tax planning for real estate, part 1 & part 2 first run ... · the economic recovery tax act of...

TAX PLANNING FOR REAL ESTATE, PART 1 & PART 2 First Run Broadcast: July 14 & 15, 2015 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) Tax considerations in real estate transactions – land development and sales, long-term ownership of commercial property, outright sales of real estate entities or like-kind exchanges – are a major component of every deal. Choosing the right entity and acquiring property in the right form can set up the deal for substantial tax savings or deferral when the property or entity is eventually sold. Getting allocations and distributions right, particularly in light of the new 3.8% tax on net investment income, is essential to ensure the parties to the transaction get the economic benefit of their bargain and are not challenged by the IRS. There are also a multitude of structures beyond Like-Kind Exchanges for deferring gain on the sale of property. This program will provide the non-tax specialist real estate attorney with a real-world guide to major tax planning considerations in real estate and related drafting tips. Day 1 – July 14, 2015:

• Tax planning considerations for real estate transactions – guidance for the non-tax specialist

• Choice of entity considerations – contributions, distributions, and eventual sales • Acquiring property in a form to minimize taxes later • Getting allocation and distribution provisions right – layered allocations, target/forced

allocations, built-in-gain (or loss) allocations • Understanding and drafting for continuing ownership, including capital shifts and other

shifts in ownership • Deductions arising from non-recourse debt and minimum gain chargebacks

Day 2 – July 15, 2015:

• Advanced Like-Kind techniques for deferring gain on the disposition of property • Techniques for using partnerships – mixing bowl partnerships, freeze partnerships,

leveraged acquisition partnerships • Installment sales and cross-purchase/redemption agreements • Capital gain planning – life after the new 3.8% tax on net investment income

Speakers: Leon Andrew Immerman is a partner in the Atlanta office of Alston & Bird, LLP, where he concentrates on federal income tax matters, including domestic and international tax planning and transactional work for joint ventures, partnerships, limited liability companies and corporations. He formerly served as chair of the Committee on Taxation of the ABA Business Law Section and as chair of the Partnership and LLC Committee of the State Bar of Georgia Business Law Section. He is also co-author of “Georgia Limited Liability Company Forms and Practice Manual” (2d ed. 1999, and annual supplements). Mr. Immerman received his B.A., magna cum laude, from Carleton College, his M.A. from the University of Minnesota, and another M.A. and his Ph.D. from Princeton University, and his J.D. from Yale Law School.

Richard R. Goldberg is a retired partner, resident in the Philadelphia office of Ballard Spahr, LLP, where he established an extensive real estate practice, including development, financing, leasing, and acquisition. Earlier in his career, he served as vice president and associate general counsel of The Rouse Company for 23 years. He is past president of the American College of Real Estate Lawyers, past chair of the Anglo-American Real Property Institute, and past chair of the International Council of Shopping Centers Law Conference. Mr. Goldberg is currently a Fellow of the American College of Mortgage Attorneys and is a member of the American Law Institute. Mr. Goldberg received his B.A. from Pennsylvania State University and his LL.B. from the University of Maryland School of Law.

VT Bar Association Continuing Legal Education Registration Form

Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name ________________________ Middle Initial____Last Name___________________________

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Tax Planning for Real Estate, Part 1

Teleseminar July 14, 2015 1:00PM – 2:00PM

1.0 MCLE GENERAL CREDITS

PAYMENT METHOD:

Check enclosed (made payable to Vermont Bar Association) Amount: _________ Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # _______________________________________ Exp. Date _______________ Cardholder: __________________________________________________________________

VBA Members $75

Non-VBA Members $115

NO REFUNDS AFTER July 7, 2015

VT Bar Association Continuing Legal Education Registration Form

Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name ________________________ Middle Initial____Last Name___________________________

Firm/Organization _____________________________________________________________________

Address ______________________________________________________________________________

City _________________________________ State ____________ ZIP Code ______________________

Phone # ____________________________Fax # ______________________

E-Mail Address ________________________________________________________________________

Tax Planning for Real Estate, Part 2

Teleseminar July 15, 2015 1:00PM – 2:00PM

1.0 MCLE GENERAL CREDITS

PAYMENT METHOD:

Check enclosed (made payable to Vermont Bar Association) Amount: _________ Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # _______________________________________ Exp. Date _______________ Cardholder: __________________________________________________________________

VBA Members $75

Non-VBA Members $115

NO REFUNDS AFTER July 8, 2015

Vermont Bar Association

CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: July 14, 2015 Seminar Title: Tax Planning for Real Estate, Part 1

Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

Vermont Bar Association

CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: July 15, 2015 Seminar Title: Tax Planning for Real Estate, Part 2

Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

PROFESSIONAL EDUCATION BROADCAST NETWORK

Speaker Contact Information

TAX PLANNING FOR REAL ESTATE, PART 1 & PART 2

L. Andrew ImmermanAlston + Bird LLP - Atlanta(o) (404) [email protected]

Brian O'ConnorVenable, LLP - Baltimore, Maryland(o) (410) [email protected]

Richard GoldbergBallard Spahr, LLP - Philadelphia(o) (215) 864-8730(m) (215) [email protected]

3054782v1 © 2012 Alson R. Martin

PROFESSIONAL EDUCATION BROADCAST NETWORK

CHOICE OF ENTITY – A FRESH LOOK;TAX & NON-TAX CONSIDERATIONS

Alson R. MartinLathrop & Gage LLP

10851 Mastin BoulevardSuite 1000

Overland Park, KS [email protected]

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I. INCOME TAX CONSIDERATIONS. 1A. Tax Rates. ............................................................................................................................1

1. Personal Income Tax........................................................................................................12. Corporate Income Tax. ....................................................................................................13. Capital Gains & Dividends Tax.......................................................................................14. Health Reform – New Medicare Taxes On High Income Taxpayers In 2013.................1

B. Relative Rates. .....................................................................................................................3C. Reasons Favoring C Corporation Status. .............................................................................4

1. Public Company Or Company Planning To Go Public. ..................................................42. Existing C Corps; Problems With Changing Status. .......................................................43. Section 1202 Small Business Stock Exclusion................................................................44. No Medicare tax for owners on employer’s retirement plan contribution (applies to Scorporation also) or employer’s payments for health, dental, vision or other types ofinsurance. .................................................................................................................................75. Use Of Losses. .................................................................................................................76. Accumulation At Lower Tax Rate...................................................................................77. Fringe Benefits For Owner-Employees. ..........................................................................78. Simple Cafeteria Plans Available In 2011; Owners Can Only Be Covered In CCorporations.............................................................................................................................8

D. Reasons Favoring Any Pass-Through (S Corporation, LLC, LLP, etc) Over CCorporation. ...............................................................................................................................11

1. No double taxation upon an asset sale, unlike a C corporation. ....................................112. Losses flow through to owners annually (up to amount of basis). ................................113. No risk of unreasonable compensation resulting in double taxation as in C corporationfor compensation paid to owner-employee............................................................................114. No accumulated Earnings Tax .......................................................................................115. Personal Holding Company Tax....................................................................................12

E. Reasons Favoring S Status Over C Corporation & Other Pass-through Entities. .............121. Ability for high income shareholder employees, active in business, to receivedividends not subject to Medicare tax from distributions from business as opposed toinvestment income. Such distributions are exempt from the new Medicare tax after 2012 onbusiness income paid as a distribution (dividend) but not on investment income paid as adistribution. ............................................................................................................................122. No Medicare Tax For Owners On Employer’s Retirement Plan Contributions (appliesfor shareholder-employees of C corporations also). ..............................................................13

F. Reasons Favoring Partnerships & Entities Taxed As Partnerships. ..................................131. Ability to avoid application of 409A for retiring partners/members by use of 736payments. ...............................................................................................................................132. Ability to avoid self-employment income tax to retiring general partners who are paidsome amount until death under 1402(a)10). ..........................................................................133. Opportunity for person buying in to obtain increased basis on entity assets through 754election and re-depreciate them. ............................................................................................134. Pass-Through Tax Desired & Owners Include Ineligible S Corporation Owner. .........135. LLPs for multistate professional firms avoid state qualification and licensing issues

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that may apply to PCs and LLCs. ..........................................................................................136. Special allocations of income to owners desired. ..........................................................137. Entity debt creates owner basis, unlike in S corporation. ..............................................138. Refinancing proceeds can be distributed income tax free. ............................................139. Multiple classes of owners permitted (applicable also for C corporations)...................13

G. 736 Payments & Service Partnership Buyouts; Planning Important; Issue As To LLCs..15H. Passive Losses, LLCs and LLPs Better Than LPs For Those Wanting Current Losses....19I. Service Firms Practicing as LLLPs....................................................................................21

1. Tax consequences of converting to an LLLP. ...............................................................212. Tax Issues In Operating LLLP.......................................................................................22

J. Reducing Self Employment (SECA) Tax. .........................................................................23K. Conclusion. ........................................................................................................................31

II. NON-TAX CONSIDERATIONS. 32A. Sole Proprietorship.............................................................................................................32B. General Partnership............................................................................................................32C. Corporation. .......................................................................................................................33D. Limited Liability Company................................................................................................34E. Limited Liability Partnership.............................................................................................34F. Limited Partnership............................................................................................................35G. Limited Liability Limited Partnership. ..............................................................................36

1. General. ..........................................................................................................................362. Professional Firms. ........................................................................................................36

H. Other Issues........................................................................................................................391. Foreign State Operations................................................................................................392. State Law Merger and Conversion of Entities. ..............................................................393. Continuity of Life/Withdrawal/Right to Dissolve. ........................................................404. Claims of Outside Creditors...........................................................................................405. State Filing Fees & Taxation. ........................................................................................416. Fiduciary Duties.............................................................................................................41

III. CHART COMPARING ENTITY CHARACTERISTICS. 44

1 ©Alson R. Martin 20103054782v1

CHOICE OF ENTITY – A FRESH LOOK;TAX & NON-TAX CONSIDERATIONS

I. INCOME TAX CONSIDERATIONS.

A. Tax Rates.

1. Personal Income Tax.

The top individual rate initially was 7% for incomes in excess of $500,000. Revenue Act of 1913,§ 2A, 38 Stat. 114, 166 (1913), which is over $10 million in today’s dollars. The top rate increasedto 67% during World War I in 1917 and reached 94% during World War II.

The Economic Recovery Tax Act of 1981 (“ERTA”) reduced top individual rate to 50%. The TaxReform Act of 1986 (“TRA”) reduced the maximum individual rate to 28%. The top rate wasincreased to 31% and then 39.6%, and then reduced to its current 35%. Assuming that the Bush taxcuts expire as scheduled, it will increase to 39.6% in 2011. The effective top marginal rate will thenbe 41% for taxpayers in states that impose state income taxes because the 3% reduction in itemizeddeductions will apply. I.R.C. § 68; Pub. L. No. 107-16, § 901.

2. Corporate Income Tax.

The corporate income tax originated in 1909, imposing a 1 % tax on corporate income over $5,000.The tax rate rose to 12% by 1918, and remained at roughly that level until the late 1930’s, when aseries of rate increases increased the top tax rate to 40% in 1942. The tax rate increased in 1951 toover 50%, and did not return to below 40% until 1988. The 34% top rate applicable in 1988 hasremained consistent with only a one percent increase in 1993 to the current 35%.

3. Capital Gains & Dividends Tax.

Special treatment for capital gains began in 1922 with an alternative tax rate of 12.5% for assetsheld for at least two years and evolved into a 50% exclusion in 1942, and increased to 60% in 1978.The net capital gain was later eligible for a special top rate of 20%, which in turn was adjusteddown to 15% with the Jobs and Growth Tax Relief Reconciliation Act in 2003. I.R.C. § 1(h)(1)(C).

The top tax rate for dividends paid by C corporations was reduced to the preferential rate for netcapital gain of 15%. The top rates for net capital gain and C corporation dividends will increase in2011 to 20% and 39.6%, respectively.

4. Health Reform – New Medicare Taxes On High Income Taxpayers In 2013.

Under current law, wages are subject to a 2.9% Medicare tax. Workers and employers pay 1.45%each. Self-employed people pay both halves of the tax (but are allowed to deduct half of thisamount for income tax purposes). Health Reform, The Patient Protection And Affordable Care Act(“PPACA”), adopts the Senate proposal to increase an employee’s share of Medicare from 1.45%by 0.9 percentage points, to a total 2.35 percent for high-income workers in 2013. The employer’sshare remains at 1.45%, making the total tax paid for high-income individuals 3.8%. That would


be added to the worker’s top marginal rate, which will rise to as much as 39.6 percent in 2011 asthe Bush tax cuts expire. The extra .9% tax is also added to the self-employment tax (SECA) and isnot deductible, increasing that tax from 2.9% to 3.8%.

An increased 3.8% Medicare tax is imposed by IRC § 1411 on investment income of individuals,trusts, and estates. Beginning in 2013, it is supposed to generate an estimated $210 billion to helpfund health care reform. This is the largest tax increase in the health reform law and raises over halfof the new revenue. It would push tax rates on capital gains and dividends to 23.8 percent in 2013for high-income people if Congress goes along with Obama’s proposal to let those rates rise to 20percent in 2011 from the current 15 percent as the Bush cuts expire. This would be the highest ratefor long-term capital gains since 1997. Overall tax rates on income from interest, annuities androyalties would rise to a maximum of 43.4 percent (39.6% + 3.8%).

The tax does not apply to trades or business income of a sole proprietor, partnership, or Scorporation. In the case of the disposition of a partnership interest or stock in an S corporation, gainor loss is taken into account only to the extent gain or loss would be taken into account by thepartner or shareholder if the entity had sold all its properties for fair market value immediatelybefore the disposition. Thus, only net gain or loss attributable to property held by the entity that isnot property attributable to an active trade or business is taken into account.

Income, gain, or loss on working capital is not treated as derived from a trade or business.However, distributions of S corporation income (dividends for state law purposes) will be subjectto this tax to the extent from investment income. Income that could be paid as salary or adistribution by an S corporation to a high-income individual would be taxed at 3.8% in either case.If it is a dividend, it is subject to a 3.8% tax but only to the extent that it is from investment income.If is compensation from a corporation, the corporation pays 1.45% and the individual pays 2.35%.If it is self-employed income, it is taxed at 3.8%. Previously, in an entity taxed as a partnership, ifsome of the income is self-employment income, then all of it is self-employment income. Thatapprently will now be different and like an S corporation. Previously, there was no bifurcation ofactive and investment income in a partnership as there can be for shareholder-employees.

Example. If in 2013 your share of an S corporation's profit is $100,000 and $80,000 of this$100,000 represents profits from the business operation, with $20,000 of profit coming fromdividends, interest and capital gains on investments held by the S corporation, no matter whetheryou're a working shareholder or a passive shareholder, you'll pay the expanded Medicare tax on the$20,000 of investment income that flows through to you if your income exceeds the $200,000 or$250,000 threshold amounts. A proposed new tax, discussed below, would apply to the $80,000amount if enacted for certain S corporations engaged in personal services.

In the case of an individual, the tax is the 3.8 percent of the lesser of net investment income(investment income less deductions allocated to producing it) or the excess of modified adjustedgross income over the threshold amount. The threshold amount is $250,000 in the case of a jointreturn or surviving spouse, $125,000 in the case of a married individual filing a separate return, and$200,000 in any other case.

Investment income is the sum of (i) gross income from interest, dividends, annuities, royalties, andrents (other than income derived from any trade or business to which the tax does not apply); (ii)other gross income derived from a trade or business is that is a passive activity (within the meaningof section 469 ) with respect to the taxpayer, or trading in financial instruments or commodities (as


defined in section 475(e)(2) per IRC § 1411(c)(2); and business to which the tax applies, and (iii)net gain (to the extent taken into account in computing taxable income) attributable to thedisposition of property other than property held in a trade or business to which the tax does notapply.

The term “net investment income” does not include any distribution from a retirement plan orarrangement described in IRC § 401(a), 403(a), 403(b), 408, 408A, or 457(b). IRC § 1411(c)(5).

Gross income does not include items, such as interest on tax-exempt bonds, veterans’ benefits, andexcluded gain from the sale of a principal residence, which are excluded from gross income underthe income tax.

For purposes of computing net earnings from self-employment, taxpayers are permitted a deductionequal to the product of the taxpayer’s earnings (determined without regard to this deduction) andone-half of the sum of the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent ofnet earnings. This deduction reflects the fact that the FICA rates apply to an employee’s wages,which do not include FICA taxes paid by the employer, whereas the self-employed individual’s netearnings are economically equivalent to an employee’s wages plus the employer share of FICAtaxes. Thus, investment income does not include amounts subject to SECA tax. IRC § 1411(c)(6).

Modified adjusted gross income is adjusted gross income increased by the amount excluded fromincome as foreign earned income under section 911(a)(1) (net of the deductions and exclusionsdisallowed with respect to the foreign earned income). IRC § 1411(d).

In the case of an estate or trust, the tax is 3.8 percent of the lesser of undistributed net investmentincome or the excess of adjusted gross income (as defined in section 67(e)) over the dollar amountat which the highest income tax bracket applicable to an estate or trust begins.

The tax does not apply to a non-resident alien or to a trust all the unexpired interests in which aredevoted to charitable purposes. IRC §1411(e). The tax also does not apply to a trust that is exemptfrom tax under section 501 or a charitable remainder trust exempt from tax under section 664.

The tax is subject to the individual estimated tax provisions. The tax is not deductible in computingany income tax.

B. Relative Rates.

The relative rates are important for choosing among the various entity types that are available. Thebasic choice for tax purposes is between the pass-through treatment for partnerships and Scorporations and the potential lower rates (except for personal service corporations) and double taxof the C corporation. Prior to TRA 1986, most businesses, especially profitable ones, wereconducted through C corporations.

The primary reason for many closely-held businesses choosing this form of entity was that the Ccorporation marginal rates were significantly lower than those for individuals. Prior to ERTA, TheEconomic Recovery Tax Act of 1981, the top corporate and individual rates were 46% and 70%,respectively; ERTA reduced the top individual rate to 50%. TRA 1986 lowered the top marginalindividual income tax rate to 28%, and the top corporate rate was 34%. For the first time since1913, closely-held businesses electing pass-through status could pay less tax on income passedthrough from an S corporation or partnership, as well as avoiding the potential second tax thatwould have been triggered by the distribution of those earnings from the entity if it were a Ccorporation.


The 1986 changes fueled the popularity of pass-through entities. As a result of the 1986 changes,the trend has been toward pass-through taxation, through the use of partnerships or entities taxedlike partnerships or S corporations. In the former category are limited liability companies andactual partnerships (general partnerships, limited partnerships, limited liability partnerships, and insome states, limited liability limited partnerships) that have not elected to be taxed as corporations.In the S corporation category are state law corporations that have made the S election as well aslimited liability companies and partnerships that have elected both to be treated as S corporations. Scorporations have represented a majority of all corporate returns and remained very popular amongthe pass-through entities. One, reason has been the ability to make S distributions (state lawdividends) without Medicare tax that would apply if the amounts were paid in addition tocompensation over the Social Security Wage base. A second reason is the ability to avoid doubletaxation on the sale of assets.

C. Reasons Favoring C Corporation Status.

1. Public Company Or Company Planning To Go Public.

The largest category of entities that are taxed as C corporations is publicly-traded entities. Most ofthese entities have many more than the maximum 100 shareholders that are allowed forcorporations to elect S status, and are per se corporations; therefore, they are not eligible to electout of corporate status in order to achieve partnership treatment. Widely held partnerships(including limited liability companies not electing to be treated as corporations) have only slightlymore flexibility. If any of their interests are “traded on an established securities market” or “readilytradable on a secondary market (or the substantial equivalent thereof),” then, with limitedexceptions, they too will be taxed as corporations. I.R.C. § 7704(a) & (b). There are exceptions forpartnerships whose gross income consists at least 90% of “qualifying income” (interest, excludingfinancial or insurance business interest, dividends, real property rents and gains, mineral or naturalresource income and commodities income in certain circumstances). Id. There is also an exceptionfor certain electing 1987 partnerships. I.R.C. § 7704(g).

2. Existing C Corps; Problems With Changing Status.

In addition, there are a number of corporations that had C status prior to TRA 1986, and have notconverted to some form of pass-through entity because converting from corporate to partnershipstatus will be treated as a liquidation and trigger two levels of taxation, one at the entity level andone at the individual level. See I.R.C. §§ 336(a), 331(a). Other C corporations that could qualify forS corporation status have in some cases not converted because of the built-in gains tax. This taxeffectively imposes a double tax regime on all gain that is “built-in” as of the beginning of thecorporation’s first taxable year as an S corporation. It only lasts for a period of 10 years (7 years fortaxable years beginning in 2009 and 2010), and only applies to recognized built-in gains in excessof recognized built-in losses during that period. See I.R.C. § 1374(d)(2) & (7). There arecircumstances, often involving accounts receivable for cash basis taxpayers and inventory, wherethe potential cost of converting to S status under the built-in gains tax is for some not worth themore uncertain benefits of the single-tax S corporation. There are also circumstances where thesingle class of stock, shareholder eligibility, and excluded corporation requirements of Scorporation status prevent the conversion of C corporations. See I.R.C. §§ 1361(b)(1)(B)-(D), (2).

3. Section 1202 Small Business Stock Exclusion.


In order to qualify for the section 1202 exclusion, the entity issuing the stock must qualify as a Ccorporation “during substantially all of the taxpayer’s holding period for such stock.” See I.R.C. §1202(c)(2)(A). Thus, an individual forming a business, or investing substantial funds in it, alwaysneeds to balance the somewhat more favorable combined income/self-employment top marginal taxrates for S corporations against the benefits of this exclusion, which is only available to Ccorporations.

There is a 5 year holding requirement.

Until February 18, 2009, the exclusion was 50% of any gain from the sale or exchange of qualifiedsmall business stock held for more than 5 years but that percentage was raised to 75% for stockacquired after February 17, 2009 and before January 1, 2011 For purposes of calculating eligiblegain under this provision, pre-contribution gain on property used to acquire the qualified smallbusiness stock, or contributed to the capital of the C corporation, is excluded. See I.R.C. § 1202(i).HR 4853, the "Middle Class Tax Relief Act of 2010" and "Tax Relief, Unemployment InsuranceReauthorization, and Job Creation Act of 2010" increased the exclusion to 100% for all qualifiedsmall business stock issued after September 27, 2010, and before January 1, 2012, which is held fora minimum of 5 years.

In order to qualify as “qualified small business stock,” stock must be issued after August 10, 1993directly to the selling taxpayer at original issue in exchange for money or other property (other thanstock) or services (other than as an underwriter of the qualified small business stock). See I.R.C. §1202(c)(1). If a taxpayer is acquiring stock that would otherwise qualify, except for the fact thatsome of the consideration is ineligible stock or services, then the taxpayer should split the acquiredstock into two blocks. If qualified small business stock is converted into other stock in the samecorporation, the new stock shall be treated as such and as having been held during the period theconverted stock was held. See I.R.C. §1202(f).

At issuance, the corporation itself must be a “qualified small business.” Thus, it must be a domesticcorporation that has not had more than $50 million of aggregate gross assets since August 10, 1993and will not surpass that amount “immediately after the issuance.” In addition, the corporation mustagree to submit reports to the Secretary and shareholders as required. See I.R.C. § 1202(c)(1), (d).

“During substantially all of the taxpayer’s holding period for such stock,” the corporation must beactively engaged in the conduct of one or more qualified trades or businesses. This means that 80%(by value) of the assets of the corporation must have been used in such active conduct, though thereare special rules for start-up activities, research and experimental expenditures, and in-houseresearch expenses. See I.R.C. § 1202(e)(1).

Qualified trades or businesses exclude the following: (a) health, law, engineering, architecture,accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerageservices or any other trade or business where the principal asset is the reputation or skill of one ormore of its employees; (b) banking, insurance, financing, leasing, investing or similar businesses;(c) farming; (d) production or extraction of depletable resources and; (e) hotels, motels, restaurantsand similar businesses. See I.R.C. § 1202(c)(3). Additionally, the corporation cannot be a DISC orformer DISC, a possessions corporation (or the parent of one), a regulated investment company, areal estate investment trust, a REMIC or a cooperative. See I.R.C. § 1202(e)(4).


Not more than 10% of the value of the corporation’s net assets in excess of liabilities can consist ofstock or securities of other non-subsidiary corporations. See I.R.C. § 1202(e)(5)(C). Presumably,bank accounts do not constitute “securities in other corporations,” and corporations with low networth would be well advised to stay away from any investments in other corporations.

Not more than 10% of the corporation’s total assets, by value, can consist of real property not usedin the active conduct of its business, which, in turn, cannot consist of “ownership of, dealing in, orrenting of real property.” See I.R.C. § 1202(e)(7).

After an initial start-up period of two years, no more than 50% of the assets of the corporation canconsist of cash. See I.R.C. § 1202(e)(6).

There are requirements relating to redemptions. First, during the four-year period surrounding theissuance of such stock (two years before and two years after), the corporation cannot have “directlyor indirectly” redeemed more than $10,000 worth or 2% of the outstanding stock owned by thetaxpayer and related persons. See I.R.C. § 1202(c)(3)(A); Treas. Reg. § 1.1202-2(a). Second,during the two-year period surrounding issuance (one year before and one year after), thecorporation cannot have redeemed stock valued in excess of 5% of the aggregate value of all of thecorporation’s stock as of the beginning of such two-year period. Note that this could be a problemif the value of the stock increases dramatically during that period. In addition, the rule could beviolated even before the taxpayer purchases his or her stock. For purposes of both of the foregoingrequirements, transfers of stock by shareholders to employees or independent contractors areignored, notwithstanding the fact that they may be treated as the acquisition and reissuance of thestock by the corporation under section 83 of the Code. See Treas. Reg. § 1.1202-2(c).

In addition, there are exceptions for stock redeemed upon termination of employment, death,disability and divorce. See Treas. Reg. § 1.1202-

All of these requirements are apparently intended to prevent the indirect sale of stock by oneshareholder to a new shareholder, thereby defeating the “original issuance” requirement describedabove. These rules require constant monitoring.

In addition to the C corporation and five-year holding period requirements, the section 1202exclusion is also subject to some monetary limits. However, the limits are fairly generous. At aminimum, at least $10 million gain is eligible on a cumulative basis for each corporation in whichthe taxpayer invests.1 Thus, taxpayers should be entitled to at least up to $7.5 million of exclusionfor investments made in a qualified small business stock of any given corporation between now andJanuary 1, 2011. Moreover, even this limit is increased so that the taxpayer’s entire gain will beeligible for the partial (or possibly complete) exclusion unless his or her return on investment isgreater than 10 to 1. See I.R.C. § 1202(b)(1).

Although the current rule is that only 7% of the excluded gain will be treated as a tax preference forAMT purposes, this provision expires on December 31, 2010, at which point the preference will beincreased to 28% for stock acquired after December 31, 2000, and to 42% for stock acquired beforethat. See I.R.C. § 57(a)(7); Pub. L. No. 108-27 § 303(b)(3)(A)-(B), as amended by Pub. L. No. 109-222 § 102. Here again, however, President Obama has proposed eliminating this preferenceentirely.

In conclusion, section 1202 stock is unlikely to offset the benefits of a single level of tax in a pass-

1 There is parent-subsidiary but not brother-sister, aggregation. See I.R.C. § 1202(d)(3).


through entity upon sale unless (a) a stock sale or tax-free reorganization is the more likely form ofdisposition or (b) tax at the corporate level upon sale will not be a significant issue for some otherreason (e.g., substantial net operating loss carryforwards). In those circumstances where coupling Ccorporation status with the section 1202 exclusion might be beneficial, an analysis of the after-taxresults of ongoing operations as a C corporation vs. S corporation/partnership should be made,along with a careful determination of whether the technical requirements of small business stockqualification can be satisfied with a reasonable level of certainty.

4. No Medicare tax for owners on employer’s retirement plan contribution (applies to Scorporation also) or employer’s payments for health, dental, vision or other types ofinsurance.

For married owner making $250,000 or more with a retirement plan contribution of $49,000, thiswill be an annual savings of $1,862 per owner [3.8% times $49,000] as opposed to any other entity.

5. Use Of Losses.

Owners may prefer to accumulate losses at the corporate level so that they can be used to shelterincome at the entity level later.

6. Accumulation At Lower Tax Rate.

There are also small businesses (not, however, personal service corporations (“PSCs”), i.e., thoseengaged in health, law, engineering, etc. that are taxed at a flat 35% federal rate) that would preferto accumulate up to $50,000 a year at the low 15% rate (I.R.C. § 11(b)(1)(A), (2) for use in thebusiness, despite the fact that there may be an additional second tax sometime in the future ondividends or sale of assets. This may be easier to accomplish in settings where compensation islow enough so that it can be adjusted to prevent corporate income from hitting the 25% ($50,001-$75K), 34% ($75,001-$100K) and 39% ($100,001- $335K) rates.

This advantage must be weighed against the disadvantage of double tax on dividends or sale ofassets and liquidation.

7. Fringe Benefits For Owner-Employees.

There are also other situations, including professional service corporations, where the majority ofthe available cash is paid out in taxable compensation, and the treatment of certain fringe benefits isavailable only for “employees” (e.g., medical reimbursement, cafeteria plan, disability insurance,group term life insurance) is still more favorable for C corporation shareholder-employees. SeeI.R.C. §§ 1372, 79, 105, 125.

Until the advent of PPACA, this differential between proprietors, partners, more than 2%shareholders of S corporations and C corporation shareholder-employees was no longer applicablewith respect to health insurance. I.R.C. § 162(l). Under PPACA (ERISA 715; IRC 9815), there is anew nondiscrimination requirement for health insurance for years beginning after Sept 23, 2010,although it does not apply to any group health plan in existence on March 23, 2010 that qualifies asa “grandfathered plan.” Where the new nondiscrimination requirement does apply, it can likely beavoided by the use of the new simple cafeteria plan that becomes available beginning in 2011 underCode § 125(j), thereby allowing shareholder-employees of regular C corporations (but not ownersof other entities except 2% or less shareholder-employees of S corps) to continue to enjoy


preferential health insurance benefits. However, it may be necessary for a technical amendment toadd new Code § 9815 to the list of nondiscrimination requirements that are deemed to be met.

8. Simple Cafeteria Plans Available In 2011; Owners Can Only Be Covered In CCorporations.

The health reform law includes a provision creating “simple cafeteria plans” under IRC § 125(j) forsmall businesses, effective for years beginning in 2011. Simple cafeteria plans automatically meetnondiscrimination requirements applicable to cafeteria plans if they meet minimum eligibility,participation, and contribution requirements. This safe harbor covers the regular cafeteria plannondiscrimination requirement of section 125(b), the 25% concentration test, and thenondiscrimination requirements of 79(d), 105(h), and 129(d) applicable to group term lifeinsurance, a self-insured health insurance or medical reimbursement plan, and dependent careassistance benefits (child care).

Where a business wants to avoid the 25% concentration test and contribute for owner-employees,only a regular C corporation can do so.

Under 125(h)(3), a “qualified benefit” does not include any qualified health plan as defined insection 1301(a) of the Patient Protection and Affordable Care Act or “PPACA”) offered through anExchange unless the employer is a qualified employer under 1312(f)(2) of PPACA offering theemployee the opportunity to enroll through such an Exchange in a qualified health plan in a groupmarket.

Avoiding New Health Insurance Nondiscrimination Requirements. Simple cafeteria plans,available for plan years beginning in 2011, offer a work around to the new health insurancenondiscrimination rules applicable to all employer insured plans on and after Sept. 23, 2010 otherthan grandfathered plans. In addition, these plans allow shareholder-employees and other keyemployees to benefit under the plan and be exempt from the regular cafeteria plan rule that limitsbenefits for such individuals to 25% of the total nontaxable plan benefits – the so-calledconcentration test.

Until Sept. 23, 2010, a partnership or corporation can pay 100% of family coverage for partners orshareholder-employees, and 50% of single employee coverage for staff that are not insured througha spouse. The employer can pay for and deduct insurance only for owner-employees. Thereafter,such an employer can do so only with a grandfathered plan in existence on March 23, 2010. Asimple cafeteria plan in 2011 and thereafter can get the same result if the employer is a regular Ccorporation, although will not be exactly equivalent, as formula for employer contribution will be2% (or more if desired) with all eligible employees, including the shareholders, paying forwhatever health insurance they select with pre-tax dollars.

The simple cafeteria plan eliminates the new health insurance nondiscrimination requirementbecause it automatically meets 125(b) and 105(h). Could the IRS argue that 105(h) only applies toself insured plans. Even though that new IRC 9815 incorporates 2716 of the PHSA, which in turnincorporates IRC 105(h), it does so for insured plans. So do we fail 9815 and thus simple cafeteriaplan rules if the employer does not contribute same dollar amount for each eligible employee? Dowe fail because the salary reduction contributions are treated as employer contributions where, forexample, the same benefit options are available but all HCEs buy family coverage NHCEs buy onlysingle coverage or nothing? The answer should be no to both questions, as the intent was to give apass to all nondiscrimination requirements, but a technical correction to include Code § 9815 is


needed to make that clear. Alternatively, if the regulations under 125(j) or 9815 provide that thenondiscrimination requirement is met based on eligibility rather than use of benefits, as is the caseunder 105(h), then the nondiscrimination requirement should be easy to meet.

The simple 125(j) rules give a free pass on 79, and 105(h), 125(b), and 129 (and hopefully 9815)testing for nondiscrimination, even if most health insurance costs is paid by employees, if they soelect, by salary reduction. Therefore, the simple cafeteria plan should pass testing if it offers allparticipants eligibility under the simple rules and offers the same benefits to those similarlysituated. Under 105(h), only the benefits offered are tested. All benefits provided for highlycompensated employees and their dependents are also offered for all other participants and theirdependents. Reg. §1.105-11(c)(3)(i) provides: “This test is applied to the benefits subject toreimbursement under the plan rather than the actual benefit payments or claims under the plan.”Similarly, Reg. §1.105-11(c)(3)(ii) states: “The determination of whether plan benefitsdiscriminate in operation in favor of highly compensated individuals is made on the basis of thefacts and circumstances of each case. A plan is not considered discriminatory merely becausehighly compensated individuals participating in the plan utilize a broad range of plan benefits to agreater extent than do other employees participating in the plan.”

Technique Only Available Practically For Smaller Employers Without Penalty. For businesses thathave 50 or more FTE employees, if an employee voluntarily opts out of the employer's plan andgoes to an exchange to obtain an individual subsidized health insurance plan (the subsidies go ashigh as income of $88,000 for a family of 4) then the employer has to pay a penalty for those whodon't take the plan and get a government subsidy in connection with purchasing a plan from a state-exchange. However, the benefits of the simple cafeteria plan may outweigh any penalty in certainsituations.

100 Or Fewer Employees. An employer is eligible to implement a simple cafeteria plan if, duringeither of the preceding two years, the business employed 100 or fewer employees on average(based on business days). For a new business, eligibility is based on the number of employees thebusiness is reasonably expected to employ. Businesses maintaining a simple cafeteria plan thatgrow beyond 100 employees can continue to maintain the simple arrangement until they haveexceeded an average of 200 or more employees during a preceding year. Employees include leasedemployees.

Controlled & Affiliated Service Groups One Employer. The employer aggregation rules under IRCSections 52 (applying the rules of section 1563, except “more than 50 percent” is substituted for “atleast 80 percent” in section 1563(a)(1), and subsections 1563(a)(4) and (e)(3)(C) are disregarded)and 414 (controlled and affiliated service groups) apply for purposes of determining an eligibleemployer. Additionally, an employer includes a “predecessor employer,” which term is undefined.

Simple Cafeteria Plan Eligible “Employees.” All non-excludable employees who had at least 1,000hours of service during the preceding plan year must be eligible to participate in a simple cafeteriaplan. The new rules continue the regular cafeteria plan requirement that to a participant can only bean “employee” and thus excludes partners, LLC members taxed as partners, 2% or more owners ofS corporations, and sole proprietors.

Simple Cafeteria Plan Qualified Employees. The term “qualified employee” means any employeewho is not a highly compensated employee under section 414(q) or key employee under section

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416(i) and who is eligible to participate in the plan.2 This definition of qualified employee isrelevant only to the two alternative minimum contribution requirements, discussed below, and thatHCEs and key employees may participate like everyone else so long as they are “employees” anddo not receive disproportionate employer regular or matching contributions.

Section 125(j)(3)(C) allows comparable contributions for HCEs and key employees, as it provides:Subject to subparagraph (B)(regarding matching contributions), nothing in this paragraph shall betreated as prohibiting an employer from making contributions to provide qualified benefits underthe plan in addition to contributions required under subparagraph (A). The required contributions in(A) are for “qualified employees” but the employer contributions for at least 2% of pay are for allemployees under (A)(i), not just qualified employees, and (B) indicates that matching contributionscan be made for HCEs and key employees.

Simple Cafeteria Plan Excludable Employees. Excludable employees are those who:

• have not attained age 21 (or a younger age provided in the plan) before the end of the planyear;

• have less than one year of service as of any day during the plan year;

• are covered under a collective bargaining agreement; or

• are nonresident aliens.

An employer may have a shorter age and service requirement but only if such shorter service oryounger age applies to all employees.

Employees who previously worked 1000 in a plan year but do not currently can be excluded, asemployees who do not have a year of service in the current plan year can be excluded. However,since the rule is that they can be excluded if they do not have a year of service on any day in theyear, they will have 1000 hours if they go from full time to part time at the beginning of the currentyear. This is an important point where the employee's salary is less than the health benefits. Theyshould be entitled to the entire maximum benefit if elected, even if greater than their compensationin order to safeguard simple status.

Benefit Nondiscrimination. Each eligible employee must be able to elect any benefit under the planunder the same terms and conditions as all other participants.

Minimum Contribution Requirement. The minimum must be available for application toward thecost of any qualified benefit (other than a taxable benefit) offered under the plan.

Employer contributions to a simple cafeteria plan must be sufficient to provide benefits to non-highly compensated employees (NHCEs) under 125(j)(3)(A) of at least either:

For 2010, an individual is an HCE if his or her compensation from the same employer in 2009 exceeded $110,000 or theperson is an officer, more than 5% owner, a spouse or dependent working for the same employer. For 2010, an individual isa key employee if: An officer earning more than $160,000 in the 2009 plan year; or A more than a 5% owner; or A more than a 1% owner receiving compensation in excess of $150,000 in the prior plan year. Government entities do not have Key Employees.

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(i) A uniform percentage of at least two percent of compensation (defined as it is under 414(s)for retirement plan purposes, whether or not the employee makes salary reduction contributions tothe plan; or

(ii) The lesser of a 200% matching contribution or six percent of the employee’s compensation.Under 125(j)(C), additional contributions can be made, but the rate of any matching contributionfor HCEs or key employees cannot be greater than the rate of match for NHCEs under 125(j)(B).

The same method must be used for calculating the minimum contribution for all NHCEs. The rateof contributions for key employees and HCEs cannot exceed that for NHCEs. Compensation forpurposes of this minimum contribution requirement is compensation with the meaning of section414(s).

Safe Harbor From Nondiscrimination Rules.

Simple cafeteria plans are treated as meeting the nondiscrimination requirements of IRC Section125(b), including the concentration test that currently limits key employees’ benefits to 25% of thetotal of nontaxable benefits provided for all employees under the plan.

Nondiscrimination tests applicable to individual benefits are deemed to be satisfied, including theSection 79(d) rules for group-term life insurance, the Section 105(h) rules for self-insured medicalexpense reimbursement plans, and the dependent care rules of Section 129(d)(2),(3) and (8).

These nondiscrimination rules have discouraged utilization of cafeteria plans by small businesses.For example, if a small office with two key employees and two non-key employees providedidentical dollar amounts of benefits to all employees under a cafeteria plan, the 25% concentrationtest would be failed because 50% of total benefits go to the key employees. The new simplecafeteria plan safe harbor addresses this problem but only for small employers organized astraditional C corporations since only common law “employees” and not the self employed areeligible. Multiple classes of owners permitted (applicable also for entities other than Scorporations).

D. Reasons Favoring Any Pass-Through (S Corporation, LLC, LLP, etc) Over C Corporation.

1. No double taxation upon an asset sale, unlike a C corporation.

2. Losses flow through to owners annually (up to amount of basis).

3. No risk of unreasonable compensation resulting in double taxation as in Ccorporation for compensation paid to owner-employee.

4. No accumulated Earnings Tax

For C corporations, IRC §§ 531-537 provide that from 2003 through 2010, the accumulatedearnings tax is 15 percent on earnings a corporation accumulates above $250,000 without a validbusiness purpose. The limit is $150,000 for certain personal service corporations (i.e., corporationsin the fields of health, law, engineering, architecture, accounting, actuarial science, performing artsor consulting, where the owners provide the services). In 2011, the tax rate reverts back to thehighest individual rate, which will be 39.6 percent if the law does not change. This tax does notapply to LLCs or other entities not taxed as corporations.

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This tax is designed to dissuade corporations from accumulating earnings just to avoid payingtaxable dividends. However, this tax is usually easy to avoid, for three reasons:

Earnings can be reduced to zero, through the withdrawal of earnings in deductible wayssuch as higher (reasonable) compensation for the owners.

The corporation can accumulate earnings beyond these limits, provided it can prove it has abusiness need to do so, such as payment of anticipated future operating expenses, a plannedbusiness expansion, etc.

The corporation can elect to be treated as a conduit for tax purposes, by making asubchapter S election, which eliminates this problem.

5. Personal Holding Company Tax

A regular C corporation is a Personal Holding Company (referred to as an “incorporatedpocketbook”) if at any time during the last half of the taxable year more than 50% in value of itsoutstanding stock is owned, directly or indirectly, by no more than 5 individuals. In addition, atleast 60% of the corporation’s "adjusted ordinary gross income" must consist of passive investmentincome (dividends, interest, annuities, rents, royalties (other than mineral, oil and gas, copyright, orcomputer software royalties), capital gains, etc) or from personal services performed by a majorshareholder. I.R.C. §§ 542, 543. Real estate rents do not count if they are more than 50% of theadjusted ordinary gross income but any other passive income more than 10% of AOGI must be paidout. Banks and insurance companies are not subject to the PHC tax.

When computing the personal holding company's taxable income, several adjustments are made.Net long term capital gains are excluded, the "regular income tax paid” is deducted, and the 80%dividends-received deduction is added back. The tax is not imposed on dividends paid toshareholders.

The PHC tax is 39.6%. The penalty tax of 39.6% is applicable in addition to the corporate tax. Thispenalty tax is applied to the corporate taxable income, less distributions to shareholders, incometaxes, and certain other adjustments. The tax applies to foreign and domestic companies alike, andis in addition to the regular corporate tax.

Adverse Impact On Tech Startup Licenses. This tax can apply to tech startups that licensetechnology. For example, NewDrugCo decides to license its second patent to Big DrugCo for alarge lump sum payment of $3,000,000 in hopes of using the money to develop its first patent overthe next few years. This is particularly important because the founders will own only 60% ofNewDrugCo after the angel funding and, thus, they want to avoid the need to seek venture capitalinvestment at this stage. When NewDrugCo closes the license deal with Big DrugCo,NewDrugCo will be subjected to potential penalty tax liability for 15% of “undistributed personalholding company income.” The solution of course is not to use a C corporation.

E. Reasons Favoring S Status Over C Corporation & Other Pass-through Entities.

1. Ability for high income shareholder employees, active in business, to receivedividends not subject to Medicare tax from distributions from business as opposed toinvestment income. Such distributions are exempt from the new Medicare tax after

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2012 on business income paid as a distribution (dividend) but not on investmentincome paid as a distribution.

2. No Medicare Tax For Owners On Employer’s Retirement Plan Contributions(applies for shareholder-employees of C corporations also).

F. Reasons Favoring Partnerships & Entities Taxed As Partnerships.

1. Ability to avoid application of 409A for retiring partners/members by use of 736payments.

2. Ability to avoid self-employment income tax to retiring general partners who arepaid some amount until death under 1402(a)10).

3. Opportunity for person buying in to obtain increased basis on entity assets through754 election and re-depreciate them.

4. Pass-Through Tax Desired & Owners Include Ineligible S Corporation Owner.

5. LLPs for multistate professional firms avoid state qualification and licensing issuesthat may apply to PCs and LLCs.

6. Special allocations of income to owners desired.

7. Entity debt creates owner basis, unlike in S corporation.

8. Refinancing proceeds can be distributed income tax free.

9. Multiple classes of owners permitted (applicable also for C corporations).

This 1402(a)10) exclusion for lifetime payments to retired general partners (which also applies toLLC member-managers) is not available to severance payments to shareholder-employees ofcorporations. Under IRC § 1402(a)(10) and Reg. 1.1402(a)-17(c)(1), exclusion of payments to“general partners” from self employment tax is an all-or-nothing proposition as to whetherpayments on account of retirement received by a retired partner during the tax year of thepartnership are excluded. On retirement, a “general partner” can exclude from NEFSE (incomesubject to self-employment tax) amounts received if the requirements of IRC § 1402(a)(10) andReg. 1.1402(a)-17 are met, namely:

(1) The payments must be received by the partner pursuant to a written plan of the partnership.

(2) The payments must be made on account of retirement, on a periodic basis, to partners generallyor to a class or classes of partners, with the payments continuing at least until the partner's death.These payments can be front loaded. See PLR 200403056, where most of the payments were madein the first 5 years after retirement and $100 a year thereafter.

(3) The partner must render no services with respect to any trade or business carried on by thepartnership during the tax year of the partnership in which the amounts were received.

(4) No obligation may exist as of the close of the partnership's tax year from the other partners to

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the retired partner except with respect to retirement payments under the plan.

(5) The partner's share, if any, of the capital of the partnership must have been repaid in full beforethe close of the partnership's tax year in which such amounts were received.

(6) The retired partner must have no financial interest in the partnership except for the right toretirement payments.

If payments are not made to the retired partner on a periodic basis that continue at least until thepartner's death (but rather terminate after a fixed number of years), the former general partner willinclude the retirement payments in NEFSE. If the partner has a right to a fixed percentage of anyamounts collected by the partnership after the date of retirement that are attributable to servicesrendered prior to her retirement to clients of the partnership, the payments received by her for thattax year are not excluded from NEFSE since, as of the close of the partnership's tax year, anobligation (other than an obligation with respect to retirement payments) exists from the otherpartners to the retired partner. See Reg. 1.1402(a)-17(c)(2), Example (3).

PLR 9630012 ruled that an active member in an accounting firm LLP who carries managementrights and actively participates in the accounting business of the firm will have NEFSE on his entiredistributive share of income from the firm, and that none of his income will be excluded underSection 1402(a)(13). This indicates that an active member of an LLP (which is treated as a generalpartnership for state law purposes) is neither a limited partner nor treated as a limited partner forpurposes of Section 1402. See Shop Talk, "Are Retirement Payments to Limited Partners and LLCMembers Subject to Self-Employment Tax?," 86 JTAX 62 (January 1997).

LLP General Partner Qualifies. PLR 9630012 holds that payments made on account of a retiredpartner of an LLP that meet the requirements of Section 1402(a)(10) will be excluded from NEFSE.

LLC Member Qualifies. PLR 200142004 ruled that Section 1402(a)(10) relief is available forpayments to an attorney who was a retired member of an LLC classified as a partnership for federalincome tax purposes. The LLC maintained a retirement benefit program for its members (treated aspartners for tax purposes) that provided for payments directly from the law firm to the retiree. Onretirement, the retired partner relinquishes her interest in the LLC, in exchange for the balance ofher capital account in the firm, the retirement benefits under the nonqualified retirement program,and other benefits payable under the firm's benefit plans. The retired partner is entitled to aretirement payment equal to the sum of the average of the partner's three highest distributions forany previous calendar year. The amount is paid out, without interest, in a series of monthlypayments for a period of not less than 60 and not more than 120 months. Thereafter, the retiredpartner is entitled to payments of no less than $100 per month for the rest of the partner's life.

After describing the requirements of Section 1402(a)(10) and Reg. 1.1402(a)-17, the letter rulingconcludes that the LLC's retirement program is a bona fide retirement plan within the meaning ofSection 1402(a)(10), and meets the other requirements of the statute and the Regulation. Inconnection with the requirement that the payments by a partnership must continue at least until thepartner's death, the ruling observes that although the payments by the LLC are likely to be reducedafter the initial 60–120 month period, the monthly payments thereafter will never fall below $100per month and will continue until the retired partner's death. The letter ruling is consistent with theService's position (in earlier letter rulings) involving redemptions of general partners in a generalpartnership agreement in not requiring level, equal amounts of retirement benefit paymentsthroughout the retired partner's lifetime. A step-down in the amount is permissible as long as the

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payments are retirement payments for at least the duration of the retired partner's life.

The ruling expresses no opinion as to the treatment of the payments to the retired partners underany provision of the Code other than Section 1402(a)(10).

Retirement Payments To Limited Partners. Limited partners may enjoy an exemption from NEFSEduring the period they are limited partners. Section 1402(a)(13) provides that NEFSE does notinclude the distributive share of any item of income or loss of a limited partner, as such, other thanguaranteed payments described in Section 707(c) to that partner for services actually rendered to oron behalf of the partnership to the extent that those payments are established to be in the nature ofremuneration for those services. Section 1402(a)(13) (then numbered (a)(12)) was added to theCode by P.L. 95-216, 12/20/77 (the Social Security Amendments of 1977); prior to that time, thedistributive share of income or loss received by a limited partner from the trade or business of alimited partnership was included in NEFSE, and some limited partners made passive investments inlimited partnerships solely to become insured for Social Security benefits by incurring NEFSEwhile performing no services for the partnership. See Banoff, "Tax Distinctions Between Limitedand General Partners: An Operational Approach," 35 Tax Law Review 1 (Fall 1979), pages 76-77.

However, a limited partner who actively renders services (permitted in many states without seriousrisk of unlimited personal liability, pursuant to the Revised Uniform Limited Partnership Act) andreceives Section 707(c) guaranteed payments for services determined without regard to partnershipincome will receive NEFSE. Any remaining share of income as a limited partner will not beNEFSE. Section 1402(a)(13); Reg. 1402(a)-1(b). Moreover, if the limited partner does notreceive a Section 707(c) payment, i.e., does not receive compensation determined "without regardto partnership income," but rather merely receives her distributive share of income (e.g., apercentage of net profits) for services, no portion of her compensation constitutes NEFSE.

What is the treatment of retirement payments made to a limited partner who rendered serviceswhile a partner, but who had received an allocable share of partnership net income as remunerationfor services and never received guaranteed payments for services under Section 707(c)? While apartner, such service provider would have no NEFSE pursuant to Section 1402(a)(13). Does theanswer change with respect to payments made to the (former) limited partner on retirement? If theretirement payments meet all of the aforementioned requirements of Section 1402(a)(10) and Reg.1.1402(a)-17, the payments clearly are not NEFSE. If, however, the retirement payments did notqualify for Section 1402(a)(10) treatment, the answer is less clear. Prop. Reg. 1.1402(a)-2 does notpermit a service partner in a service partnership to be a "limited partner" for purposes of Section1402(a)(13). See Prop. Reg. 1.1402(a)-2(h)(5). If this proposed rule were adopted and applicable,the pre-retirement payments to such a limited partner would be NEFSE.) No cases, rulings, orregulations under Section 1402(a)(13) deal with payments to retired limited partners.

G. 736 Payments & Service Partnership Buyouts; Planning Important; Issue As To LLCs.

Code § 736 applies to transactions treated as a liquidation (redemption) of a partner's interest in thepartnership. If a written buyout agreement and the partnership agreement of a service partnershipdo not contain any purchase price allocation for the redemption (liquidation) of a retiring partner,the net fair market value of the equipment, furniture and other tangible assets is a capital gainpayment. The partnership can make a 754 election and amortize those assets. The balance of thepayments is ordinary income because they will be characterized as relating to accounts receivableor unstated goodwill. Moreover, they are deductible to the partnership.

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IRC § 736 dictates how liquidating final payments to the retiring partner or estate are classified. Fortax purposes, the payment, whether in the form of cash or property, is considered either a paymentfor the partner's share of partnership property or something other than his or her share ofpartnership property. The purpose of the section is to ensure that retiring partners correctly classifycertain items as ordinary income.

In 1993, Congress enacted Section 736(b)(3), which curtailed the flexibility of capital partnershipsto choose the tax consequences of payments made in redemption of a partner's interest inpartnership goodwill. Prior to this legislation, Section 736(b)(2) allowed all partnerships a choicebetween treating payments for goodwill as capital or ordinary items by allowing the partnershipagreement to control the outcome. Section 736(b)(3) eliminated this choice for partnerships otherthan service partnerships. The House Ways & Means Committee reasoned that “general partners inservice partnerships do not ordinarily value goodwill in liquidating partners. Accordingly, suchpartners may continue to receive the special rule of present law.”

Service partnerships are those in which capital is not a material income producing factor. Sec.736(b)(3)(A). For this purpose, capital is not a material income producing factor wheresubstantially all the gross income of the business is derived from fees, commissions, or othercompensation for personal services performed by individuals. Thus, a professional practice of adoctor, dentist, lawyer, architect, or accountant is not treated as a trade or business in which capitalis a material income-producing factor, even though the practitioner has a substantial investment inprofessional equipment or in a physical plant constituting the professional office, so long as thecapital investment is only incidental to the professional practice. H Rept No. 103-111 (PL 103-66)p. 783.

Code Sec. 736(b)(3) provides that if capital is not a material income-producing factor and thepartner is a general partner, Code Sec. 736(b)(2) automatically applies ordinary income treatmentto the unrealized receivables and unstated goodwill. Unstated goodwill is goodwill for which thepartnership agreement contains no provision for payment.

All payments, fixed or contingent, are 736(b) payments to the extent of the value of the partner’spercentage share of the net fair market value of partnership assets. However, payments forreceivables and unstated goodwill (where there is no dollar allocation to goodwill in the operatingor purchase agreements) to a general partner in a service partnership with no allocation of value,which are treated as 736(a) payments.

Section 409A does not apply to an arrangement that provides for section 736 payments unless thearrangement provides for payments for life that qualify under 1402(a)(10), which are excludedfrom self-employment tax. See Notice 2005-1 Q&A-7.

Section 736(a)(1) payments reduce the total amount of partnership income that would otherwisehave been allocated to the remaining partners while Section 736(a)(2) payments result in apartnership-level deduction. The partnership deducts the 736(a) payments when made, which maybe before or after the income as collected by the partnership, which is when it is taxed. Paymentsfor substantially appreciated inventory and recapture items are payments for property that are

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736(b) payments but taxed under 751(b) as ordinary income.

736 & LLCs (Taxed As Partnerships). Where there is no contrary written agreement, the probablecorrect result for the treatment of a redemption of a personal service LLC member is that theredeemed member's share of the net fair market value of the LLC's assets is a capital gain paymentunder section 731 and 736(b) (and not deductible by the LLC), with the balance of the paymentbeing a guaranteed payment under 736(a), which is ordinary income to the member bought out anddeductible to the LLC.

Service LLC Members Should Not Be Treated As General Partners. The only basis for thisproposition is that a member of an LLC is not treated as a general partner of a partnership becausethe member is not a “general partner” under state law,. While the IRS has not ruled on this issue, amanager-member or a member of a member managed LLC should be treated as a general partnerfor this purpose, based on the purpose of the provision, IRS rulings in an analogous area, and fourcourt cases, all discussed below.

Service LLC Members Should Be Treated As General Partners. "At least some LLC members,particularly managers and manager-managed LLCs and probably all members and member-managed LLCs should qualify, as should almost all partners and LLPs, since LLPs generallyoperate under the same partnership acts as general partnerships, with the only difference beinglimited liability obtained by filing an appropriate document." 811 BNA T. M. Portfolio A-120(2009).

Second, 736(b) payments are by definition distributions made in exchange for the retiring member'sinterest in LLC assets, and, therefore, any payment in excess of a member's share of LLC assetscannot be treated as a Section 736(b) payment. Therefore, in the event that such a premium is paidfor a member's interest in the LLC that exceeds the value of the member's share of the LLC's assets,that premium should be treated as a Section 736(a) deductible to the extent of the value of accountsreceivable and the balance of the payment if there is no allocation in the operating agreement or aseparate agreement to goodwill.

Third, the answer lies in whether the LLC member is more like a general partner or a limitedpartner for (purposes of) Section 736(b). Understanding that basically there are only twodifferences between a general and a limited partner—unlimited liability and the right to participatein management—and understanding that a member of an LLC may have the right to participate inthe management and business of the company (like a general partner) and limited liability (like alimited partner), whether a member is treated as a general partner or as a limited partner in anygiven instance depends on which of these two characteristics is critical in treating general partnersand limited partners differently in that case.

Fourth, the reason for the carve-out for general partners in Section 736(b)(3)(B) for Section736(b)(3)(A) service organizations is the service element and not the liability element. Thus, thefact that a general partner has unlimited liability and that an LLC member has limited liability isirrelevant. Accordingly, there is no reason to treat LLC members any differently than generalpartners where the LLC members are entitled to provide services on behalf of the firm, as would alawyer for a law firm. Therefore, it is my conclusion that professional LLCs may use Section 736

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now as they have always, pursuant to Section 736(b)(3).”

Fifth, the IRS has treated an LLC member as a general partner in a similar context. On retirement,a general partner can exclude from self employment tax amounts he receives if the requirements ofSection 1402(a)(10) and Reg. 1.1402(a)-17 are met. In a private letter ruling, the IRS treated anLLC member as a general partner for this purpose. In Ltr. Rul. 200142004, Section 1402(a)(10)treatment was granted for payments to an attorney who was a retired member of an LLC classifiedas a partnership for federal income tax purposes. The retired partner is entitled to a retirementpayment for life and the other requirements of Section 1402(a)(10) and Reg. 1.1402(a)-17 weremet. The letter ruling concludes that the LLC's retirement program is a bona fide retirement plan,within the meaning of Section 1402(a)(10), and meets the other requirements of the statute and theRegulation.

Sixth, while the IRS has not yet ruled on the characterization of an unallocated liquidation paymentattributable to the self-created goodwill of an LLC, which is paid to a retiring LLC manager oractively participating LLC member. However, Treasury in the self-employment arena has inproposed regulations put LLCs and partnerships on equal footing, which indicates that the CodeSec. 736(b)(3) choice should be available to a “personal service” LLC.

Seventh, the courts have ruled that LLC members are not limited partners. Thus, if they are notlimited partners, they are general partners, which is the only other choice. The basic reason for thecourts’ holding is that unlike limited partners, LLC members can participate in the governance andoperations of the LLC. In Garnett v. CIR, 132 TC No 19, 2009 WL 1883965 (2009), andThompson v. CIR, 87 Fed Cl 728 (Fed. Cl. Ct., 2009), the Tax Court and the Court of FederalClaims rejected the Service's attempt to treat both the members of LLCs and the partners in limitedliability partnerships (LLPs) as limited partners for purposes of the passive loss rules. The courtsconcluded that, absent direct statutory or regulatory guidance, the taxpayers could not be treated assubject to the more restrictive rules applicable to limited partners under Section 469. This was alsothe result in Hegarty v. CIR, TC Summary Opinion 2009-153 and Gregg v. CIR, 186 F Supp 2d1123 (DC Ore. 2000).

Service Partnerships-Capital Not Material Income Producing Factor. In the case of a retiring ordeceased general partner of a service partnership, one in which capital is not a material income-producing factor, 736(b) payments do not include payments made for such partner's interest in thepartnership's unrealized receivables (not including recapture items) under § 751 and goodwillunless there is a specific allocation to goodwill in the partnership agreement, in which case thegoodwill payments are also § 736(b) payments. It is probably sufficient for the agreement to be in aseparate redemption agreement as well. See CIR v. Jackson Investment Co., 346 F.2d 187 (9th Cir.1965).

Section 736 gives the partners in service partnerships significant flexibility to determine whetherdistributions are deductible ordinary income payments under section 736(a) or payment for thewithdrawing partner's interest in partnership property under 736(b).

Example. Unrealized Receivables. A service partnership has three equal partners and $90,000cash, cash method receivables of $222,000, and supplies that were properly deducted whenacquired and are worth $9,000. One partner is read deemed for a payment of $107,000 in cash. The

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supplies are substantially appreciated inventory because their sale would produce ordinary incomeand their fair market value exceeds 120% of the zero adjusted basis. 751(b) treats the redeemedpartner as having received $3000 for the supplies. The redeemed partner's outside basis is $30,000,so $30,000 of cash is tax-free. The remaining $74,000 of the payment is for the receivables and istreated as ordinary income under 736(a), a guaranteed payment, and not under 751(b). Thepartnership steps up its basis in the supplies by $3000 and can take a deduction for the "purchase"of those supplies. See BNA 811 T. M. Portfolio at pages A-119 – 120 (2009).

Example. Receivables & Unspecified Goodwill.

A service partnership with three equal partners redeems one partner for $150,000. The partnershiphas $90,000 cash and cash-method receivables worth $111,000 with a zero basis. The partnershipdetermined the amount paid based on the redeemed partner's $30,000 capital account with thebalance based on an earnings formula. There is goodwill because the amount paid is in excess ofthe redeemed partner's capital account plus the partner's $37,000 share of accounts receivable. Noamount is allocated by the partnership agreement or separate agreement to the receivables orgoodwill. The $30,000 payment allocable to the partner's capital account is a 736(b) liquidationdistribution with a gain or loss determined by that amount less the partner's outside basis. Thebalance, $120,000, is a section 736(a)(2) guaranteed payment, taxed as ordinary income to theredeemed partner and deductible to the partnership. The receivables are not taxed under 751(b). Ifthe agreement had specified an amount for goodwill, it would have been a 736(b) capital paymentamortizable by the partnership over 15 years. Accounts payable and similar obligations of a cash-method partnership that have not been deducted are not liabilities. However, if they are nottransferred to the partner (who could deduct them one the partner pays them) but are taken intoaccount in determining the amount of the liquidating distribution, they reduce the ordinary incomebecause 736(b) payments come first. See 811 BNA T.M. Portfolio A-121 (2009).

Example. Service Partnership With Bank Debt

A service partnership with three equal partners redeems one partner. Neither the partnershipagreement nor any separate agreement makes any allocation of the purchase price. The partnershiphas cash and other assets look the value of $90,000, cash-method accounts receivable of $180,000,bank debt of $60,000, and accounts payable of $18,000 deductible only when paid. The redeemedpartner's capital account is $30,000, and has outside basis in the partnership interest is $50,000.The partnership redeems his interest for $64,000 in cash and agrees to indemnify him for the bankdebt and the payables. The taxable distribution is $64,000 plus $20,000 of debt relief (the payablesare not debt for this purpose) for a total of $84,000. $30,000 of the payment is based on the valueof assets and taxed under 736(b). The remaining $54,000 is 736(a)(2) guaranteed payment, taxedas ordinary income to the redeemed partner and deductible to the partnership. This is amount is lessthan is one-third share of receivables because his $6,000 share of the payables was netted againstthat value. See 811 BNA T. M. Portfolio A-121 (2009).

H. Passive Losses, LLCs and LLPs Better Than LPs For Those Wanting Current Losses.

Under Code Section 469, passive losses may offset only passive income. Unless a partner candemonstrate his material participation, his share of the partnership's loss a passive activity loss

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rather than an ordinary loss. Section 469(c)(1)(B). In Garnett v.CIR, 132 TC No 19, 2009 WL1883965 (2009), and Thompson v.CIR, 87 Fed Cl 728 (Fed. Cl. Ct., 2009), the Tax Court and theCourt of Federal Claims rejected the Service's attempt to treat both the members of LLCs and thepartners in limited liability partnerships (LLPs) as limited partners for purposes of the passive lossrules. The courts concluded that, absent direct statutory or regulatory guidance, the taxpayerscould not be treated as subject to the more restrictive rules applicable to limited partners underSection 469. This was also the result earlier in Gregg v.CIR, 186 F Supp 2d 1123 (DC Ore. 2000).

Members of LLCs and partners in LLPs are not "limited partners" under the passive activity rulesof Section 469 based on recent cases. It is not clear how general partners of a limited liabilitylimited partnership (LLLP) should be treated for purposes of 469.

Section 469(a) provides a limitation on the ability of certain taxpayers to use losses or credits frompassive activities in determining their income. A passive activity is defined in Section 469(c) as anyrental activity or any trade or business activity in which the taxpayer does not materiallyparticipate.

Section 469(h)(1) provides that a taxpayer materially participates in an activity only if he isinvolved in the activity's operations on a regular, continuous, and substantial basis. Section469(h)(2) provides, however, that (except as provided in Regulations) "no interest in a limitedpartnership as a limited partner shall be treated as an interest with respect to which a taxpayermaterially participates."

Losses from limited partnership interests are not available to offset positive income from othersources. The Senate committee incorrectly assumed that income allocable to a limited partnerautomatically was passive due to the nature of limited partnerships and the inability of limitedpartners to participate actively in an activity if they wish to maintain limited liability status. Inmany states, limited partners can now participate in management. S. Rep't No. 99-313, 99th Cong.,2d Sess. 716 (1986).

1988 Temporary Regulations are still the latest interpretation and define material participation.Temp. Reg. 1.469-5T(a) lists seven tests for determining whether an individual materiallyparticipates in an activity; a taxpayer must satisfy one of these tests. Specifically, an individual mayestablish his material participation in an activity for a given tax year by demonstrating any of thefollowing:

(1) The individual participated in the activity for more than 500 hours during such year.

(2) The individual's participation in the activity for the tax year constituted substantially all of theparticipation in such activity of all individuals for that year.

(3) The individual participated in the activity for more than 100 hours during the tax year, and suchindividual's participation in the activity for the tax year was not less than the participation in theactivity of any other individual for that year.

(4) The activity was a significant participation activity for the tax year, and the individual'saggregate participation in all significant participation activities during that year exceeded 500hours.

(5) The individual materially participated in the activity for any five tax years during the ten taxyears that immediately preceded the tax year.

(6) The activity was a personal service activity, and the individual materially participated in the

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activity for any three tax years preceding the tax year.

(7) Based on all facts and circumstances, the individual participated in the activity on a regular,continuous, and substantial basis during that year.

On the other hand, if an individual is a limited partner in a partnership, Temp. Reg. 1.469-5T(e)(2)provides that the individual can materially participate in an activity only if the first, fifth, or sixthtest above is met. Thus, an individual who participates for less than 500 hours in the tax year in anactivity in which the taxpayer is a limited partner generally cannot materially participate in theactivity (unless the taxpayer materially participated in the activity in prior years), whereas ataxpayer can establish material participation on several other bases if the individual is not a limitedpartner (e.g., is a general partner).

Temp. Reg. 1.469-5T(e)(3)(i) defines an interest in an entity taxed as a partnership as a "limitedpartnership interest" if either of the following conditions is met:

(1) The interest is designated as a limited partnership interest in the limited partnership agreementor the certificate of limited partnership, without regard to whether the liability of the holder of suchinterest for obligations of the partnership is limited under state law.

(2) The liability of the holder of such interest for obligations of the partnership is limited, under thelaw of the state in which the partnership is organized, to a determinable fixed amount (e.g., the sumof the holder's prior capital contributions and contractual obligations to make additional capitalcontributions to the partnership).

Temp. Reg. 1.469-5T(e)(3)(ii) provides that if a person is both a general partner and a limitedpartner in the same partnership, the limited partnership interest will not be treated as a limitedpartnership interest for these purposes.

Newer Limited Partnerships

Under subsequent revisions of the uniform limited partnership act, i.e., RULPA 1976, RULPA1985, and ULPA 2001, limited partners in many states can now participate in significant activitiesof the limited partnership, without loss of limited liability.

LLLPs

An LLLP is a limited partnership whose general partners are also shielded from personal liabilityfor some or all of the partnership's debts. The shield already exists with respect to the LLLP'slimited partners, of course, although in some instances the vicarious liability protection affordedlimited partners in an LLLP is thought to be slightly greater than under traditional limitedpartnership law.

I. Service Firms Practicing as LLLPs.

1. Tax consequences of converting to an LLLP.

Assume a professional services firm is already operating as a general partnership. What are the taxconsequences of its decision to operate as an LLLP? Specifically, is the conversion of the generalpartnership into LLLP form a taxable event, and what are the collateral tax consequences?

Tax-Free Conversion From Entity Taxed As Partnership. Rev. Rul. 95-37 ruled that a conversionof a general partnership into an LLC was governed by Section 721 (providing neutral consequences

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to the partners and the unincorporated entities), and determined that the particular form used toconvert the general partnership into an LLC did not affect the tax consequences (effectively,permitting the substance of the conversion to control over the form). Similarly, in Rev. Rul. 95-55ruled that the registration of a general partnership as an LLP pursuant to that state's law was aSection 721 transaction based on Rev. Rul. 84-52 and Rev. Rul. 95-37. No Revenue Rulings orletter rulings are known to have been issued to date with respect to changes of existingpartnerships, LLCs, or LLPs into LLLP status. Nonetheless, there appears to be no reason why theIRS would not apply a similar favorable Section 721 analysis to conversions into LLLPs.

The tax consequences of operation of a professional services firm in LLLP form remain unclear.While "partnership" and "partner" are defined for tax purposes, "general partner" and "limitedpartner" are not. "Partnerships" and "partners" are included in Section 761 and Reg. 1.761-1 byreference to the Regulations under Section 7701. Section 7701(a) defines "partner" to include amember in a syndicate, group, pool, joint venture or other unincorporated organization.

2. Tax Issues In Operating LLLP.

A professional firm considering operation as an LLLP must deal with the following tax and relatedissues:

State Law Status Of Limited Partners. Are the limited partners of the LLLP treated for taxpurposes as "limited partners" because they are members of an entity organized under a state'slimited partnership laws, even though the partners will actively provide services and may take partin the firm's management?

Tax Status Of General Partners. Are the general partners of an LLLP treated for tax purposes like"general partners" because of their title and managerial authority and powers or "limited partners"because of their limited liability under the LLLP shield?

Self Employment Income. Will the income of the limited partners in the LLLP constitute netearnings from self-employment (NEFSE)? Section 1402(a)(13) provides that the distributive shareof any item of income or loss of a limited partner is excluded from the computation of NEFSE,other than guaranteed payments for services to the limited partner. If so, the professionals who arelimited partners in an LLLP would not pay SE taxes on their distributive share of partnershipincome and those amounts would not be eligible for retirement plan contributions, eliminatingsocial security and Medicare tax until the law changes in 2013 under the 2010 health reformlegislation.

Liquidation Payments Upon Termination Repurchase Of LLLP Interest. The rule is that Section736 payments to a partner are not deductible by the payor partnership pursuant to Section736(b)(2). Section 736(b)(3), however, provides an exception for such payments to a “generalpartner” of a partnership for which capital is not a material income-producing factor. Thatqualification is important because the service firm typically is using operating revenues (ordinaryincome, taxable to the remaining partners) to pay the withdrawn partner. By qualifying underSection 736(b)(3), professional service partnerships generally structure payments to a retired ordeceased partner in a manner that allows the partnership to have a deduction for the ordinaryincome paid to the exiting partner, with the remaining partners to obtain tax-advantaged treatmentfor the departed partner's share of payments for goodwill or unrealized receivables.

This same issue of 736 application has been cited by some general partnership service firms as afactor in their converting into LLP (rather than LLC) form, given the continuing uncertainty of

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whether LLC members are "general partners" for this purpose. There is no clear resolution on thisissue yet. There is a good case that 736 should be available to LLCs and LLLPs.

Cash Method Accounting. Section 448 permits qualified personal service corporations andpartnerships to use the cash method. Professionals typically use this method because collectionsoccur after the right to income is earned. Sections 446, 448, 461, 464, and 1256 provide that apartnership or other pass-through entity cannot use the cash method if more than 35% of the lossesof such entity during the tax year are allocable to limited partners or limited entrepreneurs.

Temp. Reg. 1.448-1T(b)(3) provides that a partnership or other entity may fail this test only if morethan 35% of the losses during the tax year are actually allocated to limited partners and limitedentrepreneurs. Therefore, assuming the other requirements of Section 448 are met, an LLLP, like anLLC, arguably should not lose the cash method under Section 448 before the first year in which itincurs losses in excess of income and more than 35% of such losses are allocated to the limitedpartners. See PLRs 9321047 and 9415005.

Will The LLLP's Trade Or Business Be Imputed To Its Limited Partners? The question of whethera limited partnership's trade or business is imputed to "active" limited partners is not settled. Butlerv. CIR, 36 TC 1097 (1961), acq., held that a lawyer who was an "active" limited partner in abusiness limited partnership could deduct his unpaid loan to the LP as a business bad debt.Imputation to "active" limited partners in a professional service LLLP would seem to be similarlyappropriate.

However, TAM 9728002 held that the partnership's trade or business should not be imputed tolimited partners, but only to general partners, in connection with the attempted deduction of legalfees incurred by a limited partner in a lawsuit against the general partner, thereby resulting in aSection 212 itemized deduction rather than a Section 162 above-the-line deduction. The Servicelimited Butler to its facts because Butler was more than a passive investor—he was a key memberof the firm "and more like a general partner even though labeled a limited partner." Many if not allservice LLLP partners arguably will be as active as general partners in a service LLP, and thusimputation of trade or business status may be appropriate, even under TAM 9728002.

State Income Tax. Finally, for state and local tax purposes, will the LLLP be treated as a limitedpartnership, in those jurisdictions where entity-level taxes are applied to certain types of pass-through entities (e.g., LLCs) but not to limited or general partnerships? Moreover, in thosejurisdictions where limited partnerships may be subject to entity-level taxes and withholding ondistributions to limited partners (but the same rule does not apply to general partnerships), doesoperation as an LLLP provide a tax disadvantage?

Similarly, will those out-of-state individual service partners who are limited partners in the LLLPbe less likely to have a nexus with other states, for purposes of multistate jurisdiction or taxation?In states where the service firm does business and that state's individual income tax rate ismaterially greater than the home state tax rate of the LLLP limited partner, can the latter validlyavoid taxation or nexus on his allocable share of the LLLP's net income attributable to the high taxrate state?

J. Reducing Self Employment (SECA) Tax.

As noted above, payments to limited partners and perhaps to members of LLCs other than formanagement services may be exempt from self employment tax except to the extent that they arepayments for services. This concept was attempted to be implemented in Robucci v. Cir, T.C.

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Memo. 2011-19 (January 24, 2011) holds that (1) the new structure of a sole proprietorpsychiatrist’s practice should be largely disregarded as without substance, (2) the taxpayercontinues to be taxable as a sole proprietor, and (3) the 6662 substantial understatement penaltyapplies. This case follows a much different path than numerous earlier cases upholdingconversions of sole proprietorships and partnerships into professional corporations. The entitiesinvolved were not implemented properly. The court notes that if they had been, the result mighthave been different. This reminds us of the early PC days, where the IRS was on the attack andsuccessful taxpayers were careful to dot every “I” and cross every “T.”

Robucci P.C. was wholly owned by Dr. Robucci, and this PC was a co-member, along with Dr.Robucci personally, in Tony L. Robucci, M.D. LLC (Robucci LLC). Dr Robucci personally owned95% of the LLC and his PC owned 5%. Dr. Robucci 's 95-percent interest in the LLC was dividedbetween a 10-percent general partner interest and an 85-percent limited partner interest attributableto Dr. Robucci 's personal goodwill. Westsphere was a management corporation wholly owned byDr. Robucci. The PC and Westsphere are referred to as the corporations.

The IRS argued and Tax Court Judge Halpern held that the corporations should be disregarded,leaving the Robucci LLC as a SMLLC owned solely by Dr. Robucci. Thus, as footnote 2 of thedecision noted, the court did not need to deal with the two IRS alternative 482 and 269Aarguments, both typically unsuccessful in prior litigated cases.

The Taxpayer’s Goal – Tax Reduction.

During his first meeting with Mr. Carson, an attorney and CPA, sole proprietor Dr. Robucci statedthat he wanted to do what was best from the standpoint of his own personal tax planning andwanted to minimize the amount of taxes he was paying. Mr. Carson recommended theorganizational structure described above. That discussion covered structuring Dr. Robucci'spractice so as to reduce self-employment tax while also minimizing other tax liabilities. Dr.Robucci did not seek a second opinion from any other C.P.A. or attorney, nor did Mr. Carsonprovide him with a written explanation of the need to form three separate entities. Carson explainedorally to Dr. Robucci that the LLC would conduct the practice, that for reasons not made clear toDr. Robucci, it needed to have two members (Dr. Robucci personally and Robucci P.C.), and thatWestsphere would be a business management corporation and not involved in providing patientcare.

Failure To Implement Mr. Carson's Recommended Organizational Structure

Dr. Robucci was the sole shareholder of both corporations. During that same period, Robucci LLCwas 95-percent owned by Dr. Robucci and 5-percent owned by Robucci P.C. The court says thatRobucci P.C.'s interest was as a limited partner. This seems to be incorrect, as footnote 4 of thedecision notes that Reg. § 301.7701-3(b)(1)(i) states that a multimember LLC that does not electassociation status (which describes Robucci LLC) is treated, for Federal tax purposes, as apartnership. Thus, Robucci LLC's members would most likely both constitute general partners forFederal tax purposes if it were respected as a two-member entity. Several court decisions hold thatLLC members cannot be limited partners, even if they are merely members in a manager managed

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LLC. However, the IRS has never issued final regulations on this issue. The court’s reasoning alsomakes this issue moot in this decision.

Dr. Robucci's 95-percent ownership interest was reflected on Robucci LLC's partnership returns asan 85-percent interest as a limited partner and a 10-percent interest as a general partner. While notnoted by the court, many cases hold that LLC interests of members in a manager managed LLC arenot limited partner interests but rather general partner interests. Carson based his determination ofan 85-percent limited partner ownership interest for Dr. Robucci on the value of Dr. Robucci'sgoodwill and what would be a reasonable rate of return on that goodwill at the time he formedRobucci LLC. Mr. Carson never discussed with Dr. Robucci the basis for the 85-percent-10 percentallocation between his limited and general partner interests in Robucci LLC. Dr. Robucci didunderstand that his 10-percent general partnership interest represented his interest as a provider ofmedical services and his 85-percent limited partnership interest represented his interest attributableto his capital contribution of intangibles.

Carson did not prepare a written valuation report to support his conclusions. Additionally, Dr.Robucci did not make any written assignment of the tangible or intangible assets of his practice toRobucci LLC.

Westsphere executed a loan agreement, whereby Dr. R as an "employee" was authorized to borrowmoney from Westsphere "from time to time" under specified terms and conditions.

Dr. Robucci executed an Employee Business Expense Reimbursement Plan, whereby Westsphereagreed to reimburse its employees for all employment related expenses upon submission of theproof of expenditure documentation specified in the plan. Westsphere also adopted a MedicalReimbursement Plan and a Diagnostic Medical Reimbursement Plan. The Operating Agreement ofRobucci LLC designated Robucci P.C. as manager but it was not clear whether it was signed. Dr.Robucci had a limited understanding of the need for the entities formed and the agreements andother documents drafted by Mr. Carson.

Robucci LLC and Westsphere had bank accounts, while Robucci P.C. did not. Dr. Robucci did nothave an employment agreement with any of those three entities, nor did any of them haveemployees during the years in issue. Neither Robucci P.C. nor Westsphere paid a salary to Dr.Robucci or to anyone else during those years. Dr. Robucci did not keep records of any time hemight have spent working for Westsphere. Although Robucci LLC deducted "management fees"for each of the years in issue ($31,475, $25,500, and $38,385 for 2002, 2003, and 2004,respectively), its returns and bank records do not specify to whom they were paid or for whatservices. Dr. Robucci was aware that Westsphere charged management fees to Robucci LLC but hedid not know the nature of those charges except that they related to non-patient care services.

Robucci LLC and the corporations used the same business address but there was no written leaseagreement between Robucci LLC and either of the corporations.

The corporations did not (1) have separate Web sites or telephone listings, (2) pay rent to Dr.Robucci or Robucci LLC, (3) have customers other than Robucci LLC or contracts with any otherthird parties, or (4) advertise. Westsphere did not have separate dedicated space in Dr. Robucci's

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office. Dr. Robucci continued to bill Medicare and Medicaid (a relatively small portion of hispractice) as an individual practitioner and not through Robucci LLC.

During the years in issue, Robucci LLC was a calendar year taxpayer and the corporations reportedon the basis of fiscal years ending November 30.

Dr. Robucci's Self-Employment (SECA) Taxes

Dr. Robucci's 2002, 2003, and 2004 Forms 1040, U.S. Individual Income Tax Return, show thefollowing distributions to him of "passive" and "nonpassive" income from Robucci LLC:

Year Passive Income Nonpassive Income______________________________________________________________________

2002 $48,153 $5,6652003 57,446 6,8512004 95,1431 11,193

_____________________________________________________________________

Dr. Robucci's 2004 return reported this $95,143 amount as nonpassive income onSchedule E, although the 2004 Schedule K-1 from Robucci LLC in connection withhis 85percent partnership interest lists $95,143 as the distributionattributable to that (passive) interest, and Dr. Robucci's 2004 Schedule SE,Self-Employment Tax, included only $11,193 as net earnings from self-employment.

Dr. Robucci's Schedule SE filed for each of those years lists the 10% “general partner: nonpassiveincome as gross earnings from self-employment.

The Tax Court noted that the Supreme Court in Gregory v. Helvering, 293 U.S. 465, 469 (1935)stated: "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes,or altogether avoid them, by means which the law permits, cannot be doubted." Directly after thatstatement, however, the Court added the admonition: "But the question for determination iswhether what was done, apart from tax motive, was the thing which the statute intended." Id.

In Chisholm v. Commissioner, 79 F.2d 14, 15 (2d Cir. 1935), Judge Learned Hand elaborated uponthe Supreme Court's admonition in Gregory, stating: "The question always is whether thetransaction under scrutiny is in fact what it appears to be in form".

The issue in these cases is whether the corporations, Robucci P.C. and Westsphere, are entitled torespect as viable business corporations or whether, as in Judge Hand's description of the facts inGregory, the incorporator's "intent, or purpose, was merely to draught the papers, in fact not tocreate corporations as the court * * * [understands] that word." Id. In other words, were RobucciP.C. and Westsphere corporations in fact as well as in form; i.e., were they "the thing which thestatute intended" when referring to corporations?

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A corporation will be recognized as a separate taxable entity if (1) the purpose for its formation isthe equivalent of business activity or (2) the incorporation is followed by the carrying on of abusiness by the corporation. Moline Props., Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943);Achiro v. Commissioner, 77 T.C. 881, 901 (1981).6 If neither of those requirements is satisfied, thecorporation will be disregarded for Federal tax purposes, and all of its income will be attributed tothe true earner. Shaw Constr. Co. v. Commissioner, 35 T.C. 1102, 1114-1117 (1961), affd. 323F.2d 316 (9th Cir. 1963); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582, 597-607 (1959).

The Tax Court held that it need not decide the burden of proof issue under section 7491(a) becausea preponderance of the evidence supports the resolution of that issue. Therefore, resolution of thatissue does not depend on which party bears the burden of proof. See, e.g., Estate of Bongard v.Commissioner, 124 T.C. 95, 111 (2005).

Business Purpose Of The Structure.

The taxpayers argue that as "managing member" of Robucci LLC, Robucci P.C. "performedoversight and management" services and that Westsphere was established to (1) "provide oversight,and to manage certain overheads and indirect expenses, including employee benefits such as healthinsurance", (2) "track business expenses and overheads", and (3) create a "group" for groupsickness and accident insurance coverage under Colorado law. Taxpayers also argue that theformation of a multimember LLC, including a corporate member, afforded Dr. Robucci superiorprotection, under Colorado law, against personal liability for acts of Robucci LLC, and thatRobucci P.C.'s interest in Robucci LLC was necessary to accomplish that goal.

The IRS argues that (1) the corporations "were created solely for the purpose of reducing . . . [Dr.Robucci's] tax liability" and to help him "avoid income and self-employment taxes"; (2) taxpayers"did not offer any credible explanation of the business purpose for forming the corporations"; and(3) taxpayers "did not demonstrate that either corporation engaged in any business activity after itwas formed." The court agreed with the IRS.

Taxpayers state two reasons for the formation of Robucci P.C.: (1) Its role as the "managingmember" of Robucci LLC, a role not reflected in Robucci P.C.'s articles of incorporation, whichstate that its "sole purpose" is to practice medicine "through persons licensed to practice medicine"and (2) the superior protection against personal liability that would be afforded to Dr. Robucci bythe formation of a multimember LLC.

Assuming that Robucci P.C. was properly organized under Colorado law, that fact does not meanthat it performed any function that would warrant its recognition as an entity for Federal taxpurposes. E.g., Noonan v. Commissioner, 52 T.C. 907, 909 (1969), affd. 451 F.2d 992 (9th Cir.1971). Although Robucci P.C. may have been a party to an "operating agreement" with RobucciLLC, whereby it was appointed Robucci LLC's "manager," there is no evidence that Robucci P.C.performed any management or other services for Robucci LLC. Robucci P.C. had no assets (otherthan its interest in Robucci LLC) or employees, it had no service contract with Robucci LLC, and itpaid no salary to Dr. Robucci or anyone else during the years in issue. In fact, Robucci P.C. was notintended to perform management services or other business activities. Mr. Carson's handwritten

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note states: "We need P.C. to be a partner in LLC only; Westsphere is the mgmt. corp. P.C. doesnada [nothing]."

In support of the second reason of limiting Dr. Robucci’s liability, taxpayers cite In re Albright,291 Bankr. 538 (Bankr. D. Colo. 2003), in which the court permitted the trustee in bankruptcy toliquidate all of the property of a single-member LLC on behalf of creditors. The Tax Court heldthat Taxpayers' reliance upon Albright is misplaced. That case does not involve a creditor's right tohold the sole member of a single-member LLC personally liable for the LLC's debts. Rather, itholds that all of the LLC's assets are available to satisfy the claims of the sole member's creditors(and not that the sole member's assets are available to the LLC's creditors). The trustee in Albrightdid not attempt to pierce the "corporate" veil to reach the member's personal assets to satisfy theLLC's debts

The court concluded that Robucci P.C. was not formed for a purpose that "is the equivalent of abusiness activity" within the meaning of Moline Props., Inc. v. Commissioner, 319 U.S. at 439.

Westsphere Management Corporation

Taxpayers list three purposes for the organization of Westsphere: management, the tracking ofoverhead and indirect expenses, and to form a group for insurance purposes. However, the evidencerefutes the notion that those alleged purposes constituted bona fide nontax purposes. Although,Westsphere had a checking account, like Robucci P.C., it had no employment agreement with Dr.Robucci and no employees. Nor did it perform any management or other services for Robucci LLCin the person of Dr. Robucci.

Rather, Dr. Robucci continued to conduct his practice as he always had, including the retention ofMs. Williams as his billing assistant. Both before and after the formation of Robucci LLC, Ms.Williams was the billing assistant for Dr. Robucci's practice. Although she received instructionsfrom Dr. Robucci in letters with a letterhead "Tony L. Robucci, M.D., A Professional L.L.C.," sheconsidered herself to be the employee of Dr. Robucci.

The only activity allegedly attributable to Westsphere during the audit years was its reimbursementof various expenses incurred by Dr. Robucci and Robucci LLC pursuant to the various plans. Dr.Robucci testified that that activity consisted of electronic transfers of funds between bank accounts.Thus, Dr. Robucci continued, as in prior years, to pay the expenses of his practice, but allegedly outof Robucci LLC's bank account. Westsphere's only alleged "service" was to reimburse thoseexpenses by electronic transfers of funds from its account to Robucci LLC's account. The bankaccount statements in the record provide scant evidence that there were, in fact, regularinteraccount transfers from Westsphere to Robucci LLC. For example, Westsphere's bankstatement dated January 23, 2003, shows debits of $5,097.60 and $1,114.84 for a 2002 MedicalExpenses Reimbursement and a Health Insurance Premium Reimbursement, but the absence ofcorresponding credits to Robucci LLC's account on the same date or thereafter indicates that thetransfer of funds was to Dr. Robucci's personal account. In fact, the bank statements contained nocorrelation between debits to Westsphere's bank account and credits to Robucci LLC's bankaccount. Any interaccount transfers, to the extent they occurred, were the equivalent of takingmoney from one pocket and putting it into another because Dr. Robucci controlled both entities.

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Such a procedure hardly qualifies as a "business activity" under Moline Props., Inc. v.Commissioner, supra at 439.

Taxpayers also argue that the organization of Westsphere was essential in order to create a "group"eligible for group sickness and accident insurance. Whatever the merits of taxpayers' concerns inthat regard, it is not clear how the formation of Westsphere alleviated those concerns. The "groups"to be afforded coverage are "groups of persons," generally, under policies issued to an employer forthe benefit of the employees, which include officers, managers, and other employees of theemployer. See Colo. Rev. Stat. sec. 10-16214(1)(a). It is difficult to see how the organization ofWestsphere, which neither is an employee of Robucci LLC nor has employees of its own, couldserve to qualify for small group or small employer health insurance. More importantly, there is noevidence that Robucci LLC made any effort to obtain group health insurance for its sole operative,Dr. Robucci. Dr. Robucci or Robucci LLC continued to pay premiums for health insurance but it isnot clear that the policy differed from the one Dr. Robucci had as a sole proprietor.

Taxpayers have not persuaded us that Westsphere was organized for a purpose that "is theequivalent of a business activity" under Moline Props., Inc. v. Commissioner, supra at 439.

Robucci P.C. and Westsphere were hollow corporate shells. The court ruled that neither carried ona business after incorporation, the second alternative prong for corporate viability under MolineProperties. Because Robucci P.C. and Westsphere served no significant purpose or function otherthan tax avoidance, they should be disregarded. What we said in Aldon Homes, Inc. v.Commissioner, 33 T.C. at 598, in disregarding 16 so-called alphabet corporations is equallyapplicable to this case:

The alleged business purposes impressed us simply as a lawyer's marshaling of possible businessreasons that might conceivably have motivated the adoption of the forms here employed but whichin fact played no part whatever in the utilization of the [structure employed]

Thus, Robucci LLC was a single-member LLC. The result is that Dr. Robucci is a sole proprietorfor Federal tax purposes, which was his status before the formation of Robucci LLC and thecorporations. It follows, and we hold, that the net income arising from his psychiatric practiceduring the years in issue, including any amounts paid to Robucci P.C. and Westsphere, was self-employment income of Dr. Robucci subject to self-employment tax under section 1401.

Imposition Of The 6662 Accuracy-Related Penalty

The IRS has established that Dr. Robucci's understatements of income tax for the years in issue aresubstantial as they exceed both 10 percent of the correct tax and $5,000. Therefore, there was noneed to determine whether Dr. Robucci was negligent under section 6662(b)(1).

Section 6664(c)(1) provides that the penalty shall not be imposed with respect to any portion of anunderpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayer actedin good faith with respect to, that portion. The determination of whether a taxpayer acted withreasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinentfacts and circumstances. Circumstances that may indicate reasonable cause and good faith include

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an honest misunderstanding of law that is reasonable in light of all of the facts and circumstances,including the experience, knowledge, and education of the taxpayer. Reliance on the advice of aprofessional tax advisor does not necessarily demonstrate reasonable cause and good faith. Reg. §1.6664-4(b)(1).

Under section 7491(c), the IRS bears the burden of production, but not the overall burden of proof,with respect to Dr. Robucci's liability for the section 6662(a) penalty. By demonstrating that Dr.Robucci's understatements of income tax exceed the thresholds for a finding of "substantialunderstatement of income tax" under section 6662, the IRS has satisfied his burden of production.

CPA/Attorney As Promoter. The IRS argues that there was no reasonable cause for the positionstaken by Dr. Robucci and that he did not act in good faith. In the IRS's view, "[p]etitioner shouldhave requested a second opinion after getting advice that was clearly too good to be true". the IRSviews Mr. Carson as "the promoter of the arrangement, who earned substantial fees forincorporating the various sham entities and preparing the tax returns at issue.” Taxpayers deny thatMr. Carson was a promoter and argues that, in the light of Mr. Carson's status as an independent,experienced C.P.A., Dr. Robucci was under no obligation to obtain a second opinion before hecould reasonably rely on Mr. Carson's advice.

Too Good To Be True. The court held that even if we were to agree with petitioner that Mr. Carsonwas not a promoter, we agree with the IRS that the tax result afforded by implementing Mr.Carson's suggestions, i.e., the dramatic reduction in Dr. Robucci's self-employment taxes, was "toogood to be true.” See, e.g., Neonatology Associate, P.A. v. Commissioner, 299 F.3d at 234 ("When* * * a taxpayer is presented with what would appear to be a fabulous opportunity to avoid taxobligations, he should recognize that he proceeds at his own peril."); McCrary v. Commissioner, 92T.C. 827, 850 (1989) (stating that no reasonable person should have trusted the tax scheme inquestion to work).

Carson’s Structure Might Have Worked If Implemented Properly.

Somewhat contrary to its statement that the structure led to a tax result that was too good to be true,the court stated that Mr. Carson's goal of directing some of Dr. Robucci's income to a third-partycorporate management service provider and bifurcating Dr. Robucci's interest in Robucci LLC sothat he would be separately compensated for the use of his intangibles was not unreasonable. Onthe contrary, had it been more carefully implemented, it well might have been realized, at least inpart. In footnote 11, the court noted that although it is the IRS's position that profit distributions toservice-providing members of a multimember, professional service LLC are never excepted fromnet earnings from self-employment by § 1402(a)(13), which excepts distributions to a limitedpartner other than sec. 707(c) guaranteed payments for services rendered, the Treasury has yet toissue definitive guidance with respect to that issue.

Although Robucci P.C. and Westsphere were properly formed under Colorado law to carry outlegitimate corporate functions, the fact that they were nothing more than empty shells, devoid ofproperty (Westsphere did have a bank account), personnel, or actual day-to-day activities, i.e., ofsubstance, should have sent warning signals to Dr. Robucci that those corporations were noteffecting any meaningful change in the prior conduct of his medical practice. There were also no

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contracts between the entities or with Dr. Robucci and his PC. Additionally, the LLC paid Dr.Robucci for his “active services, not his PC, which did not have any activity or even a bankaccount.

While Dr. Robucci may have had some vague notion that he was acting on behalf of Westspherewhen performing services other than actual patient care, there is little or no evidence as to theprecise nature of those services, the time Dr. Robucci may have spent performing them, or theirvalue. In short, there is no support for any charge from Westsphere to Robucci LLC for suchservices or for the claim that Dr. Robucci was wearing a Westsphere hat when he performed them.

For Dr. Robucci, aside from signing a raft of documents and shifting some money between twonew bank accounts, it was business as usual. Although he might have been justified in relying uponMr. Carson's expert valuation of his intangibles as the basis for the 85-10 split between his limitedand general partnership interests in Robucci LLC, the lack of any formal transfer of thoseintangibles to Robucci LLC should have been cause for concern.

Under those circumstances, Dr. Robucci, even though he was not a tax professional, should havequestioned the efficacy of the arrangement that purported to minimize his taxes while effectingvirtually no change in the conduct of his medical practice. He should have sought a second opinion.By not doing so, Dr. Robucci failed to exercise the ordinary business care and prudence required ofhim under the circumstances. See United States v. Boyle, 469 U.S. at 251; Haywood Lumber &Mining Co. v. Commissioner, 178 F.2d 769, 770771 (2d Cir. 1950), modifying 12 T.C. 735 (1949),which involve circumstances exemplifying the exercise of ordinary business care and prudence.

K. Conclusion.

The C corporation double tax would not be a major factor if the C corporation owners do not planto pay dividends and if it is unlikely that the business will be sold or if the sale would be a sale ofstock and not assets. Although the C corporation owners (unlike S corporation/partnership owners)do not get a basis step-up for earnings retained at the entity level, the low initial corporate incometax rate and the preferred capital gains tax rate would still likely combine to provide a lower overallpresent value effective tax rate for the purchase price attributable to these retained earnings if theowners sold their business in a stock sale. Nevertheless, most purchasers will want to “buy assets”in order to achieve a step-up in basis for the intangible assets represented by the portion of thepurchase price in excess of the corporation’s internal basis in its assets, so that those amounts canbe depreciated or amortized for tax purposes, and to avoid inheriting the sold entity’s liabilities. Ingeneral, this means a sale of assets at the entity level, either an actual sale of assets or a deemedsale of assets via a section 338(h)(10) election for an S corporation. The 34% initial tax and the20% tax on liquidation combine for an effective rate of around 48% on $500,000 of proceeds. Thiscompares with only a 20% single tax rate (plus applicable Medicare tax) applicable in the Scorporation and partnership/sole proprietorship sale scenarios. This double-tax can be mitigated bynon-compete payments directly to the individual owners, consulting and compensation payments,and sale of personal goodwill, where it exists. However, the marginal tax rate of around 46% will

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apply to ordinary income payments for someone in the highest bracket subject to deductionphaseouts. Additionally social security and Medicare taxes would apply to any consulting orcompensation payments.

II. NON-TAX CONSIDERATIONS.

In recent years, the number of business entity forms available has doubled, adding limited liabilitycompanies (“LLCs”), limited liability partnerships (“LLPs”) and limited liability limitedpartnerships (“LLLPs”), to general partnerships, limited partnerships and corporations.

The factors that differentiate these various types of business entities are:

the extent to which the entity shields its owners from personal liability for the debts orobligations of the entity;

the management structure of the organization and the extent to which management may becentralized among a group consisting of less than all the owners; and

the income tax treatment of the organization and its owners.

As a result of changes in the statutes governing certain of these entities adding flexibility to theirstructure, business planners now consider many of the forms of business organization to beinterchangeable except for the sole proprietorship and general partnership. Nonetheless, numerousissues exist as to the liability protection in operations outside the state of formation and operationalincome tax issues.

Terminology For Uniform Partnership Acts.

The correct name for the revised uniform partnership act is the Uniform Partnership Act (1997). In1994, the “Revised” was dropped. Nonetheless, “Revised” and RUPA have become firmly fixed incommon parlance as the name of the act.

The Uniform Limited Partnership Act (2001) is the successor to the Revised Uniform LimitedPartnership Act (1976). The Uniform Limited Partnership Act (1976) is referred to as ULPA. Withits 1985 Amendments, it was commonly referred to as the Revised Uniform Limited PartnershipAct or RULPA. The uniform act approved in 2001 was through the drafting process calledReRULPA, the revision of RULPA, and that unofficial acronym is often used.

A. Sole Proprietorship.

A sole proprietor is a business owned by one individual that does not have limited liability. Forincome tax purposes, its activities are reflected on Schedule C of the personal form 1040 incometax return. The owner is personally liable for the liabilities of the proprietorship.

B. General Partnership.

The definition of a partnership is “an association of two or more persons to carry on, as co-owners,a business for profit.” The basic form of partnership is a general partnership (“GP”). No formalaction, state filing, or written agreement is needed to form a general partnership. As a result, any

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business (where profits are shared) involving two or more owners will be a general partnershipunless the participants make a different agreement.In a general partnership (i) each partner has an equal right to participate in management, (ii) eachpartner has the authority to make commitments or enter into binding agreements on behalf of thepartnership, (iii) the death or withdrawal of one of the partners results in the dissolution of thepartnership for income tax purposes, and (iv) a general partnership does not provide a liabilityshield for its partners, because each partner has complete joint and several liability for all debts andobligations of the partnership.

Under versions of the Uniform Partnership Act in many states, a general partnership can be createdin which the first three characteristics described above are eliminated and are replaced with thecorporate characteristics of centralized management and continuity of life. In other words, it ispossible to have a general partnership in which certain partners do not have the ability to participatein management decisions relating to the business of the partnership or to enter into bindingagreements on behalf of the partnership. It is also possible to structure a general partnership in sucha way that the death or withdrawal of one of the partners does not cause the partnership to bedissolved.

The most significant disadvantage of a general partnership is that partners have joint and severalpersonal liability for partnership debts and obligations.

C. Corporation.

Corporations are the most formal type of business entity. They provide a liability shield for theirshareholders, have a centralized management group consisting of a board of directors elected by theshareholders (except for statutory close corporations managed by their shareholders), and they haveperpetual existence. Corporations are the preferred form of business entity for organizations thathave a large and diverse ownership group and for organizations that intend to make a publicoffering of their securities. Statutory close corporations are used when the owners want to vote onmatters on which directors vote by number of shares rather than 1-director, 1-vote.

Unless a corporation and its shareholders make an affirmative election under Subchapter S of theInternal Revenue Code, the corporate entity is separated from its owners for tax purposes and isresponsible for payment of its own income tax. All of the other forms of business organizationmentioned above are generally intended to be pass-through entities for tax purposes, meaning thatthe entity itself does not pay income tax. Instead, the owners are responsible for payment of incometaxes on their proportionate share of the entities income.

Professional corporations or associations are permitted for professionals in all states and have theirown somewhat unique rules. Only licensed professionals can be owners. Where special statutoryrules do not apply, the regular state corporation statute applies.Professional corporations can be “C” or “S” corporations for tax purposes, although 13 states donot recognize S corporations.

Additionally, in most states, there is a “corporate practice” doctrine in the statute or by case lawthat prevents the use of a general business corporation by a professional practice. Professionalssubject to a state prohibition on the corporate practice of their profession may be legally precluded

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from operating their professional medical practices through LPs (or LLLPs) and can only do sothrough GPs (or LLPs) if all partners thereof are either duly licensed individuals or PAs or PLLCslegally authorized to render the same professional medical services as the GPs are organized toprovide.

Ancillary medical ventures (specialty hospitals, ambulatory surgery centers, imaging centers, etc)principally formed to offer the technical component of medical services and not any professionalservices cannot qualify for PA or PLLC status because they are not rendering a professionalservice, even if all shareholders or members thereof are duly licensed medical professionals legallyauthorized to offer such ancillary (technical) medical services as part of their professional medicalpractices. An exceptions to the general rule that PAs or PLLCs are not available for the operation ofancillary medical ventures may include the operation of diagnostic imaging facilities by dulylicensed radiologists who offer the technical component of diagnostic imaging services through aPA or PLLC, as part of and ancillary to their provision of their professional interpretative services.

State nonprofit corporations are in a few cases used to run businesses that are taxed as for profitcorporations for federal and state purposes.

D. Limited Liability Company.

In most states, LLCs are the most popular form of organization for new business entities because ofthe liability protection they provide to all owners and the flexibility they afford in defining thebusiness relationship between the parties. An LLC is formed by filing articles of organization withthe secretary of state. After filing the articles of organization, the basic business arrangementbetween the owners of the LLC (who are referred as to “members”) is set forth in a separateagreement usually called an operating agreement. The state statute provides default operating rules,most of which can be varied in the operating agreement, which is a contract among the members ofthe LLC. The LLC itself should also adopt the operating agreement.

One popular form of LLC is the single member entity. Both the IRS and the state law authorize thecreation of a single member LLC. Such an entity is, in many ways, the equivalent of a soleproprietorship with limited liability protection or a division of a corporation or other entity thatowns the SMLLC.

Another subset of LLC available in a few states is the series LLC. There are many uncertaintiesabout its operation.

E. Limited Liability Partnership.

A limited liability partnership (“LLP”) is a general partnership that registers with the secretary ofstate as an LLP. The effect of registration is to limit the vicarious liability of each of the partners.The LLP arose in the early 1990s as a response to the malpractice joint and several liability soughtto be imposed upon attorneys and accountants who were partners in general partnerships for thefailures of the savings and loans associations, including partners who had no involvement with thatwork. The original statutes (Texas was the first) were partial shield statutes, providing limitedliability against tort liabilities for members not involved in the work but not contract liabilities.Most states LLP statutes now provide protection from both types of liability except for the partners

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involved in the work. The LLP is not itself a separate and distinct form of business organization.Rather, the LLP is a general partnership that files with the state to avoid the traditional rule of jointliability for claims arising in the course of the partnership's business.

Partners in an LLP in all states are liable for debts or obligations of the organization that arise as aresult of their own negligence, wrongful acts, or improper conduct. In many states, this limitedliability also extends to contract liabilities (these are called “full shield” states). Partial shieldstatutes include Ky. REV. STAT. ANN. § 362.220(2) (2002) prior to its revision; and TENN.CODE ANN. § 61-1-306 (2002); W. VA. CODE § 47B-3-6(c).

All general partnerships should consider whether registration as an LLP is appropriate if permittedby state law because the process of registration is simple. The form filed is a simple one-page form,and the partnership must change its name to include the words “Limited Liability Partnership” orthe abbreviation “LLP.” Some states, such as New York and California, allow only certainprofessional service firms to elect LLP status, although most states allow any type of businessgeneral partnership to elect limited liability status.

At the time of registration, modification of provisions of the written partnership agreement dealingwith indemnification and with the obligations of partners to make additional contributions to thepartnership should be made to make those provisions consistent with limited liability. For example,if a partnership agreement has provisions that require a partner with a negative partnership capitalaccount to make up such a deficit, such a provision in your LLP's operating agreement could open aback door of liability for partners, defeating the goal of having a limited liability legal entity,although the laws in some states now protect an LLP against such an oversight.

F. Limited Partnership.

A limited partnership (“LP”) is a partnership formed by two or more persons, in which at least oneof the partners is a general partner and at least one of the partners is a limited partner. Generally,the general partners in a limited partnership have the same rights and responsibilities as generalpartners in a general partnership. As a result of amendments to the Uniform Partnership Act, it isnow possible in many states to have a limited partnership in which certain of the general partnersdo not have the ability to participate in management decisions relating to the business of thepartnership or to enter into binding agreements on behalf of the partnership. It is also possible tostructure a limited partnership in such a way that the death or withdrawal of one of the generalpartners does not cause the partnership to be dissolved.

Limited partners are protected from liability for the debts and obligations of the partnership as longas they do not participate in control of the business of the partnership. Likewise, under current lawin many states, limited partners may lose their limited liability protection if they participate inmanagement in a manner that is inconsistent with their limited partner status. Under the UniformLimited Partnership Act (2001), a limited partner is no longer statutorily constrained fromparticipating in the management of the organization.

Family limited partnerships have become a popular vehicle to be used for estate planning and assetprotection planning due to liability protection for the limited partners and ability to obtain discountsin the value of the LP’s assets for estate and gift tax purposes, as well as to pay unearned income to

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lower bracket partners.

The advantage of a limited partnership, from the standpoint of a limited partner, is the limitedliability protection that the entity affords. The disadvantage is that in order to obtain the limitedliability protection, limited partners must refrain from participating in control of the business exceptin those states where it is permitted. The advantages and disadvantages from the standpoint of thegeneral partner are that the general partner has sole responsibility for management of thepartnership business and must accept personal liability for partnership debts and obligations. Insituations in which a limited partnership seems to be the appropriate form of business organizationbut the prospective general partner(s) are unwilling to accept personal liability for partnership debtsand obligations, the solution may be a limited liability limited partnership or to use a limitedliability entity as the general partner(s).

G. Limited Liability Limited Partnership.

1. General.

A limited liability limited partnership ("LLLP") is a limited partnership that registers with thesecretary of state as an LLLP, where permitted by statute. The effect of registration is to limit thevicarious liability of the general partners in the same fashion that registration as an LLP limits theliability of the general partners of a general partnership.

The earliest LLLPs were formed under both RULPA and UPA by having a RULPA limitedpartnership elect LLP status. Subsequently, certain RULPA statutes were amended to provide forthe election of LLLP status by the limited partnership. LLLP status was made an elective statusunder ReRULPA.

Certain LLLP elections take the form of the limited partnership electing to be a limited liabilitypartnership (for example, Delaware) while in other states the election is made in the certificate oflimited partnership (Florida, Hawaii and Kentucky). Most states require that an LLLP identify itselfin its name, but those requirements are not universal.

States permitting LLLPs include Alaska, Arizona, Arkansas, Colorado, Delaware, Florida, Georgia,Hawaii, Idaho, Iowa, Kentucky, Maryland, Minnesota, Missouri, Nevada, North Carolina, NorthDakota, Pennsylvania, South Dakota, Texas, and Virginia.

The factors to consider in determining whether registration is appropriate include the impact whichregistration may have on the perceptions of the limited partners concerning the proper role of thegeneral partners, and in partnerships in which there is more than one general partner, theinterrelationship between the general partners with respect to their willingness and ability tocontribute additional capital to the partnership when considered necessary for the furtherance of thepartnership business.

2. Professional Firms.

The advantage of a limitation on personal liability co-existing with favorable pass-through taxtreatment for unincorporated entities has encouraged many professional services firms to adopt the

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LLP or LLC model. Which one was chosen often depended on state rules.

For example, California prohibits law, accounting, and other firms requiring a license fromoperating in LLC form. California law firms and multistate law firms having offices in Californiahave embraced LLP status. Some firms operate in professional corporation form, as either S or Ccorporations, with the attendant applicable tax consequences to the corporations and shareholders.)

With a change in Illinois in July 2003, lawyers are now able to practice in LLPs in every state. Therules applicable to, and cost of, registration vary from state to state, and in some states the liabilityshield afforded LLPs may not be total. The rules applicable to other professionals also have becomemore flexible over recent years as laws and regulations have been changed to accommodatepractice by LLCs and LLPs. Additionally, there are many domestic limited partnerships engaged inprofessional and business services.

(a) Practical reasons for—and against—LLLPs.

A potential advantage of operating as an LLLP (compared with LLCs) is that the law involving therights and relationships of general and limited partners is fairly well settled, and the general partnerof the LLLP may obtain the same liability shield provided to LLC member-managers. The limitedpartners, for example, may require the general partner of the LLLP to have the high duties ofloyalty and other fiduciary duties owed by general partners in a traditional state law limitedpartnership.

There are also disadvantages of operating as an LLLP rather than as an LLC:

(1) Not all states recognize LLLPs, and fewer have authorized practice of licensed professions inLLLPs. Additionally, the general partner of the LLLP may be personally liable for LLLP liabilitiesof the LLLP arising in non-LLLP states.

(2) The general partner may have fiduciary duties owing to the limited partners as a matter of statepartnership law that are not applicable to member-managers of LLCs, and under ULPA 2001 thelimited partners do not have fiduciary duties, thereby distorting the duty structure within thepartnership from that generally expected in a general partnership or LLP, whereby each partnerowes similar duties to his or her partners and the partnership.

(3) The bulk of the management of the LLLP must be done by or under the supervision of a generalpartner whereas LLCs permit non-member managers, although this arrangement would beunavailable for professional service firms whose managers must be licensed.

(4) There is also the possible need to change the firm's name when one of its general partnerswithdraws or becomes a limited partner. Some states' versions of the ULPA (Texas) provide that alimited partnership may not include in its name the name of the limited partner unless that name isalso the name of a general partner. Since an LLLP is a limited partnership, presumably the firmmust change its name to delete the name of a general partner when he or she become a limitedpartner. This generally would not be a problem if the firm operated as an LLP, LLC, or otherlimited liability entity.

The use of LLLPs by professional service firms raises the question of whether use of the LLLP islegal and ethical. This a question not only of state statue but the licensing rules. In the case of lawfirms, even if otherwise so permitted, would that practice be unethical in light of ABA and state barassociation opinions?

(b) Is LLLP Legal?

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As a matter of state statute, LLLPs, where permitted, are organized and operating under the limitedpartnership acts. Under the statute, LLPs, where permitted, are permitted to operate all types oftrades and businesses, although many limited partnership acts often proscribe engaging in certainactivities such as banking and insurance.

In contrast, state rules generally permit professionals to practice in general partnership form andspecified forms of limited liability entities, such as professional corporations, LLPs (under thegeneral partnership act), and LLCs.

Delaware and Pennsylvania explicitly approve of law practice in limited partnership form (Del.S.Ct. Rule 67(a)(iii); Pa. S.Ct. Rule 5.4(d) and Comment (5)). See Donn, "Limited Liability Entitiesfor Law Firms—Ten Years Later," 7 J. Passthrough Entities, July-August 2004, page 19. Indeed,one might conclude that when the supreme court rules of a state explicitly approve of professionalcorporations, LLCs, and LLPs by name, any other type of practice, such as business corporations(unless the state as no corporate practice prohibition by statute or case law), trusts, limitedpartnerships, and LLLPs may not be permissible, even if such entities can be validly formed understate statutes.

Connecticut’s bar association has opined that limited partnerships formed under the ULPA arepermissible forms of organization. Conn. Bar Assn. Formal Opinion No. 43 (1994). New Mexicoand Pennsylvania permit lawyers to practice law as members or owners of "any limited liabilityentity." In those states, since the state court rules permit limited liability entity practice, this wouldlogically have to include limited partnerships and LLLPs. See Pa. S.Ct. Rule 5.4(d) and Comment(5); Rule 24-107 NMRA of the Rules Governing the New Mexico Bar (effective 3/28/05).

Even if a law firm is formed and successfully registers as an LLLP in its home state, there remainsthe question of whether it can validly operate as an LLLP in other jurisdictions that do notexplicitly recognize the LLLP form for law practice. Similar questions as to multistate law practiceby LLCs were faced when LLCs first gained popularity.

(c) Is LLLP Ethical?

It is now. Over forty years ago, in the ABA's Committee on Ethics and Professional Responsibilityinformally opined that law practice could not be conducted in limited partnership format.3

However, ABA Formal Opinion 96-401 (8/2/96) issued by the ABA's Ethics Committee reversedits 1965 position, and concluded that the Model Rules of Professional Conduct permit lawyers topractice in an LLP or LLLP if the applicable law provides that the lawyer rendering legal servicesremains personally liable to the client, the requirements of the law of the relevant jurisdiction aremet, and the form of business organization is accurately described by the lawyers in theircommunications. The ABA Formal Opinion makes no reference to the Committee's prior informalopinions to the contrary prohibiting practice in limited partnership form.

Opinion 96-401 assumes there is compliance with applicable state statutes and other controllinglaw, and does not purport to indicate appropriate choice of law rules involving multi-jurisdictional

3 ABA Informal Opinion 865 (9/23/65). That opinion was based on provisions of the original Uniform Limited Partnership Act(particularly the effective prohibition on limited partners taking part in control of the partnership's business), and on restrictionson limitations of liability for personal malpractice. This was viewed as antithetical to the lawyer's duties to the client andpreclude any meaningful participation with the lawyer's partners in the conduct of the firm's business. ABA Informal Opinion1265 (2/21/73) and ABA Informal Opinion 85-1514 (4/27/85) prohibited use of a limited partnership for an impermissibledivision of fees among lawyers. If it is unethical to practice as a limited partnership, it would be unethical to practice in LLLPformat.

39 ©Alson R. Martin 20103054782v1

law firms. The ABA Opinion states that a requirement of any ethically permissible business formfor lawyers is that the lawyer rendering the legal services to the client must be personallyresponsible to the client. The Opinion states the understanding that all of the LLP and LLLP laws(then enacted) of the various states meet this requirement. The ABA Opinion concludes thatlawyers can avail themselves of the LLP (or LLLP) business form without that constituting anagreement with a client prospectively limiting the lawyer's liability to a client for malpracticewithin the scope of Model Rule 1.8, because LLPs and LLLPs do not insulate a lawyer fromliability for his own negligence. Rather, the limitation on vicarious liability created by LLPs andLLLPs derives solely from state law, not from an agreement between a lawyer and his client.

Notwithstanding the green light given by the ABA Opinion, law firm and other professional LLLPsand limited partnerships are rare. There are, however, LLLP service providers in Arizona,Arkansas, Colorado, Delaware, Florida, Georgia, Hawaii, Kentucky, Maryland, Massachusetts,Minnesota, Montana, Nevada, and Texas, based on an internet Google search in late 2011.

H. Other Issues.

1. Foreign State Operations.

A limited, unsettled and contradictory body of case law exists regarding how a business entity notformally recognized in a particular foreign jurisdiction will be treated in that jurisdiction. SeeRutledge, “To Boldly Go Where You Have Not Been Told You May Go: LLCs, and LLLPs inInterstate Transactions,” 58:1 Baylor Law Review 205-242 (2006).

There is no such issue for corporations or LLCs operating in other states. The internal affairs rule,as embodied in both common law and corporate statutes, precludes any need to undertake aconflicts of law analysis with respect to internal corporate affairs. The law of the state ofincorporation governs. However, whether shareholder liability to third parties for claims incurredby the corporation falls within internal affairs is not clear.

While the law is not clear for newer types of entities as to the effect of limited liability protection inother states outside the state of formation that do not recognize the entity in question, it is likelythat courts would reach the following results:

(a) A foreign limited liability entity (“LLE”) doing a type of business in a state that the samedomestic entity may not engage in will likely not afford its owners limited liability;(b) A full shield LLP in a partial shield LLP jurisdiction likely will not afford its partners limitedliability;(c) A partial shield LLP operating in a full-shield jurisdiction likely will afford its partners only apartial liability shield;(d) A LLE owner that is not listed as having liability under a state statute where it is operating(such as a state law mentioning only corporate officials but not LLC managers as being personallyliable for unpaid wages) will be found liable if liable under the state of formation.(e) A LLLP operating in a state that does not have an LLLP statute likely will not afford its generalpartners limited liability.

2. State Law Merger and Conversion of Entities.

40 ©Alson R. Martin 20103054782v1

Although structural distinctions between the various forms of business entity have been minimized,there are certain situations in which business owners may consider one form of entity to bedesirable over another. For example, business owners may wish to transform corporations intoLLCs to obtain flexibility, or to transform an LLC or other form of unincorporated business into acorporation in the expectation of making a public offering of securities. Many states have adoptedspecial statutory provisions in order to help to facilitate these type of transformations from oneform of business entity to another. Under these provisions entities can easily convert from one formof entity in the same or another state. The statute permits these transformations to be completedadministratively without the need to wind up the business affairs of the converting entity and payits obligations or distribute its assets. As a result, the transformation is not deemed to be adissolution of the converting entity and the entity that results from the transformation is deemed tobe the same entity as the converting entity. However, for income tax purposes, conversion from a“C” or “S” corporation is treated as a liquidation followed by the formation of the new entity.

3. Continuity of Life/Withdrawal/Right to Dissolve.

Corporations and, unless otherwise specified in their respective operating or limited partnershipagreements, LLCs and LPs (but not GPs) exist in perpetuity and, except as may be expresslygranted by the terms of an applicable shareholders, operating or limited partnership agreement towhich all shareholders, members or partners are parties, no shareholder, member or partner thereofhas the unilateral right or power to dissolve or terminate any such legal entity.

Unless otherwise provided in a shareholders, operating or partnership agreement to which allshareholders, members or partners are parties, under state law, neither shareholders ofcorporations (including PAs), members of LLCs (including PLLCs) nor limited partners of LPshave the right to withdraw from their respective corporation, LLC or LP or otherwise force, byunilateral action, a mandatory purchase of their respective interests therein.

General partners of LPs subject to ReRULPA have the right to “dissociate” (or withdraw) fromtheir LP as a “general partner” at any time, even if prohibited by the terms of the applicable limitedpartnership agreement. Such dissociation does not entitle the dissociated general partner to anydistributions nor will such dissociation cause or result in a dissolution of the LP unless expresslyrequired by the applicable limited partnership agreement or unless the dissociated general partnerwas the sole general partner of the LP and within 90 days from the date of dissociation, allremaining limited partners do not otherwise agree to continue the business of the LP or agree toadmit and cause to be admitted at least one additional general partner.

By contrast, general partners of LPs not subject to ReRULPA, are entitled by statute to be paid the“fair market value” of their interest in such LPs upon their dissociation or withdrawal therefrom, ifnot otherwise provided by the terms of their applicable limited partnership agreement, even if theydissociate or withdraw from their LP in violation of the terms of their LP’s limited partnershipagreement.

Shareholders in professional corporations, absent a buy-sell agreement, are often only entitled to bebought at their death.

4. Claims of Outside Creditors.

41 ©Alson R. Martin 20103054782v1

Unlike judgment creditors of shareholders of corporations (except PCs or PAs in some statesbecause owners must be licensed professionals), who are generally able to foreclose on a debtor-shareholder’s stock in a corporation in order to satisfy their judgments, judgment creditors ofmembers of LLCs or partners (general or limited) of GPs or LPs are precluded from foreclosing ona debtor-member’s or debtor-partner’s equity interest and, instead, are limited to obtaining what isknown as a “charging order” against the debtor-member’s or debtor-partner’s respectivemembership or partnership interest. If a judgment creditor of a member or partner obtains acharging order against the debtor-member’s or debtor-partner’s membership or partnership interest,then such creditor will only be entitled to receive whatever distributions, if any, the debtor-memberor debtor-partner is otherwise entitled to receive from the LLC, GP or LP, at the time or times thedebtor-member or debtor-partner would otherwise be entitled thereto, until such time suchcreditor’s judgment (secured by such charging order) is satisfied in full.

5. State Filing Fees & Taxation.

In some cases, the use of one type of entity versus another may result in higher state filing orannual report fees or state taxes.

6. Fiduciary Duties.

There are differences in fiduciary duties and the ability to waive, limit or modify fiduciary dutiesbetween Delaware limited partnerships and Delaware LLCs. In Delaware LLCs, they may beeliminated. Outside of the Delaware context, there may be distinctions for a fiduciary duty analysisbetween limited partnerships and LLCs based on whether the limited partnership is organized in ajurisdiction that has not adopted RUPA. One would expect that this difference will recede asadditional jurisdictions adopt RUPA. Limited partnerships have been around much longer thanLLCs and have a “greater judicial track record” that might provide guidance to future courts andpractitioners. However, with the development of non-corporate limited liability entities such aslimited partnerships, limited liability partnerships, limited liability limited partnerships and LLCs,all designed in one form or another to insulate ownership from liabilities of the business enterprise,as a policy matter it appears there is no logical reason to distinguish among such forms of entity forfiduciary duties.

Neither RULPA nor DRULPA identifies the fiduciary duties of a general partner. Rather, todetermine what fiduciary duties are owed in a limited partnership by the general partners, referencemust be to the UPA or, in those jurisdictions that have adopted RUPA, to RUPA. See RULPA§404. See J. William Callison, “Blind Men and Elephants: Fiduciary Duties Under the RevisedUniform Partnership Act, Uniform Limited Liability Company Act, and Beyond”, 1 J. Small &Emerging Bus. L. 109, 161 (1997).

Case law under the RUPA identifies the fiduciary duties of general partners:1. A duty of loyalty, defined as a duty not to appropriate partnership opportunities, a duty not toenter into competition with a partnership and a duty not to act adversely to the partnership’sinterests;2. A duty of good faith and fair dealing;3. A duty of care; and4. A duty to disclose material information to the partnership.

42 ©Alson R. Martin 20103054782v1

ReRULPA takes a different approach than RUPA in that the fiduciary duties of a generalpartner are set forth within the text and without requiring a reference to UPA or RUPA for suchpurposes. ReRULPA sets forth the fiduciary duties of a general partner in a limited partnership inSection 408, “General Standards of General Partner’s Conduct.”

RULPA does not provide that a limited partner has fiduciary duties to the limited partnership or tothe other partners in the limited partnership. However, in appropriate circumstances, limitedpartners have been held to have fiduciary duties. Tri-Growth Centre City, Ltd. v. Silldorf,Burdman, Duignan & Eisenberg, 216 Cal. App. 3d 1139, 265 Cal. Rptr. 330 (Ca. Ct. App. 1989).See In Re Villa West Associates, 193 B.R. 587 (D. Kan. 1996) (limited partner not liable for breachof fiduciary duty by acting to reduce liability under personal guaranty without advising otherlimited partners of the possibility). In Re Kids Creek Partners L.P., 212 B.R. 898 (Bankr. N.D. Ill.1997) (limited partner not liable as fiduciary because it took no management role and did not act tointerfere with or mislead other equity holders).

ReRULPA provides that a limited partner may be subject to fiduciary duties and is subject to anobligation of good faith and fair dealing.

RUPA sets forth certain statutory guidelines for limitations on fiduciary duty obligations,but does not provide that such fiduciary duties may be eliminated in their entirety.47/ Indeed,RUPA provides that the default rules of the statute that include fiduciary duties may be waived orvaried with only 10 exceptions set forth in RUPA Section 103(b). Three of the 10 exceptionspertain to fiduciary duty and the duty of good faith and fair dealing. Although the duty of loyaltymay not be eliminated, the partners are free to provide by agreement for the identification ofspecific types of activity that do not violate the duty of loyalty if not “manifestly unreasonable.”The partnership agreement may specify a mechanism for a consent by the partners after fulldisclosure of a specific act or transaction that might otherwise violate the fiduciary duty of loyalty.The partnership agreement may not unreasonably reduce the duty of care (which is limited bystatute to grossly negligent or reckless conduct, intentional misconduct or knowing violation oflaw).

The non-fiduciary duty of good faith and fair dealing may be defined within the agreement but maynot be manifestly unreasonable. The manifestly unreasonable test and the outer limits ofspecification for good faith and fair dealing are left to the courts. Of course, the partnershipagreement may specify higher standards of care, loyalty and good faith. For example, partners withstrong bargaining power may insist on a higher standard of care in managing the assets of theenterprise.

ULLCA’s recitation and identification of fiduciary duties is substantially similar to RUPA. UnderSection 409 of ULLCA, fiduciary duties are limited only to the fiduciary duties of loyalty and care.The fiduciary duty of loyalty is limited to (a) accounting to the company and to hold as trustee anyproperty or profit derived from the member in winding up the business of the company or derivedfrom the use of a member of company property, including appropriation of a company opportunity,(b) refraining from dealing with the company in the conduct or winding up of the company’sbusiness in an adverse manner, and (c) competing with the company’s business before dissolution

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of the company. The duty of care is limited to refraining in engaging in grossly negligent orreckless conduct, intentional misconduct or a knowing violation of law. Like RUPA, the duty ofgood faith and fair dealing is imposed, but not as a fiduciary duty. Like RUPA, no violation of afiduciary duty or the duty of good faith and fair dealing will occur when the action in questionfurthers the member’s own interest. Furthermore, as with RUPA, lending money or transactingbusiness with the company is permitted. However, such transaction should generally be approvedby the company or members either by reference to the specific transaction or by adherence to aprocedure set forth in the operating agreement of the company.

There may be a difference between LLCs organized under ULLCA and limited partnershipsorganized under RULPA that remain bound up with UPA. Cases have held that fiduciary dutiesmay be modified or actions otherwise a breach of a fiduciary duty may be consented to. TheULLCA provides specific statutory blessing for such matters. There appears to be little todistinguish ULLCA LLCs and limited partnerships with RUPA general partners (other thanDRUPA) and, accordingly, fiduciary duty analysis would not be dispositive in considering thechoice of entity between a LLC and a limited partnership.

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III. CHART COMPARING ENTITY CHARACTERISTICS.

Comparison Chart: Regular and S Corporations, LLC, Limited Partnership (LP),Limited Liability Limited Partnership (LLLP), General Partnership (GP), and LLP

Factor C Corp S Corp LLC* LP & LLLP GP

NumberofOwners

No restrictions No more than 100shareholders

No restrictions, butneed at least twomembers to beconsidered apartnership for taxpurposes

Must have at leastone general partnerand at least onelimited partner andthey must be at leasttwo different partners

Must have at leasttwo partners

Type ofOwners

No restrictions May not haveshareholders other thanindividuals, certaintrusts, estates, andcertain exemptorganizations(including charitableorganizations andqualified retirementtrusts). May notinclude regular Scorporations, (exceptfor 100% owned Scorporationsubsidiaries), ornonresident aliens asshareholders

No restrictions No restrictions No restrictions

ClassesofOwnershipInterests

Permitted One class only, but canhave differences invoting rights

Permitted Permitted Permitted

LiabilityofOwners

Limited Limited Limited General partners havejoint and severalliability except inLLLP; limitedpartners have limitedliability except inunusualcircumstances wherethey participate inmanagement or are

General partners have joint andseveral liability

45 ©Alson R. Martin 20103054782v1

professionals, wherepermitted (as to ownconduct)

OwnerParticipation inManagement

Permitted Permitted Permitted Participation bylimited partnersgenerally restricted

Permitted

OrganizationCosts

Filing fee Filing fee Filing fee Filing fee None

Format-ionrequirements

File articles ofincorporation withstate; adopt bylaws;initial minutes oforganizers or directors

Same as for regularcorporation; file Selection with IRS

File articles oforganization withstate; adoptoperating agreement

File certificate oflimited partnership;adopt partnershipagreement

None. Partnership may exist inthe absence of any writtenagreement

ConductofBusinessin OtherStates

Most states haveforeign corporationqualificationprovisions

Same as for regularcorporation

Most states haveforeign LLCqualificationprovisions

Most states haveforeign limitedpartnershipqualificationprovisions; many donot for LLLPs

Typically no mechanism forqualification of foreignpartnerships

Name Must contain“corporation,”“limited,”“incorporated,”“company,” or anabbreviation thereof


Must contain“L.C.,” or “LLC” orwords LimitedCompany orLimited LiabilityCompany

Must containLimited, LimitedPartnership, Ltd.,L.P., or LLLP or thefull words

No requirements

InterestsTransfer-able Aswith FullSubstitu-tion ofTransfer-ee

Yes, subject toagreements amongshareholders


Only if permitted byarticles oforganization,regulations oroperatingagreement; possibletax issue if freelytransferable

Only if permitted bypartnershipagreement; possibletax issue if freelytransferable

permitted by partnershipagreement

Term Typically perpetualunless otherwiselimited incorporation


May not exceedterm specified inoperating agreement

Typically limited bypartnershipagreement

Typically limited by partnershipagreement

Dissolu- No No Determined by No for limited Yes

46 ©Alson R. Martin 20103054782v1

tion onDeath,Retire-ment,Withd-rawal,etc., ofOwner

operating agreementunless state lawrequires

partner(s); yes forgeneral partnersunless partnershipagreement providesotherwise

Level ofIncomeTaxes

At corporate andshareholder level

At shareholder levelonly, except certainitems can be taxed atcorporate level

At member levelonly, if structured tobe taxed aspartnership

At partner level only At partner level

SpecialAllocat-ions ofTaxItems

Permitted if providedas stock classes

Pro rata according tostock ownership

Permitted Permitted Permitted

Contrib-utionsonFormation

Taxable, unlesstransferors meet 80%control test of §351 ofIRC and adjusted basisof assets exceedsliabilities

Same as regularcorporation

Nontaxable unlessdisguised sale ormember is relievedfrom debt

Nontaxable unlessdisguised sale orpartner is relievedfrom debt

Same as limited partnership

Deduct-ibilityoflossesbyowners

No, except uponsale/exchange of stockif §1244 applies

Yes, subject to basislimitations; corporatedebt not included inbasis but shareholderdebt to corporation isincluded

Yes, subject to basislimitations; LLCdebt included inbasis if taxed aspartnership

Same as LLC Same as limited partnership

At-RiskLimitat-ions

Applicable, if closelyheld or PSC

Applicable Applicable Applicable Applicable

PassiveActivityLimitat-ions

Applicable, if closelyheld or PSC

Applicable Applicable Applicable Applicable

Distrib-utions

Taxable to extent ofearnings and profits

Nontaxable to extentof shareholder's taxbasis in stock or debt

Nontaxable toextent of member'stax basis in LLCinterest

Nontaxable to extentof partner's tax basisin partnership interest

Nontaxable to extent of partner'stax basis in partnership interest

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Liquida-tion

Taxable to bothcorporation andshareholders

Taxable at shareholderlevel via flow-throughof corporate items

Nontaxable toextent of member'stax basis in LLCinterest

Nontaxable to extentof partner's taxpartner's tax interest

Nontaxable to extent of basis inpartnership basis in partnershipinterest

“Empl-oyee”FringeBenefitsforOwners

Permitted Not permitted if morethan 2% shareholder

Not permitted Not permitted Not permitted

MedicareTax onRetire-mentPlan forOwners'Contributions

No No Yes Yes Yes

IRC §409A

Applies Applies Not applicable to736 payments ifmember is “generalpartner”

Not applicable to 736payments

Not applicable to 736 payments

IRC §1402(a)(10) – Nopayrolltax onretirementpayments paiduntildeath

No No Probably if memberis “general partner”but no rulings

Yes Yes

*Assumes LLC is a partnership for tax purposes.

Capital Shiftsand Ownership Changes

L. Andrew ImmermanAlston & Bird LLPAtlanta, Georgia

[email protected]

1

The Lehman Case• Authority on partnership capital shifts is sparse, and most of the little

authority that exists deals with service-related shifts.• The seminal case on partnership capital shifts is Lehman v. Commissioner, 19

T.C. 659 (1953).– In Lehman, each partner contributed $10,000 to the capital of a limited

partnership.– Under the partnership agreement once the amount that the other partners

earned or received exceeded a $50,000 hurdle, each of the petitioners (husbandand wife) became entitled to $5,000 in credits on the books of the partnership,with a like amount deducted from the capital contributions of the other partners.

– The husband was the sole general partner and ran the business; the wife held onlya limited partner interest and there is no indication in the court’s opinion that sheprovided services.

– The credits were actually made on the partnership’s books in the year followingthe year in which the petitioners became entitled to the credits.

• The court held that the petitioners were required to include $10,000 inincome.

• Moreover, they were required to report the amount in the year they becameentitled to the credit, even though the partnership books did not reflect thecredit until the following year.

2

The Lehman Case

• The $10,000 capital shift in Lehman arguably was made entirely inconsideration of the husband’s performance of services.

– However, the court saw no need to determine the reason for the capitalshift except to point out that the shift concededly was not a gift from theother partners.

– Lehman does not distinguish capital shifts that take place ascompensation for services from other capital shifts; the court did notconsider it “crucial whether the transfer to petitioners’ capital accountswas in fact ‘compensation’ for [petitioner husband’s] services.

– According to the court: “Surely the increase resulted in a gain or profit to[the Lehmans].”

• The court considered the situation:

– “no different in its tax consequences than if the partners had paid overto petitioners the $10,000 under an arrangement whereby petitionersagreed to use that sum to increase their investment in the partnershipwith a corresponding reduction in the capital shares of the otherpartners.”

3

The Lehman Case

• The court does not say whether the investorpartners were entitled to a deduction with respectto the capital shifted to the Lehmans.– If the capital shift was compensatory, the investors

very likely would have been entitled to a deduction.

• Nor does the court say whether the investorpartners had to recognize any taxable income.– Could it be argued that the investor partners in effect

used appreciated property (the partnership interest)to pay an obligation (the amount owed to theLehmans)?

– There is not much authority but many advisors wouldtake the position that the investor partners do notrecognize gain.

4

Other Cases

• Later cases test for the existence of a capital shift by asking what theresults would be on a hypothetical liquidation.– If the LLC were to sell all its assets at fair market value and distribute the

proceeds to the members in liquidation, would any members receive thecapital of other members?

• For example, Mark IV Pictures, Inc. v. Commissioner, 969 F.2d 669 (8th Cir.1992), aff’g 60 T.C.M. (CCH) 1171 (1990), states that:– “[t]o determine whether an interest is a capital one, we examine the effects of

a hypothetical liquidation occurring immediately after the partners receivedtheir interests which, in this case, was the date the partnerships were formed”(citing a leading treatise).

• This test was recently applied in Crescent Holdings, LLC v. Commissioner,141 T.C. No. 15 (2013). See also Hensel Phelps Construction Co. v.Commissioner, 74 T.C. 939 (1980), aff’d, 703 F.2d 485 (10th Cir. 1983);Johnston v. Commissioner, 69 T.C.M. (CCH) 2283 (1995).

• All the cases cited here arose in connection with service-related shifts, butsimilar reasoning may apply to capital shifts of other kinds.

5

Treasury Regulations• In addition to the judicial authorities, the Treasury Regulations under Section

721(a) of the Code offer limited guidance on the tax consequences of a capitalshift.

• Section 721, where it applies, prevents both the contributing partner and thepartnership from recognizing gain.

• However, Treas. Reg. Section 1.721-1(b)(1) contrasts the normal situation -- inwhich a partner is entitled to be repaid its contributions and Section 721 providesfor nonrecognition -- with the less common situation in which a partner gives up,in favor of another partner, some or all of its right to repayment of its capitalcontribution:

“To the extent that any of the partners gives up any part of his right to berepaid his contributions (as distinguished from a share in partnership profits)in favor of another partner as compensation for services (or in satisfaction ofan obligation), section 721 does not apply.”

• Under Lehman and the other cases, when -- or even whether -- the capital shift isactually reflected on the books of the partnership should make no difference tothe tax consequences.

6

Capital Shift as “Guaranteed Payment”

• Treas. Reg. Section 1.721-1(b)(2) analyzes a compensatory capitalshift as a “guaranteed payment for services” within the meaning ofCode Section 707(c).– A guaranteed payment generally includes any payment to a partner for

services or the use of capital, but only “to the extent determinedwithout regard to the income of the partnership.”

• A guaranteed payment need not be “guaranteed” in any commonlyunderstood sense of the word; it is simply a payment that isdetermined without regard to the partnership’s income.– Payments to a partner not acting in its capacity as a partner, however,

are subject to the slightly different rules of Code Section 707(a), andare not classified as guaranteed payments.

• A “guaranteed payment” as defined in Code Section 707(c) may bemade either for services or for the use of capital.– Although authority is lacking, if a capital shift for services is a

guaranteed payment, then by the same logic a capital shift for the useof capital may be a guaranteed payment as well.

7

Compensatory Capital Shift in New Partnership

8

• Worker and Investor form a partnership.– On day one Worker contributes services (but no cash or other

property).

– On day one Investor contributes $100.

– The operating agreement says split all distributions 50/50.

• There is a capital shift of $50 from Investor to Worker.

• The capital shift probably occurs on day one (despite theabsence of any imminent liquidation or other distribution).

• Consensus view is that the capital shift is currentcompensation income to Worker and a deductiblecompensation expense to Investor.– But don’t assume the amounts of the income and expense are

necessarily $50.

Worker Investor

$100

On immediate liquidation:-Worker gets $50-Investor gets $50

Services

The “Profits Interest” Alternative

• The compensatory capital shift in examples likethis is typically avoided by structuring Worker’sinterest as a “profits interest.”

• Rev Proc 93-27, 1993-2 CB 343, defines two typesof partnership interests, as determined at thetime of issuance:– Capital Interest: partnership interest that would

entitle the holder to a share of liquidation proceeds ifpartnership assets were sold at FMV.

– Profits Interest: partnership interest that is not acapital interest; generally entitles holder only to ashare of post-issuance partnership income and gain.

9

10

Structuring a Profits Interest• If Worker has a profits interest, he would receive nothing if the

partnership immediately liquidated.– However, he could receive a share of future profits, including

appreciation in value.– His share of future profits could be higher than 50% if the parties

agree. For example, he could be entitled to all of the first $100 ofappreciation to bring him up to where he might have been if he hadcontributed $100 in the first place.

• The IRS will accept that the receipt of a profits interest in exchangefor services is not a taxable event for the partnership or therecipient, if:– The interest isn’t related to a substantially certain and predictable

stream of income from partnership assets.– The interest is not disposed of within two years.– The interest is not a limited partnership interest in a publicly traded

partnership.• Parties that are accustomed to businesses organized as

corporations, and who have not worked extensively with LLCs andpartnerships, are very likely to enter into transactions thatinadvertently cause a taxable capital shift to service providers.– The problem of inadvertent capital shifts to service providers is

remarkably widespread.

Compensatory Capital Shift in ExistingPartnership

• Another typical example: LLC with A and B as members wantsto give C, an employee, an interest in the LLC.– Suppose A and B formed LLC on 1/1/14 by contributing $10 each.

– On 1/1/15, LLC is worth $150 (i.e., if the assets of the LLC were sold at fairmarket value and the proceeds distributed, the members would receive $150)

– A and B they want to bring in C, a service provider, and give him a “1/3interest.”

11

A B• If C gets a straight “1/3rd interest,” there is a capital

shift from A and B to C; C presumably has taxableincome.

• However, C’s interest might instead be tax-free isstructured as a profits interest. If so:

• A and B would get all $150 on an immediateliquidation but C could participate in futureprofits (including future appreciation in value).

• C should not participate in any of the $150built-in value on an immediate liquidation,even though A and B only contributed $10each.

Preferred Return Without Capital Shift

A & B form an LLC. A puts in $100, and B puts in $50.Distribution “waterfall”:(i) First, to A until A gets a cumulative 20% annual return ($10 for year 1);(ii) Then to return A’s capital contributions;(iii) Then to return B’s capital contribution; and(iv) Thereafter, equally to A and B.

However, liquidating distributions are in accordancewith capital accounts.

The LLC earns just $7 for year 1, all of its allocated to A:

Because liquidating distributions are in accordance with capital accounts, there isno capital shift, but A would not get its full 20% preference if the LLC liquidated atthe end of year 1

12

$100 $50

A B

A B Total

Beginning CapitalAccount

$100 $50 $150

Allocation of income $7 $0 $7

Ending Capital Account $107 $50 $157

Preferred Return With Capital Shift

On the other hand, if all distributions – including liquidating distributions -- are in accordance with the same “waterfall,” there would be a capitalshift.

Step 1: Starting capital account balances: A=$100 and B = $50

Step 2: Distributions on hypothetical liquidation:

So, on liquidation, $3 of B’s $50 of capital is shifted to A.

• Must A report a taxable capital shift in year one (even if A does not actuallyreceive any distribution)? Can A argue it has made a “bargain purchase” andhas realized no gain?

• The capital shift arose because the LLC income was insufficient to satisfy A’spreferred return and instead some of B’s capital had to be shifted to A. 13

A B Total

Preferred Return $10 - $10

Return of A’s Capital $100 - $100

Residual Returns B’s Capital $47 $47

Total to be Distributed $110 $47 $147

Was the Capital Shift Intended?

• It used to be most common for LLC agreements to allocate profits andlosses in accordance with “layers,” and to liquidate in accordance withcapital accounts.

• Nowadays it is probably more usual for LLCs to liquidate in accordance witha specified waterfall, and allocate profits and losses in such as way as tocause capital accounts to hit the “targeted” waterfall, without allowingcapital accounts to control liquidating distributions.

• In most instances the distributions made under the two different draftingapproaches will be identical.

• In general, targeted allocations best ensure that distributions will be madeas intended, even if targeted allocations leave more room for doubt as tothe validity of the allocations.– However, keep in mind the possibility that distributions in accordance with a

waterfall may create a capital shift, and consider whether such a capital shift isintended.

– Is it possible that the parties intended that A’s preference be paid only out ofearnings, and did not realize that the targeted approach could be inconsistent withthat intent?

14

Forfeiture As Penalty for Failing toHonor a Capital Call

• Assume A has a $1,000 capital account.– The members of LLC have agreed that there will be

mandatory capital calls.

– Upon its failure to meet the capital call, a memberforfeit all of his capital.

• On failing to meet a capital call, A forfeits its$1,000 capital account in favor of the membersthat do honor the capital call.

• Upon the forfeiture, $1,000 of capital has shiftedfrom A to the other members.

15

Income to the Remaining Partners?

16

Some alternative theories:• Most likely: Current taxable income to the remaining partners in the

amount of the capital that has shifted from the defaulting partnersto them.

• Reasonably likely: Current taxable income to the remaining partnersequal to the fair market value of the forfeited interest of thedefaulting partners, which may differ from the capital being shifted(for example, because of minority discounts or marketabilitydiscounts).

• Unlikely: No current taxable income, but with special allocations(i.e., partnership allocates items of gross loss or deduction to thedefaulting partners and/or items of gross income or gain to theremaining partners until the capital accounts have caught up withthe hypothetical liquidating distributions).

• Very aggressive: No current taxable income, and no specialallocations. Remaining partners presumably recognize gain ondisposing of their interests (or receiving distributions in excess ofbasis).

Tax-DeferredReal Estate Dispositions:

Some Partnership Techniques


[email protected]

Saba AshrafBallard Spahr LLPAtlanta, Georgia

[email protected]

Three PartnershipStructures

Mixing bowls, leveragedpartnerships, and freeze

partnerships rely on basicpartnership tax principles

to defer tax.

3

Three Partnership Forms

Described very briefly below are three related

transactional forms.

All involve the acquisition and disposition, through

partnerships, of interests in assets.

If successful, such transactions may achieve results

somewhat similar to those of a like-kind exchange

under Code § 1031.

– These transactions are not subject to the limitations of a Code

§ 1031 exchange.

– However, these transactions are difficult to plan and

implement; they certainly do not offer an easy way around

Code § 1031.

4

Three Partnership Forms All three forms are similar in that they involve a

– tax-free partnership contribution (Code § 721),

rather than a

– taxable sale of the property.

However, the contribution must have

substance.

The parties must be willing to continue as

"partners" to some extent.

It is not just a matter of "papering" a sale as if

it were a contribution.

5

Three Partnership Forms

One party (the "Owner" or "Seller") holds realproperty (the "Old Property") worth $100, with a taxbasis of zero.

Another party (the "Investor" or "Buyer") wants toacquire this property.

Owner and Investor are willing to cooperate inmaking the transaction tax-free.

In all three of the structures described below, Ownercontributes the Old Property to a partnership withInvestor.

The tax goal: Instead of a taxable sale of the OldProperty, structure the transaction as a tax-freecontribution of the Old Property to a partnership.

6

Terminology

O:

I:

New Property:

Old Property:

Newco:

Sub:

Owner (or Seller).

Investor (or Buyer).

Property that Ownerwants to unload.

Property that Investorcontributes, or that ispurchased with the cashthat Investor contributes.

Newly formed LLC (or other businessentity classified for tax purposes as apartnership).

A wholly-owned subsidiary of O.

7

Basic Mixing Bowl Partnership

O contributes Old Propertyto Newco.

I contributes either:

– Cash to Newco, and Newcouses the cash to buy NewProperty, or

– New Property to Newco(but most likely it is Cash).

8


O receives 90% of theincome from NewProperty; I receives 90%of the income from OldProperty.

The effect is similar to atax-free disposition ofmost of O's interest in OldProperty, in exchange formost of the interests inNew Property.

9


O I

NEWCO

Old PropertyNew Property/

Cash

90% in NewProperty;10% in OldProperty

10% in NewProperty;

90% in OldProperty

NEWCO

10

Freeze Partnership

O contributes OldProperty to Newco.

I either:

– Contributes cash toNewco, and Newcouses the cash to buyNew Property, or

– Contributes NewProperty to Newco.

11

Freeze Partnership

O receives 100%of Newco Preferredand 10% of NewcoCommon interests;most of the value isin the Preferred.

I receives 90% ofNewco Common.

12

Freeze Partnership

The effect is similar to a tax-freedisposition of most of O's interest in OldProperty in exchange for a reasonablyfixed return.

For business reasons, O might like NewProperty to be low-risk investmentsgenerating a predictable income stream.

For tax reasons, it might be preferablefor New Property to be an activebusiness.

13

Freeze PartnershipDiagram

O I

NEWCO

Old Property New Property/Cash

Preferredand Common Common

14

Leveraged AcquisitionPartnership: First Step

First Step

O contributes OldProperty to Newco.

I contributes either:– Cash to Newco, and

Newco uses the cashto buy New Property,or

– New Property toNewco.

15

Leveraged AcquisitionPartnership Diagram: First Step

O I

NEWCO

New Property/Cash

Old Property

10%

90%

First Step

16

Leveraged AcquisitionPartnership: Second Step

Second Step

Newco borrows money on a nonrecourse basis.

A subsidiary of O ("Sub") guarantees the debt, but isonly obligated to pay after the lender has exhaustedremedies against Newco.– It is unclear what level of assets Sub needs to maintain, but

after Canal Corp v. Comm’r, 135 T.C. 199 (2010), it is arguablethat Sub should be committed to maintaining assets equal to100% of the debt (including principal and interest).

The proceeds of the debt are distributed to O.

17

Leveraged AcquisitionPartnership Diagram: Second StepSecond Step

Guarantee

O

NEWCO

10% 90%

Sub

DebtProceeds

I

Loan

Third PartyLender

18

What Could Go Wrong? All these transactions must overcome an initial

hurdle:

– Should the contribution of assets to the partnershipbe recharacterized as a "disguised sale" of theassets?

"Disguised sales" are governed by complexregulations. Treas. Reg. § 1.707-1 to -9.

If that initial hurdle is passed, Owner’sprecontribution gain can be deferred -- but forhow long?

Several kinds of events trigger the deferredgain

19

When is Gain Triggered? Events that trigger precontribution gain:

– Sale of the Old Property at any time (if Owner isstill a member of Newco). See Code §704(c)(1)(A).

– Paydown of debt or other decrease in partner'sshare of liabilities (in the case of a leveragedpartnership). See Code § 752(b).

– Distribution of the Old Property to Investor withinseven years of the contribution. See Code §704(c)(1)(B).

– Redemption of Owner within seven years of thecontribution. See Code § 737.

20

When is Gain Triggered?

– Any one of these events triggers the gainwhen the event occurs, so gain can bedeferred at least for some period (unlike the"disguised sale" rules").

– The "anti-mixing bowl rules" -- the last twoevents -- trigger gain if they occur within 7years of contribution.

• Ideally the parties can manage to stay weddedfor 7 years.

• If they split up after 7 seven years, there may beindefinite tax deferral.

22

First Anti-Mixing Bowl Rule

Suppose Old Property is contributed by Owner.

Old Property later distributed to Investor.

– Contribution is generally tax-free.

– Distribution is generally tax-free.

– Has Owner transferred Old Property to Investor and paidno tax?

• Maybe yes, if the parties can wait 7 years (and therewas not a "disguised sale").

• If the Old Property is distributed to the non-contributing partner (i.e., Investor) within 7 years,Owner recognizes precontribution gain. Code §704(c)(1)(B).

• But after 7 years, the rule is inapplicable.

23

Mixing Bowl Partnership:Contribution

Note: "A" is added to the example sothere will be at least two partners at all times.

NEWCO

New Property/ Cash

O I

Old Property

Basis: $0Value: $100

NEWCO

A

24

Mixing Bowl Partnership:Old Property Distribution

O I

NEWCO

Old Property/

NEWCO


A

25

First Anti-Mixing Bowl Rule Assume Old Property is distributed to Investor in

complete liquidation of Investor’s interest.

If distributed in Year 6, Owner recognizes the $100"precontribution" gain.– Owner’s original deferral of gain ends.

– Owner’s basis in the Partnership increases by $100.

If distributed in Year 8, Owner does not recognizegain.– Owner’s gain continues to be deferred.

– Owner’s basis in the Partnership stays the same.

In both cases:– Investor does not recognize gain.

– No one recognizes the additional $50 of appreciation in OldProperty.

26

Back-UpAnti-Mixing Bowl Rule

Old Property is contributed by Owner.

New Property later distributed to Owner.– Contribution is generally tax-free.

– Distribution is generally tax-free.

– Has Owner transferred Old Property to Investorand paid no tax?

• Maybe yes, if parties can wait 7 years (and there was nota "disguised sale").

• If the New Property is distributed to the contributingpartner (i.e., Owner) within 7 years, Owner recognizesprecontribution gain. Code § 737.

• But after 7 years, the rule is inapplicable.

27

Mixing Bowl Partnership:Contribution

NEWCO

New Property/ Cash

O I

Old Property


NEWCO

A

28

Mixing Bowl Partnership:New Property Distribution

O I

NEWCONEWCO

ANewProperty

29

Back-Up Anti-Mixing Bowl Rule Assume New Property is distributed to Owner in

complete liquidation of Owner’s interest.

If distributed in Year 6, Owner recognizes the $100"precontribution" gain.– Owner’s original deferral of gain ends.

– Owner’s basis in the New Property increases by $100.

If distributed in Year 8, Owner does not recognize gain.– Owner’s gain continues to be deferred.

– Owner’s basis in the New Property is the same as Owner’ basisin the Partnership.

In both cases:– Investor does not recognize gain.

– No one recognizes the additional $50 of appreciation in OldProperty.

30

Final Separation If the parties are able to remain together in Newco

for more than seven years, it may be possible forOwner and Investor to go their separate wayswithout Owner recognizing its precontribution gain.

If Owner or Investor is going to be redeemed, thevalue of the redeemed interest, and the value of theproperty used for the redemption, ideally should bedetermined at the time of the redemption.

Although the parties may try to "lock in" the value atthe time of the original contribution -- so that bothparties know with some certainty what Owner orInvestor will get when it leaves -- doing so adds tothe tax risks.

Canal Corp v.Comm’r, 135T.C. 199(2010):Court DeniesTax-FreeLeveragedDistribution

In leveraged partnerships such as the one at issuein Canal Corp, the fundamental question is theextent to which property is treated as:

– “Contributed” to a partnership under Code §721, with the partnership making a non-taxabledebt-financed distribution under Code § 731 tothe “contributor,” rather than:

– “Sold” to a partnership under Code §707(a)(2)(B), with the partnership making ataxable payment of the purchase price to the“seller.”

Canal Corp v. Commissioner135 TC No. 9 (2010)

32

Initial Structure Chesapeake (later known as Canal) owned Wisconsin

Tissue Mills, Inc. (WISCO).

WISCO owned a tissue business valued at $775 million.

Georgia Pacific (GAPAC) owned a tissue businessvalued at $376 million.

33

WISCO

$775 Million

Chesapeake

100%

GAPAC

$376 Million

Sale vs. Leveraged Partnership

GAPAC was interested inpurchasing WISCO stock orassets.

– However, Chesapeakedid not want to incur theconsequences of ataxable sale.

Chesapeake’s advisorssuggested a leveragedpartnership.

34

Assets Contributed WISCO contributed its tissue business to Georgia-Pacific

Tissue LLC (Newco) and received a 5% interest.

GAPAC contributed its tissue business to Newco andreceived a 95% interest.

35

WISCO GAPAC

NEWCO

Business

95%5%

Business

Loan Made On the same day, Bank of America (BOA) loaned $755 million to Newco.

GAPAC guaranteed all obligations under debt.

WISCO agreed to indemnify GAPAC for principal payments on theguarantee.

WISCO GAPAC

NEWCOBOA

Loan

$755Million

Guarantee

Indemnity

36

Loan Proceeds Distributed Also on the same day, Newco distributed the entire loan proceeds to

WISCO.

WISCO paid the proceeds out to affiliates. However, it took back a $151million note from Chesapeake. WISCO’s other assets were worth $6million

WISCO GAPAC

NEWCOBOA

Distribution

$755 Million

37

Debt-Financed Transfer Rules

If the distribution of the loan proceeds to WISCO qualified as adebt-financed transfer of consideration under Treas. Reg. §1.707-5(b), then the transfer of its tissue business to Newco wouldbe treated as a tax-free capital contribution and not as a“disguised sale.”– The rules for such debt-financed transfers are an exception to the

“disguised sale” rules.

– The theory is that borrowing money through a partnership should notbe treated less favorably than borrowing money directly.

To the extent that WISCO’s indemnity obligation is respected,WISCO bears the ultimate risk of loss on the debt, and the debtshould be allocated to WISCO.

To the extent that the debt is “allocated” to WISCO, thedistribution of the loan proceeds should qualify as a debt-financedtransfer under the regulations.

However, if WISCO’s indemnity obligation is disregarded in full(but GAPAC’s guarantee is respected in full), the debt would be“allocated” entirely to GAPAC, and the distribution of the loanproceeds would not qualify as a debt-financed transfer.

38

Anti-Abuse Regulations

The regulations generally presume thatpartners and related persons who haveobligations to make payments will fulfill theirobligations, regardless of actual net worth.Treas. Reg. § 1.752-2(b)(6).

“For purposes of determining the extent to which apartner or related person has a payment obligationand the economic risk of loss, it is assumed that allpartners and related persons who have obligationsto make payments actually perform thoseobligations, irrespective of their actual net worth,unless the facts and circumstances indicate a planto circumvent or avoid the obligation.”

39


However, the IRS argued, and the Tax Court agreed,that WISCO’s obligation to indemnify GAPAC shouldbe disregarded under the “anti-abuse” rules in Treas.Reg. §1.752-2(j).

“(1) In general. An obligation of a partner or relatedperson to make a payment may be disregarded ortreated as an obligation of another person for purposesof this section if facts and circumstances indicate that aprincipal purpose of the arrangement between theparties is to eliminate the partner's economic risk ofloss with respect to that obligation or create theappearance of the partner or related person bearing theeconomic risk of loss when, in fact, the substance of thearrangement is otherwise. . . .

. . .

“(3) Plan to circumvent or avoid the obligation. Anobligation of a partner to make a payment is notrecognized if the facts and circumstances evidence aplan to circumvent or avoid the obligation.”

40


Some language in the decision suggests that the anti-abuserule applies whenever there is only a “remote” chance that theindemnitor will have to make a payment. For example,

“We have carefully considered the facts and circumstances andfind that the indemnity agreement should be disregarded becauseit created no more than a remote possibility that WISCO wouldactually be liable for payment.”

Such a view would be inconsistent with the regulations, whichallocate liabilities on “recourse” debt to the party that bears theultimate risk of loss, even if that risk is nominal.– The test for ultimate risk of loss in the regulations appears to be

purely mechanical, with no reference to the likelihood of loss.– It is commonly the case that a guarantor or indemnitor’s loss is

highly unlikely.

Even purely nonrecourse debt is allocated to the partners, butin Canal GAPAC’s guarantee presumably rendered the debt“recourse” in the relevant sense.

41

No Requirement To Maintain Net Worth

The tax advisor determined that WISCO had tomaintain a minimum net worth of $151 million (20%of its maximum exposure on the indemnity), notcounting its interest in Newco.

The court hinted that 20% was insufficient, butrefused to set any “bright-line percentage test.”

An even bigger problem for the court apparentlywas that WISCO had no obligation to maintain eventhat level, or any level at all, of net worth.

42

No Requirement To Maintain Net Worth

According to the court, Chesapeake, the parentof WISCO:

“ … had full and absolute control of WISCO.Nothing restricted Chesapeake fromcanceling the note at its discretion at anytime to reduce the asset level of WISCO tozero.”

The court dismissed Chesapeake’s argumentthat fraudulent conveyance principles keptChesapeake from stripping assets out ofWISCO and rendering WISCO insolvent.

43

Other Factors Loan was not directly guaranteed by the partner

taking the distribution.– WISCO did not directly guarantee the loan, but

only agreed to indemnify GAPAC.– GAPAC had to proceed first against Newco before

pursuing an indemnity claim against WISCO. Guarantee/indemnity was backed by assets

representing only a fraction of the guarantor’stheoretical exposure.– Even at best, WISCO’s indemnity was backed by

net assets equal to only 20% of the total exposure.– The indemnity was given only by WISCO, to avoid

exposing all the assets of the Chesapeake group. Indemnity covered only loan principal.

– WISCO’s indemnity only covered principal and notinterest (or, presumably, fees, expenses orpenalties).

44

Other Factors

No business need for guarantee/indemnity– GAPAC did not require the indemnity, but WISCO

gave it anyway, because its tax advisor insisted.

Increase in equity for paying out on theguarantee/indemnity.– WISCO’s equity interest in Newco would have

increased if WISCO had made indemnitypayments.

Sale treatment for non-tax purposes– Chesapeake reported $377 million of book gain,

but of course no tax gain.– Chesapeake did not treat its indemnity obligation

as a liability for accounting purposes.– Chesapeake executives represented to the rating

agencies that the only risk on the transaction wasthe tax risk.

45

Penalties Upheld

The court upheld substantial understatementpenalties of $36.6.

The court’s reasoning calls into question someopinion practices that are prevalent, if not universal.

Chesapeake received a “should”-level tax opinionfrom PWC. However, the opinion gave no protectionagainst penalties, because, in the court’s view:– It was “unreasonable for a taxpayer to rely on a tax adviser

actively involved in planning the transaction and tainted byan inherent conflict of interest.”

– An inherent conflict existed because PWC charged an“exorbitant” fixed fee ($800,000) not based on time spent.

• The court seemed to imply that a flat fee is inherently suspect,and that Chesapeake should have known that.

• The court inferred that the fee was contingent on the issuanceof the opinion (rather than, as the engagement letter said, onthe closing of the financing), presumably on the ground thatthe financing would not have closed without the opinion.

46

Penalties Upheld

The opinion relied on reasoning by analogy and onthe writer’s interpretation of the regulations.– The court seemed to be saying that an opinion must be

supported by direct authority.

The opinion was, in the court’s view, “littered withtypographical errors, disorganized and incomplete”and “riddled with questionable conclusions andunreasonable assumptions.”– The court said that only a draft of the opinion was

submitted as evidence.– Commentators claim that in fact the final opinion was in

evidence, and that the document the court criticized wasa draft memo supporting the opinion.

The court probably did not mean to apply theeconomic substance doctrine, although it said thatthe indemnity lacked economic substance.

47

Tax-Free Exchange

Cash for somepartners;

real estate

for others

49

Example

The ABC partnership owns Whiteacre.– Basis is $3 million.– Whiteacre is under contract for $21 million cash.– Buyer has agreed to cooperate with a tax-free

exchange through a Qualified Intermediary.

Each partner has an equal 1/3 interest– Each partner’s basis is $1 million.– Each partner’s capital account is $1 million.

A wants her $7 million share of the sale in cash,even if she recognizes $6 million of income.

B and C want to roll over their $14 million shareof the sale tax-free into Blackacre.

What can they do?

50

What’s the Problem?

The parties will suggest simply exchanging:

Whiteacre (worth $21 million),

for

A combination of:– Blackacre (worth $14 million), and

– Cash ($7 million).

The exchange of Whiteacre for Blackacre is intended tobe a tax-free exchange under Code § 1031.

Of course the $7 million is taxable "boot" in the exchangebut so what? A wants cash, and expects to pay tax onher gain.

51

Exchange With Boot

Whiteacre

Blackacre

+

$7 mill cash

QI

50%A B

BC

$7 mill cash

50%0%

A receives $7 millioncash in completeliquidation of herinterest in ABC.

Blackacre remains inABC.

B and C remainpartners.

C

52

The Problem

ABC is an equal partnership.

There is $7 million of "boot" in the exchange.

All of the boot gain, not A’s $6 million share of gain, isrecognized.– A’s $1 million "share" of Whiteacre’s basis does not

offset the boot.

Even worse, the $7 million of boot normally would beallocated evenly among all three partners,including B and C.

B and C together have $4.67 million of taxableincome (2/3 of $7 million).– B and C get no cash.

– B and C thought they had a tax-free exchange.

Overview of Possible Solutions

Special Allocation.

– Partnership specially allocates boot to A.

Distribution of Fractional Interest.

– Partnership distributes a 1/3 undivided fractional interest to A.

– A sells her 1/3 interest.

– Partnership exchanges its 2/3 interest for Blackacre.

Installment Sale.

– Partnership exchanges Whiteacre for Blackacre plus boot, but theboot this time in the form of an installment note.

– Partnership distributes the installment note to A.

Cross-Purchase or Redemption.

– Partners buy out A for cash prior to exchange of Whiteacre, or

– Partnership buys out A for a note prior to exchange of Whiteacre.

53

54

Special Allocation:A Simple Solution?

B and C will suggest specially allocating the boot gain toA.

After thinking about it, A may say okay:

– Special allocation of $7 million gain to A increases herbasis from $1 million to $8 million.

– On distribution of $7 million in complete liquidation of herinterest, she has no additional income and recognizes a$1 million loss.

– The $7 million gain allocation, less the $1 million loss onliquidation of her interest, nets to $6 million of income.

– A started with $1 million basis and received $7 million incash.

– Paying tax on $6 million strikes her as fair.

So can B and C avoid taxable gain?

55

A Simple Solution?

Maybe this approach is a solution butmaybe not.

There are at least three possiblepositions on the validity of the specialallocation:

– The special allocation lacks "substantialeconomic effect" and is invalid.

– The special allocation is fully valid.

– The special allocation is valid only to theextent of allocating $6 million to A.

56

Substantial Economic Effect

Treas. Reg. § 1.704-1(b)(2)(iii)(a):

– In general an allocation is "substantial" if there is areasonable possibility that the allocation will affectsubstantially the dollar amounts to be received bythe partners from the partnership, independent oftax consequences.

Does the special allocation of $7 million oftaxable income to A affect the dollar amounts tobe received by A or any of the other partners?

Some advisors say no: A, B, and C are entitled tothe same dollar values ($7 million each) with orwithout the special allocation.

57

Substantial Economic Effect

Some advisors say yes:– The special allocation reflects the fact that the

partners receive different things:• A is getting $7 million in cash.

• No one knows what B and C will ultimately receive;B and C, unlike A, will participate in the futureprofits or losses from the Replacement Property.

– It may be easier to defend:• $6 million allocation to A (bringing her capital

account up to $7 million with no tax loss), than

• $7 million allocation to A (bringing her capitalaccount to $8 million and generating a $1 millionloss).

58

Substantial Economic Effect More specifically, Treas. Reg. § 1.704-1(b)(2)(iii)(a)

says an allocation is not substantial if:

– Benefit to Some Partners.

• The after-tax economic consequences of at leastone partner may, in present value terms, beenhanced compared to such consequences if theallocation were not contained in the partnershipagreement.

AND

– No Detriment to Other Partners.

• There is a strong likelihood that the after-taxeconomic consequences of no partner will, inpresent value terms, be substantially diminishedcompared to such consequences if the allocationwere not contained in the partnership agreement.

59

Substantial Economic Effect Is there a benefit to B and C?

– Yes. B and C benefit because taxable income isallocated away from them to A.

Is there any detriment to A?

– Some advisors say no: The gain allocationincreases A’s basis. For a partner like A whoseinterest is being completely liquidated, gainallocation under Code § 704(b) may simply reducegain recognition (or increase loss recognition) underCode § 731(a) on the liquidation.

– Some advisors say yes: Is it a detriment to A thatshe will not participate in future gains or losses fromthe Replacement Property?

60

Distribution of Fractional Interest

1. Distribution

A B

BC

1/3 Whiteacre

Basis: $1 mill

Fmv: $7 mill

50%0% C

50%

A receives 1/3 undivided fractional interest inWhiteacre in complete

liquidation of her interest in ABC.

A and BC now own fractional interests inWhiteacre together as "tenants in common."

2/3 Whiteacre:

Basis: $2 mill

Fmv: $14 mill

61


2/3 Whiteacre

BlackacreQI

B

BC

50%

C50%

2. Swap

Partnership BC,with A gone,

exchanges its 2/3interest in

Whiteacre forBlackacre

62


Buyer

1/3 Whiteacre

$7 mill cash

A

3. Sale

A sells her 1/3 interest inWhiteacre for cash, outside

the QI arrangement.

A recognizes $6 mill taxablegain.

63

Is Fractional InterestDistribution a Solution?

Maybe this approach is a solution, but maybe not.

Were the Parties Tenants in Common for TaxPurposes?– Even after the "fractional interest" is distributed, is the

relationship between A (on the one hand) and BC (on theother) for tax purposes a tenancy in common (as the partieswant) or merely a continued partnership among A, B, and C?

– Rev. Proc. 2002-22, 2002-1 C.B. 733, which indirectlysparked explosive growth in the "TIC" industry, is of limitedhelp at best here.

• Consider net-leasing the property prior to the distribution; net leasedproperty held by tenants in common arguably is less likely to berecharacterized as partnership-owned than the property otherwise mightbe.

– If A, B, and C remain partners, then ABC partnershippresumably exchanged Whiteacre for a combination ofBlackacre and cash, and the distribution to A accomplishednothing.

64

Is FractionalDistribution a Solution?

Did A Really Sell Her Separate Interest?

– If ABC negotiated to sell Whiteacre, will the IRSargue that in substance ABC partnershipexchanged Whiteacre for a combination ofBlackacre and boot, and distributed the boot toA?

• See Comm’r v. Court Holding Co., 324 U.S. 331(1945).

– Once again, if the IRS’s argument succeeds, thedistribution to A accomplished nothing.

65

Installment Sale

B and C are frustrated:– They face risks if the partnership receives cash in

the sale of Whiteacre and distributes the cash to A.– They face risks if the partnership lets A sell her

share of Whiteacre outside the partnership, and thecash goes directly to A.

– They do not want to incur additional debt to buy Aout.

The underlying problem is that the boot iscurrently taxable.

They ask their tax advisor:– Isn’t there any kind of boot that is tax-deferred?

Your answer, to their surprise:– Yes, an installment note.

66

Installment Sale

Sale of property in exchange for a note or other promiseby the purchaser to pay in the future is treated as fullytaxable in the year of sale, unless the sale qualifies to bereported on the "installment method."

An installment sale is "a disposition of property where atleast one payment is to be received after the close of thetaxable year in which the disposition occurs." Code §453(b)(1).

Some other requirements must be met.

The installment sale alternative is essentially the same asthe initial proposal, except that:– Instead of receiving cash boot of $7 million, the partnership

receives a $7 million installment note.

– Instead of distributing $7 million of cash to A, the partnershipdistributes a $7 million installment note to her.

67

Installment Sale

Whiteacre

Blackacre

+

$7 mill installmentnote

QI

50%A B

BC

$7 millinstallment

note

50%0%

A receives

$7 millioninstallment note

in completeliquidation ofher interest in

ABC.

C

68

Is Installment Sale a Solution?

Maybe.

Assuming the "boot" gain qualifies forinstallment reporting, there seems to beno tax at partnership level either on:– Receipt of the installment note, or

– Distribution of the installment note to A.

A takes a basis in the installment noteequal to her "outside" basis in ABC, i.e.,$1 million. Code 732(b).

69

Is Installment Sale a Solution?– Will A be willing to accept, and Buyer be willing to provide, an

installment note?

– Installment note is riskier than cash.

– Risk can be reduced by:

• Having most (not all) of the note payable shortly after closing (atleast some portion of the note must be payable after the end ofthe current tax year).

• Backing up the note with a letter of credit.

– How much risk will A accept, given that the use of aninstallment note was proposed by B and C as a way out oftheir tax problem?

– If the installment note bears a favorable interest rate, A ismore likely to accept it, but will Buyer be willing to pay it?

– Consider whether the installment note can come from the QI.

– Note that if Whiteacre is subject to debt, Blackacre must besubject to at least as much debt (not just 2/3 of the amount).

Cross-Purchase or Redemption

What if the installment sale is notpractical?

– Before the exchange, B and Ccould buy A out for cash.

– But where do B and C get thecash? In this situation the buyer isnot supplying it.

70

Nonrecourse Debt, Minimum Gain,and Why the LLC Agreement KeepsGoing On and On About Allocations


[email protected]

July 14, 2015

1

Many LLC Agreements Have TwoSets of Allocations

– Primary Allocations: These apply except as otherwiseprovided by another set of allocations, often called"Regulatory Allocations" (or sometimes labeled "SpecialAllocations").

– Regulatory Allocations: Override the primary allocationsand address special situations singled out by the regulationsunder Section 704(b) of the Code. Regulatory allocationsoften include:

• Minimum Gain Chargeback.• Partner (or Member) Minimum Gain Chargeback.• Qualified Income Offset.• Gross Income Allocation.• Nonrecourse Deductions.• Limitation on Loss Allocations.

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Why Are "Regulatory Allocations"Needed?

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Answer: Because of the possibility of negative capitalaccounts (when the LLC member is not required to makeany contribution to bring its capital account back up tozero).

A positive capital account generally should imply theamount that a member would be entitled to receive if theLLC sold all its assets at their "book value" and distributedthe proceeds. For present purposes, "book value" means the value as

determined in accordance with the 704(b) regulations Does a negative capital account therefore imply the

amount that a member would be required to contributeto the LLC if the LLC sold all its assets at their "book value"and distributed the proceeds?

"Capital Accounts" In General Typical LLC Agreements define "Capital Accounts" in

accordance with the regulations under Section 704(b) ofthe Internal Revenue Code.

The positive capital account as defined by the typical LLCagreement is generally the amount that each memberwould receive if the LLC were to: Sell all its assets at "book value," Pay its liabilities as necessary, and Distribute the remaining proceeds to the members in

liquidation. Positive allocations (and contributions) generally should

increase the amount that the members would receiveon liquidation.

Negative allocations (and distributions) generally shoulddecrease the amount that the members would receiveon liquidation.

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"Capital Accounts" In General

If the member does not have to contribute capitalthen what does a negative capital account mean?

It might seem logical that if the member’s capitalaccount is negative at the time of the liquidation,the member would have to contribute capital to theLLC to bring its capital account back to zero.

After the LLC has paid off all its liabilities anddistributed all its assets in liquidation, it shouldhave no assets or liabilities.

If the LLC has no assets or liabilities, the capitalaccounts of the members should be zero.

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The Tax Rules Cannot Impose an Obligation toRestore a Negative Capital Account

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If the capital account system weretheoretically pure, perhaps a negative capitalaccount would always imply an obligation tomake a capital contribution. However, the tax regulations cannot force a

member to make a capital contribution. Moreover, as the law has developed, members

may receive tax-free distributions, and/or takedeductions, that are funded by debt -- even if themember has no liability for ever repaying thedebt.

The Tax Rules Can Require Allocations thatPrevent or Cure a Negative Capital Account

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However, if the member doesn’t have an obligationto make a capital contribution when its capitalaccount is negative, the IRS can require the LLC tomake allocations that prevent a negative capitalaccount from arising or eliminate one that doesarise.

Many of the regulatory allocations address problemscreated when negative capital accounts result fromthe losses or distributions that are funded withnonrecourse debt (i.e., debt for which the memberhas no liability).

What Causes Negative CapitalAccounts?

• Negative capital accounts arise because the member:– Receives distributions in excess of its capital account, and/or– Is allocated deductions in excess of its capital account.

• Where do those distributions and deduction allocationscome from, if not from the member’s own capital account?– Most commonly, they come from amounts that the LLC has

borrowed, including amounts borrowed on a nonrecourse basis.– Amounts that the LLC borrows are included in the tax basis that

the members have in their LLC interests but they are notincluded in the members’ capital accounts.

– The amount of liabilities (including nonrecourse liabilities) thatare included in a member’s basis is determined by theregulations under Section 752 of the Code.

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•A and B contribute $50 each to LLC.–A and B have exactly equal interests in the LLC.

–Their capital accounts start at $50 each.

–Each has a $50 basis in its LLC interest.

•LLC takes out an $900 interest-only nonrecourse loan fromunrelated bank to acquire a $1,000 building.

–Capital accounts of A and B remain at $50 each.

–However, the debt increases basis from $50 each to $500 each.

• The building has a $1,000 basis.

–The fact that the building was largely debt-financed does changethe fact that its basis is the full purchase price.

•Assume the building is depreciable at $100/year over ten years.

Example:Nonrecourse Debt

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•Year 1: The Easy Case; No Regulatory Allocations Needed

–In Year 1 LLC takes $100 depreciation, allocated $50 each to A and B.

–A and B have enough basis to deduct the depreciation (although there may be otherlimitations on their ability to take deductions).

–Capital accounts of A and B decrease from $50 each to zero each.

–"Book value" of the building (under the 704(b) regulations) is now $900.

–If the LLC sells the building for the $900 "book value":

»The bank gets the $900, and the loan is repaid in full.

»A and B get zero.

»Zero capital account of A and B equals the zero amount they receive onliquidation.

»Allocation of $100 depreciation to A and B reflects that instead of receiving $100on liquidation they receive zero.

–The LLC has nonrecourse debt outstanding, but the $100 depreciation is notattributable to the debt, so is not considered a nonrecourse deduction.

–No negative capital accounts and no need to apply regulatory allocations.

Equity-Financed Deductions

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•Year 2: Regulatory Allocations Are Needed

–In Year 2 LLC takes an additional $100 depreciation, but how is it allocated?

–If it is allocated to A and B their capital accounts will become negative $50each.

–However, because of the borrowing, A and B do have enough basis todeduct the depreciation (if the depreciation is allocated to them).

–"Book value" of the building is now $800.

–If the LLC sells the building for the $800 "book value":

»The bank gets only $800.

»The remaining $100 of debt owed to the bank does not get paid.

»A and B still get zero – the same as in Year 1 -- and have no obligationto pay $100 to restore the negative capital accounts.

–The allocation of $100 depreciation to A and B does not reflect a reductionin the amount they get on liquidation or an additional amount they arerequired to contribute on liquidation.

–The $100 depreciation is a "nonrecourse deduction," reflecting a reductionin the amount the bank receives in repayment of the loan on a liquidation ofthe LLC at "book value."

Nonrecourse Deductions

Minimum Gain Chargeback

• Is it a mistake to allocate the year two depreciation toA and B?– Should the $100 depreciation be allocated to the bank?

• Depreciation cannot be allocated to the lender; thelender is not an LLC member/partner.– Depreciation must be allocated to A and B.

• Did A and B get a costless $100 depreciation deductioncourtesy of the bank?• A and B did get a tax benefit by deducting $100 when they

did not suffer an economic loss.• However, the "minimum gain" rules force them to pay for

that tax benefit eventually, even if they otherwise couldhave avoided paying.

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Minimum Gain andMinimum Gain Chargeback

• "Minimum gain" tracks deductions where a lender (not apartner or member) is at risk for an LLC liability.

• "Minimum gain" is the excess of the nonrecourse debtover the "book value" of the property that the debtencumbers.– In our example, after year two the minimum gain is $100.– $100 is the minimum amount of gain that will have to be

allocated ("charged back") to A and B when the building issold.

– If the building is simply surrendered to the bank, with nocash proceeds going to A and B, they will have to recognizethat $100 minimum gain.

– The chargeback is a kind of "phantom income" to A and B,but offsets the "phantom deduction" (i.e., the deduction ofthe bank’s money) that A and B previously enjoyed.

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"Partnership Minimum Gain"vs. "Partner Minimum Gain"

• What we have been discussing so far technically is "PartnershipMinimum Gain" (sometimes referred to in LLC agreements as"Company Minimum Gain" or "LLC Minimum Gain").– Partnership minimum gain arises when no partner is deemed to bear the economic

risk of loss for the nonrecourse debt (i.e., when deductions are attributable to"partnership nonrecourse debt").

• The rules for so-called "Partner Nonrecourse Debt Minimum Gain"(or "Member Nonrecourse Debt Minimum Gain") parallel these rules.– However, partner nonrecourse debt minimum gain arises when one or more

partners bears the risk of loss for nonrecourse debt (i.e., when deductions areattributable to "partner nonrecourse debt").

• In our example, if A had guaranteed the debt (or even if the lenderhad simply been related to A), the debt would have been partnernonrecourse debt rather than partnership nonrecourse debt.– All the depreciation in excess of capital accounts would have been allocated to A.– The minimum gain would have been partner nonrecourse debt minimum gain, and

would have been charged back entirely to A when the property was sold.14

Copyright © 2013 by Daniel L. Daniels and David T. Leibell. All rights reserved.

Estate Planning for Real Estate

by Daniel L. Daniels and David T. LeibellPrincipals, Wiggin and Dana LLP, Greenwich, Conn.

I. Introduction

In our practice representing corporate executives, business owners and wealthy families, we findthat a real estate represents an increasingly large proportion of our clients’ wealth. Real estateoften presents the potential for both growth and income production. In addition, the valuation ofreal estate is an art rather than a science, meaning that reasonable people can differ as to thevalue of the same parcel. If minority or fractional interests in property are being valued, it mayalso be possible to apply discounts in valuing the property. For all of these reasons, real estatepresents unique opportunities for the estate planner. But it also poses particular challenges,requiring the planner to be alert not only to estate and gift tax concerns, but also to issuesinvolving income tax, corporate, partnership and LLC law and many other matters.

II. Liability Planning.

Ownership of real estate involves risk, especially if business operations are conducted on theproperty or the property is leased. In order to limit the owner's liability and protect his otherassets from claims related to the real estate, the owner should be sure to review all of hisinsurance coverages. In addition, the real estate should be owned through a liability-shieldingentity. The available entities are a C corporation, S corporation, limited partnership or LLC. Taxconsiderations make the S corporation, LLC or limited partnership more attractive than a Ccorporation because the former entities generally are not subject to a separate level of tax on theirearnings; instead the owners of the entity are taxed on its earnings in proportion to theirownership shares. C corporations, by contrast, are subject to tax on their earnings and thoseearnings can then be taxed again when they are passed out to shareholders in the form ofdividends.

Furthermore, the LLC or limited partnership generally are preferable over both the S corporationand the C corporation for the following reason. When the owner of an S or C corporation dies,his estate receives a new cost basis in the corporate stock. When the owner of an LLC dies, hisestate receives a new cost basis in the LLC interest, and, if an appropriate election is made, theestate receives a new cost basis in the assets of the LLC itself, as well. As a result, the transfereesof the deceased owner's interest in the LLC or limited partnership would have a new basis in thereal estate owned by the entity, which they can then either use to take longer depreciationdeductions or sell at reduced capital gains tax cost. This “inside basis stepup” is not availablewith an S or C corporation owning real estate.

As for choosing between an LLC and a limited partnership, we generally favor the LLC. TheLLC can be established as a single entity, whereas the limited partnership will need a separatecorporation or LLC to act as general partner if the owner is to obtain full liability protection.Furthermore, many states' statutes permit an LLC to have a single member, while it is generallynot possible to form a limited partnership with only one partner.

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Whichever entity is chosen, the client should make certain to respect the entity, taking care not tointermix entity and personal assets and not to use the entity for personal reasons. This will helpensure that a potential creditor or litigant cannot successfully argue that the entity should beignored, thereby exposing the client's personal assets to a claim. It is also generally good practiceto separate different parcels of real estate into separate entities owned by a single “master” LLC.In this way, a damage award involving one of the parcels should not be recoverable against anyof the other parcels. Income from all of the parcels would flow up into the master LLC tosimplify administration and permit cash flow from one parcel to be invested in others or in newproperties.

III. Non-charitable Tax Planning

A. Valuation. One of the key advantages of planning with real estate is the fact thatunlike cash or marketable securities, reasonable people can differ as to the value of a particularpiece of real estate. Moreover, if the interest transferred is a fractional interest or an interest in anentity such as an LLC or limited partnership, valuation discounts may be applicable. Thesefactors can lead to the transfer of significant amounts of wealth without a transfer tax. In order toensure that the appraised valuation, especially one showing fractional interest or entity-relateddiscounts, is binding on the IRS, the transfer in question should be disclosed on a gift tax returnin a manner sufficient to comply with the adequate disclosure rules. 1

B. Simple Techniques for Noncharitable Lifetime Transfers of Real Estate.

For real estate with relatively modest value, use of the $14,000 annual exclusioncan be a simple and effective means of removing the value of the property from the owner'staxable estate. For property of greater value, if the owner has a large number of children andgrandchildren, she could consider making gifts to an irrevocable trust containing Crummeywithdrawal powers for each child and grandchild (a “Crummey Trust”). For example, suppose amarried person has three children and seven grandchildren. The client could establish anirrevocable trust for the benefit of all nine descendants, granting each one a Crummeywithdrawal power. Gifts of up to $280,000 worth of real estate per year could be made to such atrust without the imposition of federal gift tax.

The Crummey Trust provides a number of benefits over simple outright gifts.First, the client would not be required to break up the property among multiple individualbeneficiaries in order to make the gifts. Instead the property could be kept intact in the hands ofthe Trustee. (An LLC could produce a similar benefit.) Second, the trust could be structured as ageneration-skipping trust designed to remove the gifted property not only from the client's estate,but also from the estates of the children and even the grandchildren. If the trust is structured as ageneration-skipping trust, the client should make certain to allocate generation-skipping taxexemption to each year’s gifts to the trust. Third, the trust could be structured as a grantor trustfor income taxes, with the result that the client continues to pay tax on any income generated bythe trust property, thereby enhancing the value of the trust and depleting the client's estate. TheIRS has announced that the payment of tax on behalf of the grantor trust by the grantor will notbe treated as a taxable gift.2

In addition to the annual exclusion, each individual has a lifetime exemption fromfederal gift tax of $5,250,000.3 Although gifts made using the $5,250,000 they are effective toremove any appreciation in the value of the gifted property from the estate.4 The CrummeyTrust described above could be structured to be the repository of such a gift as well. The client’s

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spouse could be added as another beneficiary of the Crummey Trust. Many clients, especiallythose just beginning to dip their toes in the water of lifetime gifting, find this feature comforting.The spouse could receive distributions from the trust and, if he or she desires, share them withthe client if needed. Of course, if the spouse is given access to the trust, he or she should makeno gifts to the trust as that would cause the trust property to be included in the spouse’s estate atdeath.

C. Advanced Techniques for Noncharitable Transfers of Real Estate DuringLifetime. The alphabet soup of tax advantaged noncharitable techniques for transferring realestate during lifetime includes the Qualified Personal Residence Trust (QPR T), GrantorRetained Annuity Trust (GRAT), Sale to Defective Grantor Trust (SDGT), Freeze LLC, Sale fora Private Annuity and Sale for a Self Canceling Installment Note (SCIN). These are discussedbriefly below.

1. QPRT. A QPRT is an irrevocable trust designed to own all or aportion of a “personal residence” (i.e., primary residence or vacation home). The grantor retainsthe right to reside in the residence for a term of years. At the expiration of the term of years,ownership of the residence passes to the grantor’s children or other beneficiaries. The QPRTproduces two main tax benefits. First, the gift tax value of the transfer is fixed based on the valueof the property at the time the trust is established, even though the transfer to the grantor'schildren or other beneficiaries will take place in the future when the market value of theresidence may be higher. Second, the gift tax value is discounted from fair market value of theresidence to reflect (1) the value of the grantor’s retained use of the property during the QPRTterm, and (2) the possibility that the residence will be revert to the grantor’s estate in the event heor she does not survive the QPRT term.

For example, suppose a 70 year old grantor transfers a $1,000,000 residence to aQPRT, retaining the right to live in the property for 10 years, after which the property will passto the grantor’s children. Assuming a 6% section 7520 rate, the value of the taxable gift to thechildren is only $368,450. In effect, the grantor has removed $631,550 from his taxable estate.Assuming the grantor's estate would be taxed at a 40% rate, the benefit of establishing the QPRTis a tax savings of $252,620.

If the grantor wishes to continue to reside in the residence after the expiration ofthe QPRT term, he can rent it back from the children. The rent should be for fair value with awritten lease. The payment of rent enhances the estate tax benefits of the QPRT in that the rentalpayments deplete the grantor’s estate but do not constitute taxable gifts to the children. Therental payments will, however, constitute taxable income to the children. To avoid this adverseincome tax result, the QPRT could be designed so that the remainder interest passes to acontinuing grantor trust for the benefit of the grantor’s children. 5

2. Grantor Retained Annuity Trust (“GRAT”). The basic concept behind aGRAT is to allow an individual to give property to a trust and retain a set annual payment (an“annuity”) from that property for a set period of years. At the end of that period of years,ownership of the property passes to the individual's children or trusts for their benefit. The valueof the individual’s taxable gift is the value of the property contributed to the trust minus thevalue of his right to receive the annuity for the set period of years, which is valued using interestrate assumptions provided by the IRS each month. If the GRAT is structured properly, the value

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of the individual's retained annuity interest will be exactly equal to the value of the propertycontributed to the trust, with the result that his taxable gift to the trust is zero.

The benefit to the individual’s children or other transferees depends on theinvestment performance of the property placed in the GRAT. If the property appreciates and/orproduces income at exactly the same rate as that assumed by the IRS in valuing the individual'sretained annuity payment, the children do not benefit, because the property contributed to thetrust will be just sufficient to pay the individual his annuity for the set period of years. However,if the property contributed to the trust appreciates and/or produces income at a greater rate thanthe section 7520 rate in effect for the month the GRAT was created, there will be property “leftover” in the trust at the end of the set period of years, and the children will receive that property--yet the individual would have paid no gift tax on it.

The advantage of a GRAT for the real estate owner can be seen in the followingexample. Suppose an individual owned real estate worth $1,000,000 that produces net cash flowannually of $1,000,000 and that he places that property in a GRAT in a month when the section7520 rate is 6%. In this example, the GRAT would pay the individual an annuity payment ofapproximately $100,000 per year for 16 years. At the end of 16 years, any property remaining inthe GRAT would pass to a trust for the individual’s children. The value of the gift is the initialvalue of the property contributed to the trust (i.e., $1,000,000) minus the discounted presentvalue of the individual’s right to receive a payment of $100,000 for 16 years at a 6% discountrate. The present value of the right to receive $100,000 per year for 16 years, using a 6%discount rate, is roughly $1,000,000. Accordingly, the taxable gift the individual would berequired to report is zero ($1,000,000 initial value of property placed in the GRAT minus thepresent value of his annuity payments). However, at the end of the 16 year term of the GRAT,the trust for the children would receive the $1,000,000 piece of real estate and the continuingincome on it. In order for the GRAT to work, the individual creating the GRAT must outlive theGRAT term. Therefore, in the example above, if the individual does not survive the 16 year termof the GRAT, the GRAT property comes back into the individual’s estate.

3. Sale to Intentionally Defective Grantor Trust. A cousin of the GRAT isthe Sale to Intentionally Defective Grantor Trust (SDGT). Under an SDGT, an individual makesa gift to an irrevocable trust of, say, $100,000. Some time later, the individual sells an asset tothe trust in return for the trust’s promissory note. The note provides for interest only to be paidfor a period of, say, 9 years. At the end of the 9th year a balloon payment of principal is due.There is no gift because the transaction is a sale of assets.6 The interest rate on the note is set atthe lowest rate permitted by IRS regulations. Like the GRAT, if the property sold to the trustappreciates and/or produces income at exactly the same rate as the interest rate on the note, thechildren do not benefit, because the property contributed to the trust will be just sufficient toservice the interest and principal payments on the note. However, if the property contributed tothe trust appreciates and/or produces income at a greater rate than the interest rate on the note,there will be property left over in the trust at the end of the note, and the children will receivethat property, gift tax free.

The SDGT can be used with income-producing real estate in much the samemanner as described for the GRAT above. The only difference would be that the cash flowrequired under the ISDGT may be less than under the GRAT because the interest rate factor usedin valuing the GRAT is often higher than the factor used in the SDGT. The GRAT has generally

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been regarded as a more conservative technique than the SDGT. With a properly structuredGRAT, there is no risk of a taxable gift in the event the property contributed to the GRAT isrevalued on audit. Instead, the regulations governing GRATs permit the trust to be drafted suchthat the size of each year’s annuity payment to the grantor is simply increased by a an amountcorresponding to the increase in the value of the property on audit, and the size of the taxable giftremains at or close to zero. With the SDGT, on the other hand, there are no regulationspermitting a “re-sizing” of the payments under the note in the event of a change in the value ofthe transferred property in an audit. Having said that, recent case law, including the Wandry andPetter cases, give planners hope that a valuation adjustment clause that the IRS would respectcould be drafted into an SDGT transaction.7

While the GRAT is generally regarded as more conservative with respect to therisk of revaluation of the gifted property on audit, the SDGT is the superior transaction on otherfronts. First, the interest rate “hurdle” to be overcome in order for the SDGT to be successful isgenerally lower than that for a GRAT. Second, the SDGT is a better vehicle through which to dogeneration-skipping planning. A GRAT poses a poor opportunity to leverage GST exemptionbecause the ETIP rules prevent allocation of GST exemption to a GRAT until the end of theGRAT term when, presumably, the real estate will have appreciated in value. With the SDGT,GST exemption can be allocated to the trust as of the first day of the transaction when values arepresumably lower. Finally, there is no need for a grantor in an SDGT transaction to survive for acertain term in order for the transaction to work.

4. Freeze LLC. A Freeze LLC could be established as a holding companyfor one or more pieces of real estate (or one or more sub-LLCs owning real estate). The primaryfeature distinguishing a Freeze LLC from a typical family limited partnership or family LLC isthat the Freeze LLC generally has two classes of membership interests, preferred and common.The preferred partnership interests would be entitled to a fixed, cumulative payment (akin to adividend) from the LLC and a guaranteed amount upon the liquidation of the entity. These rightswould typically be structured in such a way that the preferred interests would account forapproximately 90% of the LLC’s value, as determined by a qualified business appraiser.

The remaining 10% of the partnership’s value would be ascribed to the commoninterests.8 These common interests could be gifted or sold to one or more trusts for the client'sfamily which would not be taxed in the client's estate at death. While the common owners wouldnot have any guaranteed distributions or liquidation preference attached to their interests, theywould be entitled to all income and appreciation in the value of the LLC over and above thatneeded to service the dividend payments to the preferred owners. In short, the interest of thepreferred owners would be “frozen” at its initial value plus the preferred payments while anyappreciation in excess of the preferred payments would pass to your children, as owners of thecommon interests, free of estate tax.

The Freeze LLC is beneficial as an estate freezing device if the assets of the LLCproduce a rate of return greater than that needed to service the dividend payment on the preferredinterest. However, with the Freeze LLC--unlike the GRAT or SDGT-- there is no IRS table towhich we can refer to determine what the lowest required dividend rate is. The applicablestatutes provide simply that the dividend must be set at a "fair" interest rate as determined by aqualified appraiser. Typically, however, the “fair” interest rate is something higher than theinterest rate used in valuing either the GRAT or the SDGT.

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D. Advanced Noncharitable Testamentary Techniques. Noncharitable planning withreal estate is not limited to transfers of the property during lifetime. There are also techniquesavailable for tax advantaged transfers of property at death as well. These include “Mellinger”planning and taking advantage of sections 2032A and 6166 of the Internal Revenue Code.

1. Mellinger Planning. Named for a case in which it was successfullyused10, Mellinger planning refers to the use of a qualified terminable interest trust to place theclient in a position to obtain valuation discounts for real estate at the death of the survivor of theclient and his spouse. It’s best understood by example. Suppose the client's real estate business isoperated through LLCs, each of which is owned 49% by the client, 49% by his spouse and 2%by trusts for the couple's children. Each of the client and his spouse would therefore be treated asa noncontrolling minority owner, and each’s interest in the LLCs should be valued by applying aminority interest discount. Suppose, however, that when the client dies, he leaves his 49%interest % outright to his spouse. The spouse now becomes a majority owner and, at her laterdeath, her interest in the LLCs would not be valued with a minority interest discount.

It may be possible to avoid this result if the client utilizes the following plan: Atthe client's death, his 49% interest in the LLCs is left to a QTIP trust for the benefit of hisspouse. When the spouse later dies, the spouse personally only owns 49% of the LLC; the other49% is owned by the QTIP trust. Although the QTIP trust's assets will be included in thespouse’s estate at her death, under the Mellinger case the LLC interests held in the QTIP trustshould be valued separately from the LLC interests held in the spouse's individual name. In otherwords, the two blocks of LLC interests can each be valued with a minority discount.

2. Section 2032A valuation and section 6166. Planners also should notoverlook the special valuation rules of section 2032A and the estate tax payment extensionprovisions of section 6166. Subject to certain limits, Section 2032A permits real property usedfor farming or a closely held business to be valued on the basis of the property’s value as a farmor in the closely held business, rather than at its fair market value. Section 6166 permits anexecutor to elect to pay part or all of the estate tax up to ten equal installments if a decedent wasa citizen or resident of the United States on the date of death, and if the value of an interest in aclosely held business exceeds 35 percent of the decedent's adjusted gross estate. The IRS hasrecently liberalized its position on section 6166 with the result that extended estate tax paymentsmay be available to many more real estate owners than under prior law. 11

______________________________________________________1 IRC § 6501(c)(9); Treas. Regs. § 301.6501(c)-I(f). Although a full discussion of the adequate

disclosure rules is beyond the scope of this article, planners should note that many of therequirements of the rules can be satisfied if a qualified appraisal is attached to the gift tax returnreporting the transfer. The requirements for such an appraisal are set forth in section 301.6501(c)-1(f) of the Gift Tax Regulations.

2 Rev. Rul. 2004-64, 2004-27 I.R.B. 7, 2004, 2004-2 C.B. 7.

3 IRC § 2505.

4 IRC § 2001(b).

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5 Rev. Rul. 85-13,1985-7 LR.B. 28,1985-1 C.B. 184.

6 There is no gift as long as the value of the assets sold is equal to the face amount of the note. Ifthe IRS were to increase the value of the assets sold on audit, there would be a gift equal to thedifference between the audited value of the assets and the face amount of the note. This risk isnot present with the GRAT technique.

8 Ordinarily, the value of the common units is simply the total value of the LLC minus the value ofthe preferred units. The planner must be careful to draft the Freeze LLC to comply with theprovisions of section 270 I of the Code, if the LLC does not comply with this provision, thepreferred units will be assigned a value of zero for gift tax purposes, with the result that 100% ofthe value of the entity will be assigned to the common.

9 Frane v. Commissioner, 998 F.2d 567 (8th Cir. 1993).

10 Estate of Meliinger v. Commissioner, 112 T. C. 26, (Tax Ct. 1999) ,acq. 1999-35 I.R.S. 314, 1999WL 33541675, 1999-2 C.S. XVI.

11 Rev. Rul. 2006-34, 2006-261.R.B. 1171,2006 WL 1723550.

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