Tiered Partnerships: Resolving Tax Law...

Tiered Partnerships: Resolving Tax Law Complexities Navigating Section 704(b) and (c) Allocations, Disposition of 704 (c) Property and Basis Adjustments

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Paul Schockett, Skadden Arps Slate Meagher & Flom, Washington, D.C.

Amanda Wilson, Partner, Lowndes Drosdick Doster Kantor & Reed, Orlando, Fla.

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Tiered Partnerships Resolving Tax Law Complexities

October 17, 2013

Amanda Wilson

Lowndes, Drosdick, Doster, Kantor & Reed, P.A.

Paul Schockett

Skadden, Arps, Slate, Meagher & Flom LLP

Agenda

• Ownership of an Interest in a Tiered Partnership – Allocations of Book Items

– Allocations of Tax Items

– Allocations of Liabilities

• Transactions With Respect to Interests in Tiered Partnerships – Hot Asset Allocations

– Technical Terminations

– Special Basis Adjustments

– Mergers

– Disguised Sales

6

Agenda







– Mergers

– Disguised Sales

7

Allocations of Book Items – Section 704(b)

• Section 702(a)(1)-(7) requires certain partnership items to be separately stated in computing taxable income

• Under section 702(a)(8), all other partnership items are aggregated into a residual income/loss allocation

• Section 704(b) provides as follows: • "A partner's distributive share of income, gain, loss, deduction, or credit (or

item thereof) shall be determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances), if (1) the partnership agreement does not provide as to the partner's distributive share of income, gain, loss, deduction, or credit (or item thereof), or (2) the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect."

• The regulations under section 704(b) provide that special allocations of partnership items may be respected

8

Allocations of Book Items – Section 704(b) (cont'd)

• Each of S's items are either separately stated or included in the residual income/loss allocation – Can P fragment and then specially

allocate the items aggregated into S's residual income/loss allocation?

– What if S is aware that P intends to specially allocate such items?

P

S

A B

C

9

Agenda







– Mergers

– Disguised Sales

10

Allocations of Tax Items – "Forward" 704(c)

• Section 704(c)(1)(A) provides that "income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution"

• Under the regulations, the three methods for making allocations under section 704(c) are the traditional method, the traditional method with curative allocations, and the remedial allocation method – Each method varies from the others in its ability to cure "ceiling rule" problems

– The ceiling rule limits the allocation of tax items to a partner, for purposes of section 704(c), to the partnership's tax items

11

Allocations of Tax Items – "Forward" 704(c) (cont'd)

• Scenario: – A contributes to P $50 cash

– B contributes to P a machine worth $50 with a $30 basis • The machine is depreciable over 5 years

– P contributes to S the machine and the $50 cash

– C contributes to S $100 cash

P

S

A B

C

$50 Machine

V=$50, B=$30

Machine and $50 $100

12


• What happens if P sells its interest in S for $100? – Does section 704(c) apply to P's interest

in S?

– How is P's gain allocated between A and B?

• P's initial balance sheet is as follows:

P

S

A B

C

Machine and $150

Asset Capital Accounts

Basis Book Tax Book

S interest $80 $100 A $50 $50

B $30 $50

13


• If P retains its interest in S, what happens as the machine depreciates? – Is there a ceiling rule problem?

– How does section 704(c) apply at the P level?

– How are the results different if different section 704(c) methods are used?

– Are the results different because of the tiered partnerships?

P

S

A B

C

Machine and $150

14


• S's initial balance sheet is as follows:

• P's initial balance sheet is as follows:

P

S

A B

C

Machine and $150


Basis Book Tax Book

S interest $80 $100 A $50 $50

B $30 $50

Assets Capital Accounts

Basis Book Tax Book

Machine $30 $50 P $80 $100

Cash $150 $150 C $100 $100

15


• If P and S each use the traditional method…

• After 5 years, S's balance sheet is as follows:

• After 5 years, P's balance sheet is as follows:

P

S

A B

C

Machine and $150


Basis Book Tax Book

Machine $0 $0 P $75 $75

Cash $150 $150 C $75 $75


Basis Book Tax Book

S interest $75 $75 A $45 $37.50

B $30 $37.50 16


• If A, B and C had directly invested in the same partnership, the initial balance sheet would have been as follows:

• After 5 years, the balance sheet would have been as follows:

A B C

Machine and $150


Basis Book Tax Book

Machine $30 $50 A $50 $50

Cash $150 $150 B $30 $50

C $100 $100


Basis Book Tax Book

Machine $0 $0 A $40 $37.50

Cash $150 $150 B $30 $37.50

C $80 $75 17

Slide Intentionally Left Blank

Allocations of Tax Items – "Reverse" 704(c)

• Section 704(c) also applies upon a revaluation ("book up") of the partnership's property pursuant to the regulations

• Under section 1.704-1(b)(2)(iv)(f), a partnership may book up its property upon certain events, including a contribution of money or other property to the partnership, the liquidation of the partnership, the grant of an interest in the partnership as consideration for the provision of services to or for the benefit of the partnership, and the issuance by the partnership of a non-compensatory option

19

Allocations of Tax Items – "Reverse" 704(c) (cont'd)

• Scenario: – A and B had each contributed to P $50

cash

– P and C had each contributed to S $100 cash

– S had purchased a depreciable machine with the $200 cash

– At a time when the machine is worth $300 and had not yet been depreciated for book or tax purposes: • D contributes to P $75 cash,

• P then contributes to S the $75 cash, and

• P and S each book up their capital accounts

P

S

A B

C

$75

$75

D

Machine V=$300, B=$200

20


• Is the depreciation allocated by S to P treated differently at the P level than in the forward 704(c) context?

• Should it be treated differently?

P

S

A B

C

D


$75

21


• S's balance sheet after the book-up is as follows:

• P's balance sheet after the book-up is as follows:

P

S

A B

C

D


$75


Basis Book Tax Book

Machine $200 $300 P $175 $225

Cash $75 $75 C $100 $150


Basis Book Tax Book

S interest $175 $225 A $50 $75

B $50 $75

D $75 $75

22


• P will be allocated $180 of the machine's book depreciation, which will be allocated $60 to each of A, B and D

• P will be allocated $130 of the machine's tax depreciation – How will that tax depreciation be

allocated among A, B and D?

P

S

A B

C

D


$75

23


• Alternative Scenario: – P does not contribute to S the $75 cash

received from D

– Accordingly, S does not book up its capital accounts

P

S

A B

C

D

$75


24


• S's balance sheet, without a book-up, is as follows:

• P's balance sheet after the book-up is as follows:

P

S

A B

C

D

$75



Basis Book Tax Book

Machine $200 $200 P $100 $100

C $100 $100


Basis Book Tax Book

S interest $100 $150 A $50 $75

Cash $75 $75 B $50 $75

D $75 $75

25


• After depreciating the machine, S's balance sheet is as follows:

• And P's balance sheet is as follows:

• What would happen if the machine were actually worth $0 at this point?

P

S

A B

C

D

$75

Machine


Basis Book Tax Book

Machine $0 $0 P $0 $0

C $0 $0


Basis Book Tax Book

S interest $0 $50 A $16.67 $41.67

Cash $75 $75 B $16.67 $41.67

D $41.67 $41.67

26

Agenda







– Mergers

– Disguised Sales

28

Allocations of Liabilities – Section 752

• Section 752(a) provides that an increase in a partner's share of the partnership's liabilities shall be considered as a contribution of money by such partner to the partnership

• Similarly, section 752(b) provides that a decrease in a partner's share of the partnership's liabilities shall be considered as a distribution of money to such partner by the partnership

• The regulations have detailed rules for determining a partner's share of a partnership's recourse and nonrecourse liabilities

29

Allocations of Liabilities – Section 752 (cont'd)

P

S

A B

C

• Is P's allocable portion of S's liability taken into account as a liability of P?

• What if P has guaranteed S's liability, but P's liabilities are nonrecourse to A and B?

Bank Loan

30

Agenda







– Mergers

– Disguised Sales

31

Hot Asset Allocations – Section 751(a)

• Pursuant to section 741, a partner recognizes capital gain or loss upon the sale or exchange of a partnership interest, except to the extent provided by section 751

• Section 751(a) generally provides that a partner recognizes ordinary income or loss upon such a sale or exchange to the extent attributable to the partnership's "hot assets" (unrealized receivables or inventory items)

• Section 751(f) states that “[i]n determining whether property of a partnership is (1) an unrealized receivable, or (2) an inventory item, such partnership shall be treated as owning its proportionate share of the property of any other partnership in which it is a partner."

• The regulations under section 751 adopt a deemed sale approach for determining a partner's share of a partnership's hot assets

32

Hot Asset Allocations – Section 751(a) (cont'd)

• Scenario: – A contributes to P $50 cash

– B contributes to P inventory worth $50 with a $40 basis

– P contributes to S the inventory

– C contributes to S $50 cash

P

S

A B

C

$50 Inventory

V=$50, B=$40

Inventory $50

33

Hot Asset Allocations – Section 751(a) (cont'd)

• If B sells its interest in P for $50, what is the character of B's $10 gain recognized on the sale?

• What would the character have been had P retained the inventory (and not contributed it to S)?

P

S

A B

C

Inventory V=$50, B=$40

D

$50

$50

34

Agenda







– Mergers

– Disguised Sales

35

Technical Terminations – Section 708(b)(1)(B)

• Section 708(b)(1)(B) provides that a partnership terminates if within a 12-month period there is a sale or exchange of 50% or more of the total interest in partnership capital and profits

• Section 1.708-1(b)(2) states as follows: – "[I]f the sale or exchange of an interest in a partnership (upper-tier partnership)

that holds an interest in another partnership (lower-tier partnership) results in a termination of the upper-tier partnership, the upper-tier partnership is treated as exchanging its entire interest in the capital and profits of the lower-tier partnership."

– "If the sale or exchange of an interest in an upper-tier partnership does not terminate the upper-tier partnership, the sale or exchange of an interest in the upper-tier partnership is not treated as a sale or exchange of a proportionate share of the upper-tier partnership's interest in the capital and profits of the lower-tier partnership."

36

Technical Terminations – Section 708(b)(1)(B) (cont'd)

P

S

A B

C

• Is there a technical termination of S if A sells its interest? – Should there be?

• Is there a technical termination of S if B and C sell their interests? – Should there be?

70%

30% 70%

30%

37

Agenda







– Mergers

– Disguised Sales

39

Special Basis Adjustments – Section 743(b)

• In general, under section 743(a), no basis adjustments are made with respect to a partnership's assets upon a sale or exchange of an interest in the partnership

• If the partnership has a section 754 election in place, however, basis adjustments under section 743(b) are made

• In the case of tiered partnerships, Rev. Rul. 87-115 provides that in determining whether section 743(b) adjustments should be made in connection with section 754 elections, the separate entity status of each partnership is respected

40

Special Basis Adjustments – Section 743(b) (cont'd)

• Scenario: – A and B are equal partners in P

• P owns a machine with a value of $100 and a basis of $50

– P and C are equal partners in S • S owns a machine with a value of $200 and a

basis of $100

– B sells its interest in P to D for $100

P

S

A B

C

D



41


• What are the basis adjustments under section 743(b) if: – P and S each have a section 754 election

in place?

– Only P has a section 754 election in place?

– Only S has a section 754 election in place?

• What if both P and S have section 754 elections in place, but P has fair market value basis in its S interest?

• What if P subsequently contributes its machine to S?

P

S

A B

C

D



42

Special Basis Adjustments – Section 734(b)

• In general, under section 734(a), no basis adjustments are made with respect to a partnership's assets upon a distribution by the partnership

• If the partnership has a section 754 election in place, however, basis adjustments under section 734(b) generally are made

• In the case of tiered partnerships: – Section 734(b) provides that upward basis adjustments are not made with

respect to a partnership's property if the partnership distributes an interest in another partnership which does not have in place a section 754 election

– Rev. Rul. 92-15 describes how certain basis adjustments are made with respect to the property of an upper-tier partnership and a lower-tier partnership upon a distribution by the upper-tier partnership of an interest in the lower-tier partnership or of other property held by the upper-tier partnership

43


• Scenario: – At a time when B's basis in its P interest

is $0, P distributes a 50% interest in its machine to B

– P and S each have a section 754 election in place

• May the section 734(b) adjustment at the P level be allocated to its S interest? – If so, is there any special basis

adjustment at the S level?

P

S

A B

C Machine

V=$100, B=$50


44


• Alternative Scenario: – At a time when B's basis in its P interest

is $0, P distributes half its S interest to B

– P has a section 754 election in place

• What are the P level results if S has a section 754 election in place? – What if S does not have a section 754

election in place?

• What are the S level results if S has a section 754 election in place?

P

S

A B

C Machine

V=$100, B=$50


45

Agenda







– Mergers

– Disguised Sales

47

• Section 708(b)(2)(A) provides that where two partnerships merge, the resulting partnership is considered the continuation of any merging partnership whose members own more than 50% of the capital and profits interest of the resulting partnership

• Section 1.708-1(c)(1) states that “[i]f the resulting partnership can … be considered a continuation of more than one of the merging … partnerships, it shall … be considered the continuation solely of that partnership which is credited with the contribution of assets having the greatest fair market value (net of liabilities) to the resulting partnership."

• The regulations generally adopt an "assets-over" form for partnership mergers

Mergers – Section 708(b)(2)(A)

48

Mergers – Section 708(b)(2)(A) (cont'd)

P

S

A B

C

• Scenario: – Under state law, P merges with and into

S with S surviving

• What is the characterization of the merger for U.S. federal income tax purposes? – What are the section 704(c)

consequences?

– What if the terminating partnership held assets with respect to which a partner had a section 743(b) adjustment?

49

Agenda







– Mergers

– Disguised Sales

50

Disguised Sales – Section 707(a)(2)(B)

• Section 707(a)(2)(B) and the regulations thereunder generally provide that where a partner transfers property to a partnership and, in a related transaction, the partnership transfers money or other property to the partner, then the two transfers may be treated as a sale or exchange between the partner and the partnership

• Section 1.707-5(a)(5) states that "[i]f a transfer of property by a partner to a partnership is not otherwise treated as part of a sale, the partnership's assumption of or taking subject to a qualified liability in connection with a transfer of property is not treated as part of a sale"

• Qualified liabilities generally include those that are "old and cold" or not incurred in connection with, or in anticipation of, the transfer

51

Disguised Sales – Section 707(a)(2)(B) (cont'd)

• Scenario: – B contributes to P land that is subject to

debt

– P contributes to S the land subject to the debt

• Does the characterization of the debt as "qualified" or "nonqualified" carry over from P to S?

P

S

A B

C

Land subject to debt


52

Disguised Sales – Section 707(a)(2)(B) (cont'd)

• Alternative Scenario: – B contributes to S land that is subject to

debt

– B contributes to P its interest in S

• Does the characterization of the debt as "qualified" or "nonqualified" carry over from S to P?

S

B C


P

A B

S interest

53

For More Information

Paul Schockett

(202) 371-7815

[email protected]

Amanda Wilson

(407) 418-6220

[email protected]

54

Disclaimer

To ensure compliance with Treasury Department regulations, we advise you that, unless otherwise expressly indicated, any tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

DC1/1262946/10-3 55

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