IRC Sect. 704(b): Allocations to Partners Navigating Complex Rules - - PowerPoint PPT Presentation

IRC Sect. 704(b): Allocations to Partners

Navigating Complex Rules on Determining Validity of Partnership Allocations

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WEDNESDAY, DECEMBER 12, 2012

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

Brian O'Connor, Partner, Venable LLP, Baltimore Steven Schneider, Director, Tax Group, Goulston & Storrs PC, Washington, D.C.

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IRC Sect. 704(b): Allocations to Partners Seminar

Steven R. Schneider, Goulston & Storrs PC sschneider@goulstonstorrs.com

• Dec. 12, 2012

Brian O'Connor, Venable LLP bjoconnor@venable.com

Today’s Program

Review Of Partnership Allocation Rules [Steven R. Schneider and Brian O'Connor] Rules For Allocations Related to Non-Recourse Debt; Cancellation Of Debt Income [Steven R. Schneider and Brian O'Connor] Targeted Capital Accounts Vs. Liquidating With Capital Accounts [Brian O'Connor and Steven R. Schneider] Slide 7 – Slide 64 Slide 65 – Slide 76 Slide 77 – Slide 89

REVIEW OF PARTNERSHIP ALLOCATION RULES

Steven R. Schneider, Goulston & Storrs PC Brian O’Connor, Venable LLP

• Sect. 704(a) And (b) Overview
• Sect. 704(a): A partner’s share of tax items is determined by

partnership agreement.

• Sect. 704(b): Ensures that allocations of partnership items match

economics of deal (i.e., ensures each partner receives economic benefit or bears economic burden associated with allocations of income and deduction)

8

• Sect. 704(c) And (d) Overview
• Sect. 704(c): Governs allocations of tax items related to property

that have a tax basis different from the Sect. 704(b) book value

• Sect. 704(d): Partner is only entitled to deduct allocated losses to

extent of partner’s basis in his or her partnership interest at end of year.

9

Basic Principles: Reg. 1.704-1(b)(1)(i)

• Tax allocations of economic income = “distributive share”
• Distributive share determined under general partner’s interest in the

partnership (PIP) test if: – No partnership agreement – Partnership agreement allocations fail substantial economic effect (SEE) test

10

• Sect. 704(b) Allocations = Economic Deal
• Sect. 704(b) capital accounts are intended to reflect the economic

“deal” between the partners and allocate the related tax items according to the same deal.

• If the capital accounts do not equal the economic deal, then the

economics will govern, and the Sect. 704(b) allocations will not be

• respected. Tax must follow the economics.

11

Basic Principles: Reg. 1.704-1(b)(1)(i)

• Three ways allocations you can have SEE:

– Satisfy primary, alternative or economic equivalence test under Reg. 1.704-1(b)(2) – Allocations fail safe harbors but are still consistent with facts and circumstances PIP test under Reg. 1.704-1(b)(3). – Allocations do not affect economics (credits, and non-recourse deductions) but are deemed to have SEE under Reg. 1.704- 1(b)(4) or Reg. 1.704-2.

• In all other cases, distributive share will be reallocated in

accordance with PIP. This creates uncertainty.

12

Effects Of Other Sections: Reg. 1.704-1(b)(1)(iii)

• Allocation may not be respected if fails economic substance

(Goldstein).

• Allocations of deductions may be suspended due to lack of actual or

at-risk basis ( 704(d) and 465).

• Allocations may be reallocated under common law or statutory

assignment of income principles ( 482, 704(e)(2), 706(d)).

• Hot asset rules may mandate allocations of gain or loss (Reg. 1.751-

1(b)(2)(ii)).

• Recharacterization of debt-to-equity can override prior debt-sourced

deductions.

13

Other Possible Tax Consequences: Reg. 1.704-1(b)(1)(iv) And (v)

• Gift tax consequences (

2501)

• Compensation (

61 and 83)

• Capital shifts (Reg.

1.721-1(b)(1))

• Sect. 38 credit recapture (Reg.

1.47-6)

• Sect. 704(b) is not applicable if person is not respected as a partner,
• r to a partner who is not acting in the capacity as a partner.

14

Bottom Line Allocations: Reg. 1.704-1(b)(1)(vii)

• Gross vs. net allocations: Sect. 704(b) is applicable to allocations of

income, gain, loss, deduction and credit; of specific items of income, gain, loss, deduction and credit; and of partnership net or “bottom line” taxable income and loss.

• Effect of net allocations: “Bottom line” allocations of net or residual

income are treated as an allocation to such partner of the same share of each item of income, gain, loss and deduction that is taken into account in computing such net or “bottom line” taxable income

• r loss.

15

Capital Account Maintenance In General

• Contributions (at FMV net of liabilities)
• Distributions (at FMV net of liabilities)
• Income:

– Increase for taxable income – Increase for non-taxable income

• Deductions and losses

– Decrease for deductible losses and expenditures. – Decrease for nondeductible, non-capitalizable expenditures

• Depreciation and gain or loss on sale of property computed using

book basis

16

Must Maintain Capital Accounts

• Except as otherwise provided under the economic equivalence test,

an allocation of income, gain, loss or deduction will not have economic effect under paragraph Reg. 1.704-1(b)(2)(ii) (primary or alternative test), and will not be deemed to be in accordance with PIP under Reg. 1.704-1(b)(4) (credits etc.), unless the capital accounts of the partners are determined and maintained throughout the full term of the partnership in accordance with the capital accounting rules of Reg. 1.704-1(b)(2)(iv). See Reg. 1.704- 1(b)(2)(iv)(a)

17

Basic Rules: Reg. 1.704-1(b)(2)(iv)(b)

• Increase capital accounts by:

– (1) The amount of money contributed by the partner to the partnership – (2) The fair market value of property contributed by the partner to the partnership (net of liabilities that the partnership is considered to assume or take subject to) – (3) Allocations to the partner of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in Reg. 1.704-1(b)(2)(iv)(g) (book ups), but excluding income and gain described in Reg. 1.704- 1(b)(4)(i) (reverse 704(c) taxable income/loss)

18

Basic Rules: Reg. 1.704-1(b)(2)(iv)(b) (Cont.)

• Decrease capital accounts by:

– (1) The amount of money distributed to the partner by the partnership – (2) The fair market value of property distributed to the partner by the partnership (net of liabilities that such partner is considered to assume or take subject to) – (3) Allocations to the partner of expenditures of the partnership described in 705(a)(2)(B) (non-deductible, non-capitalizable expenses such as the non-deductible portion of M&E expenses) – (4) Allocations of partnership loss and deduction, including loss and deduction described in Reg. 1.704-1(b)(2)(iv)(g) (book downs), but excluding items described in (6) above and loss or deduction described in Reg. 1.704-1(b)(4)(i) (reverse 704(c))

• r Reg.

1.704-1(b)(4)(iii) (excess percentage depletion)

19

Single Capital Account: Reg. 1.704-1(b)(2)(iv)(b)

• A partner who has more than one interest in a partnership shall have

a single capital account that reflects all such interests, regardless of the class of interests owned by such partner (e.g., general or limited) and regardless of the time or manner in which such interests were acquired.

20

Liabilities: Reg. 1.704-1(b)(2)(iv)(c)

• Increase capital account by partner’s deemed contribution, if partner

assumes partnership liability

• Decrease capital account by partner’s deemed distribution, if

partnership assumes partner liability

• Do not adjust for mere shifts in partner’s share of partnership

liabilities under sections 752(a) and 752(b)

• Obligee must be aware of liability assumption and can enforce.

21

Cost Recovery Deductions: Reg. 1.704-1(b)(2)(iv)(g)(3)

• Book amortization is the same ratio as the tax amortization: The

amount of book depreciation, depletion or amortization for a period with respect to an item of partnership property is the amount that bears the same relationship to the book value of such property as the depreciation (or cost recovery deduction), depletion or amortization computed for tax purposes with respect to such property for such period bears to the adjusted tax basis of such property.

• If no tax basis – any reasonable method: If such property has a zero

adjusted tax basis, the book depreciation, depletion or amortization may be determined under any reasonable method selected by the partnership.

22

Transfers Of Partnership Interests: Reg. 1.704-1(b)(2)(iv)(l)

• Carryover: Upon the transfer of all or a part of an interest in the

partnership, the capital account of the transferor that is attributable to the transferred interest carries over to the transferee partner.

• Technical termination under

708(b)(1)(B): Carryover of capital accounts, even upon the deemed formation of a new partnership

23

Revaluations Of Partnership Property: Reg. 1.704-1(b)(2)(iv)(f)

• Reasons needed

– Maintain relative economic interests of the partners – Prevent capital shifts

• Mandatory vs. optional

– Mandatory for property distributed to a partner – Optional for all assets on non-de minimis contributions and distributions, grants of profits interests to service partners, and in accordance with industry standards for securities partnerships – If not made, may have capital shift, gift, etc.

• Differences created between partners’ book and tax capital

accounts; must be taken into account under 704(c) principles

24

Other Capital Account Rules

• Guaranteed payments: Guaranteed payment income does not affect

capital accounts, but guaranteed payment deduction reduces capital

• accounts. Reg.

1.704-1(b)(2)(iv)(o)

• Minor discrepancies: Minor capital account errors made in good faith

will not affect the validity of an allocation. Reg. 1.704-1(b)(2)(iv)(p)

• Guidance lacking: Reg.

1.704-1(b)(2)(iv)(q). If guidance is lacking, capital account adjustments should: – Maintain a balance between partnership capital and partner capital accounts – Be consistent with the underlying economic arrangement between the partners – Based, wherever practical, on federal tax accounting principles

25

Three Tests For Economic Effect

• Primary test
• Alternate test for economic effect
• Economic equivalence test

26

Liquidating Distributions

• Must be made in accordance with the partners’ positive capital

account balances

• Determined after taking into account all capital account adjustments

for partnership taxable year during which liquidation occurs

• Generally, must be made by the earlier of:

– The end of the year of liquidation, or – 90 days following the date of liquidation

27

Economic Effect Test Requirements

Primary test

• Capital account maintenance
• Liquidation in accordance with positive

capital accounts

• Deficit restoration obligation (DRO)

28

Alternate test

• Capital account maintenance
• Liquidation in accordance with

positive capital accounts

• Loss allocation may not cause or

increase adjusted capital account deficit.

• Qualified income offset (QIO)

Deficit Restoration Obligation

• Requires partner with deficit capital account balance upon

liquidation of his partnership interest to unconditionally restore the amount of such deficit – Actual DRO in partnership agreement, or – Deemed DRO

• State law requirements
• Promissory notes of partner or related entity that are

contributed to partnership

• Unconditional obligation to contribute
• Ultimate payor on partnership recourse debt
• Minimum gain

29

Qualified Income Offset Provision

• In lieu of DRO required under primary test for economic effect,

alternate test requires that partnership agreement contain a QIO. – Partnership agreement must provide that unexpected distributions causing/increasing deficit balance in partner’s capital account will be eliminated as quickly as possible. – Some agreements contain protective allocation provision to prevent future deficit capital accounts, by requiring the allocation

• f gross income to partner with deficit capital account balance at

end of any year (i.e., protective gross income allocation).

• Agreement must also restrict loss allocations so as not to cause or

increase adjusted capital account deficit.

30

Economic Effect Equivalence: Reg. 1.704-1(b)(2)(ii)(i)

• Allocations made to a partner that do not otherwise have economic

effect under Reg. 1.704-1(b)(2)(ii) shall nevertheless be deemed to have economic effect, provided that as of the end of each partnership taxable year a liquidation of the partnership at the end of such year or at the end of any future year would produce the same economic results to the partners as would occur if requirements of Reg. 1.704-1(b)(2)(ii)(1), (2), and (3) had been satisfied [i.e. the primary and alternate test], regardless of the economic performance

• f the partnership.

31

Reallocation Under PIP

• Reg.

1.704-1(b)(3) Partner’s interest in the partnership--(i) In general: References in Sect. 704(b) and this paragraph to a partner’s interest in the partnership, or to the partners’ interests in the partnership, signify the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction or credit (or item thereof) that is allocated.

• The determination of a partner’s interest in a partnership shall be

made by taking into account all facts and circumstances relating to the economic arrangement of the partners.

32

Reallocation Under PIP: Factors Considered

• Reg.

1.704-1(b)(3)(ii) Factors considered: In determining a partner’s interest in the partnership, the following factors are among those that will be considered: – (a) The partners’ relative contributions to the partnership – (b) The interests of the partners in economic profits and losses (if different than that in taxable income or loss) – (c) The interests of the partners in cash flow and other non- liquidating distributions – (d) The rights of the partners to distributions of capital upon liquidation

33

Reallocation Under PIP: Objective Test

34

Reg. 1.704-1(b)(3)(iii): If: – Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied (maintain capital accounts and liquidate with positive capital accounts), and – All or part of an allocation fails the economic effect safe harbor, – Then:

• PIP for that allocation is determined by comparing the manner in

which distributions (and contributions) would be made if all partnership property were sold at book value, and the partnership were liquidated immediately following the end of the taxable year to which the allocation relates with the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership were liquidated immediately following the end of the prior taxable year, and adjusting the result for the items described in Reg. 1.704-1(b)(2)(ii)(d)(4), (5), and (6) (reasonably expected income, loss, and distributions to create adjusted capital account.

35

Reg. 1.704-1(b)(5), Example 1(i)

PRS A B

$40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall 50% 50% Conclusion: Special allocation of depreciation reallocated under PIP 50:50

36

Reg. 1.704-1(b)(5), Example 1(ii): Waterfall = Capital Accounts

PRS A B

$40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – years 1 – 5 Capital accounts Liquidation waterfall – after year 5 50% 50% Conclusion: Special allocation of depreciation reallocated under PIP 50:50

37

Reg. 1.704-1(b)(5), Example 1(iii): Satisfy Alternate Test

PRS A B

$40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, add QIO, don’t drive adjusted CA negative Conclusion: Allocations satisfy the alternate test for economic effect.

38

Reg. 1.704-1(b)(5), Example 1(iv): Partial PIP Reallocation

PRS A B $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, add QIO, don’t drive adjusted CA negative Depreciation = $45,000 Conclusion: Allocations satisfy the alternate test for economic effect up to $40K; remaining $5K is reallocated to B under PIP. 704(b) Capital Accounts LLC A B Beginning $80,000 $40,000 $40,000 Depreciation $45,000 ($45,000) $ 0 Ending $35,000 ($5,000) $40,000 PIP reallocation $5,000 ($5,000)

39

Reg. 1.704-1(b)(5), Example 1(vi): Anticipated Distributions and Value = Basis

PRS A B $40,000 $40,00

Depreciable property purchased for $80,000

Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, add QIO, don’t drive adjusted CA negative Depreciation = $40,000 Conclusion: Allocations satisfy the alternate test for economic effect up to $35K; remaining $5K is reallocated to B under PIP. 704(b) Capital Accounts LLC A B Beginning $80,000 $40,000 $40,000 Adjust for expected distribution ($5,000) ($5,000) depreciation $40,000 ($40,000) $ 0 Ending $35,000 ($5,000) $35,000 PIP reallocation $5,000 ($5,000)

New facts: Partnership will borrow and distribute $5,000 to A in next year. Property valued at above 704(b) book, but there is no book-up event.

40

Reg. 1.704-1(b)(5), Example 1(vii): Full DRO

PRS A B $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, and DRO Depreciation = $45,000 Conclusion: Allocations satisfy the primary test for economic effect, because A would satisfy the $5,000 negative capital account with the DRO. 704(b) Capital Accounts LLC A B Beginning $80,000 $40,000 $40,000 Depreciation $45,000 ($45,000) $ 0 Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

41

Reg. 1.704-1(b)(5), Example 1(viii): Limited DRO

PRS A B $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, $5,000 DRO for A Depreciation = $45,000 Conclusion: Allocations satisfy the alternate test for economic effect, because A would satisfy the $5,000 negative capital account with the DRO. 704(b) Capital Accounts LLC A B Beginning $80,000 $40,000 $40,000 Depreciation $45,000 ($45,000) $ 0 Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

42

Reg. 1.704-1(b)(5), Example 1(ix): Promissory Note Equivalent To Limited DRO

PRS A B $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, $5,000 No DRO, but A contributes negotiable promissory note for $5,000 (payable earlier of year 4 or liquidation) Depreciation = $45,000 Conclusion: Allocations satisfy the alternate test for economic effect, because A would satisfy the $5,000 negative capital account with the promissory note. 704(b) Capital Accounts LLC A B Beginning $80,000 $40,000 $40,000 Depreciation $45,000 ($45,000) $ 0 Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

43

Reg. 1.704-1(b)(5), Example 1(x): Fixed Capital Contribution Obligation Equivalent To Limited DRO

PRS A B $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts Maintain CA, $5,000 No DRO, but partnership agreement requires A to contribute $5,000 (payable earlier

• f year 4 or liquidation)

Depreciation = $45,000 Conclusion: Allocations satisfy the alternate test for economic effect, because A would satisfy the $5,000 negative capital account with the contribution obligation. 704(b) Capital Accounts LLC A B Beginning $80,000 $40,000 $40,000 Depreciation $45,000 ($45,000) $ 0 Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

44

Reg. 1.704-1(b)(5), Example 4(ii): Economic Effect Equivalence

PRS G H $25,000 $75,000

Allocations E F All income and loss 75% 25% Liquidation rights 75% 25% Does NOT maintain CA, liquidate with capital accounts or include DRO G and H are ultimately liable (under a state law right of contribution) for 75% and 25%, respectively, of any debts of the partnership. Conclusion: Allocations are deemed to have economic effect under economic effect equivalence.

Substantiality

• An allocation is substantial “if there is a reasonable possibility that

the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.” You should look through certain pass-through partners and consolidated group members to test. T.D. 9398 (2008)

• Three general rules

– Intra-year shifting rule – Inter-year transitory allocation rule – Overall tax effect rule

• IRS proposed to remove de minimis exception see REG-

109564-10

45

Shifting Allocations

• Taxable vs. tax-exempt income
• Ordinary income vs. capital gain
• Ordinary loss vs. capital loss
• Domestic vs. foreign-source income
• Active vs. passive income (loss)
• Passive vs. portfolio income (loss)

46

Transitory Allocations

• Testing period: All tax years in which allocations may occur
• Hallmarks

– Aggregate tax reduction – Minimal capital impact

• Exceptions

– Five-year waiting period – Value-equals-basis rule

47

Overall Tax Effect Rule

• Rule strikes down allocation if after-tax economic consequences of

at least one partner may, in present value terms, be enhanced; and a strong likelihood exists that after-tax consequences of no partner will, in present value terms, be substantially diminished (taking into account partners’ non-partnership tax attributes). – Requires that projected after-tax economic results to each partner under prescribed allocation scheme be compared to same after-tax economics that would result under allocation scheme if the allocations being tested were not included in the agreement – However, virtually no guidance is provided as to the various factors that should be considered in arriving at this “base-line” allocation.

48

Six Steps To Substantiality

• Step 1: Determine “baseline” and “special” allocations. If they are

the same, then there is nothing to test for substantiality.

• Step 2: Determine if special allocations have a reasonable

possibility of affecting pre-tax dollars received by the partners compared to the baseline. If not, allocate in accordance with partners’ Interests in the partnership (PIP) [Step 6]; if so, go to Step 3.

• Step 3: Determine if pass intra-year shifting test; if not, allocate in

accordance PIP [Step 6]; if so, go to Step 4. (Continued on next slide)

49

Six Steps To Substantiality (Cont.)

• Step 4: Determine if pass inter-year transitory allocation test; if not,

allocate in accordance with PIP [Step 6]; if so, go to Step 5.

• Step 5: Determine if pass overall tax effects test (i.e., general rule); if

not, allocate in accordance with PIP [Step 6]; if so, special allocation satisfied substantiality.

• Step 6: Determine reallocation, if any, under general facts and

circumstances PIP test.

50

Step 1: Determining The Baseline

• Overview: The substantiality regulations are premised on a clear distinction

between “baseline” and “special” allocations and require a comparison of the pre- and post-tax consequences, “if the allocation (or allocations) were not contained in the partnership agreement.” Reg. 1.704-1(b)(iii)(a)

• No specific definition of baseline: The regulations do not define the

“baseline” in the text of the regulations, but examples under Reg. 1.704- 1(b)(5) demonstrate fact patterns where the special allocations differed from the baseline. Simple regulation examples assume baseline to be “straight up” allocations in accordance with relative capital contributions.

• Failing substantiality when real economic differences baseline and special

allocations: The reallocations under PIP in the regulation examples did not change the real economic consequences of the special allocations, but instead reallocated the underlying tax items in the ratio of the net increases

• r decreases to the partners’ relative capital accounts.

51

Step 2: Pre-Tax Change In Economics

• An allocation is substantial “if there is a reasonable possibility that

the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.” [Reg. 1.704-1(b)(iii), first sentence]

• Defined in the positive, but implies that offsetting allocations with no

pre-tax variance from baseline fail substantiality

• Example

– Two equal partners in same tax bracket, with historical 50:50 allocations – At end of tax year (when partnership knows all items of income and deduction), partnership allocates $100 taxable income to Partner A and $100 of tax-exempt income to Partner B. – At time allocation is made, it is known that there is no net change to 50:50 economics.

52

Step 3: Shifting Test - Reg. 1.704-1(b)(iii)(b)

• Strong likelihood that within a single year, (i) capital accounts will not differ

substantially from the baseline, and (ii) there will be a reduction in overall aggregate tax liability

• Specific rules

– 1.704-1(b)(2)(iii)(b) shifting tax consequences: The economic effect of an allocation (or allocations) in a partnership taxable year is not substantial if, at the time the allocation (or allocations) becomes part of the partnership agreement, there is a strong likelihood that: (1) The net increases and decreases that will be recorded in the partners’ respective capital accounts for such taxable year will not differ substantially from the net increases and decreases that would be recorded in such partners’ respective capital accounts for such year, if the allocations were not contained in the partnership agreement; and (2) The total tax liability of the partners (for their respective taxable years in which the allocations will be taken into account) will be less than if the allocations were not contained in the partnership agreement (taking into account tax consequences that result from the interaction of the allocation (or allocations) with partner tax attributes that are unrelated to the partnership).

53

Step 3: Shifting Test - Presumption

• Rebuttable presumption that special allocations fail substantiality, if

at the end of the taxable year, there is: – (i) No substantial difference in capital accounts, and – (ii) A reduction in overall tax liability as compared to baseline

54

Step 3: Shifting Test – Presumption (Cont.)

• Specific language

– “If, at the end of a partnership taxable year to which an allocation (or allocations) relates, the net increases and decreases that are recorded in the partners’ respective capital accounts do not differ substantially from the net increases and decreases that would have been recorded in such partners’ respective capital accounts had the allocation (or allocations) not been contained in the partnership agreement, and the total tax liability of the partners is . . . less than it would have been had the allocation (or allocations) not been contained in the partnership agreement, it will be presumed that, at the time the allocation (or allocations) became part of such partnership agreement, there was a strong likelihood that these results would occur. This presumption may be overcome by a showing of facts and circumstances that prove

• therwise.”

55

Step 4: Transitory Test – Reg. 1.704-1(b)(iii)(c)

• Special allocations will not be substantial if original allocations may

be largely offset by offsetting allocations; and at the time such special allocations become part of the partnership agreement, there is a strong likelihood that (i) capital accounts will not differ substantially from the baseline, and (ii) there will be a reduction in

• verall aggregate tax liability of the partners.

(Continued on next slide)

56

Step 4: Transitory Test – Reg. 1.704-1(b)(iii)(c), Cont.

• Specific language

– (c) Transitory allocations: If a partnership agreement provides for the possibility that one or more allocations (the “original allocation(s)”) will be largely offset by one or more other allocations (the “offsetting allocations(s)”), and, at the time the allocations become part of the partnership agreement, there is a strong likelihood that: – (1) The net increases and decreases that will be recorded in the partners’ respective capital accounts for the taxable years to which the allocations relate will not differ substantially from the net increases and decreases that would be recorded in such partners’ respective capital accounts for such years, if the original allocation(s) and offsetting allocation(s) were not contained in the partnership agreement; and – (2) The total tax liability of the partners (for their respective taxable years in which the allocations will be taken into account) will be less than if the allocations were not contained in the partnership agreement (taking into account tax consequences that result from the interaction of the allocation (or allocations) with partner tax attributes that are unrelated to the partnership); – Then, the economic effect of the original allocation(s) and offsetting allocation(s) will not be substantial.

57

Step 4: Transitory Test – Presumption

• Rebuttable presumption that special allocations fail substantiality if, at the

end of the taxable year of the offsetting allocation, there is:- – (i) No substantial difference in capital accounts, and – (ii) A reduction in overall tax liability as compared to baseline

• Specific language

– “If, at the end of a partnership taxable year to which an offsetting allocation(s) relates, the net increases and decreases recorded in the partners’ respective capital accounts do not differ substantially from the net increases and decreases that would have been recorded in such partners’ respective capital accounts had the original allocation(s) and the offsetting allocation(s) not been contained in the partnership agreement, and the total tax liability of the partners is (as described in (2) above) less than it would have been had such allocations not been contained in the partnership agreement, it will be presumed that, at the time the allocations became part of the partnership agreement, there was a strong likelihood that these results would occur. This presumption may be overcome by a showing of facts and circumstances that prove

• therwise. See examples (1)(xi), (2), (3), (7), (8)(ii), and (17) of

paragraph (b)(5) of this section.”

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Step 5: Overall Tax Effects Test

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The economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement: – (1) The after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement; and – (2) There is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership

• agreement. In determining the after-tax economic benefit or

detriment to a partner, tax consequences that result from the interaction of the allocation with such partner’s tax attributes that are unrelated to the partnership will be taken into account.

Five-Year Safe Harbor

• For purposes of the transitory and overall tax effects tests,

allocations will be substantial if, at the time of the original allocation, there is a strong likelihood that the offsetting allocation(s) will not, in large part, be made within five years after the original allocation(s) is made (determined on a first-in, first-out basis).

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Five-Year Safe Harbor (Cont.)

• Specific language

– Reg. 1.704-1(b)(2)(iii)(c): “Notwithstanding the foregoing, the

• riginal allocation(s) and the offsetting allocation(s) will not be

insubstantial (under this paragraph (b)(2)(iii)(c)) and, for purposes of paragraph (b)(2)(iii)(a), it will be presumed that there is a reasonable possibility that the allocations will affect substantially the dollar amounts to be received by the partners from the partnership if, at the time the allocations become part of the partnership agreement, there is a strong likelihood that the

• ffsetting allocation(s) will not, in large part, be made within five

years after the original allocation(s) is made (determined on a first-in, first-out basis).”

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Value-Equals-Basis Safe Harbor

• Unrealized appreciation and depreciation are not taken into account

in applying the substantiality test until such amounts are reflected in partner capital accounts. – Note that expected tax depreciation is taken into account

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Value-Equals-Basis Safe Harbor (Cont.)

• Specific language

– Reg. 1.704-1(b)(2)(iii)(c): “For purposes of applying the provisions of this paragraph (b)(2)(iii) (and paragraphs (b)(2)(ii)(d)(6) [alternate test for economic effect] and (b)(3)(iii) of this section) [limited PIP safe harbor], the adjusted tax basis of partnership property (or, if partnership property is properly reflected on the books of the partnership at a book value that differs from its adjusted tax basis, the book value of such property) will be presumed to be the fair market value of such property, and adjustments to the adjusted tax basis (or book value) of such property will be presumed to be matched by corresponding changes in such property’s fair market value. Thus, there cannot be a strong likelihood that the economic effect of an allocation (or allocations) will be largely offset by an allocation (or allocations) of gain or loss from the disposition of partnership property.”

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Step 6: Reallocation Under PIP – Factors Considered

• Reg.

1.704-1(b)(3)(ii) Factors considered: In determining a partner’s interest in the partnership, the following factors are among those that will be considered: – (a) The partners’ relative contributions to the partnership – (b) The interests of the partners in economic profits and losses (if different than that in taxable income or loss) – (c) The interests of the partners in cash flow and other non- liquidating distributions – (d) The rights of the partners to distributions of capital upon liquidation

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RULES FOR ALLOCATIONS RELATED TO NON-RECOURSE DEBT; CANCELLATION OF DEBT INCOME

Steven R. Schneider, Goulston & Storrs PC Brian O’Connor, Venable LLP

Non-Recourse Debt Rules

• Reg.

1.704-2 – No partner bears the economic burden. – Rules provide a “safe harbor” under the partner’s interest in partnership. – Failure to satisfy rules means allocation will be tested under all facts-and-circumstances test.

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NR Deduction Safe Harbor: Reg. 1.704-2(e)

• Throughout full term of the partnership:

– Capital accounts are properly maintained. – Partnership liquidates with positive capital accounts. – Either full DRO or qualified income offset

• Through full term of partnership after year of NR borrowing:

– Partnership has minimum gain chargeback provision. – Partnership agreement allocates NR deductions “in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities.”

• All other material allocations and capital account adjustments are

proper.

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• Sect. 704(b) Definition Of NR And PNR
• “Nonrecourse liability” means a non-recourse liability as defined in

1.752-1(a)(2) (or a 1.752-7 liability assumed by the partnership from a partner on or after June 24, 2003). Reg. 1.704-2(b)(3)

• “Partner nonrecourse liability” means any partnership liability, to the

extent the liability is non-recourse for purposes of 1.1001-2, and a partner or related person (within the meaning of 1.752-4(b)) bears the economic risk of loss under 1.752-2 because, for example, the partner or related person is the creditor or a guarantor. Reg. 1.704-2(b)(4)

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752 Definitions: Recourse Vs. Non-Recourse Debt

• Recourse debt: A partnership liability is a recourse liability to the

extent that any partner or related person bears the economic risk

• f loss (EROL) for that liability under Treas. Reg.

1.752-2. Treas. Reg. 1.752-1(a)(1)

• Non-recourse debt: A partnership liability is a non-recourse

liability to the extent that no partner or related person bears the EROL for that liability under Treas. Reg. 1.752-2. Treas. Reg. 1.752-1(a)(2)

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Partnership Minimum Gain: Definition – Reg. 1.704-2(d)(1)

The amount of partnership minimum gain is determined by first computing for each partnership non-recourse liability any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability, and then aggregating the separately computed gains. For any partnership taxable year, the net increase or decrease in partnership minimum gain is determined by comparing the partnership minimum gain on the last day of the immediately preceding taxable year with the partnership minimum gain on the last day of the current taxable year.

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Example: Minimum Gain Measurement

LLC A B Bank $1M 50% 50% $1M debt $1.1M cost Building $0.8M 704(b) value Minimum gain = $0.2M ($1M debt less 0.8M 704(b) value)

• Sect. 108(e)(8): CODI

I. 108(e)(8) - Indebtedness satisfied by corporate stock or partnership interest. For purposes of determining income of a debtor from discharge of indebtedness, if: (A) A debtor corporation transfers stock, or (B) A debtor partnership transfers a capital or profits interest in such partnership,

• A. To a creditor in satisfaction of its recourse or non-recourse

indebtedness, such corporation or partnership shall be treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock or interest.

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Allocation Of Income



In the case of any partnership, any discharge of indebtedness income recognized under this paragraph shall be included in the distributive shares of taxpayers which were the partners in the partnership immediately before such discharge.

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COD Income For The Discount

I. The IRS finalized regulations under sections 108(e)(8) and 721 in

• 2011. The regulations provided that, when a debtor partnership

transfers a capital or profits interest in satisfaction of a recourse

• r non-recourse debt, the partnership is treated as having

satisfied the debt with an amount of money equal to the fair market value of the partnership interest transferred. In other words, any discount is treated as COD income.

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Example 1: Measuring COD Income

I. Facts: In year 1, A and B each contributed $100 of cash to form the PRS partnership. PRS bought a building for $1,000, financed with its $200 of equity and an $800, interest-only note from

• Lender. At the end of year 5, PRS’s sole asset is the building,

which has declined in value to $500 and remains encumbered by the $800 Note. PRS issues a PRS interest with a $500 fair market value to Lender in satisfaction of the note.

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PRS A B Lender

$800 Note $500 FMV

• f Equity

Example 1 Single Asset Depreciated to $500. Result: PRS has $300 of COD income for the discount between the value of the equity issued and the amount owed on the note.

TARGETED CAPITAL ACCOUNTS VS. LIQUIDATING WITH CAPITAL ACCOUNTS

Brian O’Connor, Venable LLP Steven R. Schneider, Goulston & Storrs PC

78

Basic Concepts

• Layer cake allocation

– Basic concept is to allocate 704(b) book profit/loss first and use this allocation to determine the cash distributions.

• Targeted allocations

– Basic concept is to allocate profit/loss so that, at the end of the taxable year, each partner’s capital account is equal to:

• The amount that would be distributed to that partner in

liquidation if all partnership assets were sold at their 704(b) book value, less

• The partner’s share of minimum gain.

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Basic Concepts (Cont.)

• Layer cake vs. target and

704(b) safe harbors – As a technical matter, liquidation with 704(b) capital accounts (often referred to as a “safe harbor” agreement) can occur with either a layer cake or a target allocation. – As a matter of practice, most target allocations instead liquidate with the cash waterfall in which they target the income, and most layer cake liquidate with positive 704(b) capital accounts. – It is possible to use target allocations to target capital accounts to equal the cash waterfall, but instead liquidate with capital

• accounts. The risk is that if the capital accounts do not equal the

waterfall; the capital accounts govern the economics.

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Basic Steps: Layer Cake Allocations

• Profit allocations

– Reverse prior losses – Preferred return – Residual sharing ratio

• Loss allocations

– Reverse prior profits (in reverse order) – Residual sharing ratio

• Adjust capital accounts for contributions, distributions and

allocations

• Liquidate with positive capital accounts

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Basic Steps: Targeted Allocations

• Calculate cash waterfall target

– Preferred return – Preferred capital – Common capital

• Profit/loss allocations to bring adjusted capital account to equal

target

• Adjust the capital accounts for distributions
• Generally liquidate with cash waterfall, but can liquidate with

positive capital accounts

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Three Steps To Target Allocations

• Step 1: Determine partially adjusted capital account (adjust

beginning of year capital for current year contributions and distributions)

• Step 2: Determine target capital account (based on distribution

waterfall at book value)

– Net value in partnership up on deemed liquidation

– Run value through distribution waterfall

• Step 3: Allocate profit for loss, to bring partially adjusted capital

accounts to target capital account

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Example 1: Net Income In Excess Of Preference

LLC A $100,000 $100,000 Year 1 income = $50,000 10% preferred to A, residual A=40%, B=60% Beginning balance sheet Assets Liabilities Cash: $200,000 $0 Capital A: $100,000 B: $100,000 Total $200,000 Total: $200,000 B

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Capital Account-Based Liquidation: Layer Cake Allocations

• Sect. 704(b) income allocations

A B Opening capital $100,000 $100,000 $50,000 income

• 1. 10% pref to A.

$10,000 $0

• 2. 40:60 A and B

$16,000 $24,000 Total income $26,000 $24,000 Ending capital $126,000 $124,000

Capital Account-Based Liquidation: Targeted Allocations

• Sect. 704(b) income allocations

A B Opening capital $100,000 $100,000 Adjustments during year Partially adjusted cap acct $100,000 $100,000 Determine cash waterfall $250,000 cash

• 1. 10% pref to A.

$10,000 $0

• 2. Return original capital

$100,000 $100,000

• 3. 40:60 A and B

$16,000 $24,000 Ending target capital $126,000 $124,000 Income allocation $26,000 $24,000

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Example 2: Net Income Less Than Preference

Year 1 income = $8,000 10% preferred to A, residual A=40%, B=60% Beginning balance sheet Assets Liabilities Cash: $200,000 $0 Capital A: $100,000 B: $100,000 Total $200,000 Total: $200,000 LLC A $100,000 $100,000 B

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Capital Account-Based Liquidation: Targeted Allocations (Cont.)

• Sect. 704(b) income allocations

A B Opening capital $100,000 $100,000 Adjustments during year Partially adjusted cap acct $100,000 $100,000 Determine cash waterfall $208,000 cash

• 1. 10% pref to A.

$10,000 $0

• 2. Return original capital

$99,000 $99,000

• 3. 40:60 A and B

$ $ Ending target capital $109,000 $99,000 Target income allocation $9,000 ($1,000) Net income allocation $8,000 $0 Shortfall (Gpmt?) $1,000 ($1,000)

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Capital Account-Based Liquidation: Layer Cake Allocations (Cont.)

• Sect. 704(b) income allocations

A B Opening capital $100,000 $100,000 $8,000 income

• 1. 10% pref to A.

$8,000 $0

• 2. 40:60 A and B

$ $ Total income $8,000 $0 Ending capital $108,000 $100,000

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Comparison Of Examples 1 And 2

Ending cash received by A and B A B Example 1 Target/waterfall $126,000 $124,000 Layer cake/cap acct $126,000 $124,000 Example 2 Target/waterfall $109,000 $99,000 Layer cake/cap acct $108,000 $100,000