Structuring Targeted Partnership Tax Allocations: Complying With IRC 704(b)

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Structuring Targeted Partnership Tax Allcatins: Cmplying With IRC 704(b) Determining Substantial Ecnmic Effect, Distinguishing Targeted and Regulatry Allcatins WEDNESDAY, FEBRUARY 17, pm Eastern 12pm Central 11am Muntain 10am Pacific Tday s faculty features: Nel P. Brck, Assistant Prfessr, West Virginia University, Mrgantwn, W. Va. Lynn E. Fwler, Partner, Kilpatrick Twnsend & Stcktn, Atlanta The audi prtin f the cnference may be accessed via the telephne r by using yur cmputer's speakers. Please refer t the instructins ed t registrants fr additinal infrmatin. If yu have any questins, please cntact Custmer Service at ext. 10. NOTE: If yu are seeking CPE credit, yu must listen via yur cmputer phne listening is n lnger permitted.

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4 TARGET VERSUS REGULATORY ALLOCATIONS Nel P. Brck, J.D., LL.M., C.P.A. Assistant Prfessr West Virginia University 2015 Nel P. Brck

5 REGULATORY (SAFE HARBOR) ALLOCATIONS

6 REGULATORY ALLOCATIONS What are they? Establish an rdering (r layers) fr allcating partnership prfit and lsses after cnsidering regulatry allcatins. Generally, prfits are allcated first t ffset prir years lsses that eliminated the partners cntributed capital and undistributed prfits that were reflected in their capital accunts at the time such lsses were allcated, and finally t reflect the manner in which the prfits wuld be distributed if the partnership had cash available t distribute. Lsses are generally allcated in the reverse rder f prfits. Liquidating distributins generally will be made in accrdance with psitive capital accunt balances. Allcating prfits t fill-up waterfall layers / / 6

7 REGULATORY ALLOCATIONS Cmmn Issues/Cnsideratins Often the waterfall prvisins are in the distributin sectin f the agreement. There may be a different ways f sharing prfits versus sharing lsses. The allcatins may be tied t target capital accunts even thugh they are layered allcatins. / / 7

8 TARGETED ALLOCATIONS

9 TARGETED ALLOCATIONS What are they? Specifies hw cash will be distributed frm peratins and in liquidatin f the partnership. Allcates prfit/lss s that at the end f the taxable year, each partner s capital accunt is equal t the amunt that wuld be distributed t that partner in liquidatin if all partnership assets were sld at their sectin 704(b) bk value, less the partner s share f minimum gain. They are distributin driven allcatins that have the fllwing characteristics: Liquidatin in accrdance with the distributin prvisins Plug incme s that capital accunts equal what a partner wuld receive upn a hypthetical liquidatin if the assets f the partnership were sld fr their sectin 704(b) value / / 9

10 TARGETED ALLOCATIONS Cmmn Issues/Cnsideratins Targeted allcatins wn t satisfy the substantial ecnmic effect safe harbr because they dn t liquidate in accrdance with capital accunt balances. If drafted prperly, shuld be respected under the ecnmic equivalence test r else are cnsistent with PIP Use f Qualified Incme Offset prvisins Impact f current tax distributins Impact n statutry allcatins Impact f revaluatin events Targeted allcatins may create taxable capital shifts / / 10

11 PARTNERSHIP AGREEMENT PROVISIONS ALLOCATIONS AND DISTRIBUTIONS Allcatin Driven Upn liquidatin, distributins are made t the partners based n their capital accunt balances Referred t as allcatin driven because the allcatins determine the capital accunts, which ultimately determine the ecnmics Smetimes referred t as layer cake allcatins because there is ften a waterfall with multiple layers in the allcatin prvisins Distributin Driven Distributins are nt based n capital accunts Referred t as distributin driven because the allcatins d nt drive the ecnmics Therefre, partnership items must be allcated in such a way that they track the ecnmics i.e., the distributins drive the allcatins / / 11

12 PARTNERSHIP AGREEMENT PROVISIONS ALLOCATIONS AND DISTRIBUTIONS Examples f Allcatin Driven Agreements Safe Harbr Agreements > Agreements satisfying the test fr ecnmic effect > Agreements satisfying the alternate test fr ecnmic effect Nn-Safe Harbr Agreements That Liquidate by Capital Accunts > Agreements that allcate incme and lss n a nn-sectin 704(b) basis fr example, agreements that allcate GAAP incme and lss, r bth realized and unrealized incme and lss, determined n a FMV basis Examples f Distributin Driven Agreements Targeted allcatin agreements Any ther agreement that des nt prvide fr liquidatin by capital accunts / / 12

13 EXAMPLE OF REGULATORY (SAFE HARBOR) AND TARGETED ALLOCATIONS

14 REGULATORY (SAFE HARBOR) AND TARGETED ALLOCATIONS THE FORMULAE Layered allcatins cmpute ending capital under the fllwing frmula: beginning capital + cntributins + - distributins - incme lss = ending capital Targeted allcatins plug incme under the fllwing frmula: target ending capital + cntributins - beginning = capital - distributins incme r lss / / 14

15 REGULATORY (SAFE HARBOR) AND TARGETED ALLOCATIONS CLASSIC 80/20 EXAMPLE Cmmn Issues/Cnsideratins LP cntributes $200 and GP cntributes $0 t partnership Partnership buys tw securities (1 and 2) fr $100 each All distributins are made t LP until it gets its $200 back Then, distributins are made 80% t LP and 20% t GP In Year 2, the partnership sells 1 fr $200 (gain f $100) Partnership distributes the $200 f prceeds t LP / / 15

16 REGULATORY ALLOCATION PROVISION SECTION 1. ALLOCATIONS. (a) Net Incme. Net Incme fr any perid will be allcated: (I) FIRST, 100% TO THE LP UNTIL THE TOTAL NET INCOME ALLOCATED UNDER THIS SECTION 1(A)(I) EQUALS THE TOTAL NET LOSS ALLOCATED UNDER SECTION 1(B)(II), AND (II) SECOND, 80% TO THE LP AND 20% TO THE GP. (B) NET LOSS. NET LOSS FOR ANY PERIOD WILL BE ALLOCATED: (I) FIRST, 80% TO THE LP AND 20% TO THE GP UNTIL THE TOTAL NET LOSS ALLOCATED UNDER THIS SECTION 1(B)(I) EQUALS THE TOTAL NET INCOME ALLOCATED UNDER SECTION 1(A)(II), AND (II) SECOND, 100% TO THE LP. / / 16

17 REGULATORY ALLOCATIONS CAPITAL ACCOUNTS LP GP Bk Tax Bk Tax Cntributin Cntributin 0 0 Gain Gain Distributin (200) (200) Distributin 0 0 Ttal Ttal / / 17

18 SAMPLE TARGET ALLOCATION PROVISION LANGUAGE Except as therwise prvided in this Article, Prfits and Lsses (r items theref) fr any Fiscal Perid shall be allcated amng the Members in such manner that, as f the end f such Fiscal Perid, the respective Capital Accunts f the Members shall be equal t the respective amunts that wuld be distributed t them, determined as if the Cmpany were t (i) liquidate the assets f the Cmpany fr an amunt equal t their Grss Asset Value and (ii) distribute the prceeds f liquidatin pursuant t Sectin Nt all agreements have the r items theref language Puts pressure n guaranteed payment determinatin Might make allcatin fail ecnmic effect equivalence and fall int PIP / / 18

19 SAMPLE TARGET ALLOCATION PROVISION LANGUAGE Targeted allcatins are cmputed under a 6-step prcess: Step 1. Step 2. Step 3. Step 4. Step 5. Step 6. Determine beginning capital fr each partner Allcate cntributins and distributins by partner Add Steps 1 and 2 t determine adjusted capital accunt fr each partner Determine aggregate ending capital Allcate aggregate ending capital t the partners in accrdance with the distributin prvisins Subtract Step 3 frm Step 5 t determine incme fr each partner / / 19

20 TARGETED ALLOCATIONS CAPITAL ACCOUNTS Step 1. Determine Beg. Capital Step 2. Determine Cntrib. and Dist. Step 3. Adjusted Capital Step 4. Determine Aggregate End. Capital Step 5. Allcate Ending Capital 1 st Return Cap. t LP 2 nd Return remainder 80/20 Ttal Ending Cap. Step 6. Taxable Incme by Partner (SUBTRACT STEP 3 FROM STEP 5) LP GP Ttal (200) 0 (200) / / 20

21 BENEFITS AND DETRIMENTS OF TARGETED ALLOCATIONS Lynn Fwler 2014 Kilpatrick Twnsend

22 Why D Targeted Allcatins? Primary Benefit-Certainty f Distributins Target allcatins attempt t replicate safe-harbr allcatins withut requiring liquidating distributins t be in prprtin t psitive capital accunt balances Safe harbr, Treas. Reg (b)(2) If capital accunts dn t reflect parties ecnmic deal, safe harbr allcatins can alter the ecnmics 22 22

23 Why D Targeted Allcatins? Example: Preferred Returns A and B each cntribute $500 t partnership P n 1/1 Year 1 B is entitled t a preferred return f 10% n unreturned capital Next distributins g 1 st t B t return its capital, then t A t return its capital Remaining distributins split 60% t A and 40% t B P invests capital in tw assets, Asset 1 and Asset 2, investing $500 in each asset P sells Asset 1 n 12/31 Year 1 fr $700 P sells Asset 2 n 12/31 Year 2 fr $500 P liquidates and distributes $1200 t A and B pursuant t partnership agreement P engages in n ther transactins 23 23

24 Why D Targeted Allcatins? Example: Preferred Returns Capital Accunt Cmputatin A B Ttal Beginning Capital $500 $500 $1000 Year 1 Preferred Return Allcatin $0 $50 $50 Year 1 Residual Prfit Allcatin $90 $60 $150 Year 2 Preferred Return Allcatin $0 $0 $0 Year 2 Residual Prfit Allcatin $0 $0 $0 Ending Capital Accunt Balances $590 $610 $

25 Why D Targeted Allcatins? Example: Preferred Returns Distributin Waterfall A B Ttal Cumulative Preferred Return $0 $100 $100 Return f B Capital $0 $500 $500 Return f A Capital $500 $0 $500 Residual Distributins $60 $40 $100 Ttal Expected Distributins $560 $640 $

26 Why D Targeted Allcatins? Example: Preferred Returns Cmparisn f Capital Accunts t Distributin Waterfall A B Ttal Capital Accunt Balance $590 $610 $1200 Expected Distributins $560 $640 $1200 Difference $30 ($30) $

27 Why D Targeted Allcatins? Other Benefits Perceived ease f drafting But puts pressure n drafter t draft distributin waterfall crrectly Less risk f surprise distributin result t parties 27 27

28 Issues with Targeted Allcatins Tax Cnsequences f Distributins incnsistent with Capital Accunts Cmparisn f Capital Accunts t Distributin Waterfall A B Ttal Capital Accunt Balance $590 $610 $1200 Expected Distributins $560 $640 $1200 Difference $30 ($30) $0 What are tax cnsequences t A and B f distributin pursuant t Waterfall? Capital shift? Guaranteed payment? Distributin in excess f basis? 28 28

29 Issues with Targeted Allcatins Issues with Applying Allcatins Targeted allcatins require alternate calculatins f actual capital accunt at BOY and target capital accunt at EOY: Partnership return preparer must have systems in place t determine bth amunts 29 29

30 Issues with Targeted Allcatins Issues with Respecting Special Allcatins Many partnerships desire t specially allcate depreciate deductins separately frm the general ecnmic arrangement Special allcatins f gain frm the sale f the depreciated prperty allcated t ffset special allcatins f depreciatin Example: P allcates items generally 50% t A and 50% t B. Hwever, P allcates depreciatin 80% t A and 20% t B. When P sells the partnership prperty, P allcates the gain 80% t A and 20% t B in an amunt equal t prir depreciatin deductins. Are these respected as having substantial ecnmic effect? Substantiality test nt met if allcatins f depreciatin are reasnably expected t be ffset by subsequent allcatins f incme r gain If safe harbr allcatin methd chsen, generally respected because value f prperty deemed t be equal t basis, s gain nt reasnably expected t ffset depreciatin Targeted allcatin methd des nt meet safe harbr fr ecnmic effect, s can t assume value = basis 30 30

31 Issues with Targeted Allcatins Issues with Fractins Rule Fractins Rule IRC 514(c)(9)(E) Permits certain tax exempt partners t invest in leveraged real estate partnerships withut realizing debt financed incme Fractins Rule requires that allcatins have substantial ecnmic effect within the meaning f IRC 704(b)(2) Targeted allcatins d nt meet safe harbr fr ecnmic effect 31 31

32 Issues with Targeted Allcatins Issues with Allcatins f Nnrecurse Deductins Nnrecurse Deductins cst recvery deductins when bk value f partnership assets are less than nnrecurse debt secured by depreciated assets Cannt have ecnmic effect, s must be allcated in accrdance with partners interest in the partnership Treas. Reg (b)(1) Certain allcatins deemed t be in accrdance with partners interest in the partnership Treas. Reg (e) Requires that partnership allcatins generally meet safe harbr ecnmic effect Targeted allcatins d nt meet safe harbr fr ecnmic effect 32 32

33 Issues with Targeted Allcatins Issues with Allcatins f Nnrecurse Debt Nnrecurse Debt Debt fr which n partner has ecnmic risk f lss IRC 752(a) partners include in the basis f their partnership interest allcable share f partnership debt Partners include their share f partnership nnrecurse debt in prprtin t their share f partnership prfits Treas. Reg (a)(3) Partnership agreement may specify interest in partnership prfits as lng as it is cnsistent with allcatins f significant item f incme r gain that have substantial ecnmic effect under IRC 704(b)(2) Targeted allcatins d nt meet safe harbr fr ecnmic effect 33 33

34 Allcatins and Distributins - Prs and Cns Allcatin Driven (Safe Harbr) Advantages Safe harbr, Treas. Reg. c (b)(2) Fractins rule, 514(c)(9)(E) Allcatins f nnrecurse deductins, Treas. Reg (b)(1) Allcatins f nnrecurse liabilities, Treas. Reg (a) Disadvantages Cmplex t draft prperly If wrng, interferes with deal ecnmics Distributin Driven (Targeted/Frced) Advantages Easier t understand the ecnmic deal Easier t draft prperly Disadvantages May prduce unexpected tax results leaving allcatins t accuntants t determine with knwledge that they are ften wrng Allcatins may be challenged 34 34

35 SECTION 704(B) COMPLIANCE REQUIREMENTS Nel P. Brck, J.D., LL.M., C.P.A. Assistant Prfessr West Virginia University 2015 Nel P. Brck

36 OVERVIEW OF OPERATING PARTNERSHIP AGREEMENTS DISTRIBUTIVE SHARE Sectin 704(a) determined by partnership agreement Sectin 704(b) determined in accrdance with partner s interest in a partnership ( PIP ) if: The partnership agreement des nt prvide partners distributive shares, r Allcatins in the partnership agreement lack substantial ecnmic effect ( SEE ) / / 36

37 SUBSTANTIAL ECONOMIC EFFECT Ecnmic Effect Safe harbr - Treas. Reg (b)(2)(ii)(b) (The Big Three ) Maintenance f capital accunts under Treas. Reg (b)(2)(iv) Liquidatin f partner s interest in accrdance with psitive capital accunt balances Deficit Restratin Obligatin ( DRO ) r Qualified Incme Offset ( QIO ) (Alternate Test) Ecnmic Effect Equivalence Treas. Reg (b)(2)(ii)(i) Allcatins are deemed t have ecnmic effect if, at the end f each year, a liquidatin wuld prduce the same ecnmic effect as if the safe harbr had been satisfied, regardless f the ecnmic perfrmance f the partnership / / 37

38 SUBSTANTIAL ECONOMIC EFFECT Substantiality Must be a reasnable pssibility that the allcatin will affect substantially the dllar amunts t be received frm the partnership, independent f tax cnsequences. An allcatin is nt substantial if: Overall tax effect fr any partner is substantially diminished ver the life f the partnership There are shifting tax cnsequences There transitry allcatins / / 38

39 PARTNER S INTEREST IN THE PARTNERSHIP If allcatin fails t satisfy SEE safe harbr, partners distributive shares f partnership items determined in accrdance with PIP. PIP signifies the manner in which the partners have agreed t share the ecnmic benefit r burden (if any) crrespnding t the item being allcated. Reg (b)(3). Takes int accunt all the facts and circumstances relating t the ecnmic arrangement f the partners Factrs include: > Relative cntributins t the partnership > Interest in ecnmic prfits and lsses > Interest in cash flw and ther nn-liquidating distributins > Rights f partners t distributins f capital n liquidatin / / 39

40 TARGETED ALLOCATIONS: AGREEMENT DRAFTING BEST PRACTICES Lynn Fwler 2014 Kilpatrick Twnsend

41 Drafting the Targeted Allcatin Prvisins Include 704(b) Bilerplate Cmputatin f Capital Accunts Definitin f Capital Accunt Definitin f bk prfits and lsses Prvisins fr capital accunt revaluatins and cntributins at FMV Nnrecurse Deductin Prvisins Definitins f nnrecurse deductins and partner nnrecurse deductins Definitins f minimum gain Prvisins fr allcating nnrecurse deductins and partner nnrecurse deductins, Negative capital accunt prvisins Limitatin n lss allcatins Qualified incme ffset-prbably nt necessary but gd windw dressing Curative allcatins-nt necessary 41 41

42 Drafting the Targeted Allcatin Prvisins Tw Imprtant Definitins Target Capital Accunt The amunt that any partner wuld receive if the partnership sld all f its assets at Bk Value (r if greater, the amunt f nnrecurse debt secured by such asset), paid all f liabilities, and distributed the remainder pursuant t the distributin frmula In ther wrds, the amunt that the parties have agreed t distribute t each partner if the partnership liquidated at Bk Value Partially Adjusted Capital Accunt The partner s Capital Accunt balance at the beginning f the year, adjusted fr cntributins t the partnership and distributins frm the partnership during the fiscal year 42 42

43 Drafting the Targeted Allcatin Prvisins Allcatins Partnership Incme allcated t any partner whse Partially Adjusted Capital Accunt is less than its Target Capital Accunt Partnership Lss allcated t any partner whse Partially Adjusted Capital Accunt is greater than its Target Capital Accunt 43 43

44 Special Cnsideratins Targeted Allcatins f Grss vs. Net Incme r Lss In many cases, target allcatins f net incme nt sufficient t create safe harbr result 44 44

45 Net vs. Grss Targeted Allcatins? Example: Preferred Returns A and B each cntribute $500 t partnership P n 1/1 Year 1 B is entitled t a preferred return f 10% n unreturned capital Next distributins g 1 st t B t return its capital, then t A t return its capital Remaining distributins split 60% t A and 40% t B P invests capital in land and leases fr $300/year in Year 1 with $100/year in perating expenses Lease ends in April Year 2, with P earning $100 f rental incme and $100 f perating expense P sells asset fr $1000 P liquidates and distributes $1200 t A and B pursuant t partnership agreement P engages in n ther transactins 45 45

46 Net vs. Grss Targeted Allcatins? Example: Preferred Returns Year 1 Capital Accunt Cmputatin A B Ttal Beginning Capital $500 $500 $1000 Year 1 Preferred Return Allcatin $0 $50 $50 Year 1 Residual Prfit Allcatin $90 $60 $150 Ending Capital Accunt Balances $590 $610 $

47 Net vs. Grss Targeted Allcatins? Example: Preferred Returns Year 2 Capital Accunt Cmputatin Net Incme Only A B Ttal Beginning Capital Balances $590 $610 $1200 Year 2 Preferred Return Allcatin $0 $0 $0 Year 2 Residual Prfit Allcatin $0 $0 $0 Ending Capital Accunt Balances $590 $610 $

48 Net vs. Grss Targeted Allcatins? Example: Preferred Returns Year 2 Capital Accunt Cmputatin Grss Incme and Deductins A B Ttal Beginning Capital Balances $590 $610 $1200 Year 2 Preferred Return Allcatin $0 $50 $50 Year 2 Residual Lss Allcatin ($30) ($20) ($50) Ending Capital Accunt Balances $560 $640 $

49 Special Cnsideratins Targeted Allcatins f Grss vs. Net Incme r Lss Many partnership agreements apply targeted allcatins n a grss basis One-step apprach-allcate net incme/lss under targeted mechanism and nly allcate grss incme t the extent that net incme/lss nt sufficient t achieve safe harbr result Tw-step apprach-allcate all items f grss incme and gain alne under target apprach (as if there were n items f deductin r lss); then allcate all items f deductin and lss under target apprach Tw appraches culd yield substantially different tax answers depending n tax character f incme, gain, lss and deductin 49 49

50 Special Cnsideratins Varying Participatin in Different Items In many cases, partners have different agreement n hw they share perating incme vs. hw they share gain n exit Example: P distributes perating incme 50% t A (capital partner) and 50% t B (service partner with n capital cntributins). P distributes sales prceeds 2/3 t A and 1/3 t B. Partnership agreement shuld set up tw targets, ne t address liquidatin with nthing but existing assets and perating incme, and ne t address sales f assets (tie t tw different distributin waterfalls) 50 50

51 Trap t Avid Circularity Target capital accunt = amunt distributed n liquidatin f partnership Target capital accunt shuld always refer t specific distributin frmula fr amunt distributed n liquidatin Make sure that amunt distributed n liquidatin f partnership psitive capital accunt balances, r yu can t cmpute target capital accunt 51 51