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

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IRC Sect. 704(b): Allocations to Partners

Navigating Complex Rules on Determining Validity of Partnership Allocations

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, JANUARY 10, 2012

Today’s faculty features:

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

Brian O'Connor Partner Venable LLP Baltimore Brian OConnor, Partner, Venable LLP , Baltimore Jorge Otoya, S enior Tax Manager, BDO USA, New Y

• rk

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IRC S t (b) All ti t P t IRC Sect. 704(b): Allocations to Partners Seminar

• Jan. 10, 2012

Jorge Otoya, BDO US A jotoya@ bdo.com Brian O'Connor, Venable LLP bjoconnor@ venable.com

Today’s Program

Review Of Partnership Allocation Rules [Jorge Ot oya and Brian O'Connor] S lide 7 – S lide 64 Rules For Allocations Related to Non-Recourse Debt [Jorge Ot oya and Brian O'Connor] S lide 65 – S lide 87 Targeted Capital Accounts Vs. Liquidating With Capital Accounts [Brian O'Connor and Jorge Ot oya] S lide 88 – S lide 100

J O BDO USA

REVIEW OF PARTNERSHIP

Jorge Otoya, BDO USA Brian O’Connor, Venable LLP

REVIEW OF PARTNERSHIP ALLOCATION RULES

• Sect. 704(a) And (b) Overview
• Sect. 704(a) And (b) Overview

( ) ( ) ( ) ( )

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

• Sect. 704(c)

704(c) And And (d) Overview (d) Overview ( ) ( ) ( ) ( )

• Sect 704(c): Governs allocations of tax items related to property
• 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
• 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 Basic Principles: Reg Principles: Reg. . §1.704 1.704-

• 1(b)(1)(i)

1(b)(1)(i) p g p g § ( )( )( ) ( )( )( )

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

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

10

Sect.

• Sect. 704(b) Allocations = Economic Deal

704(b) Allocations = Economic Deal Sect.

• Sect. 704(b) Allocations Economic Deal

704(b) Allocations Economic Deal

• Sect 704(b) capital accounts are intended to reflect the economic
• 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 Basic Principles: Reg Principles: Reg. . § §1.704 1.704-

• 1(b)(1)(i)

1(b)(1)(i)

• Three ways allocations can have SEE:
• Three ways allocations 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 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( )( ) §1 2 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 Effects Of Other Other Sections: Reg. Sections: Reg. §1 704 1 704 1(b)(1)(iii) 1(b)(1)(iii) §1.704 1.704-1(b)(1)(iii) 1(b)(1)(iii)

• Allocation may not be respected if fails economic substance
• Allocation may not be respected if fails economic substance

(Goldstein).

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

t i k b i (§704(d) d §465) 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

Recharacterization of debt to equity can override prior debt sourced deductions.

13

Other Possible Tax Other Possible Tax Consequences: Consequences: Reg Reg §1 704 1 704-1(b)(1)(iv) 1(b)(1)(iv) And And (v) (v) Reg Reg. . §1.704 1.704-1(b)(1)(iv) 1(b)(1)(iv) And And (v) (v)

• Gift tax consequences (§2501)
• 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 Bottom Line Allocations: Allocations: Reg Reg §1 704 1 704 1(b)(1)(vii) 1(b)(1)(vii) Reg Reg. . §1.704 1.704-1(b)(1)(vii) 1(b)(1)(vii)

• Gross versus net allocations: Sect 704(b) is applicable to
• Gross versus 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 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 Capital Account Maintenance Maintenance In In General General In In General General

• Contributions (at FMV net of liabilities)
• 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

p g p p y p g book basis

16

Must Maintain Capital Accounts Must Maintain Capital Accounts Must Maintain Capital Accounts Must Maintain Capital Accounts

• Except as otherwise provided under the economic equivalence test
• 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 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 p p p accounting rules of Reg. §1.704-1(b)(2)(iv). See Reg. §1.704- 1(b)(2)(iv)(a)

17

Basic Basic Rules: Rules: Reg Reg §1 704 1 704-1(b)(2)(iv)(b) 1(b)(2)(iv)(b) Basic Basic Rules: Rules: Reg.

• Reg. §1.704

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

• Increase capital accounts by:
• 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 – (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 – (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- p ), g g g § 1(b)(4)(i) (reverse §704(c) taxable income/loss)

18

Basic Basic Rules: Rules: Reg Reg §1 704 1 704 1(b)(2)(iv)(b 1(b)(2)(iv)(b) Cont ) Cont Basic Basic Rules: Rules: Reg.

• Reg. §1.704

1.704-1(b)(2)(iv)(b 1(b)(2)(iv)(b), Cont. ), Cont.

• Decrease capital accounts by:
• 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 ( ) p p y p y 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 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 g § ( )( )( )(g) ( 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 Single Capital Account: Account: Reg Reg §1 704 1 704 1(b)(2)(iv)(b) 1(b)(2)(iv)(b) Reg Reg. . §1.704 1.704-1(b)(2)(iv)(b) 1(b)(2)(iv)(b)

• A partner who has more than one interest in a partnership shall have
• 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 and regardless of the time or manner in which such interests were acquired.

20

Liabilities: Liabilities: Reg.

• Reg. §1.704

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

• Reg. §1.704

1.704 1(b)(2)(iv 1(b)(2)(iv)(c) )(c)

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

assumes partnership liability

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

p y p , partnership assumes partner liability

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

li biliti d ti 752( ) d 752(b) liabilities under sections 752(a) and 752(b)

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

21

Cost Recovery Cost Recovery Deductions: Deductions: Reg Reg §1 704 1 704 1(b)(2)(iv)(g)(3) 1(b)(2)(iv)(g)(3) Reg Reg. . §1.704 1.704-1(b)(2)(iv)(g)(3) 1(b)(2)(iv)(g)(3)

• Book amortization is the same ratio as the tax amortization: The
• 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 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 p p y p j property.

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

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

22

Transfers Transfers Of Of Partnership Partnership Interests: Interests: Reg Reg §1 704 1 704 1(b)(2)(iv)( 1(b)(2)(iv)(l) Reg Reg. . §1.704 1.704-1(b)(2)(iv)( 1(b)(2)(iv)(l)

• Carryover: Upon the transfer of all or a part of an interest in the
• 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 Revaluations Of Of Partnership Partnership Property: Property: Reg Reg §1 704 1 704 1(b)(2)(iv)(f) 1(b)(2)(iv)(f) Reg Reg. . §1.704 1.704-1(b)(2)(iv)(f) 1(b)(2)(iv)(f)

• Reasons needed
• Reasons needed

– Maintain relative economic interests of the partners – Prevent capital shifts Mandatory vs optional

• 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 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

Differences created between partners book and tax capital accounts; must be taken into account under §704(c) principles

24

Other Capital Account Rules Other Capital Account Rules Other Capital Account Rules Other Capital Account Rules

• Guaranteed payments: Guaranteed payment income does not affect
• 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)

Mi di i Mi it l t d i d f ith

• 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 Three Tests For For Economic Effect Economic Effect Three Tests Three Tests For For Economic Effect Economic Effect

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

26

Liquidating Distributions Liquidating Distributions Liquidating Distributions Liquidating Distributions

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

account balances

• Determined after taking into account all capital account adjustments

g p j for partnership taxable year during which liquidation occurs

• Generally, must be made by the earlier of:

Th d f th f li id ti – The end of the year of liquidation, or – 90 days following the date of liquidation

27

Economic Effect Test Requirements Economic Effect Test Requirements

Primary test Alternate test Primary test

• Capital account maintenance
• Liquidation in accordance with positive

Alternate test

• Capital account maintenance
• Liquidation in accordance with

capital accounts

• Deficit restoration obligation (DRO)

positive capital accounts

• Loss allocation may not cause or

increase adjusted capital account d fi it deficit.

• Qualified income offset (QIO)

28

Deficit Restoration Obligation Deficit Restoration Obligation Deficit Restoration Obligation Deficit Restoration Obligation

• Requires partner with deficit capital account balance upon
• 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 – Actual DRO in partnership agreement, or – Deemed DRO

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

contributed to partnership

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

29

Qualified Income Offset Provision Qualified Income Offset Provision Qualified Income Offset Provision Qualified Income Offset Provision

• In lieu of DRO required under primary test for economic effect
• 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 Economic Effect Equivalence: Equivalence: R §1 704 1 704 1(b)(2)(ii)(i 1(b)(2)(ii)(i) Reg Reg. . §1.704 1.704-1(b)(2)(ii)(i 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

• 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 Reallocation Under PIP Under PIP

• Reg. §1.704-1(b)(3) Partner’s interest in the partnership--(i) In

g § ( )( ) p p ( ) 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) 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. Th d t i ti f t ’ i t t i t hi h ll b

• 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 Reallocation Under PIP: Under PIP: Factors Considered Factors Considered Factors Considered Factors Considered

• Reg §1 704 1(b)(3)(ii) Factors considered: In determining a
• 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: ( ) Th t ’ l ti t ib ti t th t hi – (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) ( ) Th i t t f th t i h fl d th – (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 liquidation

33

Reallocation Reallocation Under PIP: Under PIP: Objective Test Objective Test



Reg §1 704-1(b)(3)(iii): If:



• 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 t f ll ti f il th i ff t f – All or part of an allocation fails the economic effect safe harbor, – Then:

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

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 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)

34

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.

Reg.

• Reg. §1.704

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

• Reg. §1.704

1.704 1(b)(5 1(b)(5), ), Example 1(i) Example 1(i)

A B A B

$40,000 $40,000

PRS

Depreciable property purchased for $80,000 Allocations A B Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall 50% 50% 35 Liquidation waterfall 50% 50% Conclusion: Special allocation of depreciation reallocated under PIP 50:50

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(ii Example 1(ii): ): W t f ll W t f ll C it l A t C it l A t Waterfall Waterfall = Capital Accounts = Capital Accounts

A B A B

$40,000 $40,000

PRS

Depreciable property purchased for $80,000 Allocations A B D i ti 100% Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – years 1 – 5 Capital accounts Liquidation waterfall – after year 5 50% 50% 36 q y % % Conclusion: Special allocation of depreciation reallocated under PIP 50:50

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(iii Example 1(iii): ): S ti f S ti f Alt t T t Alt t T t Satisfy Satisfy Alternate Test Alternate Test

A B A B

$40,000 $40,000

PRS

Depreciable property purchased for $80,000 Allocations A B 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 37 Conclusion: Allocations satisfy the alternate test for economic effect.

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(iv Example 1(iv): ): P ti l P ti l PIP R ll ti PIP R ll ti Partial Partial PIP Reallocation PIP Reallocation

A B PRS $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% 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 E di $35 000 ($5 000) $40 000

38

Ending $35,000 ($5,000) $40,000 PIP reallocation $5,000 ($5,000)

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(vi Example 1(vi): ): A ti i t d A ti i t d Di t ib ti d V l B i Di t ib ti d V l B i Anticipated Anticipated Distributions and Value = Basis Distributions and Value = Basis

A B

New facts: Partnership will borrow and

PRS $40,000 $40,00

Depreciable property purchased

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.

Depreciable property purchased for $80,000

Allocations A B Depreciation 100% Residual income or loss 50% 50% Liquidation waterfall – all years Capital accounts 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 E di $35 000 ($5 000) $35 000

39

Ending $35,000 ($5,000) $35,000 PIP reallocation $5,000 ($5,000)

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(vii Example 1(vii): ): F ll F ll DRO DRO Full Full DRO DRO

A B PRS $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% R id l i l 0% 0% 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 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 E di $35 000 ($5 000) $40 000

40

Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(viii Example 1(viii): ): Li it d Li it d DRO DRO Limited Limited DRO DRO

A B PRS $40,000 $40,000 Depreciable property purchased for $80,000 Allocations A B Depreciation 100% Residual income or loss 50% 50% 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

41

Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(ix Example 1(ix): ): Promissory Promissory Note Equivalent to Limited DRO Note Equivalent to Limited DRO Promissory Promissory Note Equivalent to Limited DRO Note Equivalent to Limited DRO

A B $ PRS $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

42

p ( ) Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 1(x Example 1(x): ): Fixed Fixed Capital Contribution Obligation Equivalent Capital Contribution Obligation Equivalent To To p g q p g q Limited Limited DRO DRO

A B $40 000 $40 000 PRS $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 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

43

Ending $35,000 ($5,000) $40,000 PIP reallocation NONE NONE

Reg.

• Reg. §

§1.704 1.704-

• 1(b)(5

1(b)(5), ), Example 4(ii Example 4(ii): ): E i E i Eff t E i l Eff t E i l Economic Economic Effect Equivalence Effect Equivalence

G H G H $25,000 $75,000 PRS

Allocations E F 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.

44

equivalence.

Substantiality Substantiality

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

45

Shifting Allocations Shifting Allocations g

• Taxable vs tax exempt income
• Taxable vs. tax-exempt income
• Ordinary income vs. capital gain
• Ordinary loss vs capital loss

Ordinary loss vs. capital loss

• Domestic vs. foreign-source income
• Active vs. passive income (loss)

p ( )

• Passive vs. portfolio income (loss)

46

Transitory Allocations Transitory Allocations y

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

– Aggregate tax reduction – Minimal capital impact

• Exceptions

– Five-year waiting period e yea a t g pe od – Value-equals-basis rule

47

Overall Tax Effect Rule Overall Tax Effect Rule

• Strikes down allocation if after tax economic consequences of at
• 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 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 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 g – However, virtually no guidance is provided as to the various factors that should be considered in arriving at this “base-line” allocation.

48

Six Six Steps Steps To To Substantiality Substantiality

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

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

d PIP [St 6] if t St 4 accordance PIP [Step 6]; if so, go to Step 4 (C ti d t lid ) (Continued on next slide)

49

Six Six Steps Steps To Substantiality (Cont.) To Substantiality (Cont.) y ( ) y ( )

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

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 Step 1: Determining The 1: Determining The Baseline Baseline g

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

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 p g p g 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 Step 2: Pre 2: Pre-

• Tax

Tax Change Change In In Economics Economics

• An allocation is substantial “if there is a reasonable possibility that
• 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
• 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 y ( p p 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 to 50:50 economics.

52

Step Step 3: Shifting 3: Shifting Test Test -

• Reg.
• Reg. §

§1.704 1.704-

• 1(b)(iii)(b)

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 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 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 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 Step 3: 3: Shifting Test Shifting Test -

• Presumption

Presumption g

• Rebuttable presumption that special allocations fail substantiality if
• 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 – (i) No substantial difference in capital accounts, and – (ii) A reduction in overall tax liability as compared to baseline

54

Step Step 3: 3: Shifting Test Shifting Test – – Presumption (Cont.) Presumption (Cont.)

• Specific language
• 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 p p p 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 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) p ( ) 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 ”
• therwise.

55

Step Step 4: 4: Transitory Test Transitory Test – – Reg Reg §1 704 1 704 1(b)(iii 1(b)(iii)(c) )(c) Reg.

• Reg. §1.704

1.704-1(b)(iii 1(b)(iii)(c) )(c)

• Special allocations will not be substantial if original allocations may
• 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 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 Step 4: 4: Transitory Transitory Test Test – – Reg Reg §1 704 1 704 1(b)(iii)(c 1(b)(iii)(c) Cont ) Cont Reg Reg. . §1.704 1.704-1(b)(iii)(c 1(b)(iii)(c), Cont. ), Cont.

• Specific language

– (c) Transitory allocations: If a partnership agreement provides for the (c) a s o y a oca o s a pa e s p ag ee e p o des o e 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 p p p 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 y ) 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 Step 4: 4: Transitory Test Transitory Test – – Presumption Presumption

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

end of the taxable year of the offsetting allocation, there is:- y g , – (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 y y g p

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

paragraph (b)(5) of this section.”

58

Step Step 5: 5: Overall Tax Effects Test Overall Tax Effects Test



The economic effect of an allocation (or allocations) is not substantial e eco o c e ec o a a oca o (o a oca o s) s

• subs a

a if, at the time the allocation becomes part of the partnership agreement: – (1) The after-tax economic consequences of at least one partner ( ) q p 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 i t ti f th ll ti ith h t ’ t tt ib t th t

59

interaction of the allocation with such partner’s tax attributes that are unrelated to the partnership will be taken into account.

Five Five-

• Year

Year Safe Harbor Safe Harbor

• For purposes of the transitory and overall tax effects tests
• 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 large part, be made within five years after the original allocation(s) is made (determined on a first-in, first-out basis).

60

Five Five-

• Year

Year Safe Safe Harbor (Cont.) Harbor (Cont.) ( ) ( )

• Specific language
• 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 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 substa t a y t e do a a

• u ts to be ece ed by t e pa t e s

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).”

61

Value Value-

• Equals

Equals-

• Basis Safe Harbor

Basis Safe Harbor

• Unrealized appreciation and depreciation are not taken into account
• 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

62

Value Value-

• Equals

Equals-

• Basis Safe

Basis Safe Harbor (Cont.) Harbor (Cont.)

• Specific language
• 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 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 di h i h ’ f i k l 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 allocation (or allocations) of gain or loss from the disposition of partnership property.”

63

Step Step 6: 6: Reallocation Reallocation Under Under PIP PIP – – Factors Considered Factors Considered Factors Considered Factors Considered

• Reg §1 704 1(b)(3)(ii) Factors considered: In determining a
• 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 – (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 ( ) g p p p liquidation

64

J O BDO USA

RULES FOR ALLOCATIONS

Jorge Otoya, BDO USA Brian O’Connor, Venable LLP

RULES FOR ALLOCATIONS RELATED TO NON‐RECOURSE DEBT

Non Non-Recourse Recourse Debt Rules Debt Rules Non Non Recourse Recourse Debt Rules Debt Rules

• Reg §1 704 2
• Reg. §1.704-2

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

66

NR Deduction Safe NR Deduction Safe Harbor: Harbor: Reg Reg §1 704 1 704 2(e) 2(e) Reg Reg. . §1.704 1.704-2(e) 2(e)

• Throughout full term of the partnership:
• 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 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 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

• All other material allocations and capital account adjustments are

proper.

67

Sect.

• Sect. 704(b) Definition

704(b) Definition Of Of NR NR And And PNR PNR

• “Nonrecourse liability” means a non recourse liability as defined in
• 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)

68

§752 Definitions: Recourse 752 Definitions: Recourse Vs. Vs. Non Non Recourse Recourse Debt Debt Non Non-Recourse Recourse Debt Debt

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

• 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)

69

Example: Non Example: Non-

• Recourse Debt

Recourse Debt p

A B Net value $0 2M Alternatives

• 1. $1M secured only

Net value $0.2M Bank $1M by building

• 2. $1M a general
• bligation of LLC

LLC Bank Bldg

• Misc. rent proceeds

70

g p

Example: Partner Non Example: Partner Non-

• Recourse Debt

Recourse Debt

A B $1M loan Alternatives

• 1. $1M secured only

by building $1M loan by building

• 2. $1M a general
• bligation of LLC

LLC Bldg

• Misc. rent proceeds

71

g p

Partnership Minimum Partnership Minimum Gain: Gain: Definition Definition – – Reg Reg §1 704 1 704 2(d)(1) 2(d)(1) Reg Reg. . §1.704 1.704-2(d)(1) 2(d)(1)



The amount of partnership minimum gain is determined by first



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, y y 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 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.

72

Example: Example: Minimum Gain Measurement Minimum Gain Measurement p

A B 50% 50% $1M debt $1.1M cost 50% 50% ding $0.8M 704(b) value Bank $1M Build LLC Bank

73

Minimum gain = $0.2M ($1M debt less 0.8M §704(b) value)

Shares Shares Of Of Minimum Minimum Gain: Gain: Reg Reg §1 704 1 704 2(g) 2(g) Reg Reg. . §1.704 1.704-2(g) 2(g)

• (A) minus (B)

(A) l

• (A) equals:

– The sum of non-recourse deductions allocated to that partner (and to that partner’s predecessors in interest) up to that time; and – The distributions made to that partner (and to that partner’s – The distributions made to that partner (and to that partner s predecessors in interest) up to that time of proceeds of a non-recourse liability allocable to an increase in partnership minimum gain.

• (B) equals:

(B) equals: – The sum of that partner’s (and that partner's predecessors in interest) aggregate share of the net decreases in partnership minimum gain; plus – Their aggregate share of decreases resulting from revaluations of partnership property subject to one or more partnership non-recourse liabilities.

74

Minimum Gain Akin Minimum Gain Akin To To Limited Limited DRO: DRO: Reg Reg §1 704 1 704 2(g) 2(g) Reg Reg. . §1.704 1.704-2(g) 2(g)

• For purposes of Reg §1 704 1(b)(2)(ii)(d) a partner’s share of
• For purposes of Reg. §1.704-1(b)(2)(ii)(d), a partner s share of

partnership minimum gain is added to the limited dollar amount, if any, of the deficit balance in the partner’s capital account that the partner is obligated to restore partner is obligated to restore.

75

Shares Shares Of Of Decrease Decrease In In Minimum Minimum Gain: Gain: Reg Reg §1 704 1 704 2(g)(2) 2(g)(2) Reg Reg. . §1.704 1.704-2(g)(2) 2(g)(2)

• A partner’s share of the net decrease in partnership minimum gain
• A partner s share of the net decrease in partnership minimum gain

is: – The amount of the total net decrease multiplied by the partner’s t h f th t hi ’ i i i t th d percentage share of the partnership’s minimum gain at the end

• f the immediately preceding taxable year.

– A partner’s share of any decrease in partnership minimum gain f f resulting from a revaluation of partnership property equals the increase in the partner’s capital account attributable to the revaluation, to the extent the reduction in minimum gain is caused by the revaluation caused by the revaluation.

76

Distributions Distributions Of Of NR Debt NR Debt Proceeds: Proceeds: Reg Reg §1 704 1 704 2(h) 2(h) Reg Reg. . §1.704 1.704-2(h) 2(h)

• If during its taxable year a partnership makes a distribution to the
• If, during its taxable year, a partnership makes a distribution to the

partners allocable to the proceeds of a non-recourse liability, then the distribution is allocable to an increase in partnership minimum gain to the extent the increase results from encumbering partnership gain to the extent the increase results from encumbering partnership property with aggregate non-recourse liabilities that exceed the property’s adjusted tax basis.

• Reg. §1.704-2(m), Example 1(vi)

77

Partner NR Partner NR Liabilities: Liabilities: Reg Reg §1 704 1 704 2(i) 2(i) Reg.

• Reg. §1.704

1.704-2(i) 2(i)

• Partnership losses deductions or Sect 705(a)(2)(B) expenditures
• Partnership losses, deductions or Sect. 705(a)(2)(B) expenditures

that are attributable to a particular partner non-recourse liability (“partner nonrecourse deductions”) must be allocated to the partner that bears the economic risk of loss for the liability.

• The amount of partner non-recourse deductions with respect to a

partner non-recourse debt equals the net increase during the year in minimum gain attributable to the partner non-recourse debt (“partner g p ( p nonrecourse debt minimum gain”), reduced (but not below zero) by proceeds of the liability distributed during the year to the partner bearing the economic risk of loss for the liability that are both attributable to the liability and allocable to an increase in the partner attributable to the liability and allocable to an increase in the partner non-recourse debt minimum gain.

78

Partner NR Minimum Gain Partner NR Minimum Gain Charge Charge-

• Back:

Back: Reg Reg §1 704 1 704-2(i)(4) 2(i)(4) Reg Reg. . §1.704 1.704-2(i)(4) 2(i)(4)

• If during a partnership taxable year there is a net decrease in
• If, during a partnership taxable year, there is a net decrease in

partner non-recourse debt minimum gain, then any partner with a share of that partner non-recourse debt minimum gain as of the beginning of the year must be allocated items of income and gain for beginning of the year must be allocated items of income and gain for the year (and, if necessary, for succeeding years) equal to that partner’s share of the net decrease in the partner non-recourse debt minimum gain. g

79

Partnership Minimum Gain Partnership Minimum Gain Charge Charge-

• Back:

Back: General General Rule Rule - Reg Reg §1 704 1 704-2(f)(1) 2(f)(1) General General Rule Rule - Reg.

• Reg. §1.704

1.704-2(f)(1) 2(f)(1)

• If there is a net decrease in partnership minimum gain for a
• If there is a net decrease in partnership minimum gain for a

partnership taxable year, then the minimum gain chargeback requirement applies, and each partner must be allocated items of partnership income and gain for that year equal to that partner’s partnership income and gain for that year equal to that partner s share of the net decrease in partnership minimum gain.

80

Minimum Gain Minimum Gain Charge Charge-

• Back: Recourse

Back: Recourse C i C i E ti E ti R §1 704 1 704 2(f)(2) 2(f)(2) Conversion Conversion Exception Exception – Reg.

• Reg. §1.704

1.704-2(f)(2) 2(f)(2)

• A partner is not subject to the minimum gain charge back
• A partner is not subject to the minimum gain charge-back

requirement to the extent the partner’s share of the net decrease in partnership minimum gain is caused by a recharacterization of non- recourse partnership debt as partially or wholly recourse debt or recourse partnership debt as partially or wholly recourse debt or partner non-recourse debt, and the partner bears the economic risk

• f loss (within the meaning of Reg. §1.752-2) for the liability.

81

Minimum Cain Minimum Cain Charge Charge-

• Back: Capital

Back: Capital Contribution Contribution Exception Exception – Reg Reg §1 704 1 704-2(f)(3) 2(f)(3) Contribution Contribution Exception Exception – Reg Reg. . §1.704 1.704-2(f)(3) 2(f)(3)

• A partner is not subject to the minimum gain chargeback
• A partner is not subject to the minimum gain chargeback

requirement, to the extent the partner contributes capital to the partnership that is used to repay the non-recourse liability or is used to increase the basis of the property subject to the nonrecourse to increase the basis of the property subject to the nonrecourse liability; and the partner’s share of the net decrease in partnership minimum gain results from the repayment or the increase to the property’s basis. p p y

82

Items Items To To Use Use For Chargeback: For Chargeback: Reg Reg §1 704 1 704 2(f)(6) 2(f)(6) Reg Reg. . §1.704 1.704-2(f)(6) 2(f)(6)

• Any minimum gain charge back required for a partnership taxable
• Any minimum gain charge-back required for a partnership taxable

year consists first of certain gains recognized from the disposition of partnership property subject to one or more partnership non- recourse liabilities; and then if necessary consists of a pro rata recourse liabilities; and then, if necessary, consists of a pro rata portion of the partnership’s other items of income and gain for that

• year. If the amount of the minimum gain charge-back requirement

exceeds the partnership's income and gains for the taxable year, p p g y , then the excess carries over.

83

Reg.

• Reg. §

§1.704 1.704-

• 2(f

2(f), Example 1: ), Example 1: Measuring Measuring Minimum Gain Minimum Gain Measuring Measuring Minimum Gain Minimum Gain

A B $300 cost $200 debt $90 $10 LLC Bank $200 $0.8M 704(b) value $90 $

Allocations Loss: 90:10 (A,.B) Profit: 1. Reverse loss

• 2. 50:50

Income/loss Min gain A B Year 1 (100) depr. 0 [debt = book] Year 2 (100) depr. 100 [200 debt – 100 book] 90 10 Y 3 (100) d 200 [200 d bt 0 b k] 180 20

84

Year 3 (100) depr. 200 [200 debt – 0 book] 180 20

Reg.

• Reg. §

§1.704 1.704-

• 2(f

2(f), Example 2: ), Example 2: Minimum Minimum Gain Gain And And Multiple Properties Multiple Properties Minimum Minimum Gain Gain And And Multiple Properties Multiple Properties

A B

$100 cost & debt

A B $25 $25 LLC Bank

$100 NR to bldg

$ 5

Allocations 50:50

Income/loss Min gain A B §704b A B

Stock = 50 Bldg = 100

Beginning 50 25 25 Each year 1 - 5 (20) depr. 20 10 10 (20) (10) (10) Cumulative (100) depr. 100 50 50 (100) (25) (25)

85

Reg.

• Reg. §

§1.704 1.704-

• 2(m

2(m), Example 1, Years 1 ), Example 1, Years 1-

• 2:

2: Equity Equity Sourced Deductions Sourced Deductions Equity Equity Sourced Deductions Sourced Deductions

LP GP

$1,000 cost

$180 $20

$800 NR

PRS Bank

$800 NR to bldg

Allocations Loss: 90:10 (LP, GP) Profit: 1. Reverse loss

• 2. 50:50

Income/loss each of years 1 & 2 Rent inc. 95

• Op. ex.

(10) I t (80) Capital Accounts Total LP GP Beginning 200 180 20 Year 1&2 (170) (153) (17) E di 30 27 3

86

• Int. ex.

(80) Depr. (90) Net (85) Ending 30 27 3

Reg.

• Reg. §

§1.704 1.704-

• 2(m

2(m), Example 1, Year 3: ), Example 1, Year 3: D bt D bt S d S d D d ti D d ti Debt Debt-Sourced Sourced Deductions Deductions

LP GP LP GP

$180 $20

$800 NR $730 §704b

PRS Bank

$800 NR to bldg $20

$730 §704b

PRS

Income/loss each of years 3 Rent inc. 95 O (10) Beginning of Year 3 Balance Sheet Assets Liabilities

• Op. ex.

(10)

• Int. ex.

(80) Depr. (90) Net (85) Cash: $10 $800 Bldg: $820 Capital LP: $27 GP: $3 $ ( )

87

Total $830 Total: $830 $70 min. gain (800-730) allocated 90:10 ($63 LP, $7 GP), because consistent with equity deductions

Brian O’Connor, Venable LLP

TARGETED CAPITAL

Brian O Connor, Venable LLP Jorge Otoya, BDO USA

ACCOUNTS VS. LIQUIDATING WITH CAPITAL ACCOUNTS WITH CAPITAL ACCOUNTS

Basic Concepts Basic Concepts

• Layer cake allocation
• 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.

89

Basic Basic Concepts (Cont.) Concepts (Cont.) ( ) ( )

• Layer cake vs target and §704(b) safe harbors
• 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 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 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

p q waterfall; the capital accounts govern the economics.

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Basic Basic Steps: Steps: Layer Cake Allocations Layer Cake Allocations p y

• Profit allocations
• Profit allocations

– Reverse prior losses – Preferred return Residual sharing ratio – Residual sharing ratio

• Loss allocations

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

• Adjust capital accounts for contributions, distributions and

allocations allocations

• Liquidate with positive capital accounts

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Basic Basic Steps: Steps: Targeted Allocations Targeted Allocations p g

C l l t h t f ll t t

• Calculate cash waterfall target

– Preferred return – Preferred capital – Common capital

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

target g

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

positive capital accounts positive capital accounts

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Three Three Steps Steps To To Target Allocations Target Allocations g

• Step 1: Determine partially adjusted capital account (adjust
• 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)

• (a) Net value in partnership up on deemed liquidation

( ) p p p q

• (b) 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 Example 1: 1: Net Income Net Income In In Excess Of Excess Of Preference Preference Excess Of Excess Of Preference Preference

A Beginning Balance Sheet Assets Liabilities B $100 000 $100 000 Assets Liabilities Cash: $200,000 $0 C it l LLC $100,000 $100,000 Capital A: $100,000 B: $100,000 Year 1 income = $50,000 Total $200,000 Total: $200,000

94

10% preferred to A, residual A=40%, B=60%

Capital Account Capital Account-

• Based Liquidation:

Based Liquidation: L C k C k All ti All ti Layer Layer Cake Cake Allocations Allocations

• Sect. 704(b) Income Allocations

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

• 1. 10% pref to A.

$10,000 $0 2 40:60 A and B $16 000 $24 000

• 2. 40:60 A and B

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

95

Ending capital $126,000 $124,000

Capital Account Capital Account-

• Based Liquidation:

Based Liquidation: Targeted Allocations Targeted Allocations

• Sect. 704(b) Income Allocations
• Sect. 704(b) Income Allocations

A B Opening capital $100,000 $100,000 Adjustments during year djust e ts du g yea 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

• 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

Example 2: Net Income Example 2: Net Income Less Less Than Preference Than Preference Than Preference Than Preference

Beginning Balance Sheet Assets Liabilities A B Assets Liabilities Cash: $200,000 $0 C it l $100 000 $100 000 Capital A: $100,000 B: $100,000 LLC $100,000 $100,000 Year 1 income = $8,000 Total $200,000 Total: $200,000

97

10% preferred to A, residual A=40%, B=60%

Capital Account Capital Account-

• Based Liquidation:

Based Liquidation: Targeted Targeted Allocations Allocations (Cont.) (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

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Target income allocation $9,000 ($1,000) Net income allocation $8,000 $0 Shortfall (Gpmt?) $1,000 ($1,000)

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

• Sect. 704(b) Income Allocations

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

• 1. 10% pref to A.

$8,000 $0 2 40:60 A and B $ $

• 2. 40:60 A and B

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

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Ending capital $108,000 $100,000

Comparison Comparison Of Of Examples 1 and 2 Examples 1 and 2

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

100

Layer cake/cap acct $108,000 $100,000