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Presenting a live 110‐minute teleconference with interactive Q&A

Tax Challenges in Real Estate Partnership and Joint Venture AgreementsStructuring Provisions to Achieve Tax Benefits and Avoid Common Pitfalls

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, AUGUST 25, 2011

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Stephen L Feldman Partner Morrison & Foerster New YorkStephen L. Feldman, Partner, Morrison & Foerster, New York

Leon Andrew Immerman, Partner, Alston & Bird, Atlanta

Eric Kea, Tax Partner, Imowitz Koenig & Co., New York

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P t hi F tiPartnership Formation

Stephen L. FeldmanpMorrison & [email protected]

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212.336.8470

Capital Contributionsp

Basic rule of Section 721(a)[1] – nonrecognition of gain or ( )[ ] g gloss for contribution of “property” in exchange for partnership interest.

No “control” requirement – compare Section 351.

Contribution versus sale, loan or lease.

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Capital Contributions (cont’d)p ( )

Definition of property Not defined in Code or Treasury Regulations. Includes cash. Excludes services. Excludes services.

Receipt of capital interest for services—recipient taxed on liquidation value.

Receipt of profits interest for services recipient not taxed Receipt of profits interest for services—recipient not taxed. Rev. Procs. 93-27 and 2001-43.

Historically, courts have applied an expansive construction of the term “property ” See e g United States v Stafford 727 F 2dterm “property.” See, e.g., United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984) (letter of intent); United States v. Frazell, 335 F2d 487 (5th Cir. 1964) (cert. denied) (geological maps); Ambrose, 15 TCM 643 (1956) (purchase contract.)

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Ambrose, 15 TCM 643 (1956) (purchase contract.)

Capital Contributions (cont’d)C p Co bu o s (co d)

Definition of property (cont’d) p p y ( ) Section 351 authority on definition of property may be relevant.

Rev. Rul. 64-56, 1964-1 (pt. 1) CB 133 (secret processes and formulas; Section 351)formulas; Section 351).

Rev. Rul. 71-564, 1971-2 CB 179 (trade secret; Section 351).Rev. Rul. 79-288, 1979-2 CB 139 (goodwill; Section 351).

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Definition of property (cont’d) p p y ( ) Personal note of a partner? Partial interests in property? Cancellation of partnership debt Section 108(e)(8)(B) If a Cancellation of partnership debt. Section 108(e)(8)(B). If a

partnership transfer of a partnership interest to a creditor to satisfy a partnership debt, it recognizes COD income as if the debt had been satisfied with cash equal to the value of the partnershiphad been satisfied with cash equal to the value of the partnership interest. Proposed Regulations generally allow the partnership and the creditor to value the partnership interest transferred to the creditor based on liquidation value. Proposed Regulations state q p gthat Section 721(a) applies in full to the creditor, so the creditor does not recognize a loss equal to the partnership’s COD income, and has a basis for its interest equal to the basis of the debt.

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Definition of partnership interest p p Includes capital interest and profits interest. Section 721 has no nonqualified preferred stock rule – compare

Section 351(g)Section 351(g). It must still be considered whether the interest received is debt or

equity under general tax principles, particularly if appreciated property is being contributed to the partnershipproperty is being contributed to the partnership.

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Exception to basic nonrecognition rule of Section 721(a) –f i hi (S i 721(b))transfers to an investment partnership (Section 721(b))

Section 721(b) generally mirrors the Section 351(e)(1) exception to tax-free treatment for contributions to an investment company.

Under Section 721(b) gain is recognized if appreciated property is Under Section 721(b), gain is recognized if appreciated property is contributed to a “partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated.”

I l t hi ill b i t t if ft In general, a partnership will be an investment company if, after the exchange, more than 80 percent of the value of its assets is held for investment and consists of stocks or securities, including money, or interests in RICs, REITs or PTPs.

If gain is recognized under Section 721(b), this results in a basis increase to the contributing partner for his interest, and to the partnership for the contributed property. Sections 722 and 723.

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Initial Basis Partner’s initial basis for its partnership interest is cash plus e s b s s o s p e s p e es s c s p us

basis of property contributed. Section 722. Partnership’s initial basis for contributed property is a carryover

basis. Section 723. Except for gain recognized under Section 721(b) there is no Except for gain recognized under Section 721(b), there is no

increase in the partnership’s basis of contributed assets for gain recognized by contributing partner unless there is a Section 754 election. (But see disguised sale rules, discussed below)below).

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Initial Holding Period g Section 1223(1) governs a partner’s initial holding period for

partnership interest. For capital assets or Section 1231 property there is tacking For capital assets or Section 1231 property, there is tacking. For other assets or cash, there is no tacking. Potential for fragmented holding period.

i i f i ’ i i i i i f There is tacking for the partnership’s initial holding period for contributed property. Section 1223(2).

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Depreciation p Depreciation recapture is not triggered except to the extent gain is

recognized on the contribution. Section 1.1250-3(c)(1), 1.1250-3(c)(2)(vi).( )( )( )

Generally, for contributions of property depreciable under Section 168, the partnership steps into the shoes of the contributor to the extent the partnership’s basis is determined by reference to the p p ycontributor’s basis. Section 168(i)(7).

For the year of contribution, the available deduction is generally prorated between the contributor and the partnership.p p p

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Property Contributions--Liabilities

Partnership’s assumption of, or taking property subject to, liabilities., To the extent liabilities secured by contributed property are

allocated to other partners, this is treated as a cash distribution to the contributing partner under Section 731, unless the disguised sale rules (discussed below) applydisguised sale rules (discussed below) apply.

Liabilities in excess of basis does not automatically trigger gain –compare Section 357(c). Contributing partner’s basis for its partnership interest is (i)

h ib d l (ii) b i f ib d lcash contributed, plus (ii) basis of property contributed, plus(iii) preexisting partnership liabilities allocated to the contributing partner, reduced (but not below zero) by (iv) the portion of the liabilities on the contributed property that

ll t d t th th tare allocated to the other partner. Gain is recognized to the extent that basis would be less than

zero after netting (i)-(iv). See Section 1.752-3(c), Example 3.

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Property Contributions—Liabilities (cont’d)ope y Co bu o s b es (co d)

Consider impact on other partners of a portion of the p p ppartnership’s preexisting liabilities being reallocated to the contributing partner Deemed cash distribution under Section 731 Deemed cash distribution under Section 731. Potential application of Section 751(b).

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Liability Sharing Rulesb y S g u es

Liability sharing rules are set forth in Section 1.752-2 and y g1.752-3. Recourse liabilities are generally defined as liabilities for which one

or more partners (or related parties) bear the economic risk of lossor more partners (or related parties) bear the economic risk of loss. Such liabilities are allocated in proportion to the sharing of risk of loss. Risk of loss is generally determined by who would have a payment obligation (without any right of recovery) in a p y g ( y g y)constructive liquidation scenario.

Nonrecourse liabilities are generally shared per profit sharing ratio, but with special rules for liabilities on contributed built-in , pgain property, and for minimum gain property. The special rule for built-in gain property will tend to minimize gain recognition on contribution. But see the disguised sale rules for liability sharing.

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Disguised sales –Section 707(a)(2)g ( )( )

General rule – If the disguised sale rules apply, a purported contribution of property may be treated inpurported contribution of property may be treated in whole or in part as a sale of the property to the partnership in exchange for the transfer by the partnership to the purported contributor of cash or otherpartnership to the purported contributor of cash or other consideration.

If th i di i d l it t th ti t i If there is a disguised sale, it occurs at the time property is transferred to the partnership even if payments relating to the sale occur over time. Section 1.707-3(a)(2).

In appropriate circumstances, a disguised sale of a partnership interest may also result.

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Disguised sales –Section 707(a)(2) (cont’d)sgu sed s es Sec o 707( )( ) (co d)

EXAMPLE: Part contribution/part sale for cash. A transfers property X to partnership P on April 9, 2011, in exchange for an interest in P. At the time of the transfer, X has a fair market value of $4,000,000 and an adjusted tax basis of $1,200,000. Immediately after the transfer, P transfers $3,000,000 in cash to A. Assume that P’s transfer of cash to Atransfers $3,000,000 in cash to A. Assume that P s transfer of cash to A is treated as part of a sale of X to P. Because the amount of cash A receives on April 9, 2011, does not equal the fair market value of the property, A is considered to have sold a portion of X with a value of $3 000 000 t P i h f th h A di l A t$3,000,000 to P in exchange for the cash. Accordingly, A must recognize $2,100,000 of gain ($3,000,000 amount realized less $900,000 adjusted tax basis ($1,200,000 multiplied by $3,000,000/$4,000,000)). Assuming A receives no other transfers that are treated as gconsideration for the sale of the property, A is considered to have contributed to P, in A’s capacity as a partner, $1,000,000 of the fair market value of X with an adjusted tax basis of $300,000. Section 1 707 3(f) Example 1

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1.707-3(f), Example 1.

Disguised sales –Section 707(a)(2) (cont’d)g ( )( ) ( )

Determination of disguised sale

The overall issue under the disguised sale rules is whether the transaction is “properly characterized” a sale rather than a contribution.

Treasury Regulations look to all the facts and circumstances in making this determination, and enumerate many factors that may be relevant, but the key factor is whether the transfer of y , ymoney or other consideration by the partnership to the contributing partner is dependent on the entrepreneurial risks of partnership operations. Section 1.707-3(b).

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Presumptions under disguised sale rules Transfers made by the partnership more than two years before s e s de by e p e s p o e wo ye s be o e

or after the purported contribution (favorable). Section 1.707-3(d).

Transfers made by the partnership within two years of the purported contribution (unfavorable)purported contribution (unfavorable). EXAMPLE: Partner A transfers undeveloped

unencumbered land with a built-in gain of $500x (fair market value of $1,000x and adjusted tax basis of $500x) to partnership P P intends to develop the land by constructingpartnership P. P intends to develop the land by constructing a building on it, and P’s partnership agreement provides that upon completion of construction P will distribute $900x to A. If within two years of A’s contribution the building is completed and P makes a distribution to A pursuant to thecompleted and P makes a distribution to A pursuant to the partnership agreement, such distribution will be presumed a disguised sale of the land by A unless rebutted.

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Disguised Sale Presumptions (cont’d) Either presumption may be rebutted if the facts and circumstances

clearly establish that treatment contrary to the presumption is appropriate.

EXAMPLE: A and B are partners of equal partnership AB AB EXAMPLE: A and B are partners of equal partnership AB. AB owns parcel 1 (fair market value of $500x) and parcel 2 (fair market value of $1,500x). A transfers an additional parcel 3 (fair market value of $100x) to AB in exchange for an increased partnership interest equal to two-thirds of AB. Immediately afterpartnership interest equal to two thirds of AB. Immediately after the transfer, AB sells parcel 1 for $500x, and distributes two-thirds of the proceeds to A in accordance with A’s partnership interest. The transfers are presumed to be a disguised sale. However, the presumption is (at least partially) rebutted because A would have apresumption is (at least partially) rebutted because A would have a right to one-half of the proceeds of the sale irrespective of the contribution of additional property. Accordingly, only a portion of the amount distributed (the excess of two-thirds over one-half) is treated as a partial sale of parcel 3. Section 1.707-3(f), example 4.

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treated as a partial sale of parcel 3. Section 1.707 3(f), example 4.


Disguised Sale Reporting requirements T f d ithi 2 t b di l d t th S i Transfers made within 2 years must be disclosed to the Service.

Section 1.707-3(c). The reporting requirement doesn’t apply if the transfer of money

th id ti t th t i d t bor other consideration to the partner is presumed to be a guaranteed payment for capital, is a reasonable preferred return, or is an operating cash flow distribution.

S S ti 1 707 8 di th d f di l See Section 1.707-8 regarding method of disclosure.

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Qualified and non-qualified liabilities Q q Treatment of qualified liabilities

If there is no other circumstance that causes a transaction to be t t d di i d l th th ti f ( t kitreated as a disguised sale, then the assumption of (or taking subject to) a “qualified liability” by a partnership will not by itself trigger disguised sale treatment. Section 1.707-5(a)(5).

If th th th f t j tif i t ti t ib ti If the there are other facts justifying treating a contribution as in part a sale (e.g., presence of cash), then a portion of the qualified liability is treated as part of the sale consideration. Section 1 707-5(a)(5)Section 1.707-5(a)(5).

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Definition of qualified liability: q y Generally, the liability must be incurred more than two years

before the purported contribution (or, if earlier the date the purported contribution is agreed to in writing). Section 1.707-p p g g)5(a)(6)(i)(A).

Other types of qualified liabilities: a liability incurred within two years prior to the purported contribution (or written agreement to y p p p ( gcontribute), but not incurred in anticipation of the contribution (taxpayer needs to disclose and to rebut an unfavorable presumption); liabilities allocable to capital expenditures; certain liabilities incurred in the ordinary course of business. Sections 1.707-5(a)(6)(i)(B)-(D) and 1.707-5(a)(7).

A liability that refinanced a qualified liability. Section 1.707-5(c).

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Non-qualified liabilities A portion of a non-qualified liability assumed or taken subject to

by a partnership is always treated as disguised sale consideration.by a partnership is always treated as disguised sale consideration. Section 1.707-5(a)(1).

The formula for determining the portion treated as disguised sale consideration is less favorable than for qualified liabilities.consideration is less favorable than for qualified liabilities. Generally the amount of disguised sale consideration is the excess of the liability in question over the partner’s share of that liability immediately after the transfer.y y

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Non-qualified liabilities (cont’d)q ( ) For recourse liabilities, the partner’s share after the transfer is

determined under the rules of Section 752 and the Treasury Regulations thereunder.

For non-recourse liabilities, the partner’s share after the transfer is determined using the percentage for excess nonrecourse liabilities, i.e., ignoring any share of minimum gain or Section 704(c) gain. Section 1 707-5(a)(2); Section 1 752-3(a)(3) (penultimate sentence)Section 1.707 5(a)(2); Section 1.752 3(a)(3) (penultimate sentence). Thus, for purposes of Section 707(a)(2), a partner’s share of a nonrecourse liability may be less than his actual share of that liability under Section 752.

Special rules may apply if multiple persons transfer multiple properties subject to liabilities to a partnership at the same time. Section 1.707-5(a)(4).

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Exceptions to disguised sales: Reasonable guaranteed payments and preferred returns –e so b e gu eed p y e s d p e e ed e u s

Section 1.707-4 Operating cash flow – Section 1.707-4 Reimbursement of pre-formation capital expenditures – Section

1 707 41.707-4

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Reimbursement of pre-formation expenditures (cont’d)p p ( ) Permits transfers to the partner by the partnership made to

reimburse the partner for, capital expenditures: (1) incurred during the two-year period preceding the transfer by the partner to th t hi d (2)i d b th t ith t tthe partnership; and (2)incurred by the partner with respect to— Partnership organization and syndication costs described in

section 709; or Property contributed to the partnership by the partner Property contributed to the partnership by the partner,

For contributed property, reimbursement cannot exceed 20 percent of the fair market value of such property at the time of the contribution. However, the 20 percent of fair market valuecontribution. However, the 20 percent of fair market value limitation does not apply if the fair market value of the contributed property does not exceed 120 percent of the partner's adjusted basis in the contributed property at the time of contribution.

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Exceptions to disguised sales (cont’d) Debt financed distributions by partnership. Section 1.707-5(b). Certain transfers of cash or other consideration made by the

partnership to a partner within 90 days of incurring debt are not taken into account as disguised sale consideration to the extent oftaken into account as disguised sale consideration to the extent of the partner’s share (determined as described above) of that liability.

In certain abuse situations, subsequent reductions in the partner’s share of a liability may be taken into account Section 1 707share of a liability may be taken into account. Section 1.707-5(b)(2)(iii).

Note that this may present a method to get cash to a partner at the time of a property contribution without triggering disguised sale t t t b t th t f id di i d l t t ttreatment, but the transfer can avoid disguised sale treatment completely only if the partner’s share of the liability in question is 100% (e.g., is a recourse liability for which the partner receiving the distribution bears the economic risk of loss).

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Debt-financed distributions (cont’d) ( ) Special rules may apply if a partnership transfers proceeds of one

or more liabilities to more that one partner pursuant to a plan. Section 1.707-5(b)(2)(ii).( )( )( )

In applying the rules for liabilities, the amount of a liability assumed (or taken subject to) by a partnership is reduced by cash contributed by the partner pursuant to the same plan.y p p p

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Debt finance distributions (cont’d) ( ) The debt financed distribution exception was the subject of the

recent, and heavily criticized, case Canal Corporation, 135 TC No. 9. In that case, the Tax Court held that the debt-financed ,distribution exception to disguised sale treatment did not apply, invoked the partnership anti-abuse rule to disregard an indemnity agreement entered into by the recipient of the debt financed distribution, and held that the recipient did not bear the economic risk of the partnership’s liability. The Tax Court further held that a “should” level opinion obtained from PWC did not provide the

i i i h d f i h d bl b i d f irecipient with a good faith and reasonable basis defense against a substantial understatement penalty. For the Court, a key fact was that the provider of the indemnity did not have assets equal in value to the amount of the indemnity

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value to the amount of the indemnity.

Additional capital contributions and dilution provisions

The admission of a new partner or the contribution of additional capital by some but not all existing partners can lead to dilution of th th t ’ i t t It l l d t t ti l t ithe other partners’ interests. It can also lead to potential tax issues.

If a partnership has built-in gain in its property at the time a new partner is admitted, and if there is neither a special allocation of suchpartner is admitted, and if there is neither a special allocation of such built-in gain nor a revaluation of the original partners’ capital accounts, a taxable “capital shift” from the original partners to the newly admitted partner could result.

This capital shift could result in income or gain to the newly admitted partner. See Section 1.704-1(b)(1)(iii) and (iv).

In general, the partnership to avoid such a capital shift by “booking up” the original partners’ capital accounts to fair market value. Thus, the preadmission appreciation would be allocated solely to the original partners.

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y g p

Additional capital contributions and dilution provisions (cont’d)

In addition, contributions to a partnership of property subject to a recourse liability could lead to gain recognition for the contributor d t hift f f th t li bilit t th th t U ddue to a shift of some of that liability to the other partners. Under Section 752, partners share recourse liabilities in the proportion to which they share the burden of the ultimate risk of economic loss in respect to such liabilities. Hence, taxpayers could contribute

b d t d d th i i k f i itiencumbered property and reduce their risk of gain recognition on such contribution if they are willing to bear all or a disproportionately large share of the economic risk of loss on the contributed liability. If the contributing partner bears all of the

i i k f l th li bilit i t d ith th t ib t deconomic risk of loss on the liability associated with the contributed property, then none of this liability would be allocated to the other partners and there would be no constructive distribution to the contributing partner under Section 752(b).

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Additional capital contributions and dilution provisions (cont’d)

Dilution provisions. If one or more partners fail to contribute required capital contributions, a partnership agreement may call for

i dj t t i th t i t tvarious adjustments in the partners interests. If the adjustment affects only the partners shares of future profits,

this generally should not raise any tax issues, but allocations must be drafted properly to take into account the change in percentage interests. If the adjustment affects the partners’ capital accounts, e.g., a

noncontributing partner’s capital account is reduced as a penalty for failure to make a required capital contribution, could this be a capital hif h ib i ?shift to the contributing partners?

Section 1.704-1(b)(2)(ii)(b) ( flush language) provides that the capital account rules are not violated if all or part of the partnership interest of one or more partners is purchased by the partnership or by one or more partners pursuant to an agreement negotiated at arms length by personspartners pursuant to an agreement negotiated at arms length by persons who at the time such agreement is entered into have materially adverse interests and if a principal purpose of such purchase and sale is not to avoid the fundamental principles of the capital account rules.

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ENDNOTESN NO S

[1] All references herein to “Sections” are to sections of the [ ]Internal Revenue Code (“Code”) and the Treasury Regulations thereunder.

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Carried Interests

August 25, 2011

L. Andrew ImmermanAlston & Bird LLP

g ,

Alston & Bird [email protected]

Typical LLC CompensationTypical LLC Compensation

Limited Partner/General Partner/

Managing

Limited Partner/

Non-Managing M b

g gMember

(Provides services, gets a carried interest and maybe

MemberLLC/LPcarried interest, and maybe

other compensation)LP

Assets(Real Estate Securities

383838

(Real Estate, Securities, or anything else)

Carried InterestsCarried Interests Carried interest = “carry” or “promote.”y p

Often used interchangeably with “profits interest.” It is a profits interest issued for services; the holder It is a profits interest issued for services; the holder

has a greater interest in profits than in capital.

The holder of a carried interest (“Manager”) f foften participates in a straight percentage of the

LLC’s future profits (for example, 20%), after some return to the cash investorsome return to the cash investor.

Manager may put in cash (perhaps 1% - 10% of the total equity) but the carried interest is not

3939

the total equity), but the carried interest is not granted for the cash.

Carried InterestsCarried Interests Manager reports its distributive share of income, g p

gain, loss, deduction and credit. No one deducts any amount as wages,

ti th i ith t tcompensation or otherwise with respect to Manager’s share of income.

If the LLC recognizes long term capital gain If the LLC recognizes long-term capital gain, Manager (or individual owners of the Manager entity) is taxed on its share of the gain at capital y) g pgain rates.

Maximum long-term capital gain rate for individuals i ll 15% th th 35% (f 2011 d

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is generally 15%, rather than 35% (for 2011 and 2012).

Carried InterestsCarried Interests Carried interests have been around for many decades,

especially in real estate deals.

They suddenly spawned controversy in 2007, largely because of publicity surrounding private equity managers’because of publicity surrounding private equity managers huge capital gains and lavish spending.

Anti-carried interest legislative proposals are discussed g p pbelow.

Although real estate LLCs are not necessarily the intended target of the proposals they may be hitintended target of the proposals, they may be hit.

If the LLC has ordinary income, Manager’s share is ordinary as well.

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ordinary as well.

Receipt of Profits InterestReceipt of Profits Interest Rev Proc 93-27 1993-2 CB 343 defines Rev Proc 93 27, 1993 2 CB 343, defines

two types of partnership interests, as determined at time of issuance:Capital Interest: partnership interest that

would entitle the holder to a share of li id ti d if t hi tliquidation proceeds if partnership assets were sold at FMV.

Profits Interest: partnership interest that is notProfits Interest: partnership interest that is not a capital interest; generally entitles holder only to a share of post-issuance partnership

C f4242

income and gain. Carried interest is a profits interest.

Receipt of Profits Interest IRS will accept that the receipt of a profits interest in

Receipt of Profits Interestp p p

exchange for services is not a taxable event for the partnership or the recipient, if:

The interest isn’t related to a substantially certain and predictable stream of income from

t hi tpartnership assets. The interest is not disposed of within two years. The interest is not a limited partnership interest

in a publicly traded partnership.

4343

Drafting ConsiderationsDrafting Considerations Key to tax-free carried interest is that the Manager Key to tax free carried interest is that the Manager

starts out with zero capital account (or a capital account no higher than the value of cash or other property contributed).

Manager should be entitled to none of the proceeds if the LLC were to liquidate immediately after the interest is granted.S LLC ifi ll i Some LLC agreements specifically state an intent to comply with Rev Proc 93-27.E th th t d ’t t t thi ll t i t d t

44

Even those that don’t state this generally to intend to comply. 44

Unvested Profits InterestUnvested Profits Interest

Rev Proc 2001 43 2001 2 CB 191 says that Rev Proc 2001-43, 2001-2 CB 191, says that Rev Proc 93-27 applies to a profits interest that is subject to a substantial risk of forfeiture ifpartnership and recipient treat the recipient as the owner of the partnership interest from the date of grantdate of grant.

§ 83(b) election is not required, although is often recommended by advisors as a protectiverecommended by advisors as a protective measure.

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Unvested Profits InterestUnvested Profits Interest

If partnership grants an unvested profits If partnership grants an unvested profits, service provider will not be taxed on receipt or vesting if:or vesting if:Conditions of Rev Proc 93-27 are met.Partnership and service partner treat and report p p p

service partner as tax owner of the interest and service partner includes its distributive share of partnership tax items for tax purposespartnership tax items for tax purposes.

Upon grant or vesting of interest, neither partnership nor any partner takes deductions

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partnership nor any partner takes deductions based on the profits interest at grant or vesting.

Safe Harbor s S bstanti e LaSafe Harbor vs. Substantive Law

Rev Proc 93 27 and Rev Proc 2001 43 are Rev Proc 93-27 and Rev Proc 2001-43 are safe harbors; follow them and the IRS won’t challenge youchallenge you.

They are not substantive rules of law, but d t f th d th b kdepart from them and you are thrown back to a confusing mass of authorities.For example, § 83 seems irrelevant under the

two Rev Procs, but how does § 83 apply outside of them?

4747

of them?

2005 Proposals2005 Proposals

Proposed regulations under several Code sections, and Proposed regulations under several Code sections, and accompanying proposed revenue procedure, Notice 2005-43, issued in May 2005. REG-105346-03.

When effective, they would obsolete current guidance, including Rev Proc 93-27 and Rev Proc 2001-43.

H th l ld ll ll However, the proposals would generally allow partnerships to achieve the same favorable results as under current guidance, if the right elections are made:

“Safe harbor” liquidation value election.

§ 83(b) election for unvested interests.

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§ ( )

FMV or Liquidation ValueFMV or Liquidation Value

Default rule (no election): Default rule (no election): Service partner taxable on fair market value of

partnership interestpartnership interest.

Value of partnership interest is the amount a willing buyer would pay a willing sellerbuyer would pay a willing seller.

Even a pure profits interest has some fair market value and is taxable at grantvalue, and is taxable at grant.

Thus the default rule follows § 83 rather than the two Rev Procs

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two Rev Procs.

FMV or Liquidation ValueFMV or Liquidation Value “Safe Harbor” election:

Value of partnership interest equals “liquidation value.”

Thus the election more or less permits the parties to follow the Rev Procs and to sidestep § 83Procs, and to sidestep § 83 .

However, there are many obstacles to making an election: Partnership agreement must contain provisions, legally binding on all of

the partners that all partners agree to comply with the safe harborthe partners, that all partners agree to comply with the safe harbor.

Alternative: Each partner in the partnership must execute a legally binding document agreeing to the safe harbor.

Effective date of election cannot be prior to execution date Effective date of election cannot be prior to execution date.

IRS has informally acknowledged that the proposed requirements for the election were overly strict.

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Proposed legislation may make “liquidation value” the default rule, so no election would be necessary.

2005 Proposals: Unvested Interests2005 Proposals: Unvested InterestsUnder the proposals, an unvested compensatory

partnership interest in itself does not make the holder a partner for tax purposes.

Vesting of the interest makes the holder a partner.

The holder has compensation income.

Other partners have compensation deduction p p(subject to possible capitalization).

§ 83(b) election is treated like vesting; it makes

5151

§ ( ) gthe holder a partner for tax purposes.

Final Regulations?Final Regulations?

Treasury reportedly is not working on finalizing the Treasury reportedly is not working on finalizing the 2005 proposals.

T ibl i i i h Treasury, very sensibly, is waiting to see what Congress comes up with.

Some LLC Agreements refer to the 2005 proposals to ensure that they will be able to make the “li id ti l ” l ti if i il bl“liquidation value” election if one is ever available.

Proposed legislation is discussed below.

5252

p g

Do You Need an Entity of Some Kind?Do You Need an Entity of Some Kind?

A LLC A t ( t hi t) i h An LLC Agreement (or partnership agreement) is much more complicated than a service contract.

Clients sometimes want to issue the equivalent of carriedClients sometimes want to issue the equivalent of carried interests simply by entering into a service agreement.

For a recent illustration of why that does not work, seeRi U it d St t S D T (M 2 2011)Rigas v. United States, S.D. Tex. (May 2, 2011).

Even in what appears to be a simple contract for services tax advice on deal structure can make a bigservices, tax advice on deal structure can make a big difference.

5353

Example: Fee for ServicesExample: Fee for Services

B manages $1 000 of B manages $1,000 of investments for A.

B is entitled to 20% of f t fit

$400Afuture profits.

A earns $2,000 capital gain.

Bg

A pays $400 to B. BServices

A has $2,000 capital gain less $400 expense = $1,600 taxable income.

A (a corporation) pays 35% of $1,600 = $560. B (an individual) pays 35% of $400 = $140

5454

B (an individual) pays 35% of $400 = $140. B also pays self-employment tax (effective 2.4% rate in 2011

for income over $106,800).

Example: Equity for ServicesExample: Equity for Services A and B form X LLC. $1,000 Services A and B form X LLC. A contributes $1,000 for

80% of future profits. B$1,000 Services

Ap B contributes services for

20% of future profits.p X earns $2,000 capital gain. A pays 35% of $1,600 = p y % $ ,

$560. B pays 15% of $400 = $60.

X

5555

p y No self-employment tax.

Carried Interests Proposed LegislationCarried Interests: Proposed Legislation Several bills have been introduced in Congress to g

add new “Section 710” to the Code. There are differences among the bills but all would:g

Characterize allocations attributable to many carried interests as ordinary income, subject to:

O di i t t l Ordinary income tax rates plus, Self-employment tax.

Apply to many entities besides private equity funds.pp y y p q y Deny any compensation deduction to the other LLC

members.

5656

Continue to permit carried interests to be received free of initial tax, unlike compensatory corporate stock.

Investment Services Partnership InterestInvestment Services Partnership InterestAn LLC interest is an "investment services partnership interest" (and ll fit f it ill b t d di ti i ) if itall profits from it will be taxed as ordinary compensation income) if it

was reasonably expected when the interest was issued that the holder would provide a substantial amount of investment-

i i h “ ifi d ”management services with respect to a “specified asset”

Services include:

'(A) Advising as to the advisability of investing in, purchasing, or selling any specified asset.'(B) Managing, acquiring, or disposing of any specified asset.'(C) Arranging financing with respect to acquiring specified assets.

5757“Specified assets” include real estate.

Carried Interests Proposed LegislationCarried Interests: Proposed Legislation

All versions have some exception for All versions have some exception for invested capital. T th t t M i t To the extent Managers receive a return on

their own invested capital, § 710 does not applyapply.

However, the exception has been drafted narrowly.narrowly.

Versions have been passed several times by the House but not enacted.

5858

What Can Managers Do?What Can Managers Do? Techniques that might work under some versions

of § 710 are prohibited under others. For example, under the more recent proposals, it is

lik l t h l f th M tvery unlikely to help for the Managers to: Borrow from the cash investors to make a bigger

capital investment in the LLC.capital investment in the LLC. Take convertible or contingent debt, options, or

derivatives, with respect to the LLC. There have been inaccurate reports that

Managers are rushing en masse to restructure their carried interests and amend LLC

5959

their carried interests and amend LLC Agreements.

What Won’t Section 710 Affect?What Won t Section 710 Affect? The scope of § 710 – if enacted -- isThe scope of § 710 if enacted is

impossible to predict. However although the versions that have However, although the versions that have

passed the House are overbroad, Congress’ target has been investment managers.g g

LLC members active in operating businesses are the least likely to bebusinesses are the least likely to be affected, even though they (like recipients of corporate stock) often earn capital gain by

6060

performing services.

Carry vs Phantom EquityCarry vs. Phantom Equity

A carried interest is a real equity interest in the A carried interest is a real equity interest in the LLC. The holder is a “partner” for tax purposes.p p p Distribution, allocation, and contribution provisions of the

LLC Agreement must be consistent with the terms of the carried interestcarried interest.

The holder starts out with zero capital account, but that is only at the start.y

The only way to get capital gain is with real equity of some kind.

6161

Carry vs Phantom EquityCarry vs. Phantom Equity

Phantom eq it (emplo ee compensation that is Phantom equity (employee compensation that is based somehow on the LLC’s performance) is not intended to be real equityintended to be real equity. The holder is an employee. Distribution, allocation, and contribution provisions of the , , p

LLC Agreement are generally irrelevant. The holder never has a capital account. The holder never has capital gain.

6262

Allocations/DistributionsE i K CPAEric Kea, CPA

Partneri iImowitz Koenig & Co., LLP

Eric Kea, CPA ‐ PartnerImowitz Koenig & Co., LLP

ExperienceEric brings more than 18 years experience in public accounting, specializing in

t hi d l t t t ti E i i P t ith I it K i & C LLP partnership and real estate taxation. Eric is a Partner with Imowitz Koenig & Co., LLP and was formerly a tax partner for an international accounting firm, where he served in multiple roles. Eric was in charge of the Real Estate Tax Practice for the New York City office, the chairman of the National Partnership Consulting Group, and was in charge of national partnership training. Eric’s areas of specialization include:

Consulting and compliance services for both equity and mortgage REITs Consulting and compliance services for single and multi-property real estate funds, Consulting and compliance services for single and multi property real estate funds,

as well as real estate fund-of-funds Consulting and compliance services for hotel owners and operators Tax structuring of real estate transactions Consulting services regarding real estate leases, including the tax consequences of

such. Review and consulting for partnership/LLC agreements regarding substantial

economic effect and partners’ interest in the partnership regulationsp p p g Consulting regarding minimum gain regulations Consulting regarding real estate TIC interests and Like-Kind Exchanges Consulting regarding partnership §704(c) built-in-gain/loss regulations

Eric is also a frequent instructor on partnership and real estate taxation, an author of articles dealing with partnership and real estate tax issues, and has served as an expert witness in proceedings dealing with real estate and partnership issues.p g g p p

EducationBachelor of Science in Accounting from Mesa State College Masters of Taxation from the University of Denver

Professional Affiliations

Eric Kea, CPA ‐ PartnerImowitz Koenig & Co., LLP622 Third Ave. ‐ 33rd FloorNew York, NY 10017 Tel: (646) 292‐3231

American Institute of Certified Public AccountantsNew York State Society of Certified Public AccountantsNational Association of Real Estate Investment Trusts (NAREIT)

( 4 ) 9 3 3Fax: (646) 292‐[email protected]

Allocations & Distributions General Allocations of Profits and Losses Special Allocations, Including Depreciation Sale or Exchange of Contributed Property Planning for Possibility of COD Income Current Distributions/Basis Considerations

B t f th b i t t i d i t Because most of the above are intertwined in an agreement the subsequent discussion is with regard to the totality of the topic, not necessarily in the order presented above.

8/25/2011 Eric Kea CPA - Imowitz Koenig & Co., LLP 65

Allocations of Profits and Losses It can be said that the allocation of profits and losses is a conflict between the economic deal entered into by the parties and the substantial entered into by the parties and the substantial economic effect (“SEF”) provisions of the §704(b) Regulations.g

Said in a more positive way, the parties can essentially agree on whatever allocations they desire unless they run afoul of the §704(b) regs.


Allocations Although there are some hyper‐technical provisions in the §704(b) Regs. it is not the Regulations that make the allocation and Regulations that make the allocation and distribution provisions in an agreement easy or complicated; it is the economic agreement p ; gbetween the parties that does!


Allocations ‐ SEF Partnership agreement allocations will be respected unless they lack substantial economic effect [§704(b)]effect [§704(b)]. The regulations are long and detailed but are premised on one simple fact.p p A partnership is an economic agreement among its partners and the regulations were written to ensure that the tax consequences follow the economics.the tax consequences follow the economics.


SEF – Two Tests #1 ‐ Economic Effect (purely mechanical)

For the determination and maintenance of the partner’s capital accounts in accordance with the p prules of Reg. §1.704‐1(b)(2)(iv) [Reg. §1.704‐1(b)(2)(iii)(b)(1)].

Upon liquidation of the partnership (or liquidation p q p p ( qof a partner’s interest) liquidating distributions are required in all cases to be made according to positive capital account balances of the partners [R § (b)( )(ii)(b)( )][Reg. §1.704‐1(b)(2)(ii)(b)(2)].

If such partner has a deficit balance in his capital account after liquidation he is unconditionally required to restore it [Reg §1 704 1(b)(2)(ii)(b)(3)]required to restore it [Reg. §1.704‐1(b)(2)(ii)(b)(3)].


SEF – Two Tests Since most agreements will not meet the restoration of

negative capital accounts provision there is an alternatetest for economic effect. Under Reg §1 704‐1(b)(2)(ii)(b)(3) the failure of an agreement Under Reg. §1.704‐1(b)(2)(ii)(b)(3), the failure of an agreement

to have a DROwill not fail the economic effect test if The agreement contains a qualified income offset (QIO) provision The allocation does not cause or increase a deficit balance in the

partner’s specially adjusted §704(b) capital account (in excess ofp p y j §7 4( ) p (any limited dollar amount the partner is required to restore) A partner’s specially adjusted §704(b) capital account is the §704(b)

capital account reduced by All future reasonably expected deductions under §613A(c)(7)(D)

All future reasonably expected allocations of loss and deduction All future reasonably expected allocations of loss and deductionthat are mandated by provisions that may override §704(b) §704(e)(2) – family partnership rules §706(d) – anti‐retroactive allocation rules §751(b) – shift in “hot assets”

Wh b § ( )? What about §704(c)? Certain reasonably anticipated future distributions


SEF – Two Tests #2 – Substantial under the rules of Reg. §1.704‐1(b)(2)(iii), which

are failed if1. An allocation is shifting under Reg. §1.704‐1(b)(2)(iii)(b),

which invalidates allocations that do not affect the totalamount allocated to each partner, but do affect the type orcharacter of income allocated to the partners.

2. An allocation is transitory under Reg. §1.704‐1(b)(2)(iii)(c),which invalidates allocations that will be quickly reversed.which invalidates allocations that will be quickly reversed.Exceptions:

5 year rule Value = Basis Rule (great for real estate) Future income is speculativep

3. An allocation fails the overall‐tax‐effect rule of Reg. §1.704‐1(b)(2)(iii)(a), which invalidates allocations that reduce theNPV of one or more partner’s tax liability while no partner’safter tax economic consequences are reduced on an NPV basis.q


SEF – Are We Really Worried? For a real estate

partnership, or for that matter almost any business

d d i hi conducted in partnership form, meeting the SEF rules should be easy unless the agreement is “too the agreement is too clever by half”; meaning that there is some serious tax planning going on tax planning going on between the parties that takes into account the non‐partnership tax attributes Lumpy, Eddie, &

W ll h ’ Th B ?p pof one or more partners.


Wally…where’s The Beaver?

§704(b) & The Agreement Even though there should be no difficulty meeting the SEF requirements (at least the EF portion) explicit language is required – Where?

M i f C i l A i l Maintenance of Capital Accounts: capital account section

Liquidation According to Positive Balance: liquidation/dissolution section in current agreements liquidation/dissolution section…in current agreements most likely cross referencing the distribution provisions

Alternate Test for EF (QIO): allocation section Language dealing with the “Substantial” portion of Language dealing with the Substantial portion of SEF will not show in an agreement as this is determined as a result of an analysis of the overall operation of the agreement.p g


§704(b) & The Agreement: Other§704(b) & The Agreement: Other Requirements SEF is not the only requirement of §704(b) and the Regs that need to be met. There is almost always a separate allocation section dealing with other §704(b) requirementsrequirements. Section heading is usually referred to as either “Special Allocations” or “Regulatory Allocations”

Even though almost always listed after the “general” Even though almost always listed after the general allocation of profits and losses these allocations actually occur prior to the general allocation. The general allocation provisions almost always start with g p y

something similar to “Subject to Section Y below,” with “Y” being the special or regulatory allocation provisions.

The special or regulatory allocation provisions usually start with something similar to “Notwithstanding the provision of g g pSection X,” with “X” being the general allocation provisions


Special or Regulatory AllocationSpecial or Regulatory Allocation Provisions…Contain? The following represent what is usually covered in the special or regulatory

allocation provisions:a) Partner Minimum Gain Chargebackb) Partnership Minimum Gain Chargebackc) QIO provisionc) QIO provisiond) Allocation of Nonrecourse Deductions

Sometimes Partner and Partnership nonrecourse deductions are included in the same provision. Other times they are separated

e) Ordering Rules – stating that a), b), & d) are taken into account before any th ll ti dother allocations are made

Requirement comes from the §704(b) – 2 Regs.f) Deficit Balances

Not really a regulatory allocation provision as this is typically redundant to a QIO provision…Caution as this provision sometimes is mistakenly written to be more restrictive than a QIO provisionrestrictive than a QIO provision

g) Reallocation – attempt to reverse any required allocations as a result of a) – d). Usually inoperative…see “substantial rules”…transitory

h) §704(c) Built‐in gain/(loss) allocations for tax purposesi) Allocations for tax purposesp p


Regulatory Allocation Examples –Regulatory Allocation Examples Partner Minimum Gain Chargeback Holder Nonrecourse Debt Minimum Gain Chargeback.

Holder Nonrecourse Deductions shall be allocated in the manner required by Treasury Regulation §1.704‐2(i). Except as otherwise provided in Treasury Regulation Except as otherwise provided in Treasury Regulation §1.704‐2(i)(4), if there is a net decrease in Holder Minimum Gain during any Taxable Year, each Holder that has a share of such Holder Minimum Gain shall be specially allocated it f i i f h T bl Y ( d if items of income or gain for such Taxable Year (and, if necessary, subsequent Taxable Years) in an amount equal to that Holder’s share of the net decrease in Holder Minimum Gain. Items to be allocated pursuant to this pparagraph shall be determined in accordance with Treasury Regulation §1.704‐2(i)(4) and §1.704‐2(j)(2). This paragraph is intended to comply with the minimum gain chargeback requirements in Treasury Regulation §1 704‐2(i)(4) and requirements in Treasury Regulation §1.704‐2(i)(4) and shall be interpreted consistently therewith.


Regulatory Allocation ExamplesRegulatory Allocation Examples –Partnership Minimum Gain Chargeback Company Minimum Gain Chargeback. If there is a net decrease in Company Minimum Gain during any Taxable Year, each Holder shall be specially allocated items of income or gain for such Ta able Year (and if items of income or gain for such Taxable Year (and, if necessary, subsequent Taxable Years) in an amount equal to such Holder’s share of the net decrease in Company Minimum Gain, determined in accordance Company Minimum Gain, determined in accordance with Treasury Regulation §1.704‐2(g). The items to be so allocated shall be determined in accordance with Treasury Regulations §1.704‐2(f)(6) and §1.704‐2(j)(2). y g 4 4 jThis paragraph is intended to comply with the minimum gain chargeback requirement in Treasury Regulation §1.704‐2(f) and shall be interpreted consistently therewithconsistently therewith.


Regulatory Allocation Examples –Regulatory Allocation Examples QIO Qualified Income Offset. If any Holder unexpectedly receives any adjustments, allocations or distributions described in Treasury Regulation §1.704‐y g § 7 41(b)(2)(ii)(d)(4), (5) or (6), items of income and gain shall be specially allocated to such Holder in an amount and manner sufficient to eliminate the adjusted capital account deficit (determined according to Treasury Regulation §1.704‐1(b)(2)(ii)(d)) created by such adjustments, allocations or y j ,distributions as quickly as possible. This paragraph is intended to comply with the qualified income offset requirement in Treasury Regulation §1.704‐q y g § 7 41(b)(2)(ii)(d) and shall be interpreted consistently therewith.


Regulatory Allocation Examples –Regulatory Allocation Examples Nonrecourse Deductions Nonrecourse Deductions. The Company shall take such action as may be

requested by Member X such that after the Capital Accounts have been reduced to zero, nonrecourse liabilities are allocated to Member X in a manner that entitles Member X to one hundred percent (100%) of the Nonrecourse Deductions of the Company for any Fiscal Year; provided that such allocation (i) p y y ; p ( )is in accordance with Treasury Regulations §1.752‐3, (ii) does not affect distributions to Member Y pursuant to Section 5.2, and (iii) does not otherwise materially adversely affect Member Y (other than Nonrecourse Deductions Member Y would have been allocated in the absence of this Section 5.4(d)). Holder Nonrecourse Deductions for any Fiscal Year shall be specifically allocated y p yto the Member who bears (or is deemed to bear) the economic risk of loss with respect to the Holder Nonrecourse Debt (as defined in Treasury Regulation §1.704‐2(b)(4)) are attributable in accordance with Treasury Regulation §1.704‐2(i)(2). This is an opportunity for special allocation, especially with regard to real estate s s a oppo tu ty o spec a a ocat o , espec a yw t ega d to ea estate

(depreciation deductions that are nonrecourse). As a general rule partners can agree to share nonrecourse deductions in a manner different than general sharing ratios, unless such allocation fails one of the “substantial” rules. As seen above, this is an example of a nonrecourse deduction provision that provides for a special allocation.


Regulatory Allocation Examples –Regulatory Allocation Examples Ordering Rules Ordering Rules. Anything contained in this Agreement to the contrary notwithstanding, allocations for any Fiscal Year or other period of allocations for any Fiscal Year or other period of nonrecourse deductions (as defined in clause (d) above), or of items required to be allocated pursuant to the minimum gain chargeback pursuant to the minimum gain chargeback requirements contained in Section 5.4(a) and Section 5.4(b), shall be made before any other ll i h dallocations hereunder. Allocations of nonrecourse deductions and minimum gain chargeback occur prior to any other g g p yallocations…says so in the §704(b) ‐2 Regs.


Regulatory Allocation Examples –Regulatory Allocation Examples Deficit Balances Deficit Balances. No Loss (or portion thereof) shall be allocated to a Member if as a result of such allocation

the Member has a deficit balance in its “adjusted capital account;” as defined below, any shall instead be allocated to the other Members pursuant to Section 5.3. For purposes of this subsection (f), “adjusted capital account” means, with respect to any Member, the balance on such Member’s Capital Account at the end of the relevant Fiscal Year, after giving effect to the following adjustments: (a) credit to such Capital Account any amounts which such Member is obligated to contribute to the Company (pursuant to the terms of this Agreement or otherwise) or is deemed obligated to contribute to the Company pursuant to the penultimate Agreement or otherwise) or is deemed obligated to contribute to the Company pursuant to the penultimate sentence of Treasury Regulations §§1.704‐2(g)(1) and 1.704‐2(i)(5); and (b) debit to such Capital Account the items described in Treasury Regulations §§1.704‐1(b)(2)(ii)(d)(4),(5) and (6). The foregoing determination of “adjusted capital account” is intended to comply with the provisions of Treasury Regulation §§1.704‐1(b)(2)(ii)(d) and shall be interpreted consistently therewith.

As previously stated this provision is mostly redundant as it is a t f th QIO i i H th ti h thi repeat of the QIO provision. However, there are times where this

provision is written to say “if as a result of such allocation the Partner has a deficit balance in its Capital Account” (the word “adjusted” is missing and all red and italicized words are omitted). In addition, the provision will state that losses not allocated to a partner will be the provision will state that losses not allocated to a partner will be re‐allocated to partners with positive capital account balances. If written as described a literal interpretation is that a partner’s capital account

cannot go below zero, even as a result of minimum gain. Does this trump a QIO provision, which allows a partner to go negative to the extent of share of minimum gain?g


Regulatory Allocation Examples –Regulatory Allocation Examples Reallocation Reallocation. The allocations set forth in paragraphs (a) through (d) above (the

“Regulatory Allocations”) are intended to comply with certain requirements of the Treasury Regulations under Code Section 704. The Regulatory Allocations may not be consistent with the manner in which the Holders intend to allocate Profit and Loss or make Company Distributions. Accordingly, notwithstanding p y g y, gthe other provisions of this Article V, but subject to the Regulatory Allocations, income, gain, deduction and loss shall be reallocated among the Holders so as to eliminate the effect of the Regulatory Allocations and thereby to cause the respective Capital Accounts of the Holders to be in the amounts (or as close thereto as possible) they would have been if Profit and Loss (and such other p ) y (items of income, gain, deduction and loss) had been allocated without reference to the Regulatory Allocations. In general, the Holders anticipate that this will be accomplished by specially allocating other Profit and Loss (and such other items of income, gain, deduction and loss) among the Holders so that the net amount of the Regulatory Allocations and such special allocations to each such Holder is g y pzero. This is the “yes, we know we have to follow the 704(b) regs., but we don’t like the result

and are going to try to get out of it provision.” As a general rule the provision is inoperative and the provision itself acknowledges it with the words or phrases “but subject to the Regulatory Allocations,” and “(or as close thereto as possible)”. Why? See “substantial” rule transitory Having said that there is no harm in including the substantial” rule…transitory. Having said that there is no harm in including the provision and there are times when it can be utilized (Outside 5 year safe harbor?)


Regulatory Allocation Examples –Regulatory Allocation Examples §704(c) In accordance with Section 704(c) of the Code and the Treasury Regulations thereunder,

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 Holders so as to take account of any variation between the adjusted basis of such asset for federal income tax purposes and its initial Book Value. Such allocations shall be made using the “traditional” method specified in Treasury Regulations §1 704‐3 as the Managing Member determines method specified in Treasury Regulations §1.704 3 as the Managing Member determines (with the consent of Member X, if Member X is not the Managing Member). In the event the Book Value of any Company asset is adjusted pursuant to Section 4.2(b), subsequent allocations of income, gain, loss and deduction with respect to such asset shall take into account any variation between the adjusted basis of such asset for federal income tax purposes and its Book Value in the same manner as under Section 704(c) of the Code and the Treasury Regulations thereunder Such allocation shall be made based on the “traditional” Treasury Regulations thereunder. Such allocation shall be made based on the traditional method specified in Treasury Regulations §1.704‐3. Necessary to govern allocations for tax purposes of built‐in gain/(loss) assets. From a

drafting point of view the language is pretty boiler plate and only changes are if a specified method has been agreed to by the parties (yes, in this example) and/or consent is required by one or more partner to utilize a particular method (yes, in this example).q y p p (y , p ) Not really a drafting issue per se, but if the parties negotiate traditional method and

you know the ceiling limit is going to apply “in a big way” do you have to address the traditional method anti‐abuse rules?


Regulatory Allocation Examples –Regulatory Allocation Examples Tax Allocations Except as provided in Section 5.4(h), for federal, state and local income tax purposes, each item of income gain loss or deduction shall be allocated income, gain, loss or deduction shall be allocated among the Holders in the same manner and in the same proportion that the corresponding book p p p gitems have been allocated among the Holders’ respective Capital Accounts.


Real Estate Agreements Today There are two types of allocation/distribution methodologies seen today

P R [D h i ?]1. Pro‐Rata [Do they exist anymore?]2. Waterfall Agreements

The most common in today’s marketplace with two The most common in today s marketplace with two main subsetsI. Based on a preferred return or “pref” methodology

A I t l R t f R t (“IRR”) tII. An Internal Rate of Return (“IRR”) conceptThe economic deal reached between the parties impacts

which concept needs to be used.


General Allocations: The Pro‐Rata Agreement Contributions: Pro‐Rata…do not Co t but o s: o ata…do otchange

Allocations: Pro‐Rata…do not change

Distributions: Pro‐Rata…do not hchange

We are done, simple boiler plate language (okay not exactly that simple) and tonight we will actually be able to leave to make it home to have dinner with our kids!


Today’s Real Estate Agreement –Today s Real Estate Agreement Drafting Difficulties for Allocations Although not an absolute statement the main difficulty in drafting the allocations and distribution provisions of a real estate agreement distribution provisions of a real estate agreement come from the economic agreement of the parties1. Capturing the economic agreement on paper1. Capturing the economic agreement on paper2. Making sure that the drafted language matches

the deal and making sure the profit & loss i i k i j i i h h provisions work in conjunction with the

distribution provisions Sometimes the “terms” simply do not workp y


Today’s Real Estate Agreement –Today s Real Estate Agreement The Waterfall!

Al h h f ll i i i l Although waterfall provisions are not unique to real estate they tend to be more prevalent and have more tiers when compared to non‐real estate dealstiers when compared to non real estate deals As previously stated, as long as SEF is met parties can have as many tiers as they want, and real estate investors tend to like a lot of tiers!

In nature a waterfall with one large drop looks ominous, but large drop looks ominous, but with real estate agreements the more “gentle” slope with numerous tiers provides more opportunities to slip and fall!


opportunities to slip and fall! (i.e drafting mistakes).

The Waterfall – Why? By its nature a distribution waterfall implies that there is a

promote or carry in the deal. Multiple waterfall tiers implies that there is more than one promote % Okay, I agree contributions will be 98%/2%. Give me an 8.5%

IRR on my 98% and I will split cash above that threshold 80%/20%B t h t if I hit h f i thi d l? But what if I hit a home run from running this deal?

Okay, if you hit a home run I will split cash 80%/20% between an 8.5% and 14% IRR. If you get me past a 14% IRR I will split cash above that 65%/35%cash above that 65%/35%

The waterfall tiers aren’t always associated with a promote or carry as they can be related to a priority amount, although it is safe to say if there is a waterfall there is a although it is safe to say if there is a waterfall there is a promote or carry somewhere in it.


Waterfall Example ‐ Easy Distributions of Cash Flow will be made:

i. First, 100% to Class A Members in proportion to their respective Percentage Interests, until each Class A Member has received pursuant to this clause (i) an amount equal to the sum of the p ( ) qaggregate Capital Contributions to the Company by such Class A Members

ii. Second, 100% to the Class A Members in proportion to their respective Percentage Interests, until each Class A Member has p g ,received the 10% Priority Distribution, and

iii. Thereafter, (a) 90% to the Class A Members in proportion to their respective Percentage Interests and (b) 10% to the Manager.

This example shows a couple of things regardless of the difficulty: This example shows a couple of things, regardless of the difficulty:1. Defined Terms2. Even though “Priority Distribution” is not defined here (its in the

definition section), the fact that return of capital comes first tells thi i IRR t P fyou this is an IRR concept vs. a Pref.


Waterfall Example – Not Too Hot orWaterfall Example Not Too Hot or Cold (but we can’t say just right as we are not talking about porridge!) Distributions shall be made by the Company to each Holder pro rata based the

Percentage Interests of each such Holder. Notwithstanding the foregoing, distributions otherwise payable to any Holder in respect of such Holder’s Class A Units shall be distributed as follows:a) Such Distributions shall first be made to the Holders of Class A Units in the proportion a) Such Distributions shall first be made to the Holders of Class A Units in the proportion

that each such Holder’s share of Unreturned Class A Investment Amount bears to the aggregate Unreturned Class A Investment Amount, until each such Holder’s Unreturned Class A Investment Amount has been reduced to zero;

b) Such Distributions shall next be made to the Holders of Class A Units in the proportion necessary until each Holder of Class A Units has achieved an Internal Rate of Return of y8.5% on the Capital Contributions made by such Holder in respect of such Holder’s Class A Units (including, without duplication, the Capital Contributions made in respect of any Class A Units redeemed in a Senior Sale Event Redemption);

c) Such Distributions shall next be made 20% to the Holders of Class B Units (pro rata based upon the number of Class B Units owned thereby) and 80% to the Holders of p y)Class A Units (pro rata based upon the number of Class A Units owned thereby) until each Holder of Class A Units has achieved an Internal Rate of Return of 14% on the Capital Contributions made by such Holder in respect of such Holder’s Class A Units;

d) Thereafter, such Distributions shall be made 35% to the Holders Class B Units (pro rata based upon the number of Class B Units owned thereby) and 65% to the Holders of l ( b d h b f l d h b )Class A Units (pro rata based upon the number of Class A Units owned thereby).


Waterfall Example – Slip and Fall!ii. Following (w) the satisfaction of accrued and unpaid

interest on Priority Loans, in proportion to the outstanding Priority Loans, if any, and (x) the satisfaction of outstanding principal balances on Priorit satisfaction of outstanding principal balances on Priority Loans, in proportion to the outstanding Priority Loans, if any, the General Partner shall cause the Partnership to distribute Net Cash from Sales and Financings as soon as distribute Net Cash from Sales and Financings as soon as practicable after the receipt of such Net Cash from Sales or Refinancings, as follows:A. First, to Larry to the extent of any unpaid Preferred Equity y y p q y

Redemption Amount related to a prior sale or refinancing;B. Second, to Curly to the extent of any unpaid Curly Priority Return;C. Third, to Larry to the extent of any accrued and unpaid Preferred

Equity ReturnEquity Return


Waterfall Example – Slip SlidingWaterfall Example Slip Sliding Away!

D. Fourth, if involving a Qualified Assumed Asset, to Larry in an amount equal to the Preferred Equity Redemption Amount related to such Qualified Assumed Asset (but in no event will the total amount distributed under this clause (D) exceed the outstanding Preferred Equity Capital Contribution);

E. Fifth, to Larry to the extent of any unpaid Larry Priority Return;

F Sixth, to Curly until all Capital Contributions made by Curly F. Sixth, to Curly until all Capital Contributions made by Curly have been returned (solely for the purposes of this Section 7.1(a)(i)(F), Capital Contributions shall include Acquisition Fees (if any) paid by Curly);Fees (if any) paid by Curly);


Waterfall Example – Oh this hurts!G. Seventh, to Larry until all Capital Contributions (excluding

Preferred Equity Capital Contributions) made by Larry or credited on Larry’s behalf have been returned (solely for the purposes of this Section 7.1(a)(i)(G), Capital Contributions shall include 17.65% of the amount of the Acquisition Fees (if any) paid by Curly);

H. Eighth, to Larry until all Preferred Equity Capital Contributions have been returned or redeemed; and

I Thereafter, (x) so long as Moe GP is the General Partner, (1) I. Thereafter, (x) so long as Moe GP is the General Partner, (1) 65% to Curly and (2) 35% to Larry, or (y) so long as Moe GP is no longer the General Partner, (1) 85% to Curly and (2) 15% to Larry.15% to Larry.


Slip and Fall Waterfall ‐Slip and Fall Waterfall Observations First, the name “Slip and Fall” was used as this waterfall did not

work as written (some defined terms were incorrect) Second, when the first sentence of the waterfall references the

letters (w) and (x) we know it is time to grab some popcorn and letters (w) and (x) we know it is time to grab some popcorn and take a seat…we are going to be here for awhile.

Third, the first portion of the waterfall referencing payments related to priority loans are not distributions for tax purposes, related to priority loans are not distributions for tax purposes, but is defining the priority of use of cash. Agreements that contain partner loans will often include repayment

of said loans in the distribution provisions, but they are not actually part of the waterfallpart of the waterfall

It shows both a priority waterfall and a carry/promote, which did not show up until Tier (I), the 9th Tier

Since the Preferred Return Tiers came before return of capital it Since the Preferred Return Tiers came before return of capital it is a Pref concept vs. an IRR concept.


Waterfall – Pref vs. IRR? Which do you use?

Really dictated by the economic agreement and comes d t h th th t ki k i b f down to whether the carry or promote kicks in before a return of capital. If the promote partner negotiates the promote triggering p p g p gg gbefore return of capital to the non‐promote partner then you have to use a Pref concept as IRR will not work.

If the promote does not kick in prior to return of capital then p p pyou can use either one.


P f IRR A Ch tPref vs. IRR – A ChartPreferred Return IRR

QuestionReturn Concept

IRR Concept

Return of Capital Tier must come before the Return Tier? No YesReturn Tier?

Promote can trigger before Return of Capital Tier? Yes No

Can have multiple Promote Tiers Yes YesCan have multiple Promote Tiers Yes Yes

The Agreement may specifically mention a Microsoft Excel (including version) function that must be used to perform the waterfall Never Seen It Yesthat must be used to perform the waterfall calculations?

Order this chart now and pay only $9.95, but wait! If you order within the next ten minutes you get two for the price of one!* *Just pay separate Processing & Handling. **$22.00


y g p J p y p g g $

Have you noticed that it is now separate “Processing and Handling”…it used to be extra Shipping & Handling?

Distributions – More Than TheDistributions More Than The Waterfall Do this agreement need a distribution provision for tax distributions?

If i d b h i If negotiated by the parties, yes. Will a tax distribution provision cause any problems with either a Pref or IRR concept?with either a Pref or IRR concept? Not really


Profit & Loss Allocations Distributions were discussed first because you really cannot determined how profit and loss should be allocated until you know how the parties agree to allocated until you know how the parties agree to share cash As stated earlier, the §704(b) regulations were written so th t th t ( fit & l ll ti ) that the tax consequences (profit & loss allocations) follow the economic consequences (sharing of cash)

Okay, what do you do now, especially when you think y y y yabout the Slip and Fall Waterfall How do I write allocation provisions to match up to those 9 tiers?those 9 tiers?


Profit & Loss Allocations – OneProfit & Loss Allocations One Paragraph! It is obviously possible to write profit & loss allocation provisions on a tier by tier basis that match up to distribution tiers (ignoring return of capital) however distribution tiers (ignoring return of capital), however somebody came up with a way to do so in one paragraph (profit or loss), regardless of the number of p g p (p ), gdistribution tiers! Must have been someone at NASA because those rocket

i i !scientists are pretty smart!


Profit & Loss Allocations – TheProfit & Loss Allocations The Constructive Liquidation Analysis One Paragraph Handles it All:

Profits and Losses for any Fiscal Year shall be allocated among y gthe Holders such that, as of the end of such Fiscal Year, the Capital Account of each Holder shall equal (a) the amount which would be distributed to them or for which they would be liable to the Company under the Act determined as if the be liable to the Company under the Act, determined as if the Company were to (i) liquidate the assets of the Company for an amount equal to their Book Value and (ii) distribute the proceeds of such liquidation pursuant to Section 5.2 minus(b) the sum of (i) such Holder’s share of Compan Minimum (b) the sum of (i) such Holder s share of Company Minimum Gain, (ii) such Holder’s Holder Minimum Gain and (iii) the amount, if any, which such Member is obligated to contribute to the capital of the Company as of the last day of such Fiscal p p y yYear.


Specially Adjusted & TargetedSpecially Adjusted & Targeted Capital Accounts The language of some agreements use two defined terms; Partially Adjusted Capital Accounts and Targeted Capital Accounts and state that allocations Targeted Capital Accounts and state that allocations are made in a manner to reduce the difference, to the extent possible, between Partially Adjusted Capital Accounts and Targeted Capital AccountsAccounts and Targeted Capital Accounts. Partially Adjusted Capital Accounts and generally defined as Capital Accounts as of the beginning of the fi l i d dj d f l ib i d fiscal period, adjusted for actual contributions and distributions made during the year.

Targeted Capital Accounts are generally defined as equal g p g y qto (a) minus (b) in the previous slide.


Constructive Liquidation Analysis –Constructive Liquidation Analysis –Step 1, Step 2, Step 3, & Maybe Step 4 The process under the provision is simply in theory

1. Calculate each partner’s Partially Adjusted Capital Account (Beginning of Year Capital + Contributions –Account (Beginning of Year Capital + Contributions Distributions): We will call this X

2. Perform the constructive year‐end sale (sell all assets for book value (§704(b) basis)) retire liabilities for book value (§704(b) basis)) retire liabilities (including partner loans), and determine how the net cash will be distributed (run it through the waterfall!): We ill call this YWe will call this Y Since the deemed sale is at book value and assets – liabilities = capital you can skip this and just look at ending capital and say it is the net cash to distributeit is the net cash to distribute


Constructive Liquidation AnalysisConstructive Liquidation Analysis – Step 3…

3. For each partner subtract X from Y; this result is the tentative profit or loss allocation

“Tentative” because sometimes the results of step 3 will not Tentative because sometimes the results of step 3 will not wind up being the actual allocation! Uh Oh…Houston, We have a problem!


Step 3…Houston, We Have aStep 3…Houston, We Have a Problem…We Need Step 4 Under certain fact patterns you will see that when there is net income the results of Y minus X will result in a positive allocation (income) for one or more in a positive allocation (income) for one or more partners and a negative allocation (loss) for one or more other partners. The same is true in reverse when there is a net loss Because it is the “net” income or there is a net loss. Because it is the net income or loss being allocated then the tentative allocations will not work. Under this fact pattern the net income (or l ) i ll d l h i i loss) is allocated only to those partners receiving an income (or loss) allocation under Step 3. Actual ending Capital Accounts will not equal Targeted g p q gCapital Accounts.


The Fix Just as the rocket scientists at NASA were able to figure out how to put a square CO2 cartridge into a round hole for Apollo 13 they figured out a way to solve the hole for Apollo 13 they figured out a way to solve the constructive liquidation analysis problem. We need a clause, or maybe just a parenthetical, after th d P fit d L t fi th blthe words Profits and Losses to fix the problem Including individual items of income, gain, loss, or deduction (or items thereof)This allows for a special allocation of “items” which then allows some partners to receive an allocation of income, while others receive loss, when there is net income, or the reverse when there is net lossis net loss.


The Fix ObservationsThe Fix ‐ Observations Does it work in all cases?

What if the partnership’s sole activity is the ownership of an What if the partnerships sole activity is the ownership of an interest in a lower‐tier partnership? The K‐1 received shows net items. Can you specially allocate “items” if you know your share of gross income and gross deductions of the lower‐tier?

Does the allocation of “items” vs. net income or loss fail SEF? There are plenty of analogous situations whereby allocations

f “ ” ll d d h ll fp y g y

of “items” are allowed or required, thus allowing for an argument that this does not fail SEF.

Do one or more partners really want to get allocated more i th th t i ( h t i )?income than the net income (phantom income)? That is the ultimate question. Is a partner willing to receive phantom income to make sure its capital account is equal to the amount that they are entitled to upon liquidation?the amount that they are entitled to upon liquidation?


Multiple Assets, MultipleMultiple Assets, Multiple Waterfalls – Can you do it? A lot of real estate partnerships, particularly real estate funds, will own multiple assets. Can you have a waterfall and thus promotes by asset?waterfall, and thus promotes, by asset? Yes, the agreement has to specify this and the taxpayer has to maintain trial balances (capital contributions, ( p ,distributions, and P & L) by asset. You are essentially segregating each asset and performing calculations as if each were a separate partnership followed by calculations as if each were a separate partnership, followed by combining them into one.


A Claw‐back? Does the agreement need a claw‐back provision whereby the “promote” partner is required to contribute capital for excess cash that has been contribute capital for excess cash that has been received? Can only apply in agreements where a promote triggers Can only apply in agreements where a promote triggers prior to return of capital to the non‐promote partner. In an IRR agreement a promote does not trigger until capital is returned and the IRR threshold is exceeded Thus there returned and the IRR threshold is exceeded. Thus, there cannot be excess cash on the promote.

Same thing with a Pref agreement whereby the promote does t t i til P f i d d it l i t dnot trigger until Pref is earned and capital is returned.


Liquidations, Asset Sales,

and Interest Salesand Interest SalesAugust 25, 2011

L. Andrew ImmermanAlston & Bird LLP

g ,

Alston & Bird [email protected]

Allocations and DistributionsAllocations and Distributions An LLC distribution is an amount that the LLC member receives. An LLC allocation is an amount of profits, losses, or other items that

are attributed to the member on the LLC's books. Typically -- although there are many exceptions -- the distribution is

t f d th ll ti i t bltax-free and the allocation is taxable. The allocation is taxable whether or not there is a corresponding

distribution. It may seem exactly backwards that you can receive distributions tax- It may seem exactly backwards that you can receive distributions tax

free but must pay tax on accounting entries. However, for holders of LLC equity interests, that is the normal pattern.

Contributions, distributions, and allocations are interrelated tconcepts.

Over the life of the LLC, contributions plus or minus allocations equal distributions.

Any time you change one of these items – contributions distributions

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Any time you change one of these items contributions, distributions, and allocations – you must consider how the others may be affected.

Drafting for Liquidating DistributionsDrafting for Liquidating Distributions

Traditional (layer-cake) allocation. Specifies the allocation of income and loss.

Li id ti di t ib ti d t t h Liquidating distributions are made so as to match allocations. More precisely, the distributions are made in accordance with p y,

the capital accounts, which in turn reflect the allocations (and contributions, and prior distributions) that have been made.

Considered the safer approach under the tax Considered the safer approach under the tax regulations

However, may give the members less certainty about

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the way liquidating distributions will be made.

Drafting for Liquidating DistributionsDrafting for Liquidating Distributions

Targeted (forced) allocation Targeted (forced) allocation. Specifies the distribution of proceeds on liquidation of the LLC. Allocations are made so as to match liquidating distributions.

More precisely allocations are made so that capital accounts (subject More precisely, allocations are made so that capital accounts (subject to some adjustment) equal the amounts that would be distributed if the LLC sold all its assets at the values reflected in the capital accounts and distributed the proceeds to the members in a liquidation.

Validity of approach under tax regulations is less clear. However, it is intended to produce the same tax results as

traditional allocations. It is now widely used, in part because it seems to give the members more

certainty about the way liquidating distributions will be made. This approach requires special care when dealing with carried interests

issued at different times.

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issued at different times.

Simplified ExamplesSimplified Examples

Traditional Allocations: Traditional Allocations: Allocate profits to offset prior losses. Allocate all remaining profits pro rata by unit. Allocate losses in accordance with capital accounts Allocate losses in accordance with capital accounts. Liquidating distributions made in accordance with capital

account.

Targeted Allocations: Allocate profits and losses so that capital accounts (plus

required capital contributions and “minimum gain”) equal the amounts that the member would receive if the LLC sold all itsamounts that the member would receive if the LLC sold all its assets at “book value” (i.e., the values reflected in the capital accounts) and distributed the proceeds to the members.

Liquidating distributions made in a specified order of priorities, ith t f t it l t

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without reference to capital accounts.

Which Method to Use?Which Method to Use? The debate rages The debate rages. The trend is for more LLC Agreements to use targeted

allocations. One exception: If the transaction needs to comply with

the “fractions rule” (Code § 514(c)(9)), targeted allocations are generally not usedare generally not used.

Fractions rule can be important when the LLC has: Debt-financed real estate. A “qualified organization” as one of the members.

Qualified organizations generally include schools and pension plans. Many tax-exempt charities are not “qualified organizations” for this

115

y p q gpurpose.

115

Capital Gains Rate?Capital Gains Rate? What is the tax rate on the sale of an LLC What is the tax rate on the sale of an LLC

interest? Special rules for determining when:p g

Gain is ordinary income (Code § 751). Holding period is short term (Treas. Reg. § 1.1223-3).

Long-term capital gain on the sale of LLC interests is not automatically eligible for the 15% rate, which is generally the maximum long-term individual capital gain rate.

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Capital Gains Rate?Capital Gains Rate? Many real estate partnerships have large amounts of 25% long term Many real estate partnerships have large amounts of 25% long-term

capital gain ("unrecaptured section 1250 gain," defined in Code §1(h)(6)).

Long-term capital gain on the sale of an LLC interest is generally Long-term capital gain on the sale of an LLC interest is generally taxable at the 25% rate to the extent the gain is attributable to unrecaptured section 1250 gain.

If the LLC sells the property the unrecaptured section 1250 gain is If the LLC sells the property, the unrecaptured section 1250 gain is passed through to the members at the 25% rate

However, gain on an LLC distribution that is attributable to unrecaptured (and unrecognized) section 1250 gain may be entitled tounrecaptured (and unrecognized) section 1250 gain may be entitled to the 15% rate.

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Transfer Restrictions in GeneralTransfer Restrictions in General The LLC Agreement often imposes tough restrictions on The LLC Agreement often imposes tough restrictions on

the transfer of interests: categories of “permitted transfers.” rights of first refusal.g repurchase rights.

The LLC Agreement sometimes provides that unpermitted transferees – or even permitted transferees -- are "economic interest holders.”

In drafting keep in mind that the tax provisions generally will apply to economic interest holders who

t b t d t t lare not members or partners under state law. Conversely, a member or partner under state law is not

necessarily a partner for tax purposes.

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Transfer of LLC “Units”Transfer of LLC Units A term like LLC “units” is often convenient as a way to speak y p

about and keep track of transfers of LLC interest. However, the division of LLC interests into “units” is

essentially meaningless for tax purposes.y g p p LLC units do not behave like shares of corporate stock; LLC

units of the same “class” may or may not be fungible. In drafting LLC Agreements, do not assume that “unit” hasIn drafting LLC Agreements, do not assume that unit has

any meaning other than the meaning it is given in the agreement itself. Important differences among the members may exist even when all

b h “ l ” f “ it ”members have one “class” of “units.” Focus on the full package of rights and obligations that a member

has under the LLC Agreement, rather than narrowly on “units.”

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Additional Transfer RestrictionsAdditional Transfer Restrictions LLC Agreements sometimes single out certain transfers C g ee e s so e es s g e ou ce a a s e s

that pose particular tax risks, and Prohibit them entirely, or Impose tighter restrictions on them Impose tighter restrictions on them.

Some transfer restrictions are designed to ensure that the interests do not inadvertently become “publicly y p ytraded,” causing the LLC to be classified as a corporation for tax purposes under Code § 7701(a).

Some transfer restrictions are designed to avoid Some transfer restrictions are designed to avoid “technical terminations” under Code § 708(b)(1)(B).

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Additional Transfer RestrictionsAdditional Transfer Restrictions5.5 Additional Transfer Restrictions.

5.5.1. Preserve Partnership Tax Status. No Membershall be permitted to transfer any portion of its interest in theCompany or take any other action that in the judgment of theCompany or take any other action that, in the judgment of theManagers, would materially increase the risk that the Companywould be treated as a "publicly traded partnership" within themeaning of Code Section 7704 or be classified as a corporationwithin the meaning of Code Section 7701(a)within the meaning of Code Section 7701(a).

5.5.2. Technical Tax Terminations. No Member shall bepermitted to transfer all or any portion of its interest in thep y pCompany or to take any other action that would result in atermination of the Company within the meaning of Section708(b)(1)(B) of the Code, without the approval of the Managers.

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Termination of PartnershipTermination of PartnershipUnder the Internal Revenue Code, a ,

termination of a partnership results from two and only two events: "Actual Termination": The business ceases to

be carried on by the partners in a partnership If only one partner is left thepartnership. If only one partner is left, the partnership has "actually" terminated.

"Technical Termination": Within a 12-month Technical Termination : Within a 12 month period, there is a sale or exchange (not redemption) of 50% or more of the total i t t i t hi it l d fit

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interests in partnership capital and profits.

Technical TerminationTechnical Termination If a partnership terminates by reason of a sale or

exchange of an interest, the partnership is deemed to contribute all of its assets and liabilities to a new partnership in exchange for anliabilities to a new partnership in exchange for an interest in the new partnership.The terminated partnership is then deemed to p p

make a liquidating distribution of partnership interests in the new partnership to its partners (including the purchasing partner) in proportion to(including the purchasing partner) in proportion to their respective interests.

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Technical Termination

A technical termination is not necessarily

Technical Termination

A technical termination is not necessarilydetrimental. It depends on the facts.

As a result of 1997 regulations, the biggest g , ggproblem now tends to be the restart of depreciable lives.

G ll th d i bl li f t hi lGenerally, the depreciable lives for partnership real estate and other tangible property begin all over again, so that the depreciation deductions available to the

t l d dpartners are slowed down. An LLC with little depreciable property (such as a real

estate development entity) may not care much about

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p y) ytechnical terminations.

Technical TerminationTechnical Termination Tax year: The tax year of the partnership ends on the date of its termination. If some of the partners don’t have the same tax year as the

partnership, this early termination can cause a bunching of income.p p y g

Partnership elections: Elections made by the terminated partnership are not applicable to Elections made by the terminated partnership are not applicable to

the reconstituted partnership. The reconstituted partnership is free to make new elections

regarding accounting methods and other mattersregarding accounting methods and other matters. The ability to escape unfortunate elections made by the terminated

partnership may be a benefit.

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Avoiding Technical TerminationSelling partner might sell almost 50% of capital

Avoiding Technical Terminationg p g p

and profits, but hold on to a de minimis portion for a year and a day.Selling partner might dispose of interest in a transaction that is not considered a "sale or

h "exchange." Redemption by the partnership is not a sale or

exchangeexchange. If the money for the redemption is coming from the

incoming partner, the IRS might try to characterize it

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as a “disguised sale.”

Mid Year Ownership ChangesMid-Year Ownership Changes There are two basic methods for allocating There are two basic methods for allocating

income/loss for a year when ownership of the LLC changes during the year. Pro rata by day. Assumes that the LLC has the same

amount of profit or loss on each day of the year, even including days after the member’s interest has beenincluding days after the member s interest has been eliminated.

Closing of the books, which tends to be more accurate but requires more effortbut requires more effort.

Hybrid methods may be possible For example, use the pro rata method in general, but

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p , p g ,closing of the books methods for extraordinary items.

Drafting for Ownership ChangesDrafting for Ownership Changes

The LLC Agreement might: The LLC Agreement might: Designate a specific method to be used by all the

members. Delegate to a managing partner or manager the

authority to choose a method. All th th d t b h b t t th ti Allow the method to be chosen by agreement at the time

the new member is admitted, with a default rule to be used only if no method is agreed on at the time.

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Drafting for Ownership ChangesDrafting for Ownership Changes

Amendment to LLC Agreement? LLC Agreements may state that admission or withdrawal

f b d t i d tof a member does not require an amendment. However, depending on the terms of the admission or

withdrawal, an amendment may be necessary anyway.withdrawal, an amendment may be necessary anyway. Sometimes the relevant terms of a new transfer, capital or

redemption can be set forth through an amendment to the LLC AgreementAgreement.

Sometimes a separate agreement is needed or advisable. Often all Members, including the transferee, sign an "Amended

and Restated LLC Agreement "

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and Restated LLC Agreement.

Tax Provisions for TransfersTax Provisions for Transfers

3.1 Capital Account. Effective on the Effective Date, thecapital account of the Transferring Member will be transferred tothe Transferee.

3.2 Allocations. Based on an interim closing of the books as ofthe end of the day immediately preceding the Effective Date,Profits, Losses, and all other items of income, gain, loss,Profits, Losses, and all other items of income, gain, loss,deduction, or credit, allocable to the Interest under the LLCAgreement, shall be credited or charged, as the case may be, tothe Transferee and not to the Transferring Member.

3.3 Distributions. The Transferee shall be entitled to alldistributions with respect to the Interest made on or after theEffective Date, regardless of the source of those distributions.

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Effective Date, regardless of the source of those distributions.

Tax Provisions for TransfersTax Provisions for Transfers

9 2 C i h f h ll9.2 Cooperation on Tax Matters. The Transferee shallprovide notification to the Company of the informationrequired by Treas. Reg. § 1.743-1(k)(2)(i), in the form ofExhibit B attached hereto Notwithstanding any otherExhibit B attached hereto. Notwithstanding any otherprovision of this Agreement, the Transferring Member shallhave the right to receive information in connection with theCompany’s tax returns necessary for it to protect its interestCompany s tax returns necessary for it to protect its interestand comply with law and regulations, including suchinformation as may be required to prepare the statementdescribed in Treas. Reg. § 1.751-1(a)(3). In addition, the

i h ll f ll i i i h diparties shall cooperate fully in connection with any audit,litigation, or other proceeding with respect to taxes, withrespect to the Company or with respect to the interest of themembers in the Company

131131

members in the Company.

Ancillary AgreementsAncillary Agreements In transactions that are complex, a separate agreementIn transactions that are complex, a separate agreement

may be necessary in order to keep the new (or amended) LLC Agreement “uncluttered” on a going forward basis.

A purchase and sale agreement is appropriate when the seller is the interest holder.

A contribution agreement is appropriate when the g pp pinterest is being acquired directly from the company.

A contribution agreement for a piece real estate looks very much like a sale agreement and not like an LLC A b h k h h ib iAgreement, but check to see that the contribution agreement and the LLC Agreement are consistent with each other.

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Tax Treatment of RedemptionsTax Treatment of RedemptionsSometimes the LLC Agreement will spell out theSometimes the LLC Agreement will spell out the tax characterization of redemptions, for example:

7.2 The Redeemed Member herebyacknowledges and agrees that the Purchase Priceshall be treated as paid for the RedeemedMember’s interest in Company property under IRC§ 736(b)(1) only to the extent of the Fair MarketValue thereof. The balance of the Purchase Price,including (without limitation) interest or anypromissory note given in partial payment of thePurchase Price, shall be treated as guaranteed

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payments described in IRC § 736(a)(2).

Capital Accounts The capital account is increased by the Member’s share of

Capital Accounts

income, and decreased by the Member’s share of loss and by distributions to the Member.

The capital account is generally not adjusted for unrealized The capital account is generally not adjusted for unrealized increases or decreases in the value of assets.

Key exception: Capital accounts of existing Members may be revalued to then current fair market values upon a distribution or on the issuance of an interest for property or for servicesfor services.

Many LLC Agreements that provide for this exception locate it in the details of a definition (such as “Gross Asset Value”)

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where it is easy to overlook.

Change in Number of MembersChange in Number of Members

Di d d E tit t P t hi A Disregarded Entity to Partnership: A partnership becomes a disregarded entity when the entity's membership is reduced to one member.

Partnership to Disregarded Entity: A disregarded entity becomes classified asdisregarded entity becomes classified as a partnership when the entity has more than one member

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than one member.

Single Member LLC AgreementsSingle-Member LLC Agreements

An LLC Agreement for a single member LLC differs An LLC Agreement for a single-member LLC differs radically from a multi-member LLC Agreement. One big difference: a single-member LLC is not taxed as a

partnership, so all provisions relating to partnership tax are incorrect or irrelevant.

Never start with a model single-member LLC Agreement when drafting for a multi-member LLC, or vice versa.

If an LLC changes from multi-member to single-member, or vice versa the LLC Agreement should be completelyor vice versa, the LLC Agreement should be completely rethought.

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Disregarded Entity to PartnershipDisregarded Entity to Partnership

Rev Rul 99-5 / Situation 1Before After

Rev. Rul. 99-5 / Situation 1

A

100%A B

$5,000

50%50%50%

LLC LLC

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B’s purchase of fifty percent of A’s ownership interest in the LLC is treated as the taxable sale by A of a fifty percent interest in each of the LLC’s assets --assets which previously had been treated

h ld di tl b A f tas held directly by A for tax purposes. A and B are treated as then contributing

th i ti i t t i th t ttheir respective interests in those assets to a partnership in exchange for ownership interests in the partnership

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interests in the partnership.

Disregarded Entity to PartnershipDisregarded Entity to PartnershipRev. Rul. 99-5 / Situation 2

Before After

A

100%

A50%50% $10,000

A B

50%

LLC LLC

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B is treated as contributing $10,000 to a partnership in exchange for a partnership interest.

A is treated as contributing all of the assets of the LLC to the partnership in exchange for a partnership interest.

Neither A nor B recognizes any gain or loss on the deemed contributions.

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Partnership to Disregarded EntityPartnership to Disregarded EntityRev. Rul. 99-6 / Situation 1

AfterBefore

$10 000

100%

B

A B

$10,000

100%

A B

100%50% 50%

100%

LLCLLC

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Partnership to Disregarded EntityPartnership to Disregarded Entity

IRS's position is strange and confusing.p g g A is treated as selling a partnership interest. B is not treated as purchasing a partnershipB is not treated as purchasing a partnership

interest.B is treated as purchasing half the p g

partnership's assets from A, with a new holding period.

B is treated as receiving half the partnership's assets in a liquidating distribution from the

t hi ith "t k d" h ldi i d142142

partnership, with a "tacked" holding period.

Documents

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