1997) : contingent liability regulations (2003) Rise of target capital account allocations: Section 704(b) PIP BBA audit rules replace TEFRA audit procedures (2015; effective 2018) Tax reform (e.g., Section 1446(f)) 61

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