Drafting Partnership Agreements for Substantial Economic Effect
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1 Drafting Partnership Agreements for Substantial Economic Effect Todd D. Golub, EY Robert D. Schachat, EY Karen Lohnes, PwC David Raab, Latham & Watkins
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 Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a client-serving member of Ernst & Young Global Limited 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. The views expressed by panelists in this session are not necessarily those of Ernst & Young LLP or its professionals. Page 2
3 Speaker Information Todd Golub, EY Karen Lohnes, PwC 155 N Wacker Drive 1301 K Street, NW Chicago, IL Washington, DC Todd.Golub@ey.com Karen.Lohnes@us.pwc.com David S. Rabb Latham & Watkins Robert D. Schachat, EY 1101 New York Avenue, NW 885 Third Avenue Washington DC New York, NY Robert.Schachat@ey.com david.raab@lw.com Page 3
4 Section 704 Generally Section 704(a): A partner s share of tax items is determined by the partnership agreement Section 704(b): Ensures that: allocations of partnership tax items match economics of the partnership arrangement, and each partner receives economic benefit or bears economic burden associated with allocations of taxable income and deduction Page 4
5 Section 704 Generally (con t) Section 704(c): Governs allocations of tax items related to property that has a tax basis different from its Section 704(b) book value Section 704(d): Partner is entitled to deduct allocated losses only to extent of the partner s basis in its partnership interest at end of year Page 5
6 Section 704(a) Partnership Allocations Section 704(a) provides that a partner s share of partnership income generally is determined in accordance with the partnership agreement: A partner's distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this chapter, be determined by the partnership agreement. Includes all agreements among the partners or between partners and the partnership regarding their partnership relationship Page 6
7 Section 704(b) Partnership Allocations Distributions vs. Distributive Share Income allocations under Section 704(b) do not directly affect the taxability of distributions A partner s distributive share is not the same thing as a partner s share of distributions Distributions amount of cash and/or property a partner receives from a partnership in a taxable year Distributive share a partner s allocable share of taxable income from a partnership in a taxable year Page 7
8 Section 704(b) Partnership Allocations Distributions vs. Distributive Share A partner is taxable (or may offset against its other income, as appropriate) on its annual distributive share of partnership profit and loss, regardless of whether the partnership has distributed to the partner the cash flow attributable to partnership operations Among other things, this means that it will be only the more unusual situation in which a partner is taxable only if, when, and precisely to the extent that it receives a cash distribution Page 8
9 Three Models for Partnership Allocations No. 1: Distributions follow allocations 704(b) safe harbor ; liquidations per capital accounts Typical in hedge funds No. 2: Allocations follow distributions Partner s Interest in the Partnership ( PIP ) arrangements Waterfall/distribution-driven with forced allocations Typical in PIP funds No. 3: Hybrid Liquidations per capital accounts ; allocations force capital accounts to waterfall Liquidations per waterfall; allocations force capital accounts to equal waterfall distributions to extent possible Capital Accounts typically not kept according to Section 704(b) Safe Harbor definition at Treas. Reg. Sec (b)(2)(iv) Page 9
10 Section 704(b) Partnership Allocations PIP Arrangements Allocations of income, gain, loss, deduction, or credit shall be deemed to be in accordance with PIP if: The partnership agreement does not provide as to the partner's distributive share of income, gain, loss, deduction, or credit; or The allocation does not have substantial economic effect ( SEE ). Page 10
11 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Definition of a Safe Harbor Compliant Agreement: It conforms to the safe harbor in Sec. 704(b) regulations Fundamental differences from PIP Safe harbor agreements establish partner rights to cash through capital account mechanism while PIP says who gets how much cash flow Government bound to respect safe harbor allocations; PIP allocations subject to all facts and circumstances review Page 11
12 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements (cont d) Compliance teams: Can follow allocations in safe harbor agreements, but Must run hypothetical liquidation analysis to do allocations in PIP agreements Allocations in PIP agreements may be followed by engagement teams only to extent allocations actually affect distributions of cash flow Pushback from clients and lawyers re safe harbor compliant agreements Page 12
13 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Fundamental Rules Partnership allocations will be respected under the 704(b) safe harbor if they have substantial economic effect. Two requirements for substantial economic effect: Allocations must have economic effect, and That effect must be substantial. Page 13
14 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Fundamental Rule No. 1: Economic Effect Primary Test Maintain capital accounts in accordance with regulations Liquidate in accordance with positive capital accounts Deficit restoration obligation ( DRO ) Treas. Reg. Sec (b)(2)(ii) Page 14
15 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Fundamental Rule No. 2: Economic Effect Alternate Test Same first two requirements as on prior slide Loss allocation may not cause or increase adjusted capital account deficit Qualified Income Offset ( QIO ) Page 15
16 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements 704(b) Book Capital Accounts Maintained for each partner Different classes and separate contributions are sometimes tracked separately These separate capital accounts must ultimately be consolidated, because safe harbor regulations permit a partner only one capital account Page 16
17 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Capital Account Maintenance Treas. Reg. Sec (b)(2)(iv) INCREASE Capital Account balances for: Contributions (at FMV net of liabilities) Items of income and gain Page 17
18 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Capital Account Maintenance Treas. Reg. Sec (b)(2)(iv) DECREASE Capital Account balances for: Distributions (at FMV net of liabilities) Items of loss, depreciation, or other deductions (computed using book basis) Nondeductible, noncapitalizable expenditures Page 18
19 Capital Account Revaluations 704(b) Safe Harbor Agreements Capital Account Maintenance Revaluations Capital accounts adjusted to reflect unrealized gain or loss in distributed property Distributee partner s capital account reduced by FMV of distributed property Page 19
20 Capital Account Revaluations 704(b) Safe Harbor Agreements Capital Account Maintenance Optional Revaluations Adjust capital accounts based on property s current fair market value Allocate unrealized appreciation or depreciation in the same manner as realized gain or loss and adjust book capital accounts Adjust tax capital accounts by corresponding tax items applying Section 704(c) principles Page 20
21 Capital Account Revaluations 704(b) Safe Harbor Agreements Capital Account Maintenance Optional Revaluations Must be principally for a substantial non-tax business purpose in connection with: Contribution of property or money (other than de minimis amount) Liquidation of partnership or a distribution of money or property (other than de minimis amount) Grant of a partnership interest (other than de minimis) as consideration for services Under generally accepted industry accounting practices, provided all of the partnership s property consists of stock, securities or commodities, etc. Page 21
22 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Liquidations Based On Positive Capital Accounts The 704(b) safe harbor requires liquidating distributions to be made according to positive capital account balances, meaning: The liquidating distribution must be made in accordance with each partner s positive capital account balance It is determined after taking into account all capital account adjustments for partnership Page 22
23 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Qualified Income Offset The agreement of an Alternative Rule partnership must provide that unexpected distributions causing/increasing a deficit balance in a partner s capital account will be eliminated as quickly as possible Mandatory allocation provisions require an allocation of gross income to a partner to eliminate any such unexpected deficit capital account balance at end of any year Page 23
24 Allocations Under Partner s Interest in the Partnership ( PIP ) Partner s Interest in the Partnership ( PIP ) Allocations that do not satisfy the regulatory safe harbor for tax allocations will be respected if the allocations satisfy the PIP standard PIP is an all the facts and circumstances test Regulations provide that the following facts and circumstances are among those that should be considered: Relative contributions of partners Relative interests in distributions upon liquidation Relative interests in cash flow Relative interests in economic profit and loss sharing ratios Treas. Reg. Section (b)(3) Page 24
25 Partner s Interest in the Partnership The Hypothetical Liquidation Analysis Allocations in a PIP partnership agreement are typically made under a hypothetical liquidation analysis, even though many agreements do not expressly call for this approach The principle behind hypothetical liquidation is that tax allocations should follow the money A description of the hypothetical liquidation analysis can be found at Treas. Reg. Sec (b)(3)(iii) This regulation applies if the partnership otherwise maintains capital accounts and liquidates in accordance therewith Page 25
26 Partner s Interest in the Partnership The Hypothetical Liquidation Analysis Three steps in a Hypothetical Liquidation analysis: First: Determine the amount each partner would receive upon a liquidation of the partnership at the end of the year Second: Determine the amount each partner would receive upon a liquidation of the partnership at the beginning of the year Third: Subtract the result for each partner under Step 2 from the result for that partner in Step 1 Page 26
27 Partner s Interest in the Partnership The Hypothetical Liquidation Analysis A partner with a positive hypothetical liquidation number should generally get income and gain equal to the amount of the positive A partner with a negative hypothetical liquidation number should generally get loss and deduction equal to the amount of the negative Page 27
28 Partner s Interest in the Partnership The Hypothetical Liquidation Analysis Asset values used in a hypothetical liquidation analysis are based on carrying values for tax, not GAAP, purposes This generally means that the hypothetical liquidation analysis is carried out in reliance on the adjusted basis of partnership property for property that was not the subject of a realization event, and realized values for property that underwent a realization event Unrealized gain and loss recorded for GAAP purposes is generally not taken into account in a hypothetical liquidation analysis by a PIP agreement fund An exception to this general rule applies if the fund undertakes a bookup for tax purposes, under which certain unrealized appreciation and depreciation in partnership property is taken into account in capital account calculations Page 28
29 PIP Fund Sample Allocation Provision Forced Allocation Approach Net Income and Net Losses, and to the extent necessary, individual items of income, gain, loss and deduction of the Partnership, for any allocation period shall be allocated among the Partners in a manner such that the Capital Account of each Partner, immediately after making such allocation, and after taking into account actual distributions made during such allocation period (and distributions with respect to such allocation period to be made after the end of such allocation period if the General Partner is able to determine in good faith the manner in which such distributions will be made pursuant to Sections D.2 and D.3), is, as nearly as possible, equal (proportionately) to (i) the distributions that would be made to such Partner pursuant to Sections D.2 and D.3 the Partnership were to dissolve, its affairs wound up and its assets sold for cash equal to their Gross Asset Value (for purposes of Section 704(b) of the Code), all Partnership liabilities, (cont d next page.) Page 29
30 PIP Fund Sample Allocation Provision Forced Allocation Approach (Cont d) including the Partnership s share of any liability of any subsidiary treated as a partnership for U.S. federal income tax purposes in which the Partnership is a partner, were satisfied (limited, with respect to each nonrecourse liability to the Gross Asset Value of the assets securing the liability) and the net assets of the Partnership were distributed in accordance with Sections D.2 and D.3 immediately after making such allocation, minus (ii) such Partner s share of minimum gain and partner nonrecourse debt minimum gain determined pursuant to Treasury Regulations Section (g)(1) and (i)(5), computed immediately prior to the hypothetical sale of assets, if any. Page 30
31 Partner s Interest in the Partnership The Hypothetical Liquidation Analysis Most PIP fund partnership agreements contain tax allocation provisions. How does this hypothetical liquidation analysis affect those? Tax allocation provisions in a partnership agreement will not be respected if they allocate tax items in a manner different from the way the partners share the economic items attributable to them The hypothetical liquidation analysis links tax to economics Raise your hand and CONSULT if the tax allocations and a hypothetical liquidation analysis yield different results Page 31
32 Section 704(b) Partnership Allocations 704(b) Safe Harbor Agreements Fundamental Rule No. 2: Substantiality Regulation Section (b)(2)(iii) provides that an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Page 32
33 Substantiality Transitory allocations. Allocations fail substantiality if: The original allocations will be largely offset by offsetting allocations and At the time the original allocations become part of the partnership agreement, there is a strong likelihood that: The net increases and decreases in the partners capital accounts will not differ substantially from what the net increases and decreases in the partners capital accounts would be if the original and offsetting allocations were not contained in the partnership agreement; and The total tax liability of the partners will be less than what the total tax liability would be if the original and offsetting allocations were not contained in the partnership agreement. Presumption of strong likelihood. Testing Period: All tax years in which allocations may occur. Exceptions: 5-year waiting period. Value equals basis rule. Page 33
34 Substantiality Look-through entities are looked through to apply the substantiality rules. Thus, substantiality rules are applied by looking through to the owners of the look-through entity to take into account owner-level tax attributes that are unrelated to the partnership. Look-through entities include: Partnerships S corporations. Trusts. Estates. Disregarded entities. But not REITs or RICs. Similar look-through rules apply to: CFC subpart F income. Only for US shareholders who own, directly or indirectly, at least 10 percent of partnership capital or profits. Consolidated return members. Page 34
35 Substantiality De minimis rule. For purposes of applying the substantiality rules, the tax attributes of de mimimis partners need not be taken into account. A de minimis partner is any partner, including a look-through entity that owns, directly or indirectly, less than 10 percent of the capital and profits of a partnership, and who is allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit. The de minimis rule was eliminated by regs issued in December 2012, effective for: Allocations adopted after December 28, 2012; and Taxable years beginning after December 28, Page 35
36 Partner s Interest in the Partnership The distribution waterfall A preferred interest distribution waterfall commonly provides for distributions to be made in the following order: First, 100% to the partners until they have received distributions equal to their invested capital plus certain expenses, Second, 100% to the limited partners until they have received a defined preferred return with respect to their invested capital, Third, a "catch-up" allocation to the general partner so that the general partner receives a carry with respect to the limited partners preferred return, and Fourth, 20% to the GP and 80% to the LPs. In a PE fund the distribution waterfall is commonly based on either an investment-by-investment or aggregate approach (i.e. the distributions in the first tier are for either disposed investments or total invested capital). Page 36
37 PE fund overview Clawback provision PE funds generally contain a so-called "clawback" provision that requires the general partner to restore previously distributed funds to the extent early profits are offset by losses on later investment dispositions: The restored funds are redistributed to the investors, Usually the clawback funds are remitted directly to the fund, The clawback is structured as a deficit restoration obligation and usually provided for in the liquidation section of the operating agreement. Clawbacks are generally reduced by taxes the general partner was required to pay on the previously distributed funds. Page 37
38 Catch up provisions The catch up provision allows the general partner to recoup the incentive that would have been earned had the preferred return to the LP s not been in place Allocation is typically written as a priority allocation to the GP in reference to the incentive that would have been earned on the preferred return allocation to the LP s This allocation, when written, may have a 100% priority allocation up to the reference amount of incentive or a lesser but accelerated provision can be used (ex. 80% to the GP and 20% to the LP) Page 38
39 Example Waterfall calculation Assumptions: Interests Limited Partners 99%, General Partner 1% Original investment - $1,000,000 Sale price - $1,800,000 Holding period 1 year Preferred return 10% GP carried interest - 20% Remainder of profits - 80% to LPs and 20% to GP Page 39
40 Order of Waterfall for calculation Return of capital Prior loss allocations (assume zero) Limited partner preferred return GP catch-up (allocated 100% to GP) Remaining profit allocated/distributed 80/20 Page 40
41 First layer of Waterfall Return of capital Allocated pro-rata based upon partnership interests Capital invested = $1,000,000 GP 1% interest = $10,000 LP 99% interest = $990,000 Page 41
42 Second layer of Waterfall Preferred return (aka hurdle rate ) 10% preferred return on capital invested by LP s for one year: LP Capital Invested $990,000 LP Preferred Rate * 10% LP Preferred Return $99,000 Page 42
43 Third layer of Waterfall GP carried interest catch-up GP receives catch-up to 20% of profits after preferred return allocation using following calculation: LP Preferred Return / (1 20%) X 20% = GP Catch Up or $99,000 / 0.80 X 0.20 = $24,750 GP Catch Up = $24,750 (or 25% of the LP Preferred Return) Page 43
44 Final layer of Waterfall Remaining profit allocated and distributed 80/20: Total profit $ 800,000 LP preferred return (99,000) Profit remaining after preferred return 701,000 GP 20% carried interest catch-up (24,750) Profit remaining to be distributed $ 676,250 LP 80% allocation 541,000 GP 20% allocation 135,250 Page 44
45 Total allocations General partner ROC $ 10,000 Return of exp./losses - Pref. return - Catch-Up 24,750 Remainder 135,250 Total $170,000 Limited partners ROC $ 990,000 Return of exp./losses - Pref. return 99,000 Catch-up - Remainder 541,000 Total $1,630,000 Page 45
46 Check of Waterfall General partner Catch-up $ 24,750 Remainder 135,250 Total Prof. $160,000 Limited partners Pref. return $ 99,000 Remainder 541,000 Total $640,000 $160,000 =20% of $800,000 Total Profit $640,000 =80% of $800,000 Total Profit Page 46
47 PIP Fund Special Issues Partnership Agreement Tax Distribution Clause Tax Distribution. Each Fiscal Year, the General Partner (to the extent Distributable Cash is available) will cause the Partnership to make distributions to the Partners of Distributable Cash in an amount (as to each Partner) equal to the product of: (a) The net book income allocated to the Partner for the Fiscal Year; and (b) The highest effective combined Federal, New York state and New York City local income tax rate applicable during the Partnership s taxable year to a natural person resident in New York City, New York, taxable at the highest combined marginal tax rates. The highest combined marginal tax rate will include the Federal income tax deduction for New York state and local income taxes (to the extent that New York state and local income taxes are deductible in computing Federal income tax). Page 47
48 PIP Fund Special Issues Partnership Agreement Tax Distribution Clause (Cont d) Each Tax Distribution will be treated as an advance against and will be recoupable from distributions of Distributable Cash or proceeds of liquidation that otherwise would be made to the Partners under this Agreement. No Tax Distributions will be made after an Event of Liquidation of the Partnership. A Partner may have received (at the time of liquidation of the Partnership) cumulative Tax Distributions in excess of the cumulative amount that has been recouped from Distributable Cash or proceeds of liquidation otherwise distributable to the Partner. That excess (if any) constitutes a demand loan to the Partner. This demand loan will be repayable in accordance with the provisions of this Agreement regarding demand loans by the Partnership to Partners. Page 48
49 Practical issues PIP allocations GAAP vs TAX Allocations for tax can often be in a different allocation step for the waterfall than GAAP allocations GAAP allocations take into account unrealized income (fair value) in their allocations where tax should take into account only realized income GAAP allocation mechanics need to be understood so that tax allocations can be properly applied, particularly with regard to preferred allocation and catch up provision steps Page 49
50 Questions? Page 50
51 Thank you for your participation and feedback!
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