structuring targeted partnership tax allocations...

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Structuring Targeted Partnership Tax

Allocations: Complying With IRC 704(b)Determining Substantial Economic Effect, Distinguishing Targeted and Regulatory Allocations

Today’s faculty features:

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

THURSDAY, SEPTEMBER 26, 2019

Presenting a live 90-minute webinar with interactive Q&A

Robb A. Longman, Managing Member, Longman & Van Grack, Bethesda, Md.

David Stauber, Of Counsel, Pepper Hamilton, New York

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704(b) regulations work off a Hypothetical Liquidation model.

- This can result in phantom income, for example when there is an override but the limited partners are entitled to all of their money back before any override is paid.

Example 1, which illustrates this, is basic but extremely important.

Later in the Outline we will explore the limitations of the Hypothetical Liquidation model when the partners’ economic arrangement include a time value of money component.

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704(b) – Hypothetical Liquidation

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Facts: Money Partner (“MP”) joins in partnership with Service Partner (“SP”). The Deal is: MP receives 100% of cash distributions until all capital is returned and balance goes 80/20.

MP contributes $400 and Partnership buys 4 investments for $100 each. Partnership sells first investment for $120 and distributes the $120 to MP.

WRONG ALLOCATION – ALL GAIN ALLOCATED TO MP

MP SP Capital contribution $400 $0(Distribution) ($120) $0Income Allocation $20 $0

$300 $0

This is incorrect. If the Partnership distributed $300, The Deal provides that it should go $296 to MP and $4 to SP. So the Capital Accounts are wrong.

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Example 1 – “All Money Back” Deal



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CORRECT ALLOCATION – 80/20

MP SP

Capital contribution $400 $0

(Distribution) ($120) $0

Income Allocation $16 $4

$296 $4

Note that this results in an allocation of taxable income to SP even though SP has received no cash (“phantom income”).

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Example 1 (cont’d)



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Allocations of Net Profit and Net Loss

(A) If the Partnership has previously had a cumulative Net Profit then

(i) Net Profit shall be allocated 80% to MP and 20% to SP, and

(ii) Net Loss shall be allocated 80% to MP and 20% to SP, until cumulative allocations of Net Loss equal the cumulative allocations of Net Profit, and thereafter 100% to MP.

(B) If the Partnership has previously had a cumulative Net Loss then

(i) Net Loss shall be allocated 100% to MP, and

(ii) Net Profit shall be allocated 100% to MP until the cumulative allocations of Net Profit equal the cumulative allocations of Net Loss, and thereafter 80% to MP and 20% to SP.

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Formulaic Allocation



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A forced allocation is a simple method of properly maintaining Capital Accounts when The Deal can be described entirely in terms of cash – money in, money out.

Rather than crafting specific Profit and Loss allocations, you “force” the Capital Accounts to the right answer based on the cash deal.

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Forced Allocation – Defined



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Allocations of Net Profit and Net Loss. Net Profits and Net Losses for each Period shall be allocated so that the balance in each Partner’s Capital Account corresponds, as closely as possible, to the amount such Partner would receive as a cash distribution if the Partnership were to dispose of all of its assets for an amount equal to their Book Value, satisfy its liabilities, and distribute the remainder pursuant to [reference cash distribution section].

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Short Form Forced Allocation



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Assume same facts as in example 1.

First, make all Capital Account adjustments other than the income allocation. The result is referred to as the “Partially Adjusted Capital Account” (“PACA”).

PACAMP SP

Capital Contribution $400 $0(Distribution) ($120) $0

$280 $0

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Example 2 – Forced Allocation



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Second, determine how much each Partner would receive under The Deal if the Partnership liquidated at book value and made distributions under the cash distribution section. This is the “Target Capital Account” (“Target”).

The Forced Allocation is the one that causes the Capital Accounts to equal the Target Capital Accounts

In this case we know that the Targets are $296 for MP and $4 for SP.

We back into the correct allocation by forcing the PACA to the Target.

MP SP PACA Balance $280 $0Forced Income Allocation $16 $4Target $296 $4

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The “Cash Chase with Catch-up” method can be used to avoid the phantom income problem created by the income allocation in examples 1 and 2. The cash chase method allocates income (other than income in the liquidating year) to SP only when SP receives cash.

Assume the same facts as in example 1:

Capital Accounts after Year 1

MP SP Capital contribution $400 $0(Distribution) ($120) $0Income Allocation $20 $0

$300 $0

As shown in Example 1, SP’s Capital Account here is lower than The Deal. This is fixed with a “catch-up” allocation to SP prior to liquidation in order to bring SP’s Capital Account to the correct answer for The Deal. This catch-up allocation would typically be a forced allocation.

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Example 3 – Avoiding Phantom Income –Cash Chase with Catch-up at End



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Catch-up Allocation:

Assume that the Partnership liquidates and sells the remaining investments for $330:

MP SPPACA $300 $0Income Allocation $20 $10Target $320 $10

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The problem with this method is that SP bears the risk that there will not be enough remaining income to force the Capital Accounts to the correct result.

Assume that the Partnership liquidates and sells its remaining investments at book value ($300). There is no income to allocate so the Capital Accounts would be:

MP SP Balance $300 $0Income Allocation $0 $0

$300 $0

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The 704(b) regulations generally do not include time value of money concepts.

The Hypothetical Liquidation model assumes that the capital account balances at the end of any year will continue to represent the partners’ economic arrangement even if the liquidation occurs at a later time.

This model is simply inaccurate in many transactions where the general partner must clear a “hurdle” or Internal Rate of Return before receiving the override.

- As shown earlier, profit earned but not distributed may be allocated to the general partner’s capital account. Since the money, however, was not actually distributed these capital account balances can become inaccurate merely with the passage of time.

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Time Value of Money Problems



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The Deal: Distribution-driven deal--MP receives return of all capital plus 10% IRR, and balance goes 80/20.

MP contributes $300 to Partnership and Partnership buys 3 properties for $100 each. In year 1, Partnership sells investment 1 for $150 and distributes $150 to MP.

YEAR 1 CAPITAL ACCOUNTS

MP SPCapital contribution $300 $0Income allocation

IRR $30 --80/20 split $16 $4

Distribution ($150) $0$196 $4

We know that these Capital Accounts are right because, if we ran a hypothetical liquidation at book ($200), MP would get $196 and SP would get $4. (Of the $350 total amount realized, MP would get $300 R/C plus $30 IRR, and the remaining $20 would be split 80/20, or $16 to MP and $4 to SP.)

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Example 4 – 704(b) Regulations and the Time Value of Money



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Assume nothing happens in year 2. Are the Capital Accounts still right?

Run the 704(b) deemed liquidation at book ($200). Note that this is a distribution-driven deal that does not liquidate in accordance with Capital Accounts. So, upon liquidation, the amounts the partners receive are governed by the distribution provisions.

MP SPR/C $180* --Year 2 IRR $18 --80/20 split $1.60 $0.40

$199.60 $0.40

*To achieve its year 1 IRR, MP needed $30 (10% of $300 invested at time zero). So, of the $150 received in year 1, $30 represented MP’s IRR and the remaining $120 was return of capital. Thus, MP has $180 invested capital at the beginning of year 2.

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Cash distribution:

MP SP

$199.60 $0.40

Year 2 Opening Capital Accounts:

MP SP

$196 $4

No income to allocate. The Capital Accounts are wrong.

Was year 1 income allocated incorrectly?

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The Deal: “Deal-by-Deal” distribution. Distribution-driven.

First, 100% to MP until MP gets return of capital on all deals disposed of;

Second, 100% to MP until MP gets a 10% preferred return on deals disposed of;

Third, 80% to MP and 20% to SP.

MP contributes $1000. Partnership buys 10 investments for $100 each. At end of year 1, Partnership sells investment 1 for $200.

YEAR 1 DISTRIBUTIONSMP SP

Return of Capital $100 $010% pfd return $10 $080/20 split $72 $18

$182 $18

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Example 5 – Opposite of Phantom Income –SP Gets Cash But No Tax



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What is the correct income allocation?

What would the Partners get if the Partnership had also sold the other 9 investments the same year for book ($900) and then liquidated?

Total amount to distribute = $1100

MP SPR/C $1000 ---Pfd return $100 ---

$1100 $0

SP would get $0 on a deemed liquidation. But SP in fact receives $18 right now.

What is the correct allocation? No income to SP?!

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