tax-related drafting tips for real estate llc and lp...
TRANSCRIPT
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TUESDAY, SEPTEMBER 13, 2016
Presenting a live 90-minute webinar with interactive Q&A
Brian J. O'Connor, Partner, Venable, Baltimore
Peter R. Matejcak, Esq., Baker & McKenzie, Chicago
Steven R. Schneider, Partner, Baker & McKenzie, Washington, D.C.
Tax-Related Drafting Tips for
Real Estate LLC and LP Agreements Structuring Provisions to Achieve Tax Benefits and Avoid Common Pitfalls
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Tax-Related Drafting Tips for Real
Estate LLC and LP Agreements
Strafford
Brian J. O’Connor
Steven R. Schneider
Peter R. Matejcak
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Introduction
Understand the partners and their tax characteristics.
Learn the general economics/business deal (e.g., capital
commitments, preferred versus common interests,
compensatory interests, distributions (including tax
distributions), special partners, etc.).
Create an everyday working relationship, therefore needs to
be cooperative in addition to adversarial.
Review the Economics
Simple versus complex sharing arrangements.
Types of preferred interests.
Guaranteed payments versus gross or net income
allocations.
Equity-based compensation.
Profits only interests under Rev. Proc. 93-27 and
Rev. Proc. 2001-43.
Distribution waterfall.
Other: tax distributions; reimbursement of expenses; special
one-time distributions; capital calls; partner loans.
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Distributions
General. The distribution section describes the partners’ rights to cash
or property distributions. Separate paragraphs often cover operating
vs. capital events vs. liquidating distributions. Liquidation with Capital
Accounts vs. waterfall. Tax language should address partner
reimbursements or other up-front cash distributions.
Withholding. Taxes paid by the partnership on behalf of a partner are
typically treated as a deemed distribution to the partner whose income
is requiring the withholding. This is common when the partnership is
required to withhold on distributions to a foreign or out-of-state partner.
Tax Distributions. Ensure partners have cash to pay taxes.
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Tax Distributions Typically documented as an advance on the partner’s rights under
the more general distribution provisions. Sometimes distributions
are treated as a loan to the partner.
Think of distribution as a tax loan. For GP, interest rate is the hurdle
rate. More often requested by GP who is more likely to have
phantom income on promote, especially if an IRR waterfall.
Generally equal to share of net income multiplied by maximum
applicable rate for type of income.
• Variables: Actual versus assumed rates, partners subject to
different tax rates, losses followed by profits, quarterly versus
annual distributions.
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Elections and Audits
Elections: Agreement should address how partnership-level
tax elections are made. The two main elections unique to
partnerships relate to section 754 inside basis adjustments
and section 704(c) allocations of built-in gains or losses
among the partners.
Audits: Tax Matters Partner (TMP) generally represents the
partnership before the IRS and in federal civil tax litigation and
is required to keep the other partners informed. Generally,
the TMP must be a manager and member.
Although the identity and authority of the TMP may sound
boring, it is often a critical question when later controversy arises
and the details are often overlooked in the drafting process.
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Audits - Keeping the LP Informed
TMP keeps all partners “reasonably informed of the progress of any tax
audit, examination, appeals proceedings, litigation, or other tax
proceeding relating to the income or operations of the Company.”
Allow partners to provide input on IRS communication
Obtain partner approval for
IRS settlement agreements
Court petition
Extend statute of limitations
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Special Partners
REITs
Tax-Exempts
Foreign Partners
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REIT Partners
Where one of the members is a REIT, it will seek to impose
the following types of restrictions on the joint venture’s
operations in order to ensure compliance with the REIT
requirements:
Real estate asset holding and income limitations;
No prohibited transactions (e.g., condo sales);
Limitations on loans (mezz debt or secured by real property);
Limitations on leases (related party and personal property
restrictions); and
Arm’s-length transactions with REIT owners.
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Tax-Exempt Partners
Tax-exempt entities are generally subject to the unrelated business income
tax for investment returns funded with “acquisition debt.” However, there is
a Real Estate Financing Exception for “qualified organizations” that use
specific types of debt to acquire or improve real property.
To meet the Real Estate Financing Exception, qualified organizations who
invest through a partnership must meet the Fractions Rule.
To be Fractions Rule compliant, partnership allocations must satisfy the
following two requirements on actual and prospective basis:
Safe harbor allocations: The most significant economic factor in satisfying
these rules is that the partnership liquidate with positive capital accounts in lieu
of a cash waterfall.
Disproportionate allocation rule: A qualified organization’s share of overall
income for any year cannot exceed its lowest share of overall loss for any year.
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Foreign Partners
Partnerships are required to withhold taxes on a foreign
investor’s share of real estate income because special
“FIRPTA” rules treat the partner’s income from real estate as
subject to U.S. taxation even if the income is not otherwise
subject to U.S. tax.
A partnership agreement typically treats this withholding as a
partner distribution or loan.
Certain partners may be subject to reduced withholding, but
the partnership should require the partner to provide specific
documentation to the partnership to receive the reduced rate.
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Example 1: Capital
Account Basics
Section 704(b)
Property contribution; income
allocation; distribution
Facts: A contributes Building with $100 gross fair market
value, subject to $30 of debt. In year one the partnership
allocates $10 of section 704(b) book income to A and
distributes $4 of cash to A.
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Effect on Capital
Account
Ending Capital
Account
Increase by net FMV of
property contributed
+$70 $70
Increase by income
allocation
+$10 $80
Decrease by
distributions
-$4 $76
Tax Allocations – sections 704(b)
and 704(c)
How taxable income and loss are shared among the partners.
Most of the allocation language relates to the economic/book
allocations and in general taxable income will follow these
book allocations.
If a partner contributed an asset with built-in appreciation or
depreciation, special rules require that such built-in tax gain or
loss is allocated back to the contributing partner.
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Tax Allocations – section 704(b)
Partnership agreements typically break the book allocations
down into two sections.
The primary allocation section describes the general business
deal, such as allocating profits in accordance with relative
capital or profit percentages (i.e., “Percentage Interests”).
The regulatory allocation section overrides the first section
and is designed to comply with the book income tax
regulatory safe harbors.
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Tax Allocations – section 704(b)
The tax allocations will not be respected if the agreement liquidates with a
waterfall and the partners’ economic rights under the waterfall are different
from their rights based on their capital accounts.
The taxable income or loss will be re-allocated so that the capital accounts and
the waterfall rights are consistent.
Example - tax allocations send all $100 of section 704(b) income to Partner
A and none to Partner B. A’s capital account increases by all $100 and B’s
capital account remains constant. If the waterfall provides that the cash
corresponding to that profit is shared $50 each by A and B, then the IRS will
not respect the tax allocation and will reallocate $50 of income to B.
To avoid inconsistencies between tax allocations and the partners’ rights
under the waterfall, many partnership agreements simply use a Target
allocation (allocates book income or loss among the partners using a
formula that causes the partners’ capital accounts to equal the amounts the
partners would receive under the waterfall).
20
Tax Allocations – section 704(c) “Section 704(c)” generally requires the partnership to allocate
built-in gain or loss back to the contributing partner.
Partnership agreements typically include only a single
paragraph to cover these allocations and often simply repeat
the general statutory requirement that tax allocations take into
account a partner’s potential built-in tax gain or loss on
contributed property.
For many partnerships (including many real estate
partnerships), this provision is highly negotiated and includes
much more detail relating to which of several alternative
methods is chosen to allocate non-economic taxable income
or loss.
21
Facts: Partner A contributes property with a tax basis of
$20 and a value of $100 and the partnership sells the
property for $110.
704(c) effect: The partnership must allocate the first $80 of
tax gain to Partner A because that represents the inherent
built-in gain.
22
A B V
20 100
property
Partnership
later sells
property for
$110
Example 2: 704(c) Basics
Built-in Gain/Loss Boilerplate Section 704(c) Allocations. In accordance with Section 704(c) of the Code
and the Regulations thereunder, income, gain, loss and deduction with respect to any property contributed to the capital of the Partnership shall, solely for tax purposes, be allocated among the Partners under any reasonable method selected by the General Partner so as to take account of any variation between the adjusted basis of such property to the Partnership for federal income tax purposes and its initial Book Value. If the Book Value of any Partnership asset is adjusted pursuant to clause (c) or (d) of the definition thereof, subsequent allocations of income, gain, loss and deduction with respect to such asset shall take account of any variation between the adjusted basis of such asset for federal income tax purposes and its Book Value in the same manner as under Section 704(c) of the Code and the Regulations thereunder. Any elections or other decisions relating to such allocations shall be made by the General Partner in a manner that reasonably reflects the purpose and intention of this Agreement. Allocations pursuant to this section are solely for purposes of federal, state and local taxes and shall not affect, or in any way be taken into account in computing, any Partner’s Capital Account or share of Profits, Losses, other items or distributions pursuant to any provision of this Agreement.
23
Example 3: Partnership
Nonrecourse Deductions
A and B each contribute $100 to a 50-50 partnership and
have no obligation to restore negative capital accounts. The
partnership borrows $800 from an unrelated lender on a
nonrecourse basis using an interest-only loan and buys
Building for $1,000. The partnership depreciates Building by
$100 a year. After the third year, the partnership has
depreciated the initial $1,000 of section 704(b) basis in
Building down to $700.
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Computation of Minimum Gain
Adjustment Section 704(b)
Value
Nonrecourse
debt
Minimum gain
Purchase date $1,000 $800 $0
Year 1
depreciation
($100) $900 $800 $0
Year 2
depreciation
($100) $800 $800 $0
Year 3
depreciation
($100) $700 $800 $100
25
Capital Accounts, Minimum Gain,
and Adjusted Capital Accounts
A capital A
minimum
gain
A’s
Adjusted
Capital
Account
B capital B
minimum
gain
B’s
Adjusted
Capital
Account
Initial $100 $0 $100 $100 $0 $100
Year 1 $50 $0 $50 $50 $0 $50
Year 2 $0 $0 $0 $0 $0 $0
Year 3 ($50) $50 $0 ($50) $50 $0
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What Does the Tax Boilerplate
Actually Mean?
A. Boilerplate Provisions – Capital Accounts
Capital Accounts
Depreciation
Book Value
Profit and loss
27
What Does the Tax Boilerplate
Actually Mean?
B. Boilerplate Provisions – Regulatory Allocations
Loss Limitation Provision
Adjusted Capital Account Deficit
Gross Income Allocation
Nonrecourse Debt Definitions
Partnership Minimum Gain Chargeback
Partner Minimum Gain Chargeback
Partner Nonrecourse Deductions
Curative/Subsequent Allocations
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Areas of Negotiation
Section 704(c) methods to share built-in tax gain
Discretion over tax election decisions
Allocation of nonrecourse debt basis and deductions
General Tax Allocation Decisions
When to “book up” assets
How to value assets contributed or booked up
Discretion to apply tax allocation “savings clauses”
How to prorate income for mid-year changes in partners
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Areas of Negotiation
Tax-related transfer restrictions
No transfers creating a section 708(b)(1)(B) technical termination (50%
transfers in 12 months)
No transfers resulting in publicly traded partnership (unlikely an issue)
IRS audit decisions
settlement, pick court, input on IRS correspondence, who is TMP
(Manager/GP)
Tax and accounting information
Date K-1 delivered, right to review draft K-1
Keeping books based on GAAP, tax, cash/accrual
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Target vs. Layer Cake
Allocations
31
32
Layer Cake Allocation
Basic concept is to allocate section 704(b) book
profit/loss first and use this allocation to determine the
cash distributions.
Targeted Allocations
Basic concept is to allocate profit/loss so that, at the
end of the taxable year, each partner’s capital
account is equal to:
• the amount that would be distributed to that partner in
liquidation if all partnership assets were sold at their section
704(b) book value, less
• the partner’s share of minimum gain.
Basic Concepts
33
Both Layer Cake and Target Allocations COULD satisfy the safe harbors, if liquidated with capital accounts.
The practical reality is
Most Target Allocations instead liquidate with the cash waterfall in which they target the income and do not satisfy the safe harbors.
Most Layer Cake liquidate with positive section 704(b) capital accounts and otherwise meet the safe harbors.
Sometimes Target agreements also liquidate with capital accounts or Layer Cake agreements liquidate with cash waterfalls.
Satisfaction of Section 704(b) Safe
Harbors
34
Example 1: Basic Target
Allocations
Basic Facts
LP and GP contribute $90 and $10, respectively.
The distribution Waterfall
Cash is paid first to return contributed capital plus a 10% annual
preferred return.
Cash paid 80:20 to LP and GP, respectively.
The partnership earns $20 of income in year one.
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Waterfall
LP GP Total
Return of capital 90 10 100
Preferred return 9 1 10
Residual return 8 2 10
Total 107 13 120
36
•For simplicity, the example shows the GP as only receiving a 20% residual profit sharing
after the preferred return and no return on it’s capital at the residual return level.
Target Allocation
A typical target allocation provision would allocate the $20 of
year one earnings to “fill up” the LP and GP opening capital
accounts ($90 and $10, respectively) to equal their Target
rights under the Waterfall ($107 and $13, respectively).
37
LP GP Total
Beginning 90 10 100
Ending 107 13 120
Target 17 3 20
38
Basic Steps - Layer Cake
Allocations Profit allocations
Reverse prior losses
Preferred return
Residual sharing ratio
Loss allocations
Reverse prior profits (in reverse order)
Relative contributed capital (adjusted capital accounts)
Residual sharing ratio
Adjust capital accounts for contributions, distributions, and allocations
Liquidate with positive capital accounts
39
Basic Steps - Targeted
Allocations
Calculate Cash Waterfall Target
Preferred return
Preferred capital
Common capital
Residual sharing
Profit/Loss allocations to bring adjusted capital account to
equal Target
Adjust the capital accounts for distributions
Generally liquidate with cash waterfall, but can liquidate with
positive capital accounts
40
3 Steps to Target Allocations Step 1 - Determine Partially Adjusted Capital Account (adjust
beginning of year capital for current year contributions and distributions)
Step 2 - Determine Target Capital Account (based on distribution waterfall at book value less minimum gain amounts)
(a) Net value in partnership upon deemed liquidation:
(b) Run value through distribution waterfall
(c) Adjust for partner and partnership minimum gain
Step 3 - Allocate Profit or Loss to bring Partially Adjusted Capital Accounts to Target Capital Account.
41
Example 2 – Net Income in Excess of Preference
LLC
A B Beginning Balance Sheet
Assets Liabilities
Cash: $200,000 $0
Capital
A: $100,000
B: $100,000
Total $200,000 Total: $200,000
$100,000 $100,000
Year 1 Income = $50,000
10% preferred to A, residual A=40%, B=60%
42
Layer Cake Allocations
Section 704(b) Income Allocations A B Opening Capital $100,000 $100,000 $50,000 Income 1. 10% pref to A. $ 10,000 $ 0
2. 40:60 A and B $ 16,000 $ 24,000 Total Income $ 26,000 $ 24,000 Ending Capital $126,000 $124,000
43
Targeted Allocations
A B Opening Capital $100,000 $100,000 Adjustments during year 0 0 Partially adjusted cap acct $100,000 $100,000 Determine Cash Waterfall $250,000 Cash 1. 10% pref to A. $ 10,000 $ 0 2. Return original capital $100,000 $100,000 3. 40:60 A and B $ 16,000 $ 24,000 Ending Target Capital $126,000 $124,000 Income Allocation $ 26,000 $ 24,000
44
Example 3 – Net Income Less than Preference
LLC
A B Beginning Balance Sheet
Assets Liabilities
Cash: $200,000 $0
Capital
A: $100,000
B: $100,000
Total $200,000 Total: $200,000
$100,000 $100,000
Year 1 Income = $8,000
10% preferred to A, residual A=40%, B=60%
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Targeted Allocations
A B
Opening Capital $100,000 $100,000
Adjustments during year 0 0
Partially adjusted cap acct $100,000 $100,000
Determine Cash Waterfall
$208,000 Cash
1. 10% pref to A. $ 10,000 $ 0
2. Return original capital $ 99,000 $ 99,000
3. 40:60 A and B $ $
Ending Target Capital $109,000 $ 99,000
Target Income Allocation $ 9,000 ($ 1,000)
Net Income Allocation $ 8,000 $ 0
Shortfall (Gpmt?) $ 1,000 ($ 1,000)
46
Layer Cake Allocations
Section 704(b) Income Allocations
A B
Opening Capital $100,000 $100,000
$ 8,000 Income
1. 10% pref to A. $ 8,000 $ 0
2. 40:60 A and B $ $
Total Income $ 8,000 $ 0
Ending Capital $108,000 $100,000
47
Comparison of Examples 2 and 3
Ending Cash Received by A and B
A B
Example 2
Target/waterfall $126,000 $124,000
Layer Cake/cap acct $126,000 $124,000
Example 3
Target/waterfall $109,000 $ 99,000
Layer Cake/cap acct $108,000 $100,000
Final Thoughts
Targets have become the baseline and trend is growing
Some renewed sensitivity toward the limitations of target
allocations
No IRS guidance
Impact on return preparers – pros and cons
Less risk to tax allocations affecting economics
48
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For further information
Steven R. Schneider
Baker & McKenzie LLP
Washington, DC
202-452-7006
Peter R. Matejcak
Baker & McKenzie LLP
Chicago, IL
312-861-7523
Brian J. O’Connor
Venable LLP
Baltimore, MD
410-244-7863