TOP 10 THINGS EVERY NON-TAX LAWYER SHOULD KNOW ABOUT PARTNERSHIP TAX

Transcription

1 TOP 10 THINGS EVERY NON-TAX LAWYER SHOULD KNOW ABOUT PARTNERSHIP TAX Charlottesville-Albemarle Bar Association Continuing Legal Education January 29, 2014 Jeffrey G. Lenhart, JD, LLM 530 East Main Street Charlottesville, VA (434)

2 TOP 10 THINGS EVERY NON-TAX LAWYER SHOULD KNOW ABOUT PARTNERSHIP TAX Introduction. The proliferation of partnerships (for Federal and state income tax purposes) is attributable to myriad factors, including: 1. The existence of double taxation of corporations upon liquidation (because of the repeal of the General Utilities doctrine under the 1986 Tax Reform Act). 2. Startup corporations (particularly highly leveraged ones) are unable to utilize anticipated losses in the early years. 3. Since the recognition of limited liability companies in all 50 states LLCs have become the choice of entity for most newly created legal entities. Unless taxpayers affirmatively elect to be taxed as a corporation, LLCs are taxable as partnerships for Federal income tax purposes. The Virginia State Corporation Commission reported the following number of corporations and limited liability companies formed in the Commonwealth over the last several years: Year Corporations Limited liability companies ,518 45, ,324 39, ,445 34, ,640 33, ,768 34, ,721 35, ,612 37,125 The different types of domestic entities that are taxed as partnerships for Federal income tax purposes also include general partnership, limited partnerships, and limited liability partnerships. Entities taxed as partnerships are nontaxable at the entity level; rather, the income and losses are applied against each other at the entity level and passed through to their equity holders (and reflected on a Schedule K-1, as part of the entity s annual partnership tax return IRC form 1065) and reported on the owners tax returns (whether or not any cash is distributed to the owners). ISSUE #1: UNDERSTANDING CAPITAL ACCOUNTS a) Capital accounts are fundamentally important to partnership taxation in that they reflect a partner s equity in the partnership. A capital account determines what each partner 2

3 would receive in the event the partnerships assets were sold at fair market value and all liabilities were paid, with the remaining cash distributed to owners in liquidation of the entity. b) Capital accounts are calculated and maintained as follows: i) Contributions a partner s capital account is increased by the amount of money and the fair market value (or book value ) of the property contributed, less the liabilities secured by the property (a) Tax basis in the contributed property is irrelevant in determining book capital accounts. ii) Operations a partner s capital account is also increased by the partner's share of partnership income (including tax exempt income) and decreased by the partner's share of partnership losses for the year. (1) Note that the character (capital or ordinary) of the gain or loss does not matter. (2) Depreciation also reduces a partner s capital account. iii) Distributions a partner s capital account in decreased by the amount of money plus the fair market value of any property (net of any assumed liabilities) distributed to that partner c) There are book capital accounts and tax capital accounts i) Book capital accounts reflect the fair market value of the assets at the time of contribution to the partnership and distributions from the partnership. For this reason, book capital accounts capture the economic arrangement among the partners. (1) Book capital accounts are based on IRC 704(b) and according to generally accepted account principles ( GAAP ) ii) Tax capital accounts, on the other hand, reflect the tax basis of the partnership s assets. Therefore, tax capital accounts cannot represent (in the aggregate) greater than the total tax basis of the assets (less any liabilities). (1) The tax basis of contributed property is carryover basis ; it is the transferred basis of the contributing member. IRC 723. (2) Tax capital accounts can deviate from book capital accounts for a variety of reasons including: depreciation, contributed property with value different than its tax basis and revaluation of partnership assets from cost to current fair market value. 3

4 ISSUE #2: ISSUES UPON FORMATION a) Basic concepts; i) Generally, formation of partnerships is a non recognition event. Neither gain nor losses are recognized by the partners or partnership on the contribution of money or property to a partnership. IRC 721 ii) Each contributing partner takes as his basis in the partnership interest received ( outside basis ) an amount equal to the sum of the adjusted basis of any property contributed, plus any cash. IRC 722 iii) The partnership takes a transferred basis ( inside basis ) in contributed property equal to the basis of the property in the hands of the contributing partner. IRC 723 b) Issues upon formation i) Contribution of appreciated property gain or loss associated with contributed property at the time of transfer to the partnership must be taken into consideration by the contributing partner. IRC 704(c)(1)(A) ii) Contributions of services v. property contribution of services in exchange for a capital interest is not protected under IRC 721 and is taxable. iii) Contribution of depreciable property - contributions of depreciable property does not trigger gain recognition to the contributing partner under IRC 1245 or IRC 1250, but the contributed property remains subject to potential recapture gain upon a later distribution, including as a result of depreciation taken by the contributing partner prior to contribution. iv) Liabilities created upon formation (1) Each partner is treated as having made a cash contribution to the partnership to the extent of his share of partnership liabilities. IRC 752 (a) Therefore each partner is given credit in his outside basis for his share of partnership liabilities, including any initial share of partnership liabilities upon formation. IRC 722 (b) Recourse v non-recourse affects allocation (i) In general, recourse liabilities are shared among partners in accordance with how partners share losses. 4

5 (ii) Since no partners will be liable for non-recourse liabilities, such liabilities are generally allocated among the partners in the same way that partners share profits. (2) Contributions of encumbered property because the partnership assumes the liability from the partner, there is a simultaneous decrease in the contributing partner s liabilities and an increase in his share of partnership liabilities (a) Changes in a partner s share of liabilities is treated as cash transactions (i) A net increase in a partner s share of partnership liabilities is treated as a cash contribution and an net decrease in partnership liabilities is treated as a cash distribution (ii) can result in the partner contributing an encumbered property recognizing gain: v) contributions of special assets contributions of unrealized receivables by a cash basis taxpayer can result in assignment of income, with the income being taxable to the contributing partner. (1) Accounts receivable - are treated as property (IRC 721), and are assigned to the partnership as a zero basis asset (IRC 723); the income realized upon collection of the receivable as ordinary income realized by the contributing partner (IRC 724) and allocated to the contributing partner. (IRC 704(c)) vi) Transfer of assets for note - tax regulations provide an exception to the general rule of non-recognition where a transfer of property by a partner to a partnership results in the receipt by the partner of money or other consideration, including a promissory obligation. The transaction will be treated as a sale or exchange under IRC 707 rather than a non-taxable contribution under IRC 721. vii) investment company exception - generally, no gain or loss is recognized on the contribution of property to a partnership. IRC 721. However, gain will be recognized on the contribution of appreciated property to a partnership, if immediately after the contribution the partnership would be characterized as an investment company (if it were incorporated) under the provisions of IRC 351. (1) The partnership will be treated as an investment company if, after the transfers, greater than 80% of the partnership s assets (other than cash and cash equivalents) are comprised of stocks and securities and the transferors have achieved the diversification of their investments. 5

6 ISSUE #3 HOW DO DISTRIBUTIONS DIFFER FROM ALLOCATIONS? a) Allocations refer to the manner and amount by which income and loss of a partnership, generally first netted at the entity level, is apportioned among the partners. i) The general rule regarding the division of income and losses in IRC 704(a) states: A partner s distributive share of income, gain, loss, deduction or credit shall, except as otherwise provided in this chapter [Subchapter K of the IRC], be determined by the partnership agreement. ii) Therefore, subject to certain exceptions, partners are permitted to agree among themselves as to how to divide partnership income and loss. IRC 704(a). Partners ability to seek to specially allocate income and losses for purposes of reducing income taxes to one of more partners will depend on whether or not those allocations are significant independent of the tax savings, which analysis will be determined under IRC 704(b) that is, whether they have substantial economic effect. b) Distributions are payments made to partners out of their capital accounts (essentially a withdrawal of a partner s share of the capital of that entity, including capital that represents taxed but undistributed income). i) Current distributions one made to a partner whose interest in the partnership continues after the distribution, either at an equal or reduced share. ii) Liquidating distribution one or more distributions of cash and/or property that terminates a partner s interest in the partnership (and may terminate the partnership itself). iii) Non-recognition of gain or loss IRC 731 generally provides for non-recognition of gain or loss to all parties when partnership property or money is distributed (1) With a cash distribution, the recipient partner reduces his basis in his partnership interest (outside basis), but not below zero. (2) With a distribution of property, the recipient partner s outside basis is allocated among the properties received and his continuing interest in any retained partnership interest (if any). (3) Exceptions to non-recognition (a) distributions of money in excess of a partner s outside basis result in gain to the extent of the difference. ( IRC 752(b)) (i) NOTE: a reduction in a distributee partner s share of partnership liabilities is treated as a distribution of money 6

7 (b) Distributed marketable securities are treated as cash to the extent of their fair market value, reduced by the distributee s share of net appreciation in those securities. (IRC 731(c)) (4) Recognition of loss a partner recognizes losses only in a liquidating distribution, and never in a current distribution c) Approaches to capital account allocations i) Under IRC rules, for the allocation of profits and losses to have substantial economic fact, the partnership must: (1) Maintain capital accounts under detailed rules set forth in treasury regulations (2) Make liquidating distribution in accordance with capital accounts This is known as a allocation driven approach to allocation of profits and losses, and historically is the preferred method partnership agreements used to maintain capital accounts. ii) Target capital account approach profit and loss allocation provisions reflect the distribution waterfall through forced allocations commonly known as the target capital account approach to capital account maintenance (1) A forced allocation provision allocates profits and losses to partners' capital accounts so that, after making the forced allocations, each partner s capital account is equal to the distributions that would be made to the partner under the waterfall provisions had a partnership sold all of its assets at their current fair market value and then liquidated. When there are forced allocations, liquidating distributions are not based on the partners respective capital account balances, but the capital account balances are based on the amounts to be distributed among the partners. ISSUE #4 THE TAX ISSUES ASSOCIATED WITH AWARDING PARTNERSHIP INTERESTS TO A SERVICE PROVIDER a) There are three types of partnership equity compensation: i) Capital interest a capital interest entitles the holder to a share of partnership capital (i.e., current assets of the partnership). It also entitles the holder to share in the liquidating distributions in connection with a liquidation of the partnership immediately after the interest is granted. (Rev. Rul ) 7

8 ii) Profits interest the profits interest entitles the holder to a share of the partnership profits (i.e., future appreciation and income of the partnership). The holder of a profits interest does not share in the value of the partnership as of the date the profits interest is awarded. Because of their flexibility and attractive tax characteristics, profits interests are by far the most commonly used partnership equity compensation tool. iii) Options on partnership interest options are difficult to use in partnerships, and given the relative flexibility of profits interest, are infrequently used in the partnership context. b) Tax Consequences associated with equity awards vary depending on the type of equity interest granted: i) Capital Interest - under IRC 83, the grant of a capital interest is taxed as current compensation to the recipient in an amount equal to the fair market value of the capital interest. Absent a special election, the recipient of the capital interest is generally taxable when the interest becomes vested (i.e., when it is not subject to a substantial risk of forfeiture) (IRC 83; IRC 1.83(3)(e)). (1) A recipient may make an election under IRC 83(b) to include the income, immediately on being granted the property; the partnership generally deducts the amount of compensation included by the service provider as a trade or business expense under IRC 162. The deduction is allocated to the partners in accordance with their partnership interest immediately before the grant of the interest of the service provider. (a) An IRC 83(b) election may be appropriate where the partnership interest is subject to substantial risk of forfeiture, where the value at time of issue is nominal, and the potential for appreciation is significant. ii) Profits Interest Rev. Proc provides a safe harbor for the grant of certain profits interest. (1) That revenue procedure defines a capital interest as an interest that gives the holder a share of the proceeds if the partnership s assets are sold at fair market value in the proceeds are distributed in a complete liquidation of the partnership. A profits interest is then defined as a partnership interest other than a capital interest. (2) The safe harbor does not apply if any of the following apply: (a) The profits interest relates to a substantially certain and predictable stream of income in partnership assets, such as income from high quality debt securities or a high quality net lease; or 8

9 (b) Within two years of receipt, the partner disposes of the profits interest; or (c) The profits interest is a limited partnership interest in a publicly traded partnership. (3) Recently released proposed regulations provide new rules for the treatment of partnership profits interest issued in exchange for services. A compensatory partnership interest for which an election is made will be valued at its liquidation value. Provided the safe harbor election is made and the liquidation value of the partnership interest is zero, the treatment under the proposed regulations would effectively preserve the current rules set forth in the previous revenue procedure. (a) The proposed regulations also address taxation of profits interest subject to vesting. They require that an IRC 83(b) election be made in all cases at the time the profits interest is issued for it to be treated as vested on issuance. If no such election is made, any distributions in respect of the profits interest are taxed as compensation income. ISSUE #5: OPTIONAL BASIS ADJUSTMENT AND THE EFFECT OF A 754 ELECTION a) Contributions of property and other transactions that occur in connection with certain events between partners and partnerships ( 754 transactions ) can create the need to adjust the inside basis in partnership assets to equal the outside basis of a partner. i) Example of 754 transactions (1) Contributions of appreciated property to a partnership (2) When a new or existing partner contributes money or property to the partnership as consideration for additional partnership interests. (3) Money or property is distributed to a partner in liquidation of all or a part of his partnership interest. b) The intent of IRC 754 is to try to equalize a partner s share of inside tax basis in the partnership s assets with the partner s outside tax basis in his partnership interest through an adjustment to the tax basis of the partnership s assets. In so doing it puts the acquiring partner in substantially the same position as if he had purchased the asset directly and contributed it to the partnership. i) 754 elections are generally advantageous (and are made) where the result would be a positive basis adjustment, and disadvantageous (and generally not made) where the result is a net negative basis adjustment. ii) Taxpayers are now required to have a mandatory application of the IRC 743(b) and section 734(b) in the following instances: 9

10 (1) 743(b) - must be applied to partner/ partner transactions that, at the time of the transaction, the aggregate tax basis of the partnership s assets exceeded the aggregate fair market values of such assets by more than $250,000. (2) 734(b) must be applied to partner/partnership transactions at the resulting adjustments under IRC 734(b)(2) would produce any basis reduction in the partnership s assets in excess of $250,000. c) IRC 754 elections result in a basis adjustment under either IRC 743 (partner-partner transactions or IRC 734 (partner partnership transactions). i) IRC 743 basis adjustments generally involve any sales or exchanges of partnership interests among partners (e.g., the sale by a current partner of his interest to a new partner) (1) Designed to equalize inside-outside basis by attempting to adjust the acquiring partner s share of basis in the partnership property to be equal to such partner s outside basis in his partnership interest. (a) This results in a step up in the inside basis of assets if partnership assets have unrealized appreciation, and a step down if the assets have unrealized depreciation. (2) IRC 743 basis adjustments affect only the transferee partner, and has no affect on any other partner. ii) IRC 734 basis adjustments generally are limited to distributions made by partnerships to partners where either: (1) the partner recognizes gain or loss as a result of such distribution or (2) property is distributed by the partnership to the partner and the partner takes a tax basis in the distributed property that is different than the tax basis of the property in the hands of the partnership. iii) IRC 754 election is elective, and once made is irrevocable. It applies to all subsequent events (even in succeeding years) where an inside-outside basis adjustment should be made. (1) IRC 754 election is made pursuant to IRC (b) by including a statement in the partnership income tax return containing the following information (a) Name and address of the partnership; and (b) The signature of any one of the partners. iv) Mistakes often made in making election 10

11 v) Attaching the election to a partner s income tax return rather than the partnership s income tax return. vi) Having the election signed by someone who is not a partner or who does not have the authority to sign on behalf of a partner. vii) The election is made in a year where there is not a 754 transaction (such as the year of formation where there have only been contributions to the partnership.) ISSUE #6 WHAT IS SUBSTANTIAL ECONOMIC EFFECT AND WHY SHOULD YOU CARE? a) The Internal Revenue Service devised the substantial economic affect test to ensure that tax allocations correspond to partners agreed upon economic sharing arrangement; that is, that a partnership is not simply trafficking in tax credits and partnership losses. i) The fundamental principal underlying economic effect is the following: (1) In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or economic burden that corresponds to an allocation, the partner to whom the allocation is made must receive the economic benefit or economic burden. (IRC 1.704(1)(b)(2)(ii)(a)). ii) The substantial economic effect test is a two part test: the allocation is respected only if the allocation has "economic effect" and that economic effect is "substantial". (IRC 1.704(1)(b)(2)(ii)). (1) Whether an allocation has economic effect is a mechanical test. Generally speaking, an allocation has economic effect in the partnership keeps meaningful capital accounts and maintains them in accordance with a strict set of rules. Whether the economic effect of an allocation is substantial is more subjective. Generally speaking, for an allocation to be substantial, there must be a reasonable possibility that the allocation will effect substantially the dollar amounts received by partners independent of tax considerations. iii) Three alternative tests to determine whether a given allocation has economic effect. (1) the basic test, (2) the alternate test and (3) the economic effect equivalence test (1) The basic test for economic effect (a) For an allocation to have economic affect under the basic test, found at IRC 1.704(1)(b)(2)(ii)(b), the partnership agreement must meet the following three requirements (i) Capital account requirement. The partnership must maintain its capital accounts in accordance with the rules found in IRC 1.704(1)(b)(2)(iv) 11

12 (ii) Liquidation requirement. Upon liquidation, liquidating distributions must be made in accordance with the positive balances in the partner s capital accounts. (iii) Deficit makeup requirement. If after liquidation any partner has a deficit in his capital account, he must be unconditionally obligated to restore that deficit. 1. This requirement can be satisfied if the partnership agreement requires that a partner has an unconditional obligation to restore any deficit in his capital account; if present allocations of losses and deductions will be considered to have economic effect even though they create or increase the deficit in a partner s capital account. (2) Alternate test for economic effect. Under this test, an allocation is considered to have economic effect as long as: (a) The partnership agreement satisfies the first two requirements of the basic test (i.e., the capital account and liquidation requirements) (b) The agreement contains a qualified income offset ( QIO ) provision, and (c) The allocation does not create (or increase) a deficit in the partner s capital account in excess of the partner s obligation to restore any deficit. IRC 1.704(1)(b)(2)(ii)(d) (d) The intent of the alternate test is that as long as the first two requirements of the basic test are met, an allocation will generally have economic effect so long as it does not create a deficit in the partner s capital account that he is not obligated to restore. The qualified income offset provision protects the integrity of prior allocations (that may otherwise create a deficit capital account) in the partnership s capital accounts about requiring the partnership to eliminate such an unexpected deficit as quickly as possible through, allocations. (e) A QI0 provision requires that if a partner ends up with an unexpected deficit in his capital account in excess of the amount he is required to restore, the partnership must allocate items of income and gaining to that partner sufficient to eliminate that access as quickly as possible. (3) Economic effect equivalence test. A partnership that does not satisfied the basic test or the ultimate test may still come within the safe harbor rules for economic the fact if the allocations are deemed to have economic effect within the meaning of IRC 1.704(1)(b)(2) (ii)(i) 12

13 (a) As long as the partnership fulfills all three requirements, both the internal revenue service in the courts can be assured that the partnership s allocation of income, losses or deduction for tax purposes will be consistent with the economic benefits and burdens course bonding to those items. (4) Allocations will satisfy the primary economic affect test if the partnership agreement, throughout the full term of the partnership, provides for maintenance of capital accounts upon liquidation payout according to positive capital accounts and upon liquidation, restore any deficit in capital accounts. (5) Capital accounts must be maintained in accordance with the rules contained in IRC 1.704(1)(b)(2)(iv). (6) Upon liquidation of the partnership or any partner s interest in the partnership, liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners. (7) Upon liquidation, a partner with a deficit in his capital account has an unconditional obligation to restore the amount of the deficit. (8) If a partnership satisfies the primary economic affect test, then upon liquidation, a partner is entitled to any positive amount in his capital account balance or is obligated to restore a deficit capital account. (9) And an allocation must be considered to be substantial in addition to passing the primary economic effect test. (a) An allocation is considered to be substantial if there is a reasonable possibility that it will affect the amount of money that partners will receive independent of tax consequences. (b) An allocation is substantially if it affects the amount of money to be received by the partners independent of tax consequences. b) Drafting considerations i) Operating agreements that do not attempt to alter the allocation of losses in a manner other than in accordance with partners interest in the partnership will always comply with the substantial economic effect requirements. ii) Alternatively, drafters are increasingly relying on targeted allocations which simply state that taxable income and loss of the partnership will be allocated among the partners as necessary to conform their capital accounts to the amounts that the partners would be entitled to receive if the partnership were liquidated that year. 13

14 ISSUE #7 THE DIFFERENCES BETWEEN THE TAXATION OF AN S CORPORATION AND A PARTNERSHIP a) Contributions of property subject to liabilities - a stockholder in an S corporation that contributes property subject to a recourse or nonrecourse liability recognizes taxable gain on the contribution date to the extent the liability exceeds the stockholders basis in the contributed property (IRC 357(c)). i) Any gain recognized by the stockholder increases its basis in the acquired stock; however, any liability assumed by the S corporation is deemed the cash or property received by the contributing stockholder, which reduces his basis in the acquired stock. ii) A contribution to a partnership of property subject to a liability generally does not result in taxation to the partnership or the contributing partner. The contributing partner s basis in his partnership interest (his outside basis) is equal to the partner s basis in the contributed property, but the amount of nonrecourse liabilities assumed by the partnership reduces the partner s outside basis. b) Control requirement required for tax-free contributions - Stockholders of a corporation must be in control of the entity before and after contribution to qualify for tax free treatment (IRC 351). i) For this purpose, control means ownership of at least 80% of the voting stock of the corporation and at least 80% of all other stock of the corporation. ii) While this requirement generally is meet on the original formation of an S corporation, contributions after formation often do not qualify (unless the current contributing stockholder is in control of the corporation immediately after the contribution). c) Allocations of operating losses S corporations do not have ordering rules regarding loss allocations. Losses are allocated in accordance with per share per day rule. Generally, S corporation stockholders cannot include the liabilities of the S corporation in the basis of their shares. i) Because partners include their allocable share of liabilities in the basis of their partnership interest, partners have the ability to deduct more losses than S corporation stockholders. ii) Losses that exceed basis are suspended until there is income from the S corporation. (IRC 1366(d)(2)). There is an exception for loans made by stockholders to the S corporation; however in order to qualify for this exception the loan must be funded with cash. (IRC 1366(s)(1)(b)). 14

15 iii) Stockholder guarantees and other credit enhancements of S corporation indebtedness do not qualify for purposes of creating basis. d) Income/loss allocations - S corporations are subject to strict rules for allocating taxable income. Each share of stock receives a proportionate share of taxable income for each day it is outstanding (referred to as the per-share per-day rule). (IRC 1377). i) The per share per day rule is designed to take into account economic consequences of admitting stockholders into an S corporation during the year or the occurrence of significant income or loss recognition transactions that may occur before or after any admission. ii) Partnerships have more flexibility in allocating taxable income (albeit with the corresponding complexity). Generally, partnerships can divide the economic interest of the partnership in any fashion agreed to by the partners so long as the related allocations have substantial economic effect. (IRC 704). e) Employee status S corporations and partnerships both have employees. However, S corporation stockholders can also serve as employees of an S corporation in which they are a shareholder, while partners are not recognized for tax purposes as employees of any partnership in which they are also a partner. (Rev. Rul ). i) Partners must include all trade or business income of the partnership (including the amounts characterized as guaranteed payments) in self-employment income which is subject to Social Security and Medicare taxes (IRC 1402(a)). S corporation stockholders exposure for self employment taxes is limited to the salary paid to the stockholder by the S corporation, often resulting in substantial employment tax savings to S corporation stockholders. f) Taxation of asset distributions when an S corporation distributes appreciated assets to its stockholders, gain is recognized by the stockholders on the transaction (IRC 311(b)). However, unlike as corporations, the general rule for partnerships is that the distribution of property (whether appreciated or depreciate in value) does not result in the recognition of taxable income for a partner receiving the property distribution; instead, the partner takes a carryover basis in the distributed property. g) Contribution of services a contribution of services in exchange for stock in an S corporation is generally always taxable, where as a contribution of services in exchange for a profits interest in a partnership is not. (IRC 351(d)(2)). h) Adjustment to the basis of the partnership assets - The adjustment in basis of the assets held by a partnership occurs on the transfer of interest if the partnership properly elected to make basis adjustment election (referred to as a 754 election). i) There is no similar basis adjustment in assets held by an S Corporation. 15

16 ISSUE #8 DISPROPORTIONATE DISTRIBUTIONS OF CETAIN ASSETS a) Disproportionate, or non-prorata, distribution by a partnership of certain ordinary income assets (so called hot assets ) will be treated as a sale or exchange under IRC 751(b). i) Ordinary income assets include unrealized receivables and substantially appreciated inventory. (1) Inventory is considered substantially appreciated if, in the aggregate, its fair market value exceeds 120% of its basis. (IRC 751(b)(3)). b) If a distribution has the effect of shifting a partners share of hot assets, IRC 751(b) will re-characterized part of the distribution as a taxable exchange between the partnership and the distributee partner. i) The analysis for recasting such a transaction is as follows: (1) Hypothetical distribution distributee is deemed to receive a current distribution of the type of asset in which his interest decreases as a result of the disproportionate distribution (2) Section 751(b) exchange the distributee partner is then deemed to have sold the property deemed received in step #1 to the partnership for an equal amount of the type of asset in which his interest increases. (3) Non-Section 751(b) distribution the balance of the distribution (i.e., the portion that represents the distributee s pro rata share of the distributed assets is treated under the normal distribution rules. c) Disproportionate distributions are not always obvious. i) Rev. Rul addressed the admission of a new partner to a law firm, finding that the event triggered IRC 751(b) (1) Each newly admitted partner became entitled to a share of unrealized receivables and was obligated for a share of partnership liabilities, with a resulting reduction in such items for existing partners (2) Held, since each old partner s share of liabilities was reduced, and deemed a cash distribution under IRC 752(b), the old partners were deemed to have exchanged a portion of their interest in the unrealized receivables for cash, resulting in a IRC 751(b) exchange. 16

17 ISSUE # 9 WATCH OUT FOR THE DISGUISED SALE RULES a) Contributions of appreciated property to a partnership by a partner followed by distributions of cash or other property to the partner have the indicia of a disguised sale, and are subject to being re-characterized pursuant to IRC 707(a)(2)(B). That section, recasts such transactions as the economic equivalent of sales rather than nontaxable contributions and distributions under IRC 721 and 731. i) IRC 707(a)(2)(B) provides that: (1) If a partner transfers (directly or indirectly) money or property to a partnership in the partner (or another person) receives (2) (Directly or indirectly) money or property in return, and when viewed together, but transfers are properly (3) Characterized as a sale or exchange of property, then the transfers are treated as a sale of the property to the partnership or a sale between two or more partners not acting as partners in the partnership. ii) IRC 1.707(3)(a)(2) provides a two part test for determining when a transaction should be recast as a sale: (1) but for test - the partnership would not have transferred money or property to the partner but for the contribution of the property by the partner to the partnership. (IRC 1.707(3)(B)(1)(i)); and (2) facts and circumstances test - when the transfers are not simultaneous, the subs can transfer is not dependent upon the entrepreneurial risk of the partnerships operations. IRC 1.77(3)(B)(1)(ii) (3) The timing between the contribution in the distribution is important. Treasury regulations provide two presumptions: (a) Transfers that occur within two years of each other are presumed of the sales unless the facts and circumstances clearly establish that the transfers do not constitute a sale. (IRC 1.707(3)(C)(1)). (i) Certain normal distributions (e.g., distributions from normal operating cash flow, guaranteed payments, and preferred returns, etc.) are not presumed to be part of a disguised sale even if they occur within 2 years of a contribution unless the facts and circumstances indicate otherwise. (b) Transfers that are made more than two years apart are presumed not to be a sale unless the facts and circumstances clearly establish that a sale took place. (IRC 1.707(3)(d)). 17

18 (c) Treasury Regulation (b)(2) liststhe most important facts and circumstances of a sale: (i) The certainty of the timing and amount of the second sale; (ii) The second transfer is legally enforceable; (iii) A third party is obligated to make a contribution to the partnership to enable it to make the second transfer; (iv) A third party is obligated to make a loan to the partnership to enable it to make the second transfer (v) The second transfer is secured in any way (vi) The partnership has incurred or is obligated to incur debt to enable it to make the second transfer; (vii) The partnership has excess liquid assets that are expected to be available for the second transfer (viii) The partnership distributions, allocations or control of operations are designed to effect an exchange of the benefits and burdens of the ownership of the contributed property (ix) The amount of a distribution to a partner is disproportionately large in relation to his general and continuing interests in partnership profits; and (x) The partner has no obligation to return distributions to the partnership. ISSUE #10 MISCELLANEOUS ITEMS TO CONSIDER a) Partner or employee, but not both the Internal Revenue Service s position, reflecting the aggregate theory of partnership taxation, is that a partner in a partnership cannot also be an employee of that partnership. i) That is, partnership status supersedes employee status. (Rev. Rul ) ( Bona fide members of a partnership are not employees of the partnership.such a partner who devotes his time and energies in the conduct of the trade or business of the partnership or in providing services to the partnership as an independent contractor is, in either event, a self employed individual rather than an individual who, under the usual common law rules applicable in determining the employer and employee relationship, has the status of an employee. ; GCM ( a true partner cannot be an employee of the partnership of which he is a member within the meaning of the employment tax provisions ); (Rev. Rul ) ( partners are not employees and, therefore, are not eligible to purchase paid in a qualified plan. Once an individual status is established as a bona fide partner of a partnership, it is immaterial, for purposes of his participation in a qualified plan of the partnership, how his partnership interest is defined ); (Rev. Rul ). b) Allocation of income in a year of change - whenever there is a change in ownership interests in a taxable year, it is necessary to compute and allocate the appropriate amount of income taking into account such change. 18

19 i) As a general rule, IRC 706(d)(1) requires that partners relative shares of income, loss, deduction or credit be determined taking into account their varying interest. (1) If a partner's interest varies during a partnership year, (either because of sale, liquidation, death, or other transaction having that effect), the partnership must take into account these variations in determining partners share of partnership items using either of two items: interim method or proration method. The interim method is the default. Both methods divide the partnership year into component parts. (a) The proration method allows the partnership to conclude its tax year, and prorate its annual income on a daily basis. Under this method, extraordinary items cannot be prorated. (b) the interim method provides for a closing of the partnership books on the day of the transaction and calculating the share of partnership income or loss as of that day. (2) For any given tax year, the partnership may only use one method and once chosen, must be used by all partners and the partnership for that year. c) Technical terminations can have unintended consequences i) Pursuant to IRC 708(b), the partnership will terminate upon the sale or exchange of 50% or more of the total interests in partnership capital and profits within a 12 month period. ii) This provision only applies to transfers that constitute a sale or exchange, and is not applied to transfers by a gift, by devise (from the death of a partner) or as a result of contributions or liquidating distributions. (IRC 708(c)) (1) Note that the applicable time for making the determination is 12 calendar months, and not a calendar year. (2) Transfers to fund pecuniary bequests constitute a sale or exchange and can trigger a technical termination. iii) Upon a technical termination, the partnership is deemed to have contributed all of its assets and liabilities to a new partnership, and distributed the interest in the new partnership to the partners in liquidation of the terminated partnership. (1) The termination results in a closing of the tax year (2) For the terminated partnership all partnership elections, including a previously made IRC 754 election, will remain in place for the new partnership but if the 19

20 partnership has depreciable assets, those assets are treated as being contributed at their current tax basis and the depreciation schedule restarts for the assets. d) PAL s and PIG s i) The passive activity loss limitations are contained in IRC 469 ii) These rules generally apply to individuals, trusts, estates, personal service corporations, and certain closely held C corporations. iii) The passive activity rules generally permit losses and credits from a passive activity for any taxable year to only be applied against income from other passive activities or against income from other passive activities or against income generated by a passive activity (a so called PIG ). iv) A passive activity is any trade or business activity that is not a rental activity or certainly working interest in oil and gas properties, unless the taxpayer materially participates in the activity. (1) Rental activities are treated per se as a passive activity without regard to whether the taxpayer materially participates, subject to certain exceptions for real estate professionals. (2) In order to materially participate, a taxpayer must be involved in the operation of an activity on a regular, continuous, and substantial basis. (a) Seven tests for material participation. (i) (ii) More than 500 hours-this is the most commonly used test Substantially all-and individuals of participation constitutes substantially all of the participation in the activity of all individuals for the year (iii) Not less than anyone else and at more than 100 hours an individual participates in the activities or more than 100 hours during the year, and his participation for the taxable year is not less than the participation in the activity of any other individual (iv) Significant participation activities exceed 500 hours an activity is a significant participation activity, and an individual s aggregate participation in all significant participation activities during the year exceed 500 hours (v) Nickel and dime test an individual materially participate in the activity for any five taxable years during the 10 years that immediately preceded taxable year (vi) Personal service activity - an activity that involved the performance of personal services in the fields of health, law, engineering, architecture, counting, or a consenting for any three taxable years preceding the tax year 20

21 (vii) Facts and circumstances based on all of the facts and circumstances, an individual participants in an activity on a regular, continuous, and substantial basis during the taxable year (b) Contemporaneous documentation of an individual s participation in an activity (including daily time sheets, logs, and similar documents) are critical to establishing material participation (c) Effect of passive activity limitations (i) Passive losses are fully deductible against passive income (ii) If there is an aggregate passive loss after netting against passive income, the passive loss is carried forward indefinitely (iii) Unused suspended losses are deductible as a nondeductible loss upon a complete disposition in a taxable transaction (iv) $25,000 exception for active participation in rental real estate 1. phased out for income over $100,000 21

22 EXAMPLE #1: Formation A + B form AB Partnership, with each owning a 50% interest. Each contributes $500 cash to capitalize the entity. Assets Liabilities Cash $500 0 First Transaction Capital accounts Book A $ 500 B $ 500 $1,000 AB buys a building for $1000, paying $250 in cash and borrowing $750 (with a mortgage) for the balance. AB also purchases stock (for $150) and tax exempt bonds (for $150). Assets Liabilities Cash $ 450 Mortgage $750 Stock $ 150 Bonds $ 150 Building $1000 $1750 Capital accounts Book A $ 500 B $ 500 $1000 Operations -dividend income $10 -tax exempt income $15 -net rental income rental income $85 depreciation $50 $35 -stock appreciation $50 -distributions $10 22

23 Assets Liabilities Cash $ 510 Mortgage $750 Stock $ 150 Bonds $ 150 Building $ 950 $1760 Capital accounts Book A $ 505 B $ 505 $1010 End of Year Transaction -mortgage payment $100 -stock distribution to A $200 -cash distribution to B $200 Assets Liabilities Cash $ 210 Mortgage $650 Bonds $ 150 Building $ 950 $1310 Capital accounts Book A $330 B $330 $660 Capital Account Adjustments A B Opening balance $505 $505 Book gain on stock $ 25 $ 25 Distributions ($200) ($200) Closing balance $330 $330 23

24 EXAMPLE #2: A + B form AB Partnership, with each owning a 50% interest. A contributes $100 cash B contributes land: -$200 fair market value -$100 recourse mortgage (which is allocated 50/50 between partners pursuant to IRS 752) -$40 basis in land A s outside basis: $100 of contributed cash +$ 50 liabilities allocated $150 B s outside basis: $ 40 basis in land contributed - $100 decrease in personal liabilities + $ 50 liabilities allocated <$10> gain recognized 24

25 EXAMPLE #3: A + B form AB Partnership, with each owning a 50% interest. -A s outside basis is $40 - AB makes a current distribution to A of marketable securities (with a fair market value of $100) and an inside basis (to the partnership of $30). -A is treated as having received a distribution of: $65 cash -$100 of securities -less $35 of appreciation (50% of total) -because the total deemed distribution ($65) exceeds A s outside basis ($40), A is required to recognize the difference ($25) of gain -A s outside basis in the securities is $55: -$30 of basis under IRC 732(c) plus $25 of gain recognized -A s basis in the partnership is $10 (determined without regard to the gain recognized (IRC 731(c))(5)). 25

26 EXAMPLE #4: A + B form AB partnership, with each owning a 50% interest. At the beginning of 2014, AB holds the following assets: Assets Book Fair Market Value Cash $ 50 $ 50 Equipment $ 50 $210 Land $100 $140 $200 $400 Capital Account Book A $100 B $100 $200 C contributes $200 cash in exchange for a 1/3 interest in ABC Partnership. The partnership will elect to book up its assets. (IRC (b)(2)), resulting in recognition, for book purposes only, of $160 of gain in the equipment and $40 of gain in the land. These gains are allocated equally between A and B, increasing their capital accounts as follows: Assets Tax Book Cash $250 $250 Equipment $ 50 $210 Land $100 $140 $400 $600 Capital Accounts Book A $200 B $200 C $200 $600 After revaluation following a 754 election, ABC will show the following: Assets Tax Book Cash $250 $250 Equipment $ 50 $210 Land $100 $140 $400 $600 26

27 Capital Accounts Tax Book A $100 $200 B $100 $200 C $200 $200 $400 $600 If ABC sells the land for $140 (its current fair market value), the $40 of tax gain must be allocated equally to A and B under 704(c) because they were allocated the book gain. 27

28 EXAMPLE #5: A + B form AB partnership with each contributing $70 cash for a 50% interest. The operating agreement, which satisfies all 3 requirement of the basic test for economic effect, allocates partnership losses 80/20 between A and B respectively, and partnership gains 50/50 between A and B, respectively. Assuming that AB loses $50 in the first two years of operations, its balance sheet would be as follows: Assets Liabilities Book Asset $40 None Capital Accounts A B Formation $70 $70 Year #1 loss ($10) ($40) Year #2 loss ($10) ($40) $50 ($10) Because B has an obligation to restore his capital account deficit ($10), there is enough cash following liquidation of the partnership assets at book value ($40) plus the cash re-contributed by B to pay A his full capital account balance ($50). B lost $80 from the partnership and A lost $20. Assume the same facts except B has no obligations to restore a deficit capital account. If AB sold its assets for book value ($40), A would have borne the economic burden of $10 of the $80 loss that was allocated to B. As a result, none of AB s allocations have economic effect, and both year s losses would have to be reallocated in accordance with the partners interest in the partnership that is, the loss must be allocated to the partner who is actually caring the economic burden. 28

29 EXAMPLE #6: A, B and C form ABC partnership, with each owning a 1/3 interest. - A contributes land with a basis of $300 and a fair market value of $1, B and C each contribute $750 in cash. To equalize this capital accounts, ABC distributes $250 to A (thereby reducing his capital account to $750, to equal B and C). The IRS would clearly recast this transaction into two transactions: 1) the sale by A of 25% of the land to ABC; and 2) the contribution by A of 75% of the land to ABC. Sale Contribution (25%) (75%) Fair market value $250 $750 Basis $ 75 $225 Sale -A recognizes gain of $175 -ABC takes a cost basis in the land of $250 Contribution -A contributes 75% of land, with a fair market value of $750 and a cost basis of $225 -ABC taxes a carryover basis in the land of $225 -A s capital account is credited with $750 the value of the land. Partnership Balance Sheet Assets Liabilities basis book 0 cash $1250 $1250 land $ 475 $1000 $1725 $2250 Capital Accounts tax book A $ 225 $ 750 B $ 750 $ 750 C $ 750 $ 750 $1725 $