PARTNERSHIP TAX CONSIDERATIONS February 8, … and 12 Todd AND Zuc… · PARTNERSHIP TAX CONSIDERATIONS February 8, 2010 Andrew H. Zuccotti K & L Gates, LLP Brian J. Todd Davis Wright

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PARTNERSHIP TAX CONSIDERATIONS

February 8, 2010

Andrew H. Zuccotti K & L Gates, LLP

Brian J. Todd Davis Wright Tremaine LLP

Law Seminars International | Real Estate Joint Ventures and Funds | 02/08/10 in Seattle, WA

Brian Todd of Davis Wright Tremaine LLPAndrew H. Zuccotti of K&L Gates LLP

Speaker 11: 1Speaker 12: 1

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I. The Basics -- The Substantial Economic Effect Safe Harbor.

The Treasury Regulations promulgated under Code Section 704(b) provide that allocations of items of partnership (or LLC) income, gain, loss and deduction will be respected if they either (i) satisfy the “substantial economic effect” safe-harbor or (ii) are consistent with the partners’ interests in the partnership. The latter test involves a facts and circumstances analysis; the former requires that an allocation must have “economic effect” and that such economic effect must be “substantial.”

A. Economic Effect, in General. The regulations prescribe three requirements for an allocation to have economic effect. All three must be provided for in the partnership or LLC agreement throughout the full term of the LLC or partnership. The requirements are designed to assure that the organization’s profit and loss allocations are consistent with the underlying economic arrangement of the members. The requirements are:

1. That a capital account be maintained for each member in accordance with the rules set out in the regulations;

2. That liquidating distributions be made in accordance with the members’ positive capital account balances; and

3. That if a member has a deficit balance in his or her capital account following the liquidation of his or her interest in the entity, he or she is obligated to restore the amount of the deficit balance to the LLC or partnership. Treas. Reg. § 1.704-1(b)(2)(ii)(b).

Each of these requirements is discussed in more detail below.

B. Capital Account Maintenance. Each member’s capital account is increased by the amount of money and the fair market value of property (net of liabilities assumed by the LLC or partnership or to which the property is subject) contributed to the LLC or partnership by the member and by profits allocated to the member. Each member’s capital account is decreased by the amount of money and the fair market value of property (net of liabilities assumed by the member or to which the property is subject) distributed to the member and by allocations of loss to the member. Treas. Reg. § 1.704-1(b)(2)(iv).

In addition, the regulations permit the capital accounts of the members to be adjusted to reflect unrealized appreciation or depreciation in the value of the LLC’s or partnership’s assets upon the occurrence of certain events. These are:

• A contribution to the LLC or partnership by a new or existing member in exchange for an interest in the LLC or partnership;

• Liquidation of the LLC or partnership or of the member’s interest in the LLC or partnership;




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• In connection with the grant of an interest in the LLC or partnership (other than a de minimis interest) as consideration for the provision of services to or for the benefit of the LLC or partnership by an existing member acting in a member capacity, or by a new member acting in a member capacity or in anticipation of being a member;

• A distribution by the LLC or partnership to a retiring or a continuing member in consideration for an LLC or partnership interest; or

• If substantially all the assets of the LLC or partnership consist of stock, securities, commodities, options, warrants or futures that are regularly traded on an established securities exchange, then adjustments may be made in accordance with generally accepted accounting principles (GAAP). Treas. Reg. § 1.704-1(b)(2)(iv)(f).

This rule permits the capital accounts to be “booked up,” or “marked to market,” in order that unrealized appreciation or depreciation in LLC or partnership property will be allocated to the members who owned interests in the entity during the period in which the appreciation or depreciation occurred. The rule further requires that subsequent allocations of depreciation, depletion, amortization, gain and loss, as computed for tax (not book or capital account maintenance) purposes, be determined so as to take into account the variation between the adjusted basis of the property for tax purposes (which is not adjusted) and the book value of the property (which is adjusted). This requirement is imposed so that the tax burden associated with gain in partnership or LLC property, or the tax benefit associated with depreciation or other loss deductions, follow their correlative economic benefits and burdens.

C. Liquidating Distributions. The regulations require that liquidating distributions be made in accordance with the members’ positive capital account balances. For this purpose, a liquidation means either a liquidation of the entire LLC or partnership, or a liquidation of the member’s entire interest in the LLC or partnership. In either case, however, the members’ positive capital account balances are determined after taking into account all capital account adjustments for the taxable year in which the liquidation occurs.

D. Deficit Restoration Obligation.

1. In General. The third requirement necessary to satisfy the economic effect prong of the substantial economic effect safe harbor is that each member with a deficit in his or her capital account at the time of the liquidation be unconditionally obligated to restore the deficit by the end of the LLC’s or partnership’s taxable year, or, if later, within 90 days after the liquidation. However, requiring that each member be obligated to restore his or her capital account deficit may eliminate the protection from personal liability afforded LLC members and LLP partners under state law. Limited liability company agreements and partnership agreements for LLPs therefore typically provide that the members of the LLC do not have an obligation to restore any capital account deficit.




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2. Alternate Economic Effect Test. To permit the members of an LLC (or the limited partners of a limited partnership or the partners of an LLP) to preserve their limited liability while at the same time matching tax and economic consequences of profit and loss allocations, the regulations provide an alternative test for economic effect. This test requires that the first two prongs of the regular economic effect test (maintenance of capital accounts and liquidating distributions in accordance with capital account balances) be satisfied. Additionally, instead of requiring members to have a deficit make up obligation, if the partnership or limited liability company agreement contains a “qualified income offset provision,” the regulations will deem an allocation to have economic effect to the extent it does not cause, or increase, a deficit balance in a partner’s or member’s capital account as of the end of the year in which the allocation occurs in excess of any limited amount that the partner or member is by contract obligated to restore.

3. Adjustments for Reasonably Expected Events. In making the determination whether an allocation will create (or increase) a deficit in a member’s capital account in excess of any amount the member is obligated to restore, the regulations require not only that all allocations for the year be taken into account, but, in addition, that certain allocations or events reasonably anticipated to occur in future years be taken into account. The most relevant of these events typically relates to future distributions. This rule requires that the partner’s or member’s capital account be reduced by any distributions expected to be made in future years, to the extent such distributions exceed offsetting increases to the member’s capital account that reasonably are expected to occur during (or prior to) the years in which the distributions are expected to be made. The purpose of this rule is to prevent a loss allocation from being made to a partner or member in one year, which drops his capital account balance to (or close to) zero when it is expected that a distribution will be made in a subsequent year without any offsetting profit allocation, which distribution would create a deficit in the member’s capital account. Absent this requirement, since the member has no obligation to make a contribution to the LLC to restore his capital account deficit, and consequently would not bear the economic burden associated with the loss earlier allocated to him, the goal of matching economic and tax consequences would fail.

4. Qualified Income Offset. Notwithstanding that an allocation will have economic effect under the alternate test only to the extent it does not create (or increase) a deficit in a partner’s or member’s capital account, after taking into account reasonably expected distributions to the partner or member, a partner’s or member’s capital account nonetheless may become negative as a result of unexpected events or distributions. Since the partner or member has no obligation to restore the deficit, and cannot in that way bear the economic burden associated with the loss contributing to the deficit, the regulations employ a gross income allocation mechanism as a substitute for the deficit restoration obligation. In other words, a partner or member whose capital account unexpectedly drops below zero is required to bear the economic burden of the loss creating the deficit by receiving a subsequent allocation of gross income to restore his or her capital account to zero as quickly as possible. The regulations denominate this gross income allocation a “qualified income offset,” and require that a partnership or LLC agreement contain a qualified income offset provision in order to satisfy the




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alternate test for economic effect.

E. Substantiality. The second prong of the substantial economic effect safe harbor requires that the economic effect of an allocation be “substantial.” Under the regulations, the economic effect of an allocation of profit or loss will be substantial, and be respected, if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners or members from the partnership or LLC, independent of tax consequences. The focus here is on whether the after-tax consequences of at least one partner or member will (in present value terms) be enhanced by receiving the allocations in the partnership or LLC agreement without a concomitant effect on the after-tax economic consequences of any other partner or member. If so, then the allocation may not be substantial.

F. Failure to Satisfy the Substantial Economic Effect Test – the “No Harm, No Foul” Rule. Even if allocations made to a member or partner do not have “substantial economic effect” because the partnership or LLC agreement does not contain the provisions required to satisfy the economic effect test, the regulations nonetheless will deem the allocations to have economic effect if, as of the end of each partnership or LLC taxable year a liquidation of the partnership or LLC at the end of such year or at the end of any future year would produce the same economic results to the partners or members as would occurs if the economic effect requirements were satisfied. It is this provision that drafters of LLC and partnership agreements using the targeted capital account approach, discussed below, rely upon for comfort that allocations made under the agreement will be respected.

G. Failure to Satisfy the Substantial Economic Effect Test – the Partners’ Interest in the Partnership Test. If a partnership or LLC agreement provides for an allocation of profits or losses that does not satisfy the substantial economic effect safe harbor, and the “no harm, no foul rule” cannot be said to apply, the IRS may reallocate profits and losses in accordance with the partners’ or members’ interests in the partnership or LLC—that is, in accordance with the manner in which the partners or members have agreed to share the economic benefit or burden (if any) corresponding to the profit or loss allocation that does not have substantial economic effect. A partner’s or member’s interest in the partnership or LLC will be determined based upon all of the facts and circumstances, including the partners’ or members’ relative contributions to the partnership or LLC, the interests of the partners or members in economic profits and losses (if different than their interests in taxable income or loss), the interests of the partners or members in cash flow and other non-liquidating distributions and the rights of the partners or members to distributions of capital on liquidation.

II. Drafting Financial Provisions of a Partnership or LLC Agreement.

A. Overview. In general there are currently two primary methods of drafting the financial provisions of a partnership agreement or an LLC operating agreement. These typically are referred to as: (i) liquidation by capital account balances and (ii) liquidation by specified tiers with target allocations. The draftsman using the liquidation-by-capital-accounts method uses allocations of profit and loss to construct capital




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accounts that will support the distribution scheme which the businessmen have negotiated. This methodology follows the requirements set forth in the Section 704(b) regulations for “economic effect” (or, more accurately in the context of an LLC, the requirements for the so-called “alternate test for economic effect”), described above. Draftsmen who use the liquidation-by-tiers-with-target-allocations method prefer not to rely on capital account balances for liquidating distributions. Why? They are concerned that the balances may be wrong, or if not wrong there is often a suspicion that the accounting judgments or the technical minutia in the allocation of profit and loss are sufficiently judgmental that the draftsmen cannot be comfortable that the LLC operating agreement reflects the economic deal. The liquidation-by-tiers-with-target-allocations method involves (i) liquidation by specified tiers or percentages (without regard to capital account balances); and (ii) “target allocation” provisions which allocate profit and loss in a manner so that capital accounts will follow the specified tiers or percentages. In other words, with the liquidation-by-capital-accounts-balance method, cash distributions on liquidation follow allocations of profit and loss; with the liquidation-by-tiers-with-target-allocations method allocations of profit and loss follow the described cash distributions.

B. Advantages/Disadvantages. Which method is better? Frankly, it is hard to say. The liquidation-by-capital-accounts method has the advantage, indeed it is probably its greatest benefit, of being more clearly compliant with the substantial economic effect safe-harbor. It is debatable1 whether the liquidation-by-tiers-with-target-allocations method satisfies the alternate test for economic effect2.

Furthermore, there is considerable doubt whether target allocations will satisfy the so-called “fractions rule” of Code Section 514(c)(9)(E), discussed further below. Accordingly, liquidation-by-tiers-with-target-allocations method is particularly disadvantageous if the LLC or partnership will have as members charities or qualified plans which wish to avoid debt-financed unrelated business income tax. Similarly, the liquidation-by-tiers-with-target allocations method likely does not satisfy the tax-exempt use property rules of Code Section 168(h)(6) and, therefore, it may be a problem for LLCs (and other partnerships) with tax-exempt members.

Finally, it can be extremely tricky to draft a liquidation-by-tiers-with target allocations partnership or operating agreement in which a pure “profits interest” is granted to a service partner or member. It is all too easy for a taxable capital shift to occur under such an agreement.

The liquidation-by-tiers-with-target-allocations is clearly becoming more common. Presumably this is due to the draftsman’s concern to provide for cash distributions which reflect the businessmen’s deal. It is more crucial to get the right cash allocations than to be comfortable that the tax allocations will be respected by the IRS.

The other advantage of the liquidation-by-tiers-with-target-allocations method is 1 See Cuff, Some Basic Issues in Drafting Real Estate Partnership and Limited Liability Company Agreements, 65 N.Y.U. Inst. § 18.84 [7] (2007). 2 It seems clear that an agreement which provides for liquidation by tiers or percentages without target allocations does not meet the alternate test for economic effect.




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its (some would say “illusion of”3) simplicity. A draftsman can insert the target allocation provision into any operating agreement he drafts. He can exclude tax lawyers completely from the drafting process. He can save the client money and (some would say) headaches. The liquidation-by-tiers-with-target-allocations method is, in our view, more likely than the liquidation-by-capital-account method to give rise to capital shifts among the members of an LLC or the partners of a partnership, particularly in situations involving preferred returns. By its nature the liquidation-by-tiers method directs available cash be distributed in tiers. This may move one member’s capital contribution to another, senior member. (The federal income tax consequences of internal capital shifts in an LLC are not well understood by practitioners.)

But this (apparent) simplicity comes at a cost, i.e., it is difficult to predict how profit and losses will be allocated. This may be a reason why accountants typically prefer the liquidation-by-capital-accounts method. And, given new Code Section 6694, which imposes penalties on “return preparers” who take a position on a return and do not have “a reasonable belief that the position would more likely than not be sustained on the merits,” it seems likely that the accountants’ preference for greater predictability will only increase. Furthermore, this lack of predictability probably makes it even more appropriate to include in the operating agreement a provision for distributions to pay tax on allocations of income.

The best answer we can give to the question of which method to use in drafting LLC and partnership agreements is that it depends on the circumstances. If one of the members is a tax exempt plan or a charity, the liquidation-by-capital-accounts method seems clearly preferable because of Sections 168(h) and 514(c)(9)(E). If the business deal includes a flip-flop as a function of an internal rate of return calculation, the liquidation-by-tiers-with-target-allocations method is preferable because it is difficult to draft a flip-flop which is a function of an IRR – a cash return concept – using the liquidation-by-capital-accounts method.

C. Potential Pitfalls: Drafting Issues to Watch For.

Two recent cases illustrate the dangers of trying to draft an LLC agreement without input from tax counsel.

1. Imprimis Investors, LLC. v. U.S., ___F.3d___ (Cl. Ct. 2008); 102 AFTR2d 2008 5727.

The LLC Agreement provided for a “waterfall” of allocations of net profits and net losses and then, after such waterfall, 20% of net profits and net losses would be allocated to one member, Insight. If the net profits consisted of “items of ordinary income,” then Insight was to receive a special gross income allocation of such “ordinary income” items equal to the amount Insight would otherwise receive with the remainder to be allocated to the other members. If the amount of ordinary income allocated to Insight 3 Cuff, “Working with Target Allocation Provisions: Idiot-Proof or Drafting for Idiots?” (Pre-publication draft) (2008). Mr. Cuff sets forth a series of examples arguing that “the perceived simplicity of the target allocation provision is considerably overstated.




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was less than what Insight would otherwise receive, then the LLC was to allocate other income, such as capital gain, to make up the difference. The term “ordinary income” was not defined. Insight argued that the term “ordinary income” excluded capital gain and moved for summary judgment. The LLC argued that the plan meaning of “ordinary income” is income taxed at ordinary income tax rates and that the term includes, therefore, short term capital gain. The court held that the term “ordinary income” unambiguously excluded short-term capital gain.

2. Interactive Corp v. Vivendi Universal, S.A. (Del. Ch. 2004) 2004WL.

In this case, an LLLP was formed and its agreement provided for a profits allocation waterfall in which preferred units received a priority profits allocation in a specified annual percentage (the “Preferred Return”) and after such allocation residual profits were allocated based on percentage interests. Tax distributions were to be made annually in an amount “[e]qual to the product of (a) the amount of taxable income allocated to such partner for such taxable year pursuant to Section 7.02 [the entire waterfall] and (b) the highest aggregate marginal statutory federal, state, local and foreign income tax rate . . ..” Thus, the LLLP Agreement in effect made the preferred return an after-tax amount. Vivendi contended that the LLLP was not required to make tax distributions to the preferred interest holder, the tax distribution having already been satisfied by the distribution of the Preferred Return. In addition, Vivendi argued the doctrines of waiver, estoppel, unclean hands, mutual mistake and unilateral mistake, all of which it claimed supported reformation of the contract. The count rejected each of these arguments and followed the “plain meaning” of the agreement.

III. Examples.

A. “Liquidation-By-Capital-Accounts” Allocation Provisions.

8.4 Capital Accounts.

8.4.1 Maintenance. A capital account (“Capital Account”) shall be determined and maintained for each Member in accordance with the principles of Regulation Section 1.704-1(b) at all times throughout the full term of the Company. In the event of a permitted sale or assignment of all or any part of an Interest, the Capital Account of the transferor shall become the Capital Account of the transferee to the extent it relates to the transferred Interest.

8.4.2 Capital Account Adjustments, in General. The book value of all Company properties shall, upon Board Approval, be adjusted to equal their respective gross fair market values (as reasonably determined by the Board) as of the following times: (a) in connection with the acquisition of an Interest in the Company by a new or existing Member for more than a de minimis Capital Contribution; (b) in connection with the liquidation of the Company as defined in Regulation




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Section 1.704-(1)(b)(2)(ii)(g); or (c) in connection with a more than de minimis distribution to a retiring or a continuing Member as consideration for all or a portion of its Interest. In the event of a revaluation of any Company assets hereunder, the Capital Accounts of the Members shall be adjusted, including continuing adjustments for depreciation, to the extent provided in Regulation Section 1.704-(1)(b)(2)(iv)(f). The Board shall determine such values.

8.4.3 Profits Interest. Member D is receiving his interest in the Company in consideration of services to be rendered to the Company in his capacity as a Member of the Company. Member D’s interest in the Company is a profits interest only, and not a capital interest of any kind, and his initial Capital Account balance in the Company shall be zero (0).

8.5 No Interest or Right to Withdraw Capital. No interest shall be paid on Capital Contributions and no Member shall have the right to withdraw its Capital Contribution. A Member, irrespective of the nature of its Capital Contribution, has only the right to demand and receive cash in return for its Capital Contribution.

ARTICLE 9 -- ALLOCATIONS

9.1 Allocation of Net Profit and Loss – In General.

9.1.1 Allocation of Net Profit. After giving effect to the special allocations set forth in Sections 9.2 and 9.3, the net profit for any fiscal year of the Company shall be allocated among the Members in the following order of priority:

(a) First, to the Members in the reverse chronological order in which net losses were allocated to the Members pursuant to Sections 9.1.2(e), 9.1.2(d), 9.1.2(c) and 9.1.2(b), respectively, until each Member has received aggregate allocations of net profit under this Section 9.1.1(a) in an amount equal to, but not in excess of, the aggregate allocations of net loss to such Member pursuant to Sections 9.1.2(b) through 9.1.2.(e) for all prior fiscal years;

(b) Second, to the Members in proportion to and to the extent of their respective accrued Preferred Returns until the aggregate Profits allocated pursuant to this Section 9.1.1(b) is equal to, but not in excess of, each Member’s accrued Preferred Return; and

(c) Thereafter, to the Members in proportion to their respective Percentage Interests.

9.1.2 Allocation of Net Loss. After giving effect to the special allocations set forth in Sections 9.2 and 9.3, the net loss for any




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fiscal year of the Company shall be allocated among the Members as follows:

(a) First, in proportion to the amount of net profits allocated to the Members pursuant to Section 9.1.1(c) in an amount equal to the excess, if any, of (a) the cumulative net profits allocated to the Members pursuant to Section 9.1.1(c) for all prior fiscal years, over (b) the cumulative net losses allocated to the Members pursuant to this Section 9.1.2(a) for all prior fiscal years;

(b) Second, in proportion to the amount of net profits allocated to the Members pursuant to Section 9.1.1(b) in an amount equal to the excess, if any, of (a) the cumulative net profits allocated to the Members pursuant to Section 9.1.1(b) for all prior fiscal years, over (b) the cumulative net losses allocated to the Members pursuant to this Section 9.1.2(b) for all prior fiscal years;

(c) Third, to the Members in proportion to their respective Percentage Interests; provided, however, that net losses shall not be allocated to any Member pursuant to this Section 9.1.2(c) to the extent such allocation would cause such Member to have a Deficit Capital Account at the end of any fiscal year (which excess net loss shall, instead, be allocated in accordance with Section 9.1.2(d);

(d) Fourth, the remaining net loss, if any, shall be allocated among the Members who do not have Deficit Capital Accounts in proportion to their respective Percentage Interests; provided, however, that no allocation under this Section 9.1.2(d) shall cause any Member to have a Deficit Capital Account; and

(e) Thereafter, any remaining net loss shall be allocated among the Members in proportion to their respective Percentage Interests.

9.2 Special Allocations. The following special allocations shall be made for any fiscal year of the Company in the following order:

9.2.1 Minimum Gain Chargeback. If there is a decrease in the Company’s “partnership minimum gain,” as defined in and determined under Regulation Sections 1.704-2(b)(2) and 1.704-2(d), the minimum gain chargeback provisions of Regulation Section 1.704-2(f), which are hereby incorporated into this Agreement by this reference, shall be applied.

9.2.2 Member Minimum Gain Chargeback. If there is a decrease in any Member’s share of “partner nonrecourse debt minimum gain,” as defined in and determined under Regulation Section 1.704-2(i), the partner nonrecourse debt minimum gain chargeback provisions of




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Regulation Section 1.704-2(i)(4), which are hereby incorporated into this Agreement by this reference, shall be applied.

9.2.3 Qualified Income Offset. In the event that any Member unexpectedly receives any adjustments, allocations, or distributions described in Regulation Sections 1.704-1(b)(2)(ii)(d)(4), (5) or (6), items of Company income and gain shall be specially allocated to such Member in accordance with Regulation Section 1.704-(1)(b)(2)(ii)(d).

9.2.4 Nonrecourse Deductions. “Nonrecourse deductions,” as defined in and determined under Regulation Sections 1.704-2(b)(1) and (c), shall be allocated among the Members in accordance with their respective Percentage Interests.

9.2.5 Member Nonrecourse Deductions. “Partner nonrecourse deductions,” as defined in and determined under Regulation Sections 1.704-2(i)(1) and (2), shall be specially allocated among the Members in accordance with Regulation Section 1.704-2(i).

9.3 Corrective Allocations. The allocations set forth in Section 9.2 are intended to comply with certain regulatory requirements under Code Section 704(b). The parties hereto intend that, to the extent possible, all allocations made pursuant to such Sections will, over the term of the Company, be offset either with other allocations pursuant to Section 9.2 or with special allocations of other items of Company income, gain, loss, or deduction pursuant to this Section 9.3. Accordingly, the Board is hereby authorized and directed to make offsetting allocations of Company income, gain, loss or deduction under this Section 9.3 in whatever manner it determines is appropriate so that, after such offsetting special allocations are made (and taking into account the reasonably anticipated future allocations of income and gain pursuant to Sections 9.2.1 and 9.2.2), the Capital Accounts of the Members are, to the extent possible, equal to the Capital Accounts each would have if the provisions of Section 9.2 were not contained in this Agreement and all income, gain, loss and deduction of the Company were instead allocated pursuant to Section 9.1.

9.4 Other Allocation Rules.

9.4.1 General. Except as otherwise provided in this Agreement, all items of Company income, gain, loss, deduction, credit, and any other allocations not otherwise provided for shall be divided among the Members in accordance with their respective Percentage Interests, or as otherwise may be required under the Code and the Regulations thereunder.




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9.4.2 Allocation of Excess Nonrecourse Liabilities. Solely for purposes of determining a Member’s proportionate share of the “excess nonrecourse liabilities” of the Company within the meaning of Regulation Section 1.752-3(a)(3), the Members’ interests in the Company’s profits shall be in accordance with the allocation set forth in Section 9.1.1(b).

9.4.3 Allocations in Connection with Varying Interests. If, during a Company fiscal year, there is (a) a permitted transfer of all or a part of a Member’s Interest or (b) the admission or withdrawal of a Member, net profit, net loss, each item thereof, and all other tax items of the Company for such fiscal year shall be divided and allocated among the Members by taking into account their varying interests during such fiscal year in accordance with Code Section 706(d) and using any conventions permitted by law and selected by the Board.

9.5 Determination of Net Profit or Loss. The net profit or net loss of the Company, for each fiscal year or other period, shall be an amount equal to the Company’s taxable income or loss for such period, determined in accordance with Code Section 703(a), with the following adjustments:

(a) all items of income, gain, loss or deduction required to be stated separately pursuant to Code Section 703(a)(1), including income and gain exempt from federal income tax, shall be included in taxable income or loss;

(b) expenditures described in Code Section 705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures pursuant to Regulation Section 1.704-1(b)(2)(iv)(i) and not otherwise taken into account in computing net profit or loss shall be subtracted from such taxable income or loss;

(c) any adjustment to the book value of the assets of the Company pursuant to Section 8.4.2 shall be treated as an item of gain or loss, as the case may be;

(d) for purposes of computing taxable income or loss on the disposition of an item of Company property or for purposes of determining the cost recovery, depreciation, or amortization deduction with respect to such property, the Company shall use such property’s book value computed in accordance with Regulation Section 1.704-1(b); and

(e) any items that are specially allocated pursuant to Sections 9.2 and 9.3 shall not be taken into account in computing the Company’s net profit or loss., including income and gain exempt from federal income tax, shall be included in taxable income or




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loss.

9.6. Mandatory Tax Allocations Under Code Section 704(c). In accordance with Code Section 704(c) and Regulation Section 1.704-3, income, gain, loss and deduction with respect to any property contributed to the capital of the Company shall, solely for tax purposes, be allocated among the Members so as to take account of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its initial book value computed in accordance with Section 9.5.2. Prior to the contribution of any property to the Company that has a fair market value that differs from its adjusted tax basis in the hands of the contributing Member on the date of contribution, all Members shall agree upon the allocation method to be applied with respect to that property under Regulation Section 1.704-3, which allocation method shall be set forth on attached Schedule 2, as amended from time to time. The same procedure shall apply to any revaluation of Company property as permitted under Regulation Section 1.704-1(b)(2)(iv)(f). Allocations pursuant to this Section 9.6 are solely for purposes of federal, state, and local taxes and shall not affect, or in any way be taken into account in computing, any Member’s Capital Account or share of net profit, net loss, or other items as computed for book purposes, or distributions pursuant to any provision of this Agreement.

ARTICLE 10 -- DISTRIBUTIONS

10.1 Operating Distributions. Upon Board Approval, the Company shall make distributions of Distributable Cash to the Members in the following order of priority:

10.1.1 Tax Distributions. On April 15, June 15, and September 15 of each fiscal year, and on January 15 of the following year, the Company shall make a distribution to the Members (a “Tax Distribution”) in proportion to their respective Percentage Interests in the aggregate amount determined under this Section 10.1.1. The total amount of each Tax Distribution shall be the product of multiplying (a) the highest combined marginal Federal and state income tax rate applicable to any Member, or, if any Member is not itself subject to such tax, to any of its owners, for the fiscal year in question, by (b) the Company’s best estimate of its net profit allocable to the Members pursuant to Section 9.1.1 for the fiscal year through the end of the tax quarter in question (each of the periods ending March 31, May 31, August 31, and December 31 each year). The amount determined under the previous sentence shall be reduced by the amount of any Tax Distribution previously made by the Company to the Members during the fiscal year in question (other than Tax Distribution made during that fiscal year that are required to be made under the provisions of this Section 10,.1.1 with respect to a prior fiscal year);




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10.1.2 Preferred Return. Second, to the Members in proportion to and to the extent of the accrued but unpaid Preferred Return of each Member on the date of such distribution;

10.1.3 Return of Invested Capital. Third, to the Members in proportion to their respective Adjusted Capital Contributions until each Member’s Adjusted Capital Contribution is zero; and

10.1.4 Residual Distribution. Thereafter, to the Members in proportion to their respective Percentage Interests.

10.2 Liquidating Distributions. Notwithstanding Section 10.1, distributions in liquidation of the Company shall be made to the Members in proportion to the positive balances of their respective Capital Accounts, as determined after taking into account all Capital Account adjustments for the taxable year during which the liquidation occurs.

B. “Liquidation-By-Tiers-With Target Allocations” Provisions.

DEFINITIONS

“Carrying Value” means (a) with respect to any property contributed to the Company by a Member, the fair market value of such property, as determined in good faith by the Managing Member, reduced (but not below zero) by all Depreciation with respect to such property charged to the Members’ Capital Accounts and (b) with respect to any other asset of the Company, the adjusted basis of such property for federal income tax purposes, all as of the time of determination. The Carrying Value of any property shall be adjusted in accordance with the second paragraph of Section 3.9 to reflect changes, additions or other adjustments to the Carrying Value of Company properties, as deemed appropriate by the Managing Member.

“Deficit Capital Account” means, with respect to any Member, the deficit balance, if any, in such Member’s Capital Account as of the end of the taxable year, after giving effect to the following adjustments:

(a) credit to such Capital Account any amount that such Member is obligated to restore to the Company under Regulation Section 1.704-1(b)(2)(ii)(c), as well as any addition thereto pursuant to the next to last sentences of Regulation Sections 1.704-2(g)(1) and (i)(5); and

(b) debit to such Capital Account the items described in Regulation Section 1.704-1(b)(2)(ii)(d)(4), (5) and (6).

This definition is intended to comply with the provisions of Regulation Sections 1.704-1(b)(2)(ii)(d) and 1.704-2, and shall be interpreted consistently with those provisions.




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“Depreciation” means, for each fiscal year, an amount equal to the depreciation, amortization or other cost recovery deduction allowable with respect to an asset for such year or other period for federal income tax purposes; provided, that if the Carrying Value of an asset differs from its adjusted basis for federal income tax purposes at the beginning of any such year or other period, Depreciation shall be an amount that bears the same relationship to the Carrying Value of such asset as the depreciation, amortization, or other cost recovery deduction computed for federal income tax purposes with respect to such asset for the applicable period bears to the adjusted tax basis of such asset at the beginning of such period, or if such asset has a zero adjusted tax basis, Depreciation shall be an amount determined under any reasonable method selected by the Managing Member.

“Mandatory Tax Distribution” means, with respect to a Member for a fiscal year, a Distribution in cash in an amount equal to the product of (a) the net amount of all taxable income, gain, loss and deduction of the Company allocated to such Member with respect to such year pursuant to Article 7, excluding (i) any income allocated to such Member pursuant to Code Section 704(c) in accordance with Section 7.6 and (ii) any depreciation or amortization deductions attributable to basis adjustments under Code Section 743(b) for the benefit of such Member and (b) the highest marginal Federal income tax rate applicable to individuals for such fiscal year.

“Modified Adjusted Capital Account” means, with respect to any Member, an amount equal to such Member’s Capital Account, increased by the sum of such Member’s share of “partnership minimum gain,” as defined in and determined under Regulation Sections 1.704-2(b)(2) and 1.704-2(d) and such Member’s share of “partner nonrecourse debt minimum gain,” as defined and determined under Regulation Section 1.704-2(i).

“Target Capital Account” means an amount, determined with respect to each Member for any fiscal year, equal to the hypothetical Distribution such Member would receive if each Company asset (other than cash) were sold for an amount of cash equal to such asset’s Carrying Value as of the end of such fiscal year, each liability of the Company were satisfied in cash in accordance with its terms (limited, with respect to each Nonrecourse Liability, to the Carrying Value of the asset or assets securing such Nonrecourse Liability), and all remaining cash of the Company (including the net proceeds of such hypothetical transactions and all cash otherwise available after the hypothetical satisfaction of all Company liabilities) were distributed in full to the Members pursuant to Section 7.8; provided that if upon such hypothetical liquidation instead of receiving a Distribution such Member would be obligated to make a capital contribution to the Company, such Member’s Target Capital Account shall be a negative amount equal to such contribution obligation.




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ARTICLE 7 -- ALLOCATIONS AND DISTRIBUTIONS

7.1 Allocation of Income and Loss . After giving effect to the special allocations set forth in Sections 7.2 and 7.3, and subject to Section 7.8, the net profit or loss for any fiscal year of the Company and, if necessary, items of income, gain, loss and deduction included in the determination of net profit or loss, shall be allocated among the Members so as to reduce, proportionately, the differences between their respective Modified Adjusted Capital Account balances and their respective Target Capital Accounts for such fiscal year.

7.2 Special Allocations. The following special allocations shall be made for any fiscal year of the Company in the following order:

7.2.1 Minimum Gain Chargeback. If there is a decrease in the Company’s “Company minimum gain,” as defined in and determined under Regulation Sections 1.704-2(b)(2) and 1.704-2(d), the minimum gain chargeback provisions of Regulation Section 1.704-2(f), which are hereby incorporated into this Agreement by this reference, shall be applied.

7.2.2 Member Minimum Gain Chargeback. If there is a decrease in any Member’s share of “Member nonrecourse debt minimum gain,” as defined in and determined under Regulation Section 1.704-2(i), the Member nonrecourse debt minimum gain chargeback provisions of Regulation Section 1.704-2(i)(4), which are hereby incorporated into this Agreement by this reference, shall be applied.

7.2.3 Qualified Income Offset. In the event that any Member unexpectedly receives any adjustments, allocations, or distributions described in Regulation Sections 1.704-1(b)(2)(ii)(d)(4), (5) or (6), items of Company income and gain shall be specially allocated to such Member in accordance with Regulation Section 1.704-(1)(b)(2)(ii)(d); provided that an allocation pursuant to this Section 7.2.3 shall be made only if and to the extent that such Member would have a Deficit Capital Account after all other allocations provided for in this Article 7 have been tentatively made as if this Section 7.2.3 were not in this Agreement.

7.2.4 Gross Income Allocation. In the event any Member has a deficit Capital Account at the end of any fiscal year or other period which is in excess of the sum of (i) the amount such Member is obligated to restore pursuant to any provision of this Agreement, and (ii) the amount such Member is deemed to be obligated to restore pursuant to the next-to-last sentence of Regulation Sections 1.704-2(g)(1) and 1.704-2(i)(5), each




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such Member shall be specially allocated items of Company income and gain in the amount of such excess as quickly as possible, provided that an allocation pursuant to this Section 7.2.4 shall be made only if and to the extent that such Member would have a Deficit Capital Account in excess of such sum after all other allocations provided for in this Article 7 have been made as if Section 7.2.3 and this Section 7.2.4 were not in this Agreement.

7.2.5 Nonrecourse Deductions. “Nonrecourse deductions,” as defined in and determined under Regulation Sections 1.704-2(b)(1) and (c), shall be allocated among the Members in accordance with their respective Percentage Interests.

7.2.6 Member Nonrecourse Deductions. “Member nonrecourse deductions,” as defined in and determined under Regulation Sections 1.704-2(i)(1) and (2), shall be specially allocated among the Members in accordance with Regulation Section 1.704-2(i).

7.3 Corrective Allocations. The allocations set forth in Section 7.2 are intended to comply with certain regulatory requirements under Code Section 704(b). The Members intend that, to the extent possible, all allocations made pursuant to such Sections will, over the term of the Company, be offset either with other allocations pursuant to Section 7.2 or with special allocations of other items of Company income, gain, loss, or deduction pursuant to this Section 7.3. Accordingly, the Managing Member is hereby authorized and directed to make offsetting allocations of Company income, gain, loss or deduction under this Section 7.3 in whatever manner the Managing Member determines is appropriate so that, after such offsetting special allocations are made (and taking into account the reasonably anticipated future allocations of income and gain pursuant to Sections 7.2.1 and 7.2.2), the Capital Accounts of the Members are, to the extent possible, equal to the Capital Accounts each would have if the provisions of Section 7.2 were not contained in this Agreement and all income, gain, loss and deduction of the Company were instead allocated pursuant to Section 7.1.1 and Section 7.1.2.

7.4 Other Allocation Rules.

7.4.1 General. Except as otherwise provided in this Agreement, all items of Company income, gain, loss, deduction, credit, and any other allocations not otherwise provided for shall be divided among the Members in accordance with their Percentage Interests, or as otherwise may be required under the Code and the Regulations thereunder.

7.4.2 Allocation of Excess Nonrecourse Liabilities. Solely for purposes of determining a Member’s proportionate share of “excess nonrecourse liabilities” of the Company within the meaning of




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Regulation Section 1.752-3(a)(3), the Member’s interests in the Company’s profits shall be their respective Percentage Interests.

7.4.3 Allocations in Connection with Varying Interests. If, during a Company fiscal year, there is (i) a permitted transfer of all or a part of a Member’s interest in the Company, or (ii) the admission or withdrawal of a Member, net profit, net loss, each item thereof, and all other tax items of the Company for such fiscal year shall be divided and allocated among the Members by taking into account their varying interests during such fiscal year in accordance with Code Section 706(d) and using any conventions permitted by law and selected by the Managing Member.

7.5 Determination of Net Profit or Loss. The net profit or net loss of the Company, for each fiscal year or other period, shall be an amount equal to the Company’s taxable income or loss for such period, determined in accordance with Code Section 703(a), with the following adjustments:

(a) all items of income, gain, loss or deduction required to be stated separately pursuant to Code Section 703(a)(1), including income and gain exempt from federal income tax, shall be included in taxable income or loss;

(b) expenditures described in Code Section 705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures pursuant to Regulation Section 1.704-1(b)(2)(iv)(i) and not otherwise taken into account in computing net profit or loss shall be subtracted from such taxable income or loss;

(c) any adjustment to the Carrying Value of the assets of the Company shall be treated as an item of gain or loss, as the case may be;

(d) for purposes of computing taxable income or loss on the disposition of an item of Company property or for purposes of determining the cost recovery, depreciation, or amortization deduction with respect to such property, the Company shall use such property’s book value determined in accordance with Regulation Section 1.704-1(b); and

(e) any items that are specially allocated pursuant to Section 7.2 or Section 7.3 shall not be taken into account in computing the Company’s net profit or loss., including income and gain exempt from federal income tax, shall be included in taxable income or loss.

7.6 Mandatory Tax Allocations Under Code Section 704(c). In accordance with Code Section 704(c) and Regulation Section 1.704-3, income, gain, loss and deduction with respect to any property contributed




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to the capital of the Company shall, solely for tax purposes, be allocated among the Members so as to take account of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its initial Carrying Value. Prior to the contribution of any property to the Company that has a fair market value that differs from its adjusted tax basis in the hands of the contributing Member on the date of contribution, the contributing Member and the Managing Member shall agree upon the allocation method to be applied with respect to that property under Regulation Section 1.704-3, which allocation method shall be set forth on a Schedule attached to this Agreement, as amended from time to time. The same procedure shall apply to any revaluation of Company property as permitted under Regulation Section 1.704-2(b)(iv)(f); provided, however, that all decisions regarding allocation methods under Regulation Section 1.704-3 shall be made by the Managing Member.

Allocations pursuant to this Section 7.6 are solely for purposes of federal, state, and local taxes and shall not affect, or in any way be taken into account in computing, any Member’s Capital Account or share of net profit, net loss, or other items as computed for book purposes, or distributions pursuant to any provision of this Agreement.

7.7 Distributions.

(a) Subject to the restrictions set forth in Section 7.9, the Members authorize the Managing Member, acting without the further approval of the Members, to make Distributions when and if the Managing Member deems appropriate in its absolute discretion; provided that (i) after the third anniversary of the Closing Date, the Managing Member shall make a Distribution of cash held by the Company in excess of: the greater of (x) $___________ or (y) the amount of reserves established by the Managing Member to meet the anticipated cash needs of the Company; and (ii) the Managing Member shall make the Mandatory Tax Distribution with respect to a Company fiscal year within ninety (90) days after the end of such fiscal year, to the extent of cash held by the Company in excess of the amount of reserves established by the Managing Member to meet the anticipated cash needs of the Company; provided, however, that both clauses (i) and (ii) above shall be.

(b) Distributions to the Members, other than Mandatory Tax Distributions, shall be calculated and distributed as follows:

(i) Distributions shall first be made to the Class A Members, in proportion to their respective Percentage Interests, until each Class A Member has received aggregate Distributions pursuant to this Section 7.7(b)(i) equal to such Class A Member’s Invested




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Capital;

(ii) Distributions shall then be made to the Class A Members, in proportion to their respective Percentage Interests, until each Class A Member has received aggregate Distributions pursuant to Section 7.7(b)(i) and this Section 7.7(b)(ii) resulting in a ____ percent (___%) IRR on such Class A Member’s Invested Capital calculated through the date of the Distribution;

(iii) Distributions shall then be made to the Class B Members until each Class B Member has received in aggregate an amount equal to a ______ percent (___%) per year cumulative, non-compounded return on the total amount of Invested Capital contributed by the Class A Members;

(iv) Distributions shall then be made ____________ percent (___%) to the Class A Members, in proportion to their respective Percentage Interests, and ____________ percent (___%) to the Class B Members, until each Class A Member has received aggregate Distributions pursuant to Section 7.7(b)(i), Section 7.7(b)(ii) and this Section 7.7(b)(iv) resulting in an __________ percent (___%) IRR on such Class A Member’s Invested Capital calculated through the date of the Distribution; and

(v) The balance of funds available for Distribution, if any, shall be distributed _________ percent (___%) to the Class A Members, in proportion to their respective Percentage Interests, and ________ percent (___%) to the Class B Members.

Mandatory Tax Distributions shall be treated as advances against the Distributions payable to the Members pursuant to Sections 7.7(b)(i) through (v). Distributions to Class B Members as a group shall be made in accordance with Section 7.4.3.

7.8 Liquidating Distributions. Distributions in liquidation of the Company shall be made in the order of priority described in Section 7.7. It is intended that the allocation provisions of this Article 7 will produce final Capital Account balances of the Members that would permit liquidating distributions, if such distributions were made in accordance with final Capital Account balances (instead of being made in the order of priorities set forth in Section 7.7) to be made (after unpaid loans and interest thereon, including amounts owed to Members have been paid) in a manner identical to the order of priorities set forth in Section 7.7. To the extent that such allocation provisions of this Article 7 would fail to produce such final Capital Account balances, net profits and losses (including items of gross income, loss and deduction if required to fulfill the intent of this Section 7.8) will be reallocated among the Members for the fiscal year of the liquidation (and, if necessary, prior fiscal years) so as to cause the balances in the Capital Accounts to be in the correct amounts. Notwithstanding anything herein to the contrary, in the




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event the Company is liquidated within the meaning of Regulation Section 1.704-1(b)(2)(ii)(g), liquidating distributions shall be made by the end of the taxable year in which the Company liquidates or, if later, within 90 days of the date of such liquidation.

V. Allocations in LLCs and Partnerships with Exempt Entity Partners or Members.

A. Unrelated Business Taxable Income – General Rule. Under Code Section 511, a retirement plan or other entity otherwise exempt from federal income tax nonetheless will be subject to tax on its “unrelated business taxable income” (“UBTI”) which, generally speaking is the net income the tax-exempt entity derives from the conduct of any trade or business not substantially related to its exempt function. Included in the computation of UBTI is the tax-exempt entity’s allocable share of net income of a partnership (or limited liability company treated as a partnership for federal tax purposes) in which the entity is a partner or member (as the case may be), except to the extent the income is derived from activities of the partnership that are substantially related to the exempt function of the tax-exempt entity. This latter rule applies regardless of whether the income is distributed and regardless of whether the entity holds the interest as a general partner, a limited partner or a member in an LLC. Rev. Rul. 79-222, 1979-2 C.B. 236; Service Bolt & Nut Co. Profit Sharing Trust v. Comm'r, 78 T.C. 812 (1982).

B. General Exclusions from UBTI. Subject to limitations, UBTI does not include certain enumerated types of investment income – such as dividends, interest, rents and royalties – or gain from the sale of property other than inventory and property held for sale to customers in the ordinary course of business. I.R.C. § 512(b)(1), (2), (3) and (5).

C. Debt Financed Property. In addition to income derived from activities not substantially related to a tax-exempt entity’s exempt purpose, UBTI includes “unrelated debt financed income,” which is a portion of the income (including gain from a sale or exchange) derived from property held to produce income with respect to which there is “acquisition indebtedness.” I.R.C. §§ 512(b)(4); 514. The percentage of the income generated by an item of property that is unrelated debt financed income depends upon the extent to which the cost of acquisition or improvement of the property was financed through borrowing. I.R.C. § 514(a).

“Acquisition indebtedness” is indebtedness incurred directly or indirectly in connection with the acquisition or improvement of property. Acquisition indebtedness does not, however, include indebtedness incurred by certain defined categories of tax-exempt entities (“qualified organizations”), or by a partnership or LLC in which such an entity is a partner or member, to acquire or improve real property if certain conditions are satisfied. I.R.C. § 514(c)(9). These conditions are:

• The price for the acquisition or improvement must be a fixed amount, determined as of the date of the acquisition or completion of the improvement;




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• The amount of indebtedness or any other amount payable with respect to such indebtedness, or the time for making any payment of such amount, may not depend, in whole or in part, on the revenue, income or profits derived from the real property;

• The real property may not be leased back to the seller or to a person related to the seller;

• The real property may not be acquired from, or at any time after such acquisition be leased to, a related person;

• Neither the seller nor any person related to either the seller or the qualified organization acquiring the real property may provide financing in connection with the acquisition or improvement.

I.R.C. § 514(c)(9)(B).

“Qualified organizations” are limited to the following:

• Certain educational institutions and their affiliated support organizations;

• Trusts that are qualified pension plans under Code Section 401; and

• Real property holding corporations exempt from tax under Code Section 501(c)(25).

I.R.C. § 514(c)(9)(C). IRAs are not qualified organizations.

In order for this exception to the definition of acquisition indebtedness to apply to a qualified organization when the real property is held in a partnership in which the qualified organization is a partner or in an LLC in which the qualified organization is a member, one of the following three conditions must also be satisfied:

• All of the partners or members must be qualified organizations; or

• Each allocation to a partner or member that is a qualified organization is a “qualified allocation” within the meaning of Code Section 168(h)(6), that is, an allocation that both (i) has “substantial economic effect” and (ii) is consistent with the qualified organization being allocated the same distributive share of each item of income, gain, loss, deduction, credit, and basis and such share remains the same during the entire period the organization is a partner in the partnership or a member in the LLC4; or

4 It is not entirely clear whether allocations that reverse prior disproportionate allocations that were made because proportionate allocations would have caused one or more members to have a deficit capital account are qualified allocations within the meaning of Code Section 168(h)(6). Since such allocations are




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• The partnership agreement or LLC operating agreement complies with the “substantial economic effect” safe-harbor under the Treasury Regulations and also satisfies the so-called “fractions rule.” I.R.C. § 514(c)(9)(E). The fractions rule requires that the allocation of items to a partner or member that is a qualified organization cannot result in the partner or member having a percentage share of overall partnership or LLC income for any taxable year that is greater than the partner’s or member’s “fraction rule percentage,” which is the partner’s or member’s percentage of overall partnership or LLC loss for the taxable year for which the partner’s or member’s percentage share of overall partnership or LLC loss will be the smallest. Overall partnership or LLC income and loss are the respective amounts by which the aggregate items of partnership or LLC income and gain for a taxable year exceed, or are less than, (as the case may be) the aggregate items of partnership or LLC loss and deduction for the year. For purposes of applying the fractions rule, a reasonable preferred return or guaranteed payment for capital may be disregarded. Additionally, allocations that reverse prior disproportionate allocations that were made because proportionate allocations would have caused one or more non-qualifying organization members to have a deficit capital account are disregarded for purposes of the fractions rule.

disregarded for purposes of the fractions rule (discussed in the following paragraph), a solid argument can be made by analogy that such allocations should not be treated as other than qualified allocations.




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PARTNERSHIP TAX CONSIDERATIONS February 8, … and 12 Todd AND Zuc… · PARTNERSHIP TAX CONSIDERATIONS February 8, 2010 Andrew H. Zuccotti K & L Gates, LLP Brian J. Todd Davis Wright