WSBA CLE PROGRAM HOLDING REAL ESTATE ASSETS THROUGH PARTNERSHIPS AND LLCS
ADMISSION OF NEW PARTNERS
By: John J. O’Donnell Ogden Murphy Wallace, P.L.L.C. 1601 – 5th Avenue, Suite 2100 Seattle, WA 98101-1686 (206) 447-7000
Specific legal problems need specific solutions. This outline and related presentation is intended to provide a broad, general outline, and is not intended to provide legal advice.
TAX AND RELATED CONSIDERATIONS UPON ADMISSION OF NEW PARTNERS Table of Contents I.
Introduction
II.
Basic Fact Pattern ................................................................................................................1
III.
Accounting for Partner’s Distributive Share and Balance Sheet .........................................2
IV.
Partner Acquires Partnership Interest by Cash Contribution to the Partnership..................3
V.
New Partner Admitted by Cross Purchase from Existing Partners....................................10
VI.
Admission by Cash Contribution Redeux..........................................................................12
VII.
Partner Acquires Partnership Interest by Contribution of Appreciated Property to Partnership ......................................................................................................13
VIII.
Partner Acquires Partnership Interest by Contribution of Appreciated Property Subject to Debt to Partnership.............................................................................15
IX.
Depreciable Asset Issues....................................................................................................17
X.
Conclusion
Exhibit A
......................................................................................................................1
....................................................................................................................18 ....................................................................................................................20
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TAX AND RELATED CONSIDERATIONS UPON ADMISSION OF NEW PARTNERS I.
INTRODUCTION
The admission of new partners to pre-existing partnerships1 creates a variety of income tax and related problems. Solutions to these problems are not always obvious. More likely than not, the problems are resolved by compromises among the parties rather than through variations in the transactions to eliminate the problems. Perhaps the biggest problem of all is the failure to recognize problems in the first place. This outline will use a basic fact pattern to illustrate the major problems and the major variations in admission of a new partner. The exercise should sharpen your ability to recognize the major problems which is the important first step in dealing with these problems and crafting resolutions acceptable to clients. Within the basic fact pattern we will review how tax and related issues arise in the following transactions: •
Admission of new partner by cash contribution to the partnership
•
Admission of new partner by cross-purchase from existing partners
•
Admission of new partner by contribution of appreciated property to the partnership
•
Admission of new partner by contribution of appreciated property subject to indebtedness to the partnership II.
BASIC FACT PATTERN
In 1995 Groucho purchased land (Property 1) for $100,000 paying $10,000 cash down payment and the balance with a $90,000 mortgage for which he is personally liable. In 1997, Groucho, Zeppo and Chico formed the Fidonia Real Estate, LLC (the “Fidonia Partnership”.) Groucho contributed Property 1, which at the time had a fair market value of $120,000, a mortgage balance of $90,000 and a net equity value of $30,000. Zeppo and Chico each contributed cash in the amount of $30,000. Each partner has a one-third interest in the partnership. Profits, losses and cash distributions are all shared equally by the three partners. The Fidonia Partnership used the $60,000 cash contributed to purchase land (Property 2). 1
In the 21st Century most real estate transactions involving multiple parties are conducted through Limited Liability Companies (“LLCs”). Occasionally transactions still take place in older entity forms such as Limited Partnerships, Limited Liability Partnerships or even General Partnerships. Subchapter K of Chapter 1 of Subtitle A of the Internal Revenue Code entitled Partners and Partnerships applies with equal force to all of these entities if they are characterized as partnerships for federal income tax purposes, which is usually the case. Throughout this outline we will refer to entity owners as partners regardless of the type of entity used, because the term partners is used in Internal Revenue Code provisions applicable to all of these entities. The reader should remember that when we say partner, we also mean LLC member, limited partner, etc., as the case may be in the other entities.
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In 2003, the Partnership refinanced Property 2 with a non-recourse loan in the amount of $540,000. The cash proceeds from the refinancing were distributed $180,000 each to Groucho, Zeppo and Chico. III.
ACCOUNTING FOR PARTNER’S DISTRIBUTIVE SHARE AND BALANCE SHEET
There are probably infinite varieties of accounting methods used in determining partners’ distributive share of partnership income and loss and resulting capital accounts adjustments. This outline deals with only the two most common approaches; the Tax Basis Method, and the capital accounts maintenance rules in accordance with Reg. § 1.704-1(b)(2)(iv) (“704(b) Capital Accounts Method”). Under the Tax Basis Method, partners’ initial capital accounts are set at the Federal Adjusted Basis of contributions to the partnership, and assets are booked at Federal Adjusted Basis. Partnership income is considered taxable income and non-taxable income and expense items defined as such under the Internal Revenue Code. Partnership income and loss is allocated among partners according to their overall economic interest in the partnership in accordance with Reg. § 1.704-1(b)(3) (normally their general profit and loss sharing percentages unless inconsistent cash distribution provisions suggest a different economic interest). Almost no special allocations of partnership items occur. Under the 704(b) Capital Accounts Method, partners’ capital accounts are maintained according to the complicated rules of Reg. § 1.704-1(b)(2), which is a hybrid system combining tax accounting concepts and Generally Accepted Accounting Principal (GAAP) concepts. Partnership liquidating distributions are made in accordance with partner positive capital accounts. The partnership agreement contains either a deficit capital account makeup provision or a Qualified Income Offset. The partnership has considerable freedom to make special allocations of income and expense items among partners for tax purposes as long as the special allocations satisfy the tests for substantial economic effect in Reg. § 1.704(b)(2). See Exhibit A for a fairly standard set of provisions incorporating all these provisions into an LLC Agreement. IRC Section 704(c)(1)(A) mandates a special allocation for all partnerships, including partnerships using the Tax Basis Method. IRC 704(c) states that, “income, gain, loss and deduction with respect to property contributed by a partner shall be shared among the partners so as to take account of the variation between basis of property to the partnership and its fair market value at the time of contribution.” Essentially, this provision means that the pre-contribution gain of assets contributed to a partnership (excess of fair market value over federal adjusted basis on date of contribution) must ultimately be allocated to the contributing partner. For nondepreciating assets such as land, this requirement is usually simply satisfied by allocating precontribution gain for tax purposes only to the contributing partner where the partnership makes a taxable disposition of the contributed asset. As we shall see later below (Section IX at page 17) this situation gets much more complicated when depreciable property contains pre-contribution gain. In 2007, the balance sheet of the Fidonia Partnership is as follows:
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Tax Basis Method Property 1
100,000 Property 1 Recourse Debt
90,000
Property 2
60,000 Property 2 Non-Recourse Debt
540,000
Groucho Capital
(170,000)
Zeppo Capital
(150,000)
Chico Capital
(150,000)
160,000
160,000
704(b) Capital Accounts Method (Assumes no booking up) Property 1
120,000 Property 1 Recourse Debt
Property 2
90,000
60,000 Property 2 NonRecourse Debt
540,000
Groucho Capital
(150,000)
Zeppo Capital
(150,000)
Chico Capital
(150,000)
180,000
180,000
IV. PARTNER ACQUIRES PARTNERSHIP INTEREST BY CASH CONTRIBUTION TO THE PARTNERSHIP 1.
Additional Facts
On January 1, 2007 the net equity in the Fidonia Partnership is 150,000. Harpo proposes to contribute 100,000 to the Partnership in exchange for a 40% interest, and the existing partners agree. Details are as follows: FMV
DEBT
NET EQUITY
Property 1
180,000
90,000
90,000
Property 2
600,000
540,000
60,000
Total Partnership
780,000
630,000
150,000
Harpo Contribution
100,000
Post-Contribution Total Partnership
250,000
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2.
Is the Initial Transaction Taxable?
a.
General Rule
IRC Section 721(a) clearly answers the question in the negative by providing: “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.” b.
Debt Allocation Rules
The inter-relationship between the partnership basis rules, debt allocation rules and distribution rules create potential traps for the unwary in this situation. Section 705 contains the general rule for determining the basis of a partner’s interest in a partnership and is typical of most pass through entity basis determination rules. Basis is increased by the basis of property contributed to the partnership and the partner’s share of taxable and tax exempt income. Basis is decreased (but not below zero) by losses and non-deductible expenses of the partnership and distributions from the partnership. Section 731(a)(1) tells us that a partner recognizes gain to the extent any money distributed exceeds the adjusted basis of the distributee partner’s interest in the partnership. These very typical pass through entity rules are complicated by a factor unique to partnerships in the federal income tax world; the treatment of partnership liabilities under Section 752. Section 752 contemplates each partner having a particular share of partnership liabilities. An increase in a partner’s share of liabilities is treated as a contribution of money to a partnership, which under Section 705 increases the partner’s basis. A decrease in a partner’s share of partnership liabilities is treated as a distribution of money to the partner, reducing basis under Section 705, and once basis is exhausted, creating taxable income under Section 731(a)(1). The Regulations under Section 752 divide partnership debt into two main categories; recourse debt and non-recourse debt. Recourse debt is debt for which someone can ultimately be held liable. Non-recourse debt is debt for which no one is personally liable, and the lender looks solely to security interests in specific assets for ultimate satisfaction of the debt. A fair summation of the four pages of recourse debt regulations under Reg. § 1.752-2 is that recourse debt is allocated entirety to the partner or partners ultimately liable for paying the debt. The non-recourse debt regulations under Reg. § 1.752-3 are much shorter and more complicated. The regulation sets forth a three-tiered allocation system as follows: TIER 1:
The partner’s share of partnership minimum gain according to regulations under Section 704(b).
TIER 2:
An amount of debt equal to any remaining excess of non-recourse debt over the basis of partnership property subject to that debt to
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the extent such excess constitutes pre-contribution gain is allocated to the contributing partners. (Pre-contribution Minimum Gain) TIER 3: c.
The remaining non-recourse debt is allocated among the partners according to each partner’s share of partnership profits.
Application of Debt Allocation Rules to Fact Pattern
We can calculate the pre-Harpo contribution pre-debt allocation basis under Section 705 of the partners as follows: G
Z
CH
10,000
30,000
30,000
Refinancing Distributions
(180,000)
(180,000)
(180,000)
Tentative Basis Before Debt Allocations
(170,000)
(150,000)
(150,000)
Basis of Property Contributed
As explained below, application of the debt allocation rules depends on how the partnership accounts for distributive share and capital accounts. 3.
Tax Basis Method
The only pre-contribution gain in the partnership at this point is Property 1 contributed by Groucho. Because the partnership is an LLC, the debt on Property 1 is nonrecourse to the partnership. Nevertheless, Groucho remains personally liable on the debt. Therefore under Reg. § 1.752-1 all of that debt is allocated to Groucho. a.
The Problems
Regulation § 1.704-2(b)(1) tells us that unless the partnership uses the 704(b) Capital Accounts Method, then partners’ shares of non-recourse liabilities are allocated in accordance with the partner’s economic interests in the partnership, which in our case is clearly the profit sharing ratios. Therefore we have no Tier 1 allocations. We can thus calculate preHarpo contribution partner basis as follows:
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Tentative Basis Before Debt Allocation Recourse Debt
G
Z
CH
(170,000)
(150,000)
(150,000)
90,000
Non-recourse Debt (1/3 each)
180,000
180,000
180,000
TOTAL BASIS
100,000
30,000
30,000
Harpo’s admission as a 40% partner reduces the other partners from 1/3 each to 20% each. The partners experience a reduction in share of non-recourse debt as follows:
Tentative Basis Before Debt Allocation Recourse Debt
G
Z
CH
(170,000)
(150,000)
(150,000)
108,000
108,000
108,000
28,000
(42,000)
(42,000)
90,000
Non-recourse Debt (20% each) TOTAL BASIS
Because Section 705 limits negative basis adjusts to zero, 752 treats liability deductions as deemed cash distributions, and 731(a)(1) taxes cash distributions in excess of basis, both Zeppo and Chico recognize 42,000 taxable gain on the transaction. Admittedly, the numbers in the example are exaggerated to illustrate the phenomenon. Nevertheless, even with less extreme numbers, the basis reduction resulting from admission of a new partner is a real event. Even if current taxable income does not result, significant unanticipated basis reductions from new partner admissions can create tax problems in the future by limiting the ability of existing partners to enjoy future cash free distributions or tax deductions generated by the partnership. b.
Possible Fixes
There does not appear to be any silver bullets for eliminating the tax problems in this situation. Obviously, the partnership could admit Harpo as a smaller percentage partner for a smaller contribution to preserve enough debt allocation and basis to enable the other partners to avoid income recognition. Alternatively, the existing partners could enter into an agreement among themselves to make some of the debt recourse to themselves, such as by a limited deficit capital account make-up provision (See Example 2 Reg. § 1.752-2(f)). Care should be taken to
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insure that the property is still the most likely source of ultimate debt repayment. The tax rate is less than 100%. It is better to pay tax on an amount of debt than to actually pay the debt itself. Finally, perhaps some of the tax costs resulting from the debt shifting might be recovered from Harpo by adjustment to his admission price. (See Section VI at page 12 for issues in distributing this cash to the existing partners.) 4.
704(b) Capital Accounts Method
The above analysis applies with equal force if the partnership used the 704(b) Capital Account Method subject to one major exception. Reg. § 1.704-2(e), (f) and (g) requires such partnerships to adopt a Minimum Gain Charge Back provision (See Exhibit A, sections 2.1 and 2.2 for an example of such a provision). Minimum gain is the amount of gain occurring if property subject to non-recourse debt were sold solely for the amount of debt. Reg. §1.7042(d)(1). Basically, deductions and distributions financed by non-recourse loans may be allocated to partners by special allocation in exchange for a commitment to allocate to the same partners in the same ratios taxable income recognized in connection with reducing the current non-recourse debt. Such an allocation of minimum gain becomes the partner’s share of partnership minimum gain. In our example since all of the proceeds of the non-recourse financing were distributed to the pre-Harpo partners, a Minimum Gain Charge Back provision in the LLC Agreement would make all of the non-recourse debt partnership minimum gain allocable to the pre-admission partners under Tier 1 of Reg. § 752-3(a)(1), and allocable to the pre-admission partners even after Harpo was admitted. The debt reallocation upon the admission of Harpo would then be as follows:
Tentative Basis Before Debt Allocation Recourse Debt
Z
CH
(170,000)
(150,000)
(150,000)
160,000
160,000
160,000
12,000
12,000
12,000
92,000
22,000
22,000
90,000
Minimum Gain (540,000-60,000) Remaining NonRecourse Debt (540,000-480,000; 20% each) TOTAL BASIS
5.
G
Post-Admission Hypothetical Asset Sale
A highly recommended analytical tool for ferreting out potential problems in new partner admissions is to calculate a hypothetical sale of all partnership assets and proceeds distribution immediately after the new partner admission. Calculating who gets what cash and who is taxed
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on what income will often reveal problem areas. The initial calculation in our example is as follows: CASH Harpo Contribution
100,000
Property 1: Selling Price
180,000
Debt
TAXABLE INCOME 180,000
(90,000)
Basis
(100,000)
Property 2: Selling Price
600,000
Debt
600,000
(540,000)
Basis
(60,000)
Totals
250,000
620,000
Once again, the consequences to the partners will depend on the partnership’s tax accounting method. a.
Tax Basis Method
As a 40% partner Harpo gets 40% of the cash and 40% of the taxable income. Under tax basis accounting Harpo has a big problem illustrated as follows:
Totals
CASH
TAXABLE INCOME
250,000
620,000
Groucho Pre-Contribution Gain
(20,000
Available to Partners Harpo Percentage Harpo Share
250,000
600,000
X 40%
X 40%
$100,000
$240,000
Harpo gets a cash distribution equal to his contribution as one would expect. The problem, however, is that Harpo also gets his ownership share of taxable income resulting from pre-admission asset appreciation, even though Harpo has already paid cash for such appreciation. Because of the inability of the partnership to make special allocations of income and loss in the Tax Basis Method, there is really no fix for Harpo’s problem other than an admission price adjustment.
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Admission price adjustment is an easy concept, but hard to agree on in practice2. Harpo may argue for a $36,000 price reduction to compensate for the expected extra tax burden ($240,000 x 15%). Such an adjustment may not be ample protection. Tax rates often change and Harpo may ultimately be paying tax at a higher rate than the rate used in the price adjustment. Such a price adjustment may also be too large. The asset disposals that will generate the tax to Harpo may be a long time coming, suggesting that any price adjustment for Harpo’s future tax payments be discounted for the time value of money. The length of time might be predicted by the intended use of the property by the partnership. Contractual arguments limiting early disposition of partnership property might add some certainty to this prediction. Selecting an appropriate discount rate is also open to a variety of interpretations. Various partners might favor using the prevailing AFR, prime rate, partnership cost of capital, etc. Ultimately, the determination of an appropriate admission price will come from arms length bargaining among the partners after considering both tax and non-tax factors. The key here is to identify the tax problems caused by pre-admission asset appreciation and include them in the admissions price negotiations. b.
704(b) Capital Accounts Method
Harpo’s share of cash and taxable income is calculated as follows:
Totals
CASH
TAXABLE INCOME
250,000
620,000
Groucho Pre-Contribution Gain
Minimum Gain of Pre-Admission Partners
Available to all Partners Harpo Percentage Harpo Share
250,000
120,000
x 40%
x 40%
$100,000
$48,000
The Minimum Gain Charge-back to existing partners reduces, but does not eliminate the tax problems for Harpo. At least some portions of pre-admission asset appreciation still get allocated to Harpo on asset disposal. The ability to use special allocations under 704(b) Capital Accounts Method accounting offers opportunities to solve Harpo’s tax problems without admission price adjustments. A series of adjustments and allocations authorized under Reg. § 1.704-1(b)(2)(iv)(f) known as a 2
Even after the cash distribution Harpo will have a $240,000 basis in the partnership, which would produce a corresponding capital loss on liquidation of the partnership. Thus this problem can self correct in the long run, especially in a one property partnership. In an ongoing partnership, however, the problem may occur over time with self correction only a distant future hope, and possibly an eventually useless capital loss occurring in a year with no capital gains.
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Book Up, will eliminate the problem of pre-admission appreciation. The regulations authorize Book Ups in a number of specific circumstances including the admission of a new partner. The required adjustments include writing up the book value of partnership property to fair market values, increasing existing partners’ capital accounts by the amount of unrealized gain or loss inherent in partnership property as if a taxable disposition had taken place and the future allocation of taxable gain and loss in the same manner when it occurs. (See Exhibit A, sections 1.1.2 and 2.1.6 for typical book up provisions.) The balance sheet of the Fidonia Partnership would be as follows after such a preadmission book up: Property 1
180,000
Property 1 Recourse Debt
Property 2
600,000
Property 2 Non-Recourse Debt
90,000 540,000
Groucho capital
50,000
Zeppo capital
50,000
Chico capital
50,000
780,000
780,000
All of the pre-admission gain would be allocated accordingly to the existing partners. Harpo would then receive a $100,000 capital account and 40% interest in future partnership profits and losses in exchange for his $100,000 contribution. A Book-Up is a nice solution to the pre-admission gain problem for partnerships using 704(b) Capital Account Method accounting. A book up is an elective provision under this accounting method. The key then is to request a bookup in partnership admission situation when it is available to solve pre-admission partnership asset appreciation tax problems. V. 1.
NEW PARTNER ADMITTED BY CROSS PURCHASE FROM EXISTING PARTNERS
Additional Facts
In this variation Harpo pays $20,000 to each existing partner in exchange for 13-⅓% of their existing partnership interests. As a result, Harpo becomes a 40% partner and the existing partners each become 20% partners. 2.
Is the Transaction Taxable?
Section 741 clearly makes the sale or exchange of a partnership interest a taxable transaction for the selling partners. 3.
§ 754 Election
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In a cross purchase acquisition, the acquiring partner will be keenly interested in having the partnership make a 754 election. A 754 election allows the partnership to adjust the basis of partnership property in the case of certain transfers of partnership interests described in Section 743 and certain distributions of partnership property described in Section 734. The applicable provision here is Section 743(b)(1) which provides for a step up in basis of partnership assets equal to the excess of Harpo’s basis in his partnership interest over his proportionate share of the adjusted basis of partnership property before the basis step up. Under the Section 743 regulations this basis will be allocated solely to Harpo for all tax purposes. Under the facts of our example we can calculate this basis step up as follows:
Cash Paid
Tax Basis
704(b)
60,000
60,000
Share of Debt (40% of 540,000)
216,000
(40% of 60,000)
24,000
Harpo Basis in Partnership
276,000
84,000
Reg. § 1.743-1(d) defines the incoming partner’s share of partnership’s basis in property as the sum of the incoming partner’s share of partnership’s previously taxed capital and partnership liabilities. That regulation basically defines the incoming partner’s share of the partnership’s previously taxed capital as the amount of cash that partner would receive on a hypothetical asset sale and partnership liquidation decreased by the amount of taxable gain allocable to the incoming partner on such hypothetical sale.
Cash
Tax Basis
704(b)
60,000
60,000
Asset Sale Gain (See Page 8)
(240,000)
(See Page 9)
(48,000)
Share of Liabilities
216,000
24,000
36,000
48,000
Harpo Basis in Partnership
276,000
84,000
Section 754 Adjustment
240,000
48,000
Share of Partnership Basis in Property
As the above example illustrates, a partnership cross purchase at fair market value coupled with a Section 754 election will eliminate all of the book/tax differences described
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above in Section IV. Therefore other techniques such as book ups (and reverse 704(c) elections) become unnecessary. 4.
Mechanics of 754 Election
Reg. § 1.754-1(b) gives the mechanics of making a Section 754 election by filing a statement with a timely filed (including extensions) tax return for the partnership. An election, once made, remains in effect for all transactions and all subsequent years until revoked by the partnership with approval of the IRS. Because 754 elections apply with equal force to basis step downs when fair market value is less than basis, partnerships are often coy about consenting to Section 754 elections. A typical partnership provision is set forth on Exhibit A, section 2.1.7. The only safe way to insure a 754 election is made is to examine tax returns for prior elections or obtain a specific contractual commitment for one to be timely made. 5.
Absence of 754 Election
The absence of a 754 election creates the same problems for Harpo illustrated by the post-admission hypothetical asset sale discussion above at IV.5 at page 7 and ff. Even if the partnership uses the 704(b) capital accounts method, a book up is not a possible solution here because new partner admission by cross purchase is not an authorized book up event under Reg. § 1.704-1(b)(2)(iv)(f). Purchase price adjustment appears to be the only available remedy, although it is hard to imagine a situation where existing partners would allow a price adjustment instead of a 754 election. VI. 1.
ADMISSION BY CASH CONTRIBUTION REDEUX
Additional Facts
The existing partners have noticed that while the cash contribution admission method minimizes or avoids tax on the initial transaction, it leaves the cash in the partnership. The cross purchase method, while creating a taxable event, at least puts the cash in their individual pockets. Like all good clients, they ask if they can have their cake and eat it too; i.e., put Harpo’s cash in their pockets and still pay little or no tax. 2.
Mechanical Approach
A mechanical view of partnership taxation suggests a way for the existing partners to achieve this objective. First, structure Harpo’s admission as a tax free contribution of cash to the partnership. Second distribute the cash to the existing partners. Section 731(a)(1) only taxes cash distributions in excess of partner basis. If the existing partners had preserved basis on Harpo’s admission as suggested above in Section IV.3.b at page 6 and ff in some manner (e.g., limited deficit capital account make up, Minimum Gain Charge Back provision, etc.) one might think they could use this basis to absorb a tax free distribution of Harpo’s contribution to the partnership. 3.
Disguised Sale Rules 12
The disguised sales rules contained in Reg. § 1.707-3 are designed to prevent use of the mechanical rules of partnership taxation to disguise taxation of transactions whose true nature are taxable sales or exchanges. Under Reg. § 1.707-3(b) any cash distributions (other than normal cash distributions such as operating profits, etc.) to a partner contributing property to a partnership is susceptible to recharacterization as a sale of the contributed property by the contributing partner to the partnership. The recharacterization is based on consideration of a variety of facts and circumstances to determine if the cash distribution was dependent on the property contribution and not dependent on the entrepreneurial risks of partnership operations. There is a rebuttable presumption in favor of sale characterization for cash distributions within two years of property contributions and against sale characterization for cash distributions made more than two years after the property contribution. Reg. § 1.707-3 does not literally apply to the transaction contemplated here because Harpo is contributing cash rather than property and the contemplated partnership cash distributions would be to the non-contributing partner. Nevertheless, Reg. § 1.707-7 is a reserved section for Disguised Sales of Partnership Interests. The logic and spirit of Reg. § 1.707-3 suggest that the contemplated transaction here could be interpreted as a disguised sale to Harpo of partnership interests by the non-contributing partners. Prudence would suggest that if the parties would like to attempt this transaction anyway, they postpone the cash distribution beyond two years from Harpo’s contribution, and they condition the distribution on some entrepreneurial risk of partnership operations, such as an increase in rental income or fair market value of partnership property. With a combination of patience and chutzpah the existing partners might be able to have their cake and eat it too. VII. PARTNER ACQUIRES PARTNERSHIP INTEREST BY CONTRIBUTION OF APPRECIATED PROPERTY TO PARTNERSHIP 1.
Additional Facts
The facts are the same as the basic facts in Section II on pages 1 & 2, and Harpo contributes property with a fair market value of $60,000 and a basis of $40,000 to the partnership in exchange for a 40% interest in the partnership. 2.
Is the Transaction Taxable? a.
General Rule
IRC Section 721(a) applies with equal force to the contributions of appreciated property. Therefore the contribution transaction is not taxable under the general rules for partner contribution. b.
Debt Allocation Rules
Because Harpo becomes a 40% partner by the contribution, all the problems and possible solutions arising from the debt allocation rules described above at Section IV.3 and 4 at page 5 and ff apply in this situation as well. 13
3.
The Hypothetical Post Contribution Sale a.
Appreciation in Contributed Property
Section 723 gives the partnership a basis in the contributed property equal to Harpo’s basis. Because the § 704(c)(1)(A) pre-contribution allocation rules are mandatory, the pre-contribution gain will always be allocable to Harpo, regardless of whether or not the partnership uses the 704(b) Capital Accounts Method of Accounting. b.
Remaining Partnership Property
The tax problems and potential solutions from the remaining partnership income in the hypothetical sale remain the same as discussed at Section IV.5 at page 7 and ff. 4.
Other Concerns of Contributing Partner
In the absence of contractual provisions, Harpo as only a 40% partner will lose future control over distribution of the contribution property. This loss of control could cause future tax problems in at least two circumstances. First of all the partnership might seek future liquidity by selling one of its properties. If the partnership selects Harpo’s contributed property, because of the Section 704(c)(1)(A) mandatory pre-contribution gain allocation, more of the tax gain on property liquidation would fall on Harpo than would happen if other partnership property were liquidated instead. A second problem transaction would be the distribution of the contributed property to another partner. Generally, under Section 731, the distribution would be tax free to the distributee partner. However, under 704(c)(1)(B) Harpo would have to recognize taxable income up to the amount of the pre-contribution gain if the distribution transaction occurred within seven years of the contribution to the partnership. Negotiating contractual provisions limiting the ability of the partnership to conduct such transactions harmful to Harpo, or at least a preferential cash distribution to enable Harpo to pay the extra taxes imposed on him should therefore be a part of the partnership admission process whenever appreciated property is contributed. 5.
Other Characteristics of Contributed Property
Under Section 1223(1) and (2), Harpo’s pre-contribution holding period tacks on to the partnership’s holding period of the property. Under Section 168(i)(7) the pre-contribution depreciation method and schedule becomes the partnership’s depreciation method and schedule for the contributed property as well. As a general rule the character of the property becomes the character for which the partnership holds the property and loses its previous character while Harpo held it. (See Tax Management portfolio #711, Partnerships – Formation and Contributions of Property or Services, pg. A-17 and the authorities cited therein). However, Section 724 creates some exceptions to this general rule by retaining the taint of the contributing partner’s characterization of contributed property for unrealized receivables, inventory items and depreciated assets. The taint remains for five years for both inventory property and capital loss property. Thus Section 724 imposes a delay, but not an outright ban on a dealer changing dealer’s ordinary income property to capital gain property by contribution to a real estate investing partnership, or an investor converting a capital loss to an ordinary loss by contribution of investment property to a dealer partnership. 14
VIII.
1.
PARTNER ACQUIRES PARTNERSHIP INTEREST BY CONTRIBUTION OF APPRECIATED PROPERTY SUBJECT TO DEBT TO PARTNERSHIP
Additional Facts
The facts are the same as the basic facts in Section II on page 1, and Harpo contributes property with a fair market value of $110,000 and a basis of $40,000 subject to $50,000 of nonrecourse debt to the partnership in exchange for a 40% interest in the partnership. 2.
Is the Transaction Taxable? a.
General Rule
Section 721(a) makes no distinction for encumbered property. Therefore the contribution transaction is not taxable under the general rules for partner contribution. b.
Debt Allocation Rules
Because Harpo is both being relieved of debt as encumbered property transferor, and acquiring a share of partnership debt as incoming partner, a two step analysis is necessary under Sections 752 and 731. The first step analysis is as follows: Basis of property contributed
40,000
Deemed cash distribution under Section 752
50,000
Basis (or potential Gain)
$
The second step is as follows: Partner share of contributed non-recourse debt: Reg. § 1.752-3(a)(1)
-0-
-3(a)(2) (50,000-40,000)
10,000
-3(a)(3) 40% X (50,000-10,000)
16,000 26,000
Share of remaining partnership debt (per page 7) (40% X 60,000)
24,000
Total share of partnership debt
$50,000
Fortunately for Harpo Reg. § 1.752-1(f) allows the netting of the deemed distributions and deemed contributions resulting from debt allocations to determine whether the transaction is
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taxable. The netting gives Harpo a $40,000 positive basis in his partnership interest and no gain on the contribution transaction even though he contributed liabilities in excess of basis. Contribution to a partnership, then, becomes a tempting transaction for disposal of assets with liabilities in excess of basis. The transaction works quite well in a conventional LLC arrangement. Because the other members have no personal liability for LLC debt, the contributed debt is either personal to the contributing partner or non-recourse to everyone. In either case enough debt is allocated to the contributing partner to avoid gain on the transaction. Success is not so certain in traditional partnerships where at least some of the partners are allocated significant shares of the contributed debt. (The same uncertain result can occur in LLCs where partners make pro rata or cross-guarantees, have limited deficit capital account make up provisions, etc.) In these situations one must check the numbers to insure that the post debt allocated to the contributing partner is sufficient to absorb the deemed cash distribution resulting from the partnership absorption of debt in excess of basis of the contributed asset. 3.
The Hypothetical Post Contribution Sale
This situation should produce the same results as discussed at Section IV.5 at page 7 and ff. 4.
Other Concerns of Contributing Partner
In the absence of contractual provisions, as a 40% partner Harpo has lost control over the timing of the repayment of the underlying debt. A repayment of the debt on which Groucho is personally liable will have no effect on Harpo’s basis. A dollar repayment on contributed debt will reduce Harpo’s basis by $0.51 (26,000 ÷ 51,000). A dollar repayment on other partnership debt will reduce Harpo’s basis by $0.40, (or $0.05 if the partnership had a minimum gain charge back provision). Harpo could run out of basis or even be deemed to receive taxable cash distributions much sooner than originally planned, absent some control or influence over debt repayment. 5.
Disguised Sale Rules
When and why did Harpo encumber the contributed property? Reg. § 1.707-5(a) treats partnership assumption or taking property subject to a liability as a sale except for qualified liabilities. Reg. § 1.707-5(a)(6) defines qualified liabilities as basically a liability incurred more than two years prior to execution of a written commitment to contribute the property to the partnership, or a liability not incurred in anticipation of contribution of the property to the partnership. Liabilities incurred within two years of the contribution are presumed to be in anticipation of the transfer. Thus Harpo would need foresight and planning if he wanted to accomplish any tax free cash out of his investment prior to contribution to the partnership.
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IX.
DEPRECIABLE ASSET ISSUES
A final issue3 for consideration in new partner admissions is how the partnership makes allocations of depreciation and related deductions in connection with pre-contribution gain property. Section 704(2)(1) requires such special allocations of all partnerships, and Reg. § 1.704-3 sets forth the rules for such special allocations (“704(c) allocations”). Reg. § 1.7041(b)(2)(iv)(f) also requires partnerships electing bookups (see outline Section IV.5.b at page 9) to follow these rules with respect to depreciation and related deductions for depreciable asset bookups (“reverse 704(c) allocations”). (In a book up the existing partners are comparable to pre-contribution gain contributing partners and the income partner is comparable to a noncontributing partner). Reg. § 1.704-3 theoretically authorizes any reasonable method, but describes only the following three methods as reasonable: •
Traditional method
•
Traditional method with current allocations
•
Removal method
A detailed analysis of these methods is beyond the scope of the outline. A brief summary of each method is as follows: 1.
Traditional Method.
Depreciation based on the fair market value of the property on date of contribution or bookup (book depreciation) is considered allocated to the partners according to the partnership agreement. Tax depreciation is calculated on the Federal Adjusted Basis of the property and allocated first to the non-contributing partners up to their share of book depreciation. The goal is to minimize the book/tax disparity among partners by increasing the non-contributing partners’ share of anticipated ultimate asset disposal gain by excess depreciation deduction allocations now. The traditional method contains a ceiling rule which limits the special allocations to non contributing partners each year to actual tax depreciation of the asset. Thus the traditional method usually favors the contributing partner because it provides for the lowest annual amount of special allocation of partnership deductions away from the contributing partner. 2.
Traditional Method with Current Allocations
This method is the same as the Traditional Method except that the partnership allocates other income and tax deduction items in addition to tax depreciation away from the contributing partner and to the non-contributing partners to insure that the total of such special allocation is 3
Another set of issues beyond the scope of this outline concern new partner admissions after the beginning of a partnership year. Major topics include a hard close of partnership books on date of admission versus pro rata allocation of the entire partnership year results based on time as a partner, and acceleration or delay of major partnership transactions to include or exclude the new partner in them. For a good discussion of these issues, see Kling and Sloan, 712 2nd T.M. – Partnerships – Taxable Income: Allocation of Distributive Share; Capital Accounts. IIF2-Methods of Allocating Partnership Items to Entering Partners at page A-16 & ff.
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equal to the book depreciation allocable to the non-contributing partners. Usually then, deductions equal to the full amount of depreciable pre-contribution gain will have been allocated to the non contributing partners by the time the asset is fully depreciated for book purposes. Thus, this method is more favorable to non-contributing partners and less favorable to contributing partners. 3.
The Remedial Method
This method is essentially the same as the previous method with an enhanced calculation of book depreciation. Under this method book depreciation is calculated as the actual tax depreciation plus additional depreciation if the depreciable pre-contribution gain (or book up) were a newly acquired tax depreciable asset. This calculation usually produces the greatest difference between book and tax depreciation. Therefore, this method is the most favorable to non contributing partners and least favorable to contributing partners. Generally a partnership can use different methods for different assets as long as a single method is consistently applied to the same asset (Reg. § 1.704-3(a)(2)). A partnership is also not required to use the same method for a bookup to calculate reverse 704(c) adjustments, even if the bookup invokes assets already subject to one method as pre-contribution gain property. Moreover, a partnership may use a different method for each book up. Therefore, over time, various properties may have layers of pre-contribution and/or book up gain subject to different 704(c) allocation methods. All this flexibility creates a number of issues for an incoming partner. There is nothing an incoming partner can do with respect to the method the partnership uses for pre-admission pre-contribution gain property other than to be aware of the effect that method has on the incoming partner. If the partnership is doing a book up in connection with the new partner admission, then the new partner is effectively the non-contributing partner with respect to assets booked up, and should seek the Remedial Method for book up adjustments. The existing partners are essentially contributing partners and would prefer the Traditional Method. If the incoming partner is contributing appreciated property the roles are reversed with respect to the new contributed property. Thus there can be a lot of provisions to be negotiated in this area. Once again, the key is to identify these issues and deal with them as part of the partnership admission transaction. Otherwise the default provision contained in the partnership agreement[see e.g., Exhibit A, section 2.1.6] will control the situation. X.
CONCLUSION
In new partner admission situations you should: • Watch for hidden tax consequences resulting from shifts in debt allocation among partners and resulting basis changes and possible income recognition. • Do a post-admission hypothetical asset sale and cash distribution calculation to ferret out potential future tax problems. •
In a contribution to partnership transaction, seek a book up if appropriate.
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•
In a cross purchase from existing partners, seek a 754 election if appropriate.
• Pay attention to the partnership’s 704(c) and reverse 704(c) adjustment methods and seek changes where appropriate. •
Watch for traps and opportunities in the Disguised Sale Rules.
• Consider post-admission limitations on debt repayment and asset disposals if the incoming partner contributes property subject to debt. • Admission price is the ultimate solution. Identified but unresolvable tax problems can be dealt with, at least approximately, by a price adjustment if no other solution is available.
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Exhibit A 1.
Establishment and Maintenance of Capital Accounts.
1.1 Capital Account Maintenance. A separate Capital Account shall be maintained for each Unit Holder throughout the term of the Company in accordance with Section 1.704-1(b)(2)(iv) of the Regulations. 1.1.2 Adjustment of Capital Account to Fair Market Value. The book value of all Company properties shall be adjusted to equal their respective gross fair market values, as determined by a Super Majority Interest as of the following times: (1) in connection with the acquisition of an interest in the Company by a new or existing Member for more than a de minimis capital contribution; (2) in connection with the liquidation of the Company as defined in Regulation Section 1.704-(1)(b)(2)(ii)(g); or (3) in connection with a more than de minimis distribution to a retiring or a continuing Member as a consideration for all or a portion of his or its interest in the Company. In the event of a revaluation of any Company assets hereunder, the Capital Accounts of the Member shall be adjusted, including continuing adjustments for depreciation, to the extent provided in Regulation Section 1.704-(1)(b)(2)(iv)(f). 1.1.3 Compliance with Regulations. The manner in which Capital Accounts are to be maintained pursuant to Section 1.1.1 is intended to comply with the requirements of Code Section 704(b) and the Regulations promulgated thereunder. If, in the opinion of the Company’s legal counsel or accountants, the manner in which Capital Accounts are to be maintained pursuant to the preceding provisions of Section 1.1.1 should be modified in order to comply with Code Section 704(b) and the Regulations thereunder, then, notwithstanding anything to the contrary contained in the preceding provisions of Section 1.1.1, the method in which Capital Accounts are maintained shall be so modified; provided, however, that any change in the manner of maintaining Capital Accounts shall not materially alter the economic agreement between or among the Members. 2.
Special Allocations. 2.1
The following Special Allocations shall be made for any taxable year:
2.1.1 Nonrecourse Liabilities; Minimum Gain Chargeback. If there is a net decrease in Company Minimum Gain during any Company fiscal year, each Member shall be specially allocated items of Company income and gain for such year (and, if necessary, subsequent years) in an amount equal to such Member’s share of the net decrease in Company Minimum Gain, determined in accordance with Regulation Sections 1.704-2(f) and 1.7042(g)(2). The items to be so allocated, and the manner in which those items are to be allocated among the Members, shall be determined in accordance with Regulation Sections 1.704-2(f) and 1.704-2(j)(2). This Section is intended to satisfy the minimum gain chargeback requirement in Regulation Section 1.704-2(f) and shall be interpreted and applied accordingly. 2.1.2 Nonrecourse Liabilities; Member Minimum Gain Chargeback. If there is a net decrease in Member Minimum Gain during any Company taxable year, each
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Member who has a share of that Member Minimum Gain, determined in accordance with Regulation Section 1.704--2(i)(5), shall be specially allocated items of Company income and gain for such year (and, if necessary, subsequent years) in an amount equal to such Member’s share of the net decrease in Member Minimum Gain, determined in accordance with Regulation Sections 1.704-2(i)(4) and 1.704-2(i)(5). This Section is intended to satisfy the minimum gain chargeback requirement in Regulation Section 1.704-2(i)(4) and shall be interpreted and applied accordingly. 2.1.3 Qualified Income Offset. In the event that any Member unexpectedly receives any adjustments, allocations, or distributions described in Regulation Sections 1.704-1(b)(2)(ii)(d)(4), (5) or (6), items of Company income and gain shall be specially allocated to such Member in an amount that eliminates, as quickly as possible, to the extent required by Regulation Section 1.704-(1)(b)(2)(ii)(d), any Deficit Capital Account of the Member (which Deficit Capital Account shall be determined as if all other allocations provided for in this Section have been tentatively made as if this Section did not exist). 2.1.4 Nonrecourse Deductions. Nonrecourse Deductions shall be allocated among the Members in accordance with their respective Percentage Interests. 2.1.5 Member Nonrecourse Deductions. Any Member Nonrecourse Deductions shall be specially allocated among the Members in accordance with Regulation Section 1.704-2(i). 2.1.6 Mandatory Tax Allocations With Respect to Contributed or Revalued Property. In accordance with Code Section 704(c) and Regulation Section 1.704-3, income, gain, loss and deduction with respect to any property contributed to the capital of the Company or revalued by the Company in accordance with Section 4.6.2 shall, solely for tax purposes, be allocated among the Members so as to take account of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its fair market value at the time of contribution or revaluation, as the case may be. The allocation method used by the Company with respect to such contributed or revalued property shall be the “traditional method” under Regulation Section 1.704-3(b). Allocations pursuant to this provision are solely for purposes of federal, state, and local taxes and shall not affect or in any way be taken into account in computing any Member’s Capital Account or share of Net Profit, Net Loss, or other items as computed for book purposes, or distributions pursuant to any provision of this Agreement. 2.1.7 Section 754 Adjustments. To the extent an adjustment to the adjusted tax basis of any Company asset pursuant to Code Sections 734(b) or 743(b) is required, pursuant to Reg § 1.704-1(2)(b)(iv)(m), to be taken into account in determining the Members’ Capital Accounts, the amount of such adjustment to the Members’ Capital Accounts shall be treated as an item of gain (if the adjustment increases the basis of the asset) or loss (if the adjustment decreases such basis), and such gain or loss shall be specially allocated to the Members in a manner consistent with the manner in which their Capital Accounts are required to be adjusted pursuant to such Section of the Regulations.
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3.
Winding Up and Liquidation.
3.1 Winding Up, Liquidation and Distribution of Assets. Upon dissolution, the Members shall immediately proceed to wind up the affairs of the Company. The Members shall sell or otherwise liquidate all of the Company’s assets as promptly as practicable (except to the extent the Members may determine to distribute any assets in kind, in which case, the distributee Member’s Capital Account shall be adjusted pursuant to Regulation Section 1.704-1(b)(iv)(e)) and shall apply the proceeds of such sale and the remaining Company assets in the following order of priority: 3.1.1 Payment of Creditors. Payment of creditors, including Members who are creditors, to the extent otherwise permitted by law, in satisfaction of liabilities of the Company, other than liabilities for distributions to Members; 3.1.2 Reserves. To establish any Reserves that the Members deem reasonably necessary for contingent or unforeseen obligations of the Company and, at the expiration of such period as the Members shall deem advisable, the balance then remaining to be distributed in the manner provided in Section 3.1.3 below; 3.1.3 Members. By the end of the taxable year in which the liquidation occurs (or, if later, within ninety (90) days after the date of such liquidation), to the Members in proportion to the positive balances of their respective Capital Accounts, as determined after taking into account all Capital Account adjustments for the taxable year during which the liquidation occurs (other than those made pursuant to this Section 1.1.3). 3.2 No Obligation to Restore Negative Capital Account Balance on Liquidation. Notwithstanding anything to the contrary in this Agreement, upon a liquidation within the meaning of Regulation Section 1.704-1(b)(2)(ii)(g), if any Member has a Deficit Capital Account balance (after giving effect to all contributions, distributions, allocations and other Capital Account adjustments for all taxable years, including the year during which such liquidation occurs), such Member shall have no obligation to make any Capital Contribution to the Company, and the negative balance of such Member’s Capital Account shall not be considered a debt owed by such Member to the Company or to any other Person for any purpose whatsoever.
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