Beginning 2018, the IRS is authorized to collect from a partnership any tax deficiencies arising out of the partnership’s operations for a taxable year, even if the persons who were partners in the year to which the deficiency relates are no longer partners in the year that the deficiency is assessed.

Stated differently, the current-year partners will bear the economic burden of the tax liability even though the tax adjustments relate to a prior year in which the composition of the partnership may have been different.

How did we get to this, and what should partnerships and their partners be doing about it?

Bipartisan Budget Act of 2015

The number of partnerships and partners in the U.S. continues to increase, as do the total receipts and the value of total assets for all partnerships. LLCs classified as partnerships account for the majority of this growth. This development is a clear manifestation of the fact that the partnership represents the most flexible form of business entity.

As partnerships have grown in number, size, and complexity, the IRS has found it increasingly difficult to audit them and to collect any resulting income tax deficiencies, especially in the cases of large partnerships and tiered partnerships.

In response to these difficulties, Congress enacted the Bipartisan Budget Act of 2015 (the “BBA”), which added a number of new tax compliance provisions to the Code that become effective on January 1, 2018.

A key feature of the BBA is that it imposes liability for any audit adjustments with respect to an earlier partnership tax year on the partnership, rather than on those persons who were partners during the audited tax year.

Partnership Audits: Pre-2018

Prior to the BBA, two different regimes existed for auditing “closely-held” partnerships:

  • For partnerships with ten or fewer partners, the IRS generally applied the audit procedures for individual taxpayers, auditing the partnership and each partner separately.
  • For most large partnerships with more than ten partners, the IRS conducted a single administrative proceeding (under the so-called “TEFRA” rules, which were adopted in 1982) to resolve audit issues regarding partnership items that were more appropriately determined at the partnership level than at the  partner level.
    • Under the TEFRA rules, once the audit was completed and the resulting adjustments were determined, the IRS recalculated the tax liability of each partner in the partnership for the particular audit year.

New Default Rule: A “Taxable Partnership”

Under the BBA, the TEFRA rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.

Under  the streamlined  audit approach, the IRS  will examine the partnership’s  items of  income, gain, loss,  deduction, credit for  a particular  year of  the partnership  (the “reviewed  year”).

However, the IRS is no longer required to determine each partner’s share of the adjustments made to these partnership items, followed by a separate computational adjustment for each partner, to assess the correct tax due as a result of the partnership audit.

Instead, under the new default rules, any adjustments to these tax-related items of the partnership for the reviewed year will be taken into account by, and the tax liabilities attributable to these adjustments (including interest and penalties) – the “imputed underpayment” – will be assessed against, and collected from, the partnership.

Thus, the economic burden thereof will be borne by the persons who are partners of the partnership during the taxable year that the audit (or any administrative or judicial review thereof) is completed (the “adjustment year”) – not by those persons who were partners during the year to which the adjustments relate.

Moreover, the tax resulting from such adjustments will be computed at the highest marginal rate for individuals or corporations (as the case may be) in the reviewed year, without regard to the character of the income or gain.

Taxpayer Representative

In order to facilitate the application of the new audit regime, the BBA requires the designation by each partnership of a partnership representative (the “PR”). The PR, who does not need to be partner of the partnership, shall have the sole authority to act on behalf of the partnership in tax matters, and the partnership and all partners shall be bound by any actions taken by the PR, including in settlement of an audit.

Some Relief

The foregoing marks an important change in the audit of closely-held partnerships.

In recognition of this fact, and in order to address certain inequities that may result therefrom, the BBA provides some relief.

Where the imputed underpayment calculation exceeds the amount of tax that would have been due had the partnership and the partners reported the partnership adjustments properly, a partnership (and its partners) will have  the option of demonstrating  that the adjustment  would be  lower if  it were based  on certain  partner-level information  from the  reviewed year, and did not rely only on the partnership’s information for  such  year.

Thus, if one or more partners file amended returns for the reviewed year, such returns take into account the adjustments made by the IRS that are properly allocable to such partners, and payment of any tax due (calculated using the highest marginal rate of tax for the type of income and taxpayer) is included with the amended returns, the partnership’s imputed underpayment shall be determined without regard to the portion of the adjustments taken into account in the amended returns.

Small Partnership Election

The foregoing is not the only relief provided.

An eligible partnership is permitted to affirmatively elect out of the new audit regime, in which case the partnership and its partners will be audited under the pre-TEFRA audit procedures, under which the IRS must separately assess tax with respect to each partner under the deficiency procedures generally applicable to individual taxpayers.

In order to qualify for this “small partnership” election, the partnership must have 100 or fewer partners. A partnership satisfies this requirement when it is required to furnish 100 or fewer Schedule K-1s. For a partnership that has an “S” corporation as a partner, the number of Schedule K-1s that the S corporation is required to furnish to its shareholders is taken into account to determine the number of K-1s furnished by the partnership.

In addition, each partner of the partnership must be an individual, a “C” corporation, a foreign entity that would be treated as a “C” corporation if it were domestic, an “S” corporation, or the estate of a deceased partner. Thus, for example, another partnership, the estate of someone other than a deceased partner, and a trust cannot be partners of an electing small partnership.

It should also be noted that the election must be made on an annual basis, it must be made on a timely-filed partnership return (including extensions), and the partnership must notify the partners of the election.

Another Election Out?

A partnership that does not qualify for the small partnership election – or which does not elect to be treated as such – may still be able to elect out of the new audit regime.

It can do so by electing to have its reviewed-year partners take into account the adjustments made by the IRS, and pay any tax due as a result of those adjustments. In that case, the partnership will not be required to pay the imputed underpayment.

The electing partnership would pass the adjustments along to its reviewed-year partners by issuing adjusted Schedule K-1s to them. Those partners (and not the partnership) would then take the adjustments into account on their individual returns in the adjustment year through a simplified amended-return process.

A partnership must elect this alternative not later than 45 days after the date of the notice of a partnership adjustment (a “Sec. 6226 election”). Where the election is made, the reviewed-year partners will be subject to an increased interest charge as to any tax deficiency.

Effective Date

Because the BBA marks a significant change in the audit of partnerships, and because it applies to both existing and new partnerships, its effective date was delayed: the new rules will first become effective for returns filed for partnership tax years beginning after 2017.

In the case of a partnership with a taxable year that ends on December 31, that means the rules will become applicable on January 1, 2018 – only two months away.

The delayed effective date provided the IRS with time to prepare and issue proposed regulations to implement and interpret the statutory changes, which it did in June of this year; however, it is not clear when these will be issued in final form.

Amend Partnership Agreements

Partnerships were afforded plenty of time, between the 2015 passage of the BBA and its January 1, 2018 effective date, to consider the implications of the new audit regime.

That being said, there are still many partnerships out there that have not yet amended their partnership/operating agreements in response to these new rules. After all, the first partnership return that will be subject to the new rules, for the 2018 tax year, which will not be filed until March of 2019, and it will not be audited until a year or two later.

Nevertheless, partnerships should anticipate that they may admit new partners and lose old partners during the course of the 2018 tax year, and these persons will need to be aware of what their obligations will be insofar as 2018 tax liabilities are concerned.

Many partnerships will qualify, and will likely elect to be treated, as a small partnership.

However, many partnerships will not qualify for this election because they include “ineligible” partners, such as trusts or other partnerships.

These partnerships, or their partners, may want to consider a change in their ownership structure so as to qualify for the election; for example, by dissolving trust-partners, causing their partnership interests to be distributed to individual beneficiaries. (Of course, this first has to make sense from a business and familial perspective.)

Other partnerships will lose their qualification upon the admission of such a partner (for example, a partnership-investor). Still others will forget to make the annual election, and, so, will fall within the scope of the new rules.

Therefore, no partnership can assume that the new audit rules will not apply to it and, so, every partnership has to ensure that its partnership/operating agreement addresses the new rules.

Among the items for which the agreement should be amended are the following:

  • if the partnership believes it will qualify as a small partnership, it may require that the election be made;
  • it may also want to restrict the transfer of its partners’ partnership interests so as to ensure its continued qualification;
  • if the partnership does not qualify for, or fails to elect as, a small partnership, it may require that the Sec. 6226 election be made, under which the reviewed-year partners (including former partners) will amend their returns for such year to account for any audit adjustments and satisfy the resulting liability;
  • require reviewed-year partners (including former partners) to provide such information as may be necessary to reduce the tax liability for the reviewed year;
  • require reviewed-year partners (including former partners) to indemnify the partnership and the adjustment-year partners for any liability attributable to the reviewed year;
  • provide for the selection and removal of the PR;
  • require the PR to inform the partners of any audit, keep them abreast of the audit’s progress, including proposed adjustments;
  • limit the PR’s ability to settle an audit without the consent of the partners;
  • address reviewed year tax liabilities of the partners following the dissolution of the partnership.

Anything Else?

The foregoing considerations may be especially important to transferees of partnership interests (whether acquired by gift or purchase, as compensation, by distribution or otherwise), and to potential new investors.

Before acquiring an interest, these new or potential partners are likely to insist upon increased levels of due diligence of the partner’s tax returns and related documents. They will also insist upon protection against losses that may be incurred for prior year partnership tax liabilities.

The foregoing has assumed the existence of a partnership. What if the parties that are coming together to conduct business are not “formal” members of a partnership? Such persons must first determine whether their arrangement constitutes a partnership for tax purposes. This may not be an easy task, and there are no assurances that the IRS will agree with the parties’ conclusion.

What, then, can such persons do? Bite the bullet, concede they are partners, file partnership returns, and adopt a partnership agreement with the above-described safeguards? Or wait for the IRS to determine their status and, at that point, make a Sec. 6226 election?

These are new rules. Eventually, “final” regulations will be issued. At some point, the courts will interpret the new rules, and the IRS will apply its regulations. Their collective experience will inform taxpayer’s actions.

Until then, it’s best to approach the new rules as conservatively as possible, while at all times preserving the business arrangement among the parties, and maintaining enough flexibility to respond to future changes.

Relief? Not So Fast

You may recall that the President directed the Treasury Department to identify “significant tax regulations” issued during 2016 that, among other things, add undue complexity to the tax laws. An interim report to the President in June identified the proposed rules on the valuation of family-controlled business entities as “unworkable,” and recommended that they be withdrawn.

Although many taxpayers are pleased to see the demise of the proposed valuation rules, which many had heralded as the end of valuation discounts for estate and gift tax purposes, there remain a number of traps against which taxpayers and their advisers must be vigilant – but of which many are unaware – lest they inadvertently stumble onto a taxable gift.

One such trap involves the maintenance of capital accounts where the family-controlled business entity is treated as a partnership for tax purposes.

Family Partnership

Family members often combine their “disposable” investment assets in a tax-efficient family-held investment vehicle, such as an LLC that is taxable as a partnership. By pooling their resources, they may be able to better diversify their investments and gain access to larger, more sophisticated, investments that may not have been available to any single family member.

Moreover, as younger family members mature and amass their own wealth, they may decide to participate in the family investment vehicle by making a capital contribution in exchange for a partnership interest.

Capital Account Rules

An earlier post reviewed the capital account and allocation rules applicable to partnerships; in particular, the requirement that the tax consequences to each partner arising from the partnership’s operations – specifically, from such partner’s allocable share of the partnership’s items of income, gain, loss, deduction, or credit – must accurately reflect the partners’ economic agreement.

According to these regulations, an allocation set forth in a partnership agreement shall be respected by the IRS if the allocation has substantial economic effect or, if taking into account all of the facts and circumstances, the allocation is in accordance with the partners’ interests in the partnership.

Economic Effect

In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or economic burden that corresponds to the allocation, the partner to whom an allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.

In general, an allocation will have economic effect if the partnership agreement provides for the determination and maintenance of the partners’ capital accounts in accordance with the rules set forth in the regulations and, upon the liquidation of the partnership (or of a partner’s interest in the partnership), liquidating distributions are made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments. In other words, a partner’s capital account will generally reflect the partner’s equity in the partnership.

Basically, the capital account rules require that a partner’s capital account be increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value (“FMV”) of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain; and is decreased by (4) the amount of money distributed to him by the partnership, and (5) the FMV of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), and (6) allocations to him of partnership loss and deduction.

Revaluation of Property

It should be noted that the capital account rules generally do not require that the partners’ capital accounts be adjusted on an ongoing basis to reflect changes in the FMV of the partnership’s assets.

However, the rules do require that the capital accounts be adjusted to reflect a revaluation of partnership property on the partnership’s books upon the happening of certain enumerated events. In general, these adjustments are based upon the FMV of partnership property on the date of the adjustment.

These adjustments reflect the manner in which the unrealized gain inherent in such property (that has not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for its FMV on the date of a “revaluation event.”

In general, a revaluation event is one that marks a change in the economic arrangement among the partners. Among these events is the contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership. The adjustments are made among the capital accounts of the existing partners in accordance with their existing economic agreement, just prior to the above-referenced change.

In this way, the capital accounts will reflect the amount to which each existing partner would have been entitled had the partnership been liquidated immediately prior to the admission of the new partner and the change in the partners’ economic agreement.

Grandson:      Hold it, hold it! What is this? Are you tryin’ to trick me?

   Where’s the [estate tax]? Is this a [partnership tax post?]

Grandfather:  Wait, just wait.

Grandson:     Well when does it get good?

– from “The Princess Bride” (mostly)

Book-Tax Difference

When partnership property is revalued under these rules, and the partners’ capital accounts are adjusted accordingly, the gain computed for book purposes with respect to such property will differ from the gain computed for tax purposes for such property; in other words, the book value of the property reflected in the now-adjusted capital accounts will differ from the tax basis of such property (which was not adjusted in connection with the revaluation).

Consequently, the partners’ shares of the corresponding tax items – such as the gain on the sale of the property – are not reflected by further adjustments to the capital accounts, which have already been adjusted as though a sale had occurred.

Rather, these tax items must be shared among the partners in a manner that takes account of the variations between the adjusted tax basis of the property and its book value. Otherwise, the allocation may not be respected by the IRS.

Illustration

Perhaps the best way to convey the import of the foregoing rules is with an example.

Facts

Assume dad Abe and son Ben form an equal partnership to which each contributes $10,000 cash (which is credited to their respective capital account; each has a capital account of $10,000). This $20,000 is invested in securities (the book value and the tax basis of the securities are both $20,000). Assume that the partnership breaks even on an operational basis (no profit, no loss; no change to capital accounts), and that the securities appreciate in value to $50,000.

At that point, grandson Cal joins the partnership, making a $25,000 cash contribution in exchange for a one-third interest (an amount equal to one-third of the FMV of the partnership ($75,000) immediately after his capital contribution). Assume that the cash is held in held in a bank account.

Revaluation; Account for Book-Tax Difference

Upon Cal’s admission to the partnership – a revaluation event – the capital accounts of Abe and Ben are adjusted upward (from $10,000 to $25,000, each: $50,000 FMV of securities minus book value of $20,000 = $30,000 gain, or $15,000 each) to reflect their shares of the unrealized appreciation in the securities that occurred before Cal was admitted to the partnership.

Immediately after Cal’s admission, the securities are sold for $50,000, resulting in taxable gain of $30,000 ($50,000 less tax basis of $20,000), and no book gain (because the capital accounts had already been adjusted to FMV to reflect the appreciation; $50,000 less $50,000 = zero). Because there is no gain for book purposes, the allocation of the taxable gain cannot have economic effect (tax is unable to follow book in that situation).

Unless the partnership agreement provides that the tax gain will be allocated so as to account for the variations between the adjusted tax basis of the securities and their book value – by allocating the $30,000 of tax gain to Abe and Ben ($15,000 each), to whom the economic benefit of the appreciation “accrued” prior to Cal’s admission (tax to follow economics, as reflected in the adjusted capital accounts) – the IRS may not accept the allocation.

No Revaluation, but Special Allocation

Alternatively, assume that the capital accounts of Abe and Ben are not adjusted upon Cal’s admission to reflect the $30,000 of appreciation in the partnership securities that occurred before Cal was admitted.

Rather, the partnership agreement is amended to provide that the first $30,000 of taxable gain upon the sale of the securities is allocated equally between Abe and Ben, and that all other gain (appreciation occurring after Cal’s admission) will be allocated equally among all three partners, including Cal.

These allocations of taxable gain have economic effect; tax will follow book. Moreover, the capital accounts of Abe and Ben will in effect be adjusted upon the sale (by $15,000 each, to $25,000 each) to reflect the appreciation inherent in the securities immediately prior to Cal’s admission.

No Revaluation, no Special Allocation – Gift?

If the capital accounts of Abe and Ben are not adjusted upon Cal’s admission, and the partnership agreement provides for all taxable gain (including the $30,000 attributable to the appreciation in the securities that occurred prior to Cal’s admission to the partnership) to be allocated equally among Abe, Ben and Cal ($10,000 each), the allocation will have economic effect (tax will follow book). In that case, Abe and Ben will each have a capital account of $20,000 (instead of $25,000 as above), while Cal will have a capital account of $35,000 (instead of $25,000 as above).

However, the partners will have to consider whether, and to what extent, a gift may have been made to Cal in that his capital account is allocated one-third of the appreciation ($10,000 of the $30,000) that occurred prior to his admission.

As always, query whether this same result would have followed if Cal had not been related to Abe and Ben. After all, why would someone allow value that accrued on their investment, to inure to the benefit of another?

Let’s Be Careful Out There (from “Hillstreet Blues”)

The foregoing may not be easy to digest, but anyone who purports to provide estate and gift tax advice to the members of a family-owned business or investment vehicle that is formed as a tax partnership must realize that there is nothing simple about the taxation of such an entity.

Whether we are talking about the disguised sale rules, the shifting of liabilities, hot assets, the mixing bowl rules or, as in this post, the capital account revaluation rules, there are many pitfalls. The provisions of a partnership agreement, including the revaluation rule, that are so often described as “boilerplate” are anything but, and the partnership’s advisers must be familiar with their purpose and application.

It is imperative that the partnership agreement be reviewed periodically, especially in connection with the admission or withdrawal of a partner. In this way, the tax and economic consequences of such an event may be anticipated and, if possible, any adverse results may be addressed or avoided.

Setting the Stage

Over the last couple of months, I’ve encountered several situations involving the liquidation of a partner’s interest in a partnership. Years before, the partnership had borrowed money from a third party lender in order to fund the acquisition of equipment or other property. During the interim period, preceding the liquidation of his interest, the departing partner had been allocated his share of deductions attributable to the debt-financed properties, which presumably reduced his ordinary income and, thus, his income tax liability.

The departing partner negotiated the purchase price for his interest based upon the liquidation value of his equity in the partnership. Imagine his surprise when he learned (i) that his taxable gain would be calculated by reference not only to the amount of cash actually distributed to him (the amount he negotiated), but would also include his “share” of the partnership’s remaining indebtedness, and (ii) that the amount of cash he would actually receive would just barely cover the resulting tax liability.

A recent decision by the Tax Court illustrated this predicament, and much more.

The End of a Partnership

Prior to Taxpayer’s admission as a partner, Partnership had entered into a lease for office space and had borrowed funds from Lender I for leasehold improvements.

Subsequently, Taxpayer joined Partnership as a general partner. Upon joining Partnership, Taxpayer did not sign a partnership agreement. At some point after Taxpayer joined the Partnership, the Partnership entered into a line of credit loan arrangement with Lender II.

Partnership dissolved in Year One. Upon Partnership’s dissolution, the Partnership began to wind up its affairs by collecting accounts receivable and settling pending lawsuits brought against the Partnership by its lenders and landlord.

In order to create a fund out of which to make partial payments to settle with the aforementioned creditors, Partnership’s former partners signed a settlement agreement pursuant to which Taxpayer agreed to pay a fixed dollar amount, constituting X% of the Partnership settlement fund. The settlement agreement included a provision entitled “Special Tax Allocation,” which provided:

In recognition of the contribution by each of the various Partners to the settlement of the Lawsuits, to each Partners’ allocation of income and loss for the year in which the [settlement] occurs shall be credited the percentage of loss created by the settlement and satisfaction of the Lawsuits equal to the pro-rata contribution by such Partner to the fund created by the terms of this Agreement. It is specifically recognized that this is a special allocation of losses made by the Partners in recognition of the contributions to the settlement of the Lawsuits and in lieu of and in substitution for the allocation of losses pursuant to the respective interests of the Partners in the [Partnership].

In Year Two, Partnership’s former partners entered into settlement agreements with each of its Lenders, pursuant to which Partnership agreed to pay a portion of the outstanding indebtedness to settle its debts, and the Lenders forgave their remaining balance.

Partnership filed Forms 1065, U.S. Partnership Return of Income, and Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for Years One through Two which reflected the income and tax items resulting from its operations until late Year One (the year of dissolution) and the winding up of its affairs thereafter.

Taxpayer received a Schedule K-1 from Partnership for Year One, and another for Year Two, and reported his share of Partnership income and other tax items as reflected on the Schedules K-1 on his personal income tax returns.

Taxpayer’s Year Two return reported a nonpassive loss from Partnership, but it did not report any cancellation of indebtedness income from Partnership; nor did it report any capital gains.

Some Basic Partnership Tax Concepts

In general, a partner’s adjusted basis (“investment” for our purposes) in his partnership interest reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Income

A partner must recognize his distributive share of partnership income regardless of whether the partnership makes any distribution to the partner. The amount of income so recognized is reflected as an increase in the partner’s adjusted basis in his partnership interest.

Distributions

A partnership’s distribution of cash to a partner (representing, perhaps, already-taxed income, or capital contributions) reduces the partner’s adjusted basis in his partnership interest. If a cash distribution exceeds the partner’s adjusted basis in his interest, the excess amount is taxable to the partner. Thus, a partner may withdraw cash from a partnership without realizing any income or gain to the extent of his adjusted basis.

Losses

A partner can deduct his distributive share of partnership loss to the extent of his adjusted basis in his partnership interest at the end of the partnership’s tax year in which the loss occurred (one cannot lose more than one has “invested”); in general, his adjusted basis reflects the amount of cash contributed by the partner to, or left in the partnership by, the partner.

Borrowed Funds

When an individual borrows money, he does not realize any income; the loan proceeds do not represent an accretion in value to the individual. However, the individual may use the borrowed funds to pay expenses for which he may claim a deduction, or he may use them to acquire an asset for which he may claim depreciation deductions.

As a pass-through entity, a partnership tries to mirror these tax consequences of borrowing by its partners. Thus, when a partnership borrows money, the indebtedness is “allocated” among the partners, as though they had borrowed the funds and then contributed them to the partnership, thereby increasing each partner’s adjusted basis by his share of the partnership indebtedness. By doing so, the partners may withdraw the borrowed funds from the partnership without recognition of income (reducing their adjusted basis in the process), and may claim deductions for expenses paid with the borrowed funds, or for depreciation deductions with respect to property acquired with the borrowed funds.

Similarly, any increase in a partner’s share of partnership liabilities is treated, for tax purposes, as a contribution of money by the partner to the partnership, thereby increasing the partner’s basis in his partnership interest.

Conversely, any decrease in a partner’s share of partnership liabilities is treated as a distribution of money by the partnership to the partner. If the amount of this decrease exceeds the partner’s adjusted basis in his partnership interest, the partner will recognize gain to the extent of the excess.

IRS Audit

After examining Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, relating to Year Two, in which it: disallowed the Partnership loss deductions claimed; determined that Taxpayer failed to report his distributive share of Partnership’s discharge of indebtedness income; and determined that Taxpayer failed to report capital gain stemming from the deemed distribution of cash in excess of Taxpayer’s basis in his Partnership interest.

Cancellation of Debt

According to the IRS, Partnership’s settlement of its indebtedness to its Lenders, with a partial payment, resulted in cancellation of indebtedness income for the balance; it eliminated the Partnership’s outstanding liabilities.

Reduced Share of Debt

As a result of these transactions, the IRS contended that Taxpayer had to include in income his X% share of Partnership’s discharge of indebtedness income.

The IRS also argued that there had been a deemed distribution of cash to Taxpayer in an amount equal to the canceled Partnership liabilities previously allocated to Taxpayer on his Schedule K-1. According to the IRS, this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest and triggered a capital gain in an amount equal to the excess, which Taxpayer had to include in income.

Insufficient Basis for Deductions

Finally, the IRS contended that because Taxpayer had no remaining basis in his Partnership interest with which to absorb his distributive share of Partnership loss for Year Two, Taxpayer was not entitled to the deduction he claimed, and had to increase his income accordingly.

Tax Court’s Analysis

Taxpayer petitioned the Tax Court to review the IRS’s determinations.

COD Income

The Court explained that gross income generally includes income from the discharge of indebtedness; when realized by a partnership, such income must be recognized by its partners as ordinary income. The recognition of such income provides each partner with an increase in the adjusted basis in his partnership interest.

Under the settlement agreement, each partner, including Taxpayer, agreed that his distributive share of Partnership income and loss for Year Two would be calculated according to the percentage of funds that each had contributed towards the settlement fund. Taxpayer contributed X% of the total; thus, Partnership allocated X% of its discharge of indebtedness income to Taxpayer on his Schedule K-1.

Taxpayer made several arguments in an attempt to avoid the allocation of this income, but the Court found they had no merit, stating that the basic principle that partners must recognize as ordinary income their distributive share of partnership discharge of indebtedness income was well-established, even as to nonrecourse debts for which no partner bears any personal liability.

In sum, Taxpayer had to recognize his X% distributive share of Partnership’s discharge of indebtedness income for Year Two, thereby increasing Taxpayer’s adjusted basis in his Partnership interest to that extent.

Deemed Cash Distribution

The Court next determined that there was a deemed cash distribution to Taxpayer as a result of the elimination of Partnership’s outstanding liabilities during Year Two when it settled with its creditors, which “relieved” Taxpayer of his share of the partnership’s liabilities. Therefore, Taxpayer received a deemed distribution of cash from Partnership in an amount equal to his share of the liabilities.

Because this deemed distribution exceeded Taxpayer’s adjusted basis in his Partnership interest, Taxpayer was required to recognize capital gain in the amount of the excess.

No Basis? No Deduction

Finally, having determined that Taxpayer had no remaining basis in his Partnership interest as of the end of Year Two, the Court concluded that Taxpayer was not entitled to deduct his share of partnership losses for that year.

Lessons?

One often hears about the “phantom income” realized by a departing partner when his partnership has outstanding indebtedness, part of which was allocated to him, and is then deemed distributed to him in liquidation of his interest.

Many partners equate “phantom” with “unfair,” which is itself unfair, and inaccurate. In fact, the deemed cash distribution that is attributable to the departing partner’s share of partnership indebtedness results in gain to the partner only to the extent he previously received a “tax-free” distribution of the loan proceeds or was allocated partnership deductions or losses attributable to the partnership’s use of the borrowed funds. A more accurate description, therefore, may be that the departing partner is forced to recapture the tax benefit previously realized.

Theory and semantics aside, though, can the departing partner reduce or defer any of the adverse tax consequences described above? Maybe.

For example, a partner to whom income is allocated from the cancellation of a partnership’s indebtedness may be able to exclude the income if he – not the partnership – is insolvent at the time of the discharge.

As regards the deemed distribution of cash resulting from a former partner’s share partnership indebtedness, the distribution may be deferred so long as the partner remains a partner for tax purposes (for example, where his interest is being liquidated in installments). The amount of the deemed distribution may also be reduced if the partner receives an in-kind liquidating distribution of encumbered property, thereby resulting in a netting of the “relieved” and “assumed” liabilities, with only the net amount relieved being treated as a cash distribution.

The key, as always, is to analyze and understand the tax, and resulting economic, consequences of a liquidation well in advance of any negotiations. You cannot bargain for something of which you are unaware.

Coming to America

Whether they are acquiring an interest in U.S. real property or in a U.S. operating company, foreigners seek to structure their U.S. investments in a tax-efficient manner, so as to reduce their U.S. income tax liability with respect to both the current profits generated by the investment and the gain realized on the disposition of the investment, thereby increasing the return on their investment.

A recent decision by the U.S. Tax Court may mark a significant development in the taxation of the gain realized by a foreigner on the sale of its interest in a U.S. partnership.

Investment in Partnership

Taxpayer was a privately-owned foreign corporation that owned a minority membership interest in LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. Taxpayer had no office, employees, or business operation in the U.S.

Redemption

In 2008, LLC agreed to redeem Taxpayer’s membership interest; as a matter of state law, the redemption was to be effective as of December 31, 2008. LLC made two payments to Taxpayer – the first in 2008 and the second in 2009. Taxpayer realized gain on the redemption of its interest.

Tax returns

With its 2008 Form 1065, “U.S. Return of Partnership Income,” LLC included a Schedule K-1 for Taxpayer that reported Taxpayer’s share of LLC’s income, gain, loss, and deductions for 2008. Consistent with that Schedule K-1, Taxpayer filed a Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for 2008, on which it reported its distributive share of LLC’s income, gain, loss, and deductions. However, LLC did not report on that 2008 return any of the gain it had realized that year on the redemption of its interest in LLC.

With its 2009 Form 1065, LLC included a Schedule K-1 for Taxpayer that – consistent with the agreement between Taxpayer and LLC that the redemption of Taxpayer’s entire membership interest was effective as of December 31, 2008 – did not allocate to Taxpayer any income, gain, loss, or deductions for 2009. As in 2008, Taxpayer took the position that the gain realized was not subject to U.S. tax; thus, Taxpayer did not file a U.S. tax return for 2009.

IRS Audit

The IRS audited Taxpayer’s 2008 and 2009 tax years, and determined that Taxpayer should have recognized U.S.-source capital gain for those years from the redemption of its interest in LLC. This determination was based upon the IRS’s conclusion that, as a result of Taxpayer’s membership interest in LLC, its capital gain was effectively connected with a U.S. trade or business (“USTB”).

Taxpayer petitioned the U.S. Tax Court, where the issue for decision was whether the gain from the redemption of Taxpayer’s interest in LLC was U.S.-source income that was effectively connected with a USTB and, therefore, subject to U.S. taxation.

U.S. Taxation of Foreigners

Before reviewing the Court’s opinion, a brief description of how the U.S. taxes foreigners may be in order.

The income of a foreign corporation may be subject to U.S. income tax if: (1) the income is received from sources within the U.S. (“U.S.-source income”), and it is one of several kinds of income enumerated by the Code (including, for example, dividends, interest, and other “fixed or determinable annual or periodic” (“FDAP”) income); or (2) the income is “effectively connected with the conduct of” a trade or business conducted by the foreign corporation within the U.S. (“effectively connected income”).

In general, the gross amount of a foreigner’s FDAP income is subject to U.S. income tax (and withholding) at a flat 30% rate; no deductions are allowed in determining the tax base to which this rate is applied.

With some exceptions, the Code does not explicitly address the taxation of the capital gain realized by a foreigner on the sale of an equity interest in a U.S. business entity; rather, it is by virtue of addressing these exceptions that the general rule – that capital gain is not subject to U.S. tax – arises. Thus, the gain realized by a foreigner from the sale of a capital asset that is sourced in the U.S. is not subject to U.S. tax unless the asset is related to the foreigner’s USTB or the asset is “an interest in U.S. real property,” the sale of which is treated as effectively connected with a USTB.

In contrast to FDAP income, the foreigner is allowed to deduct the expenses incurred in generating its effectively connected income, and that net income is taxed at graduated rates.

Whether a foreigner is engaged in a USTB depends upon the nature and extent of the foreigner’s activities within the U.S. Generally speaking, the foreigner’s U.S. business activities must be “regular, substantial and continuous” in order for the foreigner to be treated as engaged in a USTB. In determining whether a foreigner’s U.S. activities rise to the level of a trade or business, all of the facts and circumstances need to be considered, including whether the foreigner has an office or other place of business in the U.S.

However, a special rule applies in the case of a foreigner that is a partner in a partnership that is, itself, engaged in a USTB; specifically, the foreigner shall be treated as being engaged in a USTB if the partnership of which such foreigner is a member is so engaged.

In that case, provided it is effectively connected with the conduct of a USTB, the foreigner partner must include its distributive share of the partnership’s taxable income in determining its own U.S. income tax liability.

Generally speaking, all income, gain, or loss from sources within the U.S., other than FDAP income, is treated as effectively connected with the conduct of a USTB.

Points of Agreement

Taxpayer conceded that it was engaged in a USTB by virtue of its membership interest in LLC. In fact, Taxpayer reported on Form 1120-F, and paid U.S. income tax on, its distributive share of LLC’s operating income for every tax year that it was a member of LLC, including the year in which its membership interest was redeemed.

In addition, both Taxpayer and the IRS agreed that no part of the redemption payments made to Taxpayer should be treated as a distributive share of partnership income.

The IRS also agreed with the Taxpayer that the payment made by LLC in redemption of Taxpayer’s membership interest should be treated as having been made in exchange for Taxpayer’s interest in LLC’s property. As such, the Taxpayer would recognize gain as a result of the redemption only to the extent that the amount of money distributed exceeded Taxpayer’s adjusted basis for its interest in LLC immediately before the distribution. This gain would be considered as gain from the sale or exchange of the Taxpayer’s membership interest.

Major Disagreement

In general, the gain realized on the sale of a partnership interest is treated as gain from the sale or exchange of “a capital asset.” According to Taxpayer, because the gain realized on the redemption of its membership interest was equivalent to the sale of a capital asset that was not used by Taxpayer in a USTB, it could not be subject to U.S. tax.

The IRS, however, viewed the issue differently. According to the IRS, Taxpayer’s gain did not arise from the sale of a single, indivisible asset – Taxpayer’s interest in LLC – but rather from the sale of Taxpayer’s interest in the assets that made up LLC’s business, in which Taxpayer was treated as having been engaged.

Aggregate vs. Entity

The IRS argued that the Court should employ the so-called “aggregate theory,” under which a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate interest in each asset owned by the partnership.

The Court, however, rejected the IRS’s argument. It noted that the Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.

The Court then pointed out that the Code explicitly carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.

Accordingly, the Court determined that Taxpayer’s gain from the redemption of its membership interest was gain from the sale or exchange of an indivisible capital asset: Taxpayer’s interest in LLC.

Effectively Connected?

The Court then considered whether the gain realized on the redemption was taxable in the U.S., which depended upon whether that gain was effectively connected with the conduct of a USTB — specifically, whether that gain was effectively connected with the trade or business of LLC, which trade or business was attributed to Taxpayer by virtue of its being a member of LLC.

The IRS argued that the gain was “effectively connected,” pointing to one of its own published rulings, in which it held that the gain realized by a foreigner upon the disposition of a U.S. partnership interest should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income.

The Court, however, did not find the ruling persuasive, and declined to follow it. Instead, the Court undertook its own analysis of the issue.

It considered whether the gain from the sale of the membership interest was U.S.-source. Unfortunately, the Code does not specifically address the source of a foreigner’s income from the sale or liquidation of its interest in a partnership.

However, under a default rule for sourcing gain realized on the sale of personal property (such as a partnership interest), gain from the sale of personal property by a foreigner is generally sourced outside the U.S. In accordance with this rule, the gain from Taxpayer’s sale of its LLC interest would be sourced outside the U.S.

The IRS countered, however, that this gain fell under an exception to the default rule: the “U.S. office rule.” Under this exception, if a foreigner maintains a fixed place of business in the U.S., any income from the sale of personal property attributable to such “fixed place of business” is treated as U.S.-source.

Taxpayer’s gain would be taxable under this exception, the Court stated, if it was attributable to LLC’s office, which the Court assumed – solely for purposes of its analysis – would be deemed to have been Taxpayer’s U.S. office.

In order for gain from a sale to be “attributable to” a U.S. office or fixed place of business, the U.S. office must have been a “material factor in the production” of the gain, and the U.S. office must have “regularly” carried on – i.e., “in the ordinary course of business” – activities of the type from which such gain was derived.

The IRS contended: that the redemption of Taxpayer’s interest in LLC was equivalent to LLC’s selling its underlying assets and distributing to each member its pro rata share of the proceeds; that LLC’s office was material to the deemed sale of Taxpayer’s portion of LLC’s assets; and that LLC’s office was material to the increased value of LLC’s underlying assets that Taxpayer realized in the redemption.

The Court responded that the actual “sale” that occurred here was Taxpayer’s redemption of its partnership interest, not a sale of LLC’s underlying assets. In order for LLC’s U.S. office to be a “material factor,” that office must have been material to the redemption transaction and to the gain realized.

The Court noted that Taxpayer’s redemption gain was not realized from LLC’s trade or business, that is, from activities at the partnership level; rather, Taxpayer realized gain at the partner-member level from the distinct sale of its membership interest. Increasing the value of LLC’s business as a going concern, it explained, is a distinct function from being a material factor in the realization of income in a specific transaction. Moreover, the redemption of Taxpayer’s interest was a one-time, extraordinary event, and was not undertaken in the ordinary course of LLC’s business – LLC was not in the business of buying and selling membership interests.

Therefore, Taxpayer’s gain from the redemption of its interest in LLC was not realized in the ordinary course of the trade or business carried on through LLC’s U.S. office, it was not attributable to a U.S. fixed place of business and, therefore, it was not U.S.-source.

Consequently, the gain was not taxable as effectively connected income.

It Isn’t Over ‘til the Weight-Challenged Person Sings

The Tax Court’s decision represents a victory for foreigners who invest in U.S. businesses through a pass-through entity such as a partnership or limited liability company – how significant a victory remains to be seen.

First, the IRS has ninety days after the Court’s decision is entered in which to file an appeal to a U.S. Court of Appeals. Query whether that Court would be more deferential to the IRS’s published ruling, describe above.

Second – don’t laugh – Congress may act to overturn the Tax Court’s decision by legislation. “Why?” you may ask. Foreigners who rely upon the decision will not report the gain from the sale of a partnership interest. If the partnership has in effect an election under section 754 of the Code, the partnership’s basis in its assets will be increased as a result of the sale (as opposed to the liquidation/redemption) of the foreigner’s partnership interest. This will prevent that underlying gain from being taxed to any partner in the future.

Third, the decision did not address how it would apply to “hot assets” — for example, depreciation recapture. As noted above, the Code normally looks through the sale of a partnership interest to determine whether any of the underlying assets are hot assets. Where the foreign partner has enjoyed the benefit of depreciation deductions from the operation of the partnership’s USTB – thereby reducing the foreigner’s effectively connected income – shouldn’t that benefit be captured upon the later sale of the foreigner’s partnership interest?

Finally, there is a practical issue: how many foreigners will invest through a pass-through entity rather than through a U.S. corporation? Although a corporate subsidiary will be taxable, its dividend distributions to the foreign parent will be treated as FDAP and may be subject to a reduced rate of U.S. tax under a treaty. The foreigner’s gain on the liquidation of the subsidiary will not be subject to U.S. tax. Moreover, the foreigner will not have to file U.S. returns.

Stay tuned. In the meantime, if a foreigner has paid U.S. tax in connection with the redemption of a partnership interest – on the basis of the IRS ruling rejected by the Tax Court – it may be a good idea to file a protective refund claim.

Introduction

In general, self-employed individuals are subject to employment taxes on their net earnings.

The wages paid to individuals who are non-owner-employees of a business are also subject to employment taxes, regardless of how the business is organized.

The shareholders of a corporation are not subject to employment taxes in respect of any return on their investment in the corporation, though they are subject to employment taxes as to any wages paid to them by the corporation.

In the case of an S corporation, the IRS has sought to compel the corporation to pay its shareholder-employees a reasonable wage for services rendered to the corporation, and thus to prevent it from “converting” into a distribution of investment income that is not subject to employment taxes.

Finally, in the case of a partnership, a “limited partner” is generally not subject to employment taxes in respect of his distributive share of the partnership’s income, while the shares of a “general partner” are subject to such taxes, regardless of whether or not the general partner receives a distribution from the partnership.

Application to LLC Members

The U.S. Tax Court recently considered whether the members of an LLC may be treated as limited partners for purposes of applying the self-employment tax to their distributive share of the LLC’s net income.

Specifically, the issue for decision was whether the three member-managers of the LLC (the “Taxpayers”) were entitled to claim the exclusion from self-employment income for limited partners for a portion of their LLC distributions.

The Taxpayers were attorneys who initially practiced law through a general partnership before reorganizing their firm as a member-managed professional limited liability company (the “PLLC”). The PLLC never had a written operating agreement, and it filed federal income tax returns as a partnership.

For the years at issue, the Taxpayers’/members’ compensation agreement required guaranteed payments (i.e., payments to a partner for services, determined without regard to the income of the partnership) to each member that were commensurate with local area legal salaries. Any net profits of the PLLC in excess of the amounts paid out as guaranteed payments were distributed among the members in accordance with the Taxpayers’ agreement.

The Taxpayers reported all of their guaranteed payments from the PLLC as self-employment income subject to self-employment tax. However, they did not remit self-employment tax on the excess of their distributive shares over the guaranteed payments they received, on the grounds that such distributive shares were attributable to the efforts of the PLLC’s other employees (in other words, they represented a return on investment).

The IRS challenged the Taxpayers’ treatment of this excess.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner, as such, other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services . . . .”

The Taxpayers contended that the above exclusion applied to their distributive shares in excess of the guaranteed payments. The IRS, however, argued that the members were not “limited partners” for purposes of this exclusion and, therefore, the distributive shares constituted self-employment income.

The Tax Court reviewed the history of the exclusion, explaining that it was enacted well before LLCs became widely used. The Court noted that no statutory or regulatory authority defines “limited partner” for purposes of the exclusion.

A “Historical” Digression

Prior to the enactment of the exclusion, the Code provided that a partner’s share of partnership income was includable in his net earnings from self-employment for tax purposes, regardless of the nature of his membership in the partnership.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. Thus, the exclusion was not extended to guaranteed payments received for services actually rendered by the limited partner to the partnership.

In 1997, in response to the proliferation of LLCs, the IRS issued proposed regulations defining “limited partner” for self-employment tax purposes. These generally provided that an individual would be treated as a limited partner unless the individual: (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership; or (3) participated in the partnership’s trade or business for more than 500 hours.

In response to criticism from the business community, Congress imposed a temporary moratorium on finalizing the proposed regulations, which has long since expired, yet the proposed regulations have neither been finalized nor withdrawn.

A number of courts, however, have addressed the attempts by taxpayers to distinguish between a partner’s wages and his share of partnership income. The courts have generally explained that a limited partnership has two fundamental classes of partners: general partners, who typically have management power and unlimited personal liability; and limited partners, who lack management powers but enjoy immunity from liability for debts of the partnership. A limited partner, these courts have pointed out, could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the courts have observed that the interest of a limited partner is akin to that of a passive investor.

The Court’s Opinion

The Tax Court followed this line of this reasoning in its analysis of the Taxpayers’ position. The meaning of “limited partner,” it stated, was not confined to the limited partnership context. Therefore, the issue was whether a Taxpayer/member of the member-managed PLLC was functionally equivalent to a limited partner in a limited partnership.

In a limited partnership, the Court highlighted, a limited partner does not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner (e.g., the right to vote on the dissolution of the partnership or the sale of substantially all of its assets), he takes part in the control of the business.

In this case, the management power over the business of the PLLC was vested in each of the Taxpayer-members. The Taxpayers testified that each of them participated equally in all decisions and had substantially identical relationships with the PLLC, including the same rights and responsibilities: for example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees, they each supervised associate attorneys, and they each signed checks for the PLLC.

There was no PLLC operating agreement or other evidence to suggest otherwise, nor was there any evidence to show that any member’s management power was limited in any way. Indeed, they had previously operated as a general partnership, and there was no evidence that organizing as a PLLC was accompanied by any change in the way they managed the business.

On the basis of the foregoing, the Court held that the respective membership interests held by the Taxpayers could not have been limited partnership interests, and the Taxpayers were not limited partners. Accordingly, the Taxpayers could not exclude any part of their distributive shares of PLLC net income from self-employment income.

Lessons & Planning

The Tax Court’s decision demonstrates that a business organization that is treated as a partnership for tax purposes cannot change the character of a partner/member’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation, and the “wage” and “reasonable compensation” rules that are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” provided by the Code was intended to apply to those partners who “merely invest” rather than those who actively participate in and perform services for a partnership in their capacity as partners.

Therefore, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive (as opposed to a service-intensive) business.

If a member of an LLC truly intends to be a passive investor, his status as such should be memorialized in an operating agreement, it should be reflected in his actions, and the LLC and other members should treat him accordingly.

As always, the taxpayers must be able to support their position, and the first steps in doing so are to adopt a form of operation (and, if relevant, organization) that conforms with the intended result, to contemporaneously memorialize that intention, including the “action plan” for attaining it, and to act consistently with the foregoing.

Last week, we reviewed the various U.S. federal income tax consequences that may be visited upon a foreign person who owns and operates U.S. real property (“USRP”). Today we will consider the U.S. federal gift and estate tax consequences of which a foreign individual must be aware when investing in USRP.

Gift Tax

As you probably know, the gift tax is imposed upon the transfer of property by an individual, to or for the benefit of another individual, for less than full and adequate consideration. The typical scenario involves an outright transfer to a family member, or a transfer to an irrevocable trust for the benefit of a family member.

For a U.S. person – meaning a citizen or an alien individual who is domiciled in the U.S. – who makes a gift, the Code currently affords an annual exclusion of $14,000 per donee, plus a combined lifetime/testamentary exemption of $5.49 million, plus an unlimited marital deduction provided the donor’s spouse is a U.S. citizen.  (Note that “domicile” for gift and estate tax purposes is not necessarily the same as “residency” for U.S. income tax purposes; domicile is a more subjective concept: what jurisdiction does the foreign individual consider to be his “permanent home”?)

In the case of a non-U.S. person who is also a non-domiciliary, the Code provides the same $14,000 annual exclusion as above, as well as an annual $149,000 exclusion for gifts to a non-U.S. citizen spouse (not an unlimited marital deduction). There is no other exclusion. The marginal gift tax rate is 40% for taxable gifts over $1 million.

U.S.-Situs Property

In order for the U.S. gift tax to apply to a transfer of property by a non-domiciliary, the property transferred must be located in the U.S. Thus, a gift transfer of USRP is taxable.

Importantly, however, a transfer of intangible property, including shares of stock in a USC, including a U.S. real property holding corporation (USRPHC), is not subject to the gift tax.

As a result, a gift transfer by a foreign individual (“FI”) of shares of USRPHC stock (or of cash to fund a corporation’s acquisition of USRP) to an irrevocable foreign trust for the benefit of the FI’s family is not subject to U.S. gift tax. It is imperative that the foreign donor respect the separate identity of the corporation the stock of which stock is being gifted: the corporation should have its own accounts, act in its own name, hold board meetings, etc. – it may even be advisable that the FI not use the corporation’s USRP without paying a fair market rental rate for such use; otherwise, the IRS may be able to ignore the corporate form and treat the transfer of the stock as a transfer of the underlying USRP.

Similarly, though it is not entirely free from doubt, a transfer of an interest in a partnership that owns USRP should not be subject to gift tax, provided the partnership is not engaged in a U.S. trade or business (USTB).

Estate Tax

We all have to go sometime. It’s the morbid truth. Even wealthy foreigners.

The U.S. estate tax is imposed on the FMV of the U.S. assets of a foreign decedent. This includes the foreigner’s direct interest in USRP.

It also includes the FMV of USRP in a foreign trust if the FI gifted the USRP into the trust and retained an interest in the income from, or in the use of, the trust’s property.

Where the USRP is subject to a nonrecourse debt, the amount of such debt may be applied to reduce the FMV of the property for estate tax purposes. In order to claim a reduction for any recourse debt encumbering the property, the estate of the FI must disclose his/her worldwide assets and claim only a proportionate part of the debt as a deduction, the assumption being that the FI’s worldwide assets are available to satisfy the recourse debt.

The FI’s U.S. gross estate also includes his shares of stock in a U.S. corporation (“USC”), including a USRPHC.

The state of the tax law as to the situs of a partnership interest is not entirely clear, though there is authority for the proposition that U.S. property includes an interest in a partnership that is engaged in a USTB.

The gross estate does not include shares of stock in a foreign corporation (“FC”), however, even if its only asset is USRP, and even if the FC has elected to be treated as a USC for purposes of FIRPTA (see above). Again, it is imperative that the FI have respected the corporate form: it should have its own accounts, act in its own name, etc. (see last week’s post); otherwise, the IRS may be able to ignore the corporate form, treat the FC as a sham, and include the value of the underlying USRP in the FI’s estate.

The FI’s estate does not include an interest in USRP that is held in a foreign trust, provided the FI did not retain (expressly or implicitly) any beneficial interest in, or control over, the trust.

Unlike the estate of a U.S. citizen or domiciliary, the estate of a FI will not have the benefit of the $5.49 million exemption. Rather, there is only a $60,000 exemption amount (though some treaties may provide for a greater amount provided the FI’s estate discloses its worldwide assets). The 40% rate kicks in when the U.S. taxable estate exceeds $1 million in value.

Additionally, there is no unlimited marital deduction unless the FI’s surviving spouse is a U.S. citizen. If the spouse is not a U.S. citizen, a qualified domestic trust (“QDOT”), with a U.S. trustee, will allow an unlimited marital deduction, and the resulting tax deferral benefit, though it is less than ideal for planning purposes. For example, every time principal is distributed to the surviving spouse, the U.S. trustee must report the distribution, and must withhold and transmit the applicable estate tax.

Finally, let’s not forget that any property that is included in the U.S. estate of a FI receives a basis step-up, thereby removing the depreciation in basis during the life of the decedent, and the appreciation in value of the property, from the reach of the U.S. income tax.

Takeaway

Last week’s post explained that the role of the U.S. tax adviser is to educate the foreign client as to basic U.S. tax considerations before the foreigner acquires USRP; to confer with the foreigner’s non-U.S. tax advisers as to the treatment of the investment under foreign tax law; and to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals. The many relevant, and oftentimes competing, factors that we have discussed over the last couple of weeks must be identified and weighed, the various options must be formulated and presented to the foreign client, the client must understand the advantages and disadvantages of the options available, and then the best option under the circumstances must be selected.

Catching up? Start with Part I here.

Sale of USRP – FIRPTA

Aside from planning for the taxation of U.S.-sourced rental income, the foreigner must plan for the disposition of the USRP pursuant to a sale.

The taxation of gain realized by a foreigner on the sale of an interest in USRP is governed by FIRPTA (the “Foreign Investment in Real Property Tax Act of 1980”).

Because FIRPTA treats such gain as income that is effectively connected with the conduct of a USTB, the tax rate that is applied to the gain will depend upon whether the foreign seller is an individual or a corporation.

Assuming the property is a capital asset in the hands of a foreign individual (not inventory or otherwise used in a USTB – the sale of either of which would have been taxable as effectively connected income anyway), and has been held by the foreign individual for more than twelve months, the gain from the sale will be taxed as capital gain at a rate of 20%.

If the seller is a FC, the gain will be taxed at the applicable corporate rate, up to 35%.

FIRPTA – Withholding

Upon the foreigner’s sale of USRP, the buyer is required to withhold 15% of the gross purchase price, which amount must be remitted to the IRS. The purchase price includes the amount of any liability assumed or taken subject to. The remaining tax, if any, must be paid by the foreign seller when it files its U.S. income tax return. If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreigner may use the filing of the tax return to claim a refund.

Because the 15% withholding does not necessarily bear any relationship to the amount of tax actually owed – indeed, the sale may have generated a loss – IRS regulations allow a foreign seller to request a certificate from the IRS that directs the buyer to withhold a lesser amount, based upon the information submitted by the foreigner to establish its actual tax liability.

For example, one may apply for a withholding certificate based on a claim that the transfer is entitled to nonrecognition treatment (as in the case of a like-kind exchange for other USRP), or based on a calculation of the foreigner’s maximum tax liability.

There are also other exceptions to FIRPTA withholding, where a USC, the stock of which is sold by a foreigner, certifies that it is not a USRPHC, and has not been one in the last five years.

Withholding as to Corporate Distributions

Note that special withholding rules apply to certain dispositions by corporations.

If a FC distributes USRP to its shareholders, it must withhold tax at a rate equal to 35% of the gain that is recognized by the FC on the distribution. (The distribution of appreciated property by a corporation to its shareholders in respect of their stock is treated as a sale of such property by the corporation.)

In the case of a USRPHC, it must withhold 15% of the amount distributed if the distribution is made in redemption of a foreigner’s shares or in liquidation of the corporation.

U.S. Real Property

The foregoing has assumed that the property being sold by the foreign person is a direct interest in USRP.

FIRPTA, however, covers not only direct interests in USRP, but also certain indirect interests.

Specifically, if the FMV of a USC’s USRP equals or exceeds 50% of the sum of (i) the FMV of all of its real property plus (ii) the FMV of its trade or business assets, then the corporation will be treated as a USRP Holding Corporation (“USRPHC”), and any gain realized on the disposition of any amount of stock in that USRPHC will be subject to tax under FIRPTA (so long as the disposition is treated as a sale or exchange for tax purposes).

What’s more, if a USC was a USRPHC at any time during the five-year period ending with the date of the sale of stock therein by a foreigner, the gain realized will remain subject to FIRPTA even if less than 50% of the value of the corporation is attributable to USRP at the time of the sale.

Fortunately, there is an exception to this five-year rule: under the so-called “cleansing” rule, if the USC disposes of all of its interests in USRP in taxable sales or exchanges, such that the entire gain thereon has been recognized, and the corporation owns no USRP at the time of the stock sale by the foreign person, then the stock sale shall not be taxable under FIRPTA (or at all for that matter).

Election to be treated as a USRPHC 

As you may have gathered, a FC cannot be a USRPHC. Seems straightforward enough, except that there is a special election that allows a FC to elect to be treated as a USRPHC exclusively for purposes of FIRPTA.

Why would a FC make such an election? One reason is to avoid gain recognition upon the transfer of USRP to the FC. Among the requirements that must be satisfied in order for an election to be effective, the FC must satisfy the above “50% of value” test for USRPHCs.

Exceptions to FIRPTA

Not every disposition of USRP by a foreign person is taxable and subject to withholding under FIRPTA.

For example, a foreigner may sell USRP and roll over the net proceeds therefrom as part of a deferred like-kind exchange without incurring a tax liability (provided that the replacement property is also USRP, the subsequent disposition of which would be taxable to the foreign seller).

This principle underlies other exceptions to gain recognition; specifically, if a foreign person exchanges one interest in USRP for another interest in USRP, the gain realized on the exchange may not be taxable if certain regulatory requirements are satisfied.

For example, a foreigner may contribute USRP to a USC (or to a FC that has elected to be treated as a USC under FIRPTA) in exchange for shares of stock in that corporation without incurring a tax liability, provided the foreign person “controls” the USC immediately after the exchange, and provided the transferee USC is a USRPHC after the contribution. (A narrower exception applies for certain transfers by foreigners to a non-electing FC, which is somewhat inconsistent with the above principle.)

Varieties of Dispositions

A sale of USRP is the most common type of disposition that triggers FIRPTA. However, there are many other transactions of which a foreigner needs to be aware.

For example, if a USRPHC redeems some (but not all) of the shares of a foreign shareholder, the redemption may not be subject to FIRPTA, and may instead be treated as a dividend, if the foreigner’s stock ownership is not sufficiently reduced.

If a USRPHC makes a cash dividend distribution to its shareholders in an amount that exceeds its earnings and profits, the distribution may result in taxable gain that will be subject to FIRPTA.

The partnership rules may generate similar results as to both distributions by, and contributions to, partnerships. The disguised sale rules, for example, may convert what appears to be a tax-free contribution of USRP by a foreigner to a partnership in exchange for a partnership interest into a partially taxable sale that is subject to FIRPTA.

What’s Next

Our next post will review the U.S. gift and estate tax consequences of which a foreign investor in USRP must be aware and must consider in structuring the acquisition, operation, and disposition of such property.

A Continuing Investment

In the last two posts, we saw how a Taxpayer who transfers Property A to a partnership (“Partnership”) in exchange for an equity interest therein will not be required to recognize the gain realized on the transfer. This gain will not be included in Taxpayer’s gross income because Taxpayer is viewed under the Code as continuing his investment in Property A, albeit indirectly, through his interest in Partnership; thus, the theory goes, it would not be appropriate to tax him on the gain realized.

We also saw that, because the Code views Taxpayer’s investment in Partnership as a continuation of his investment in Property A, Taxpayer’s basis for his interest in Partnership will be the same basis that he had in Property A at the time of the contribution. In this way, the gain realized by Taxpayer on his transfer of Property A is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

In what may be characterized as the other side of the same coin (I may have mentioned in some earlier post that I am “idiom-challenged”), we saw that Partnership will take Property A with a basis equal to the basis that Taxpayer had in Property A at the time of its contribution to Partnership. Thus, the gain inherent in Property A at the time it was contributed by Taxpayer (the “pre-contribution gain”) will also be preserved in the hands of Partnership, and such gain will be taxed to Taxpayer on Partnership’s taxable disposition of Property A.

An In-Kind Distribution

Distribution to Taxpayer

Instead of selling Property A, what if Partnership simply distributes Property A to Taxpayer? Taxpayer is thereby restored to his pre-contribution position, even if Property A has appreciated in value after its contribution to Partnership (as, presumably, has Taxpayer’s interest in Partnership). Thus, the distribution is not taxable.

Distribution to Another Partner

What if Partnership, instead, distributes Property A to another partner (“Partner”)? At that point, Taxpayer’s indirect interest in Property A is terminated, and Taxpayer no longer has to be concerned that the gain realized by Partnership on a later sale of Property A (to the extent of its pre-contribution gain) will be specially allocated, and taxed, to him. Rather, Partner will now be taxed on his subsequent sale of Property A; without more, and provided the distribution to Partner is not in liquidation of his interest in Partnership, he will take Property A with the same basis that Partnership had in the property. Thus, Taxpayer’s pre-contribution gain may be shifted to Partner. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain at that time?

Distribution of Another Property to Taxpayer

What if Partnership retains Property A, but distributes other property (“Property B”) to Taxpayer? Taxpayer continues to have an indirect interest in Property A, but he has also acquired a property other than the one that he originally contributed to Partnership. Taxpayer’s basis in Property B will be the same basis that Partnership had in the property. If that basis is greater than Partner’s pre-contribution basis in Property A, Taxpayer may sell Property B and realize less gain than if he had sold Property A. In addition, it follows that Taxpayer’s interest in Property A is somewhat reduced as a result of the distribution of Property B to Taxpayer, while Partner’s interest therein has increased. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain in Property A at that time?

A “Deemed” Exchange

In general, a partner who receives a distribution of property from a partnership will not recognize gain on the distribution, except to the extent that the amount of money distributed exceeds the partner’s adjusted basis for his interest in the partnership immediately before the distribution. Likewise, no gain will be recognized to the partnership on the distribution of property to a partner. In short, an in-kind distribution of property will generally not be taxable to the distributee partner or to any other partner.

There are exceptions to this general nonrecognition rule that encompass the situations described above, and that seek to prevent the shifting of the tax consequences attributable to a property’s pre-contribution gain away the contributing partner, and to another partner.

In order to accomplish this goal, these rules – often referred to as the “mixing bowl” rules – effectively treat a partnership’s in-kind distribution of a property to a partner as the second step of a taxable exchange, the first step being that partner’s, or another partner’s, contribution of another property to the partnership. The partnership is treated as a vehicle through which the exchange is effected.

Distribution to Taxpayer

Under the first exception, if property that was contributed by a partner to a partnership is then distributed by the partnership to another partner within seven years of its contribution, then the contributing partner will be required to recognize gain in an amount equal to the gain that would have been allocated to him if the property had been sold at its fair market value at the time of the distribution (the pre-contribution gain). (Congress decided that a seven-year period was necessary in order to ensure that the contribution to, and distribution from, the partnership were independent of one another, and not steps or parts of planned exchange.)

Thus, in the first scenario described above, if Property A is distributed to Partner within seven years of Taxpayer’s contribution of the property to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

Distribution to Another Partner

Under the second exception, if a partnership distributes property to a partner who, within the preceding seven years, contributed other property to the partnership (which the partnership still owns at the time of the distribution – meaning that its pre-contribution gain has not yet been recognized), then such partner shall be required to recognize the pre-contribution gain of the contributed property.

This is the same gain that would have been recognized by the contributing partner if the property which had been contributed to the partnership by such partner within seven years of the distribution, and is held by such partnership immediately before the distribution, had been distributed by the partnership to another partner (as in the first scenario described above).

Thus, in the second scenario described above, if Property B (which had been contributed to Partnership by Partner) is distributed to Taxpayer within seven years of Taxpayer’s contribution of Property A to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

A “Like-Kind” Exchange?

We stated earlier that the above “anti-gain-shifting” rules effectively treat a partnership’s distribution of a property to a partner as the second step of a taxable exchange, with the first step being that partner’s, or another partner’s, contribution of another property to the partnership.

These rules implicitly assume that the properties that are deemed to have been exchanged are not of like-kind and, so, the exchange is taxable. However, what if the properties are, in fact, of “like-kind”? In other words, what if the like-kind properties had exchanged directly, without first passing them through the partnership? In that case, the exchange may have qualified as a “tax-free” exchange under the like-kind exchange rules.

Following this line of thinking, the mixing bowl rules generally provide that if pre-contribution gain property is distributed to a partner other than the contributing partner, and other property of like-kind to the contributed property is distributed from the partnership to the contributing partner within a specified period of time, then the amount of gain that the contributing partner would otherwise have recognized under the above mixing bowl rules is reduced by the amount of built-in gain in the distributed like-kind property in the hands of the contributing partner immediately after the distribution.

Thus, if Property A and Property B are of like-kind to one another and, within seven years of Taxpayer’s contribution of Property A to Partnership, Partnership distributes Property B to Taxpayer and Property A to Partner, then Taxpayer will not have to recognize the pre-contribution gain in Property A to the extent of the gain inherent in Property B after the distribution; at least some of the pre-contribution gain in Property A is preserved in Taxpayer’s hands.

Advice to the Contributing Partner?

Last week we stated that Taxpayer would be well-advised to negotiate for a prohibition, for a period of time, on Partnership’s sale of any property contributed by Taxpayer.

Based upon this week’s discussion, it may behoove Taxpayer to also negotiate for a period of time (say, seven years) during which Partnership will not distribute Property to another partner, at least not without Taxpayer’s prior consent.

Taxpayer may also want to request that, in the event that Partnership has to distribute its properties (e.g., in liquidation), it will do so in a way that minimizes any adverse tax consequences to Taxpayer under the mixing bowl rules. This may include a provision that requires the “return” of Property A to Taxpayer, if feasible (and provided it makes sense from a business perspective).

Alternatively, Taxpayer may try to negotiate for a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

As always, it is important that Taxpayer be aware of, and that he consider the potential economic effect of, the foregoing rules prior to his contributing Property to Partnership in exchange for a partnership interest. Armed with this knowledge, Taxpayer may be able to negotiate a more tax-favorable agreement regarding the disposition of his contributed property by the Partnership.

Contributing Property to A Partnership

When a taxpayer (“Taxpayer”) sells a property (“Property”) with a fair market value (“FMV”) in excess of Taxpayer’s basis in Property in exchange for cash in an arm’s-length transaction, the amount of gain that he realizes on the sale is measured by the difference between the amount of cash received by Taxpayer over his basis for Property.

Because Taxpayer has terminated his investment in Property (by exchanging it for cash), he must include the gain realized in his gross income for the year in which the sale occurred.

If Taxpayer instead contributes Property to a partnership (“Partnership”) in exchange for an “equally” valuable equity interest therein, he will still realize a gain on the exchange, but such gain will not be recognized (i.e., it will not be included in Taxpayer’s gross income) because Taxpayer is viewed under the Code as continuing his investment in Property, albeit indirectly, through his partnership interest; thus, it would not be appropriate to tax him on the gain realized.

Preserving the Gain

As we saw last week, because the Code considers Taxpayer’s investment in Partnership as a continuation of his investment in Property, Taxpayer’s basis for his partnership interest will be the same basis that he had in Property. In this way, the gain realized by Taxpayer on his disposition of Property is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

But what if Taxpayer does not dispose of his Partnership interest in a taxable transaction? What if he leaves it to his heirs with a stepped-up basis at his death? What if Partnership disposes of Property? To whom will the gain from a sale of Property be allocated?

Never fear, the Code and the regulations promulgated thereunder have foreseen this possibility and have accounted for it.

First of all, Partnership will take Property with a basis equal to the basis that Taxpayer had in Property at the time of its contribution to Partnership.

Thus, the gain inherent in Property at the time it is contributed by Taxpayer (the “pre-contribution BIG”) will also be preserved in the hands of Partnership.

You may ask, won’t this gain be allocated among all the partners, including Taxpayer, based upon their relative interests in Partnership? Simply put, no, and that is why it is imperative that any taxpayer who intends to contribute appreciated property to a partnership in exchange for a partnership interest therein should be aware of the tax consequences described below and should plan for them.

The Allocation of Pre-Contribution Built-In Gain

In order to prevent the pro rata allocation of the pre-contribution BIG among the contributing and noncontributing partners, and the resultant “shifting” of income tax consequences, the Code and the Regulations provide a set of rules with respect to the allocation of any pre-contribution BIG. These rules require that a partnership must allocate its income, gain, loss and deduction with respect to contributed property so as to take into account the pre-contribution BIG.

In general, these rules require that when a partnership has income, gain, loss or deduction attributable to a property that has pre-contribution BIG, the partnership must make appropriate allocations among its partners to avoid shifting the tax consequences of the pre-contribution BIG away from the contributing partner. (View it as a variation of the “assignment of income” doctrine.)

Allocating Gain

Thus, if Partnership sells Property and recognizes gain, the pre-contribution BIG on Property will first be allocated to Taxpayer as the contributing partner. Then, any remaining gain will be allocated among all of the partners in accordance with their relative interests in Partnership.

Allocating Depreciation Deductions

If Property is subject to depreciation, the allocation of the deductions attributable to the depreciation for tax purposes must take into account the pre-contribution BIG on Property. Specifically, the rules provide that the tax allocation of depreciation deductions to the noncontributing partners must, to the extent possible, equal the “book allocations” of depreciation deductions to those partners. This allocation rule is often referred to as the “traditional method.”

Partnership’s depreciation deduction for tax purposes will be determined by reference to Partnership’s starting basis in Property – the same basis that Taxpayer (as the contributor) had for Property – while its depreciation deductions for financial accounting (or “book”) purposes will be determined based upon Partnership’s book value for Property. A contributed property’s starting “book value” – the amount at which it is recorded on the partnership’s financial accounting records (its “books”) – is equal to its FMV at the time of its contribution.

Where the contributed property has pre-contribution BIG (as in the case of Property), its beginning book value (the property’s FMV) will exceed its basis for tax purposes. Thus, the effect of the above allocation rule, which “matches” the tax allocation of depreciations deductions to the noncontributing partners with the allocation of such deductions to such partners for book purposes, is to shift more of the partnership’s (Partnership’s) taxable income to the contributing partner (Taxpayer) by allocating more of its tax-deductible depreciation deductions to the noncontributing partners.

In this way, over time, an amount equal to Property’s pre-contribution BIG will have been allocated to the Taxpayer, at which point the special allocation rule will cease to apply.

In order to further ensure the intended result of the above allocation rules – i.e., to prevent the shifting of tax consequences with respect to pre-contribution BIG to the noncontributing partners – the special allocation rules provide yet additional rules that may be applied where, contrary to the above matching rule, a noncontributing partner would otherwise be allocated less tax depreciation than book depreciation with respect to the contributed property. (This will usually be the case when talking about appreciated property.) The effect of these so-called “curative” allocation and “remedial” allocation rules is to make up this difference, and to reduce or eliminate the disparity, between the book and tax items of the noncontributing partners. The rules thereby prevent the shifting of any portion of pre-contribution BIG to the noncontributing partners, thus ensuring that the tax consequences attributable to the pre-contribution BIG are visited upon the contributing partner.

Protecting the Contributing Partner

Although a taxpayer generally may contribute appreciated property to a partnership in exchange for an interest therein without incurring an immediate income tax liability, the application of the pre-contribution BIG allocation rules discussed above has the potential to immediately wipe away this deferral. For example, if Partnership decides to sell Property shortly after its contribution, Taxpayer (as the contributing partner) will not have enjoyed the benefit of tax deferral.

Moreover, Taxpayer may find himself in a situation where he must include the pre-contribution BIG in his gross income for tax purposes, but he has not received any cash with which to pay the tax, and he may not be in a position to compel Partnership to make the necessary cash distribution or to give him a loan.

What is Taxpayer to do?

For one thing, it would have behooved Taxpayer to retain a tax adviser who was familiar with the above allocation rules. Such an adviser would have advised Taxpayer to try to negotiate a period during which Partnership would not sell or otherwise dispose of the Property (except as part of a “tax-free” exchange).

Alternatively, the tax adviser might have counseled Taxpayer try to negotiate a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

Insofar as the allocation of depreciation deductions pursuant to these rules is concerned, the tax adviser would likely have suggested that Taxpayer negotiate for the use of the “traditional method” so as to maximize the deferral period for “recognition” of the pre-contribution BIG, failing which he may have suggested the use of the “remedial allocation method” over the “curative allocation method,” as the former generally allows the book-tax difference (the excess of book value over tax basis) described above to be spread out over a longer period of time.

Bottom line: the foregoing options may not be available after Taxpayer has already contributed Property to Partnership. The time to consider these issues, to plan for them, and to negotiate ways to reduce any adverse impact is prior to making the contribution.

“Tax free” – two words that often bring great delight when they are spoken by a tax adviser to the owner of a business, whether he is considering the disposition of a single asset, or of substantially all of the assets, of his business. (It’s the feeling I have when the local McDonald’s offers two-for-one breakfast sandwiches.)

Yes, “tax free” can be a great result for a transfer of property out of one business and into another. However, such a transfer is not really free of tax in the sense of never being taxed; rather, it defers the recognition, and taxation, of the gain inherent in the asset being transferred.

It is important that the business owner recognize the distinction. Allow me to illustrate this concept.

Gain Recognition

When a taxpayer disposes of property, the amount of gain that he realizes is measured by the difference between the amount realized – the amount of cash plus the fair market value (FMV) of the property received by the taxpayer – over his adjusted basis for the property transferred.

Where the property received by the taxpayer is not of a kind that the Code views as a “continuation” of the taxpayer’s investment in the property disposed, the taxpayer must recognize and pay tax on the entire amount realized. This is what occurs, for example, when a taxpayer exchanges a property for other property that is not of like-kind (such as cash).

Continuing the Investment

So, what kind of property must a taxpayer receive in exchange in order to make the disposition of his property “tax free”?

Most business owners are familiar with the “like-kind exchange” transaction, especially one that involves the exchange of one real property for another, where both are held by the taxpayer for use in a trade or business or for investment.

Many owners are also familiar with the contribution of property by a taxpayer to a corporation in exchange for shares of stock in the corporation. In general, if the taxpayer does not receive any cash in the exchange and is “in control” of the corporation immediately after the exchange, the taxpayer’s disposition of the property will not be treated as a taxable event.

A similar rule applies in the case of a contribution of property to a partnership in exchange for a partnership interest. Generally speaking, such a property transfer will not be treated as a taxable event, even if the taxpayer receives a less-than controlling interest in the partnership.

Preserving the Gain

In each of the above examples of “tax free” dispositions, the taxpayer’s adjusted basis for the property or equity interest that he receives will be the same basis that he had in the property transferred.

Similarly, the business entity to which a contribution of property is made, in exchange for an equity interest therein, will take the contributed property with a basis equal to the basis that the contributing taxpayer had in the property at the time of the contribution.

Thus, the gain inherent in the property disposed of by the taxpayer is preserved in the property received by the taxpayer in the exchange, such as the shares of stock issued by a corporation.

Receipt of Cash

The foregoing discussion contemplates a situation in which a taxpayer does not receive any cash in connection with the transfer of his property. Often, however, a taxpayer will want to monetize some of his equity in connection with the transfer of what may otherwise be illiquid property. (It may also be the case that the acquiring entity wants to increase its depreciable/amortizable basis in the property by paying some cash for it, or the existing owners of the entity may not appreciate the dilution of their holdings that an issuance of only equity would cause.)

In that case, because the taxpayer is partially “discontinuing” his investment in the transferred property (by receiving cash), he is required to recognize some taxable gain.

Contribution to Corp/ Like-Kind Exchange

In the case of a like-kind exchange, or in the case of a contribution to a corporation in exchange for stock therein, the taxpayer must recognize an amount equal to the lesser of the amount of cash received or the gain realized in the exchange.

Thus, if the amount of cash received is less than the gain realized on the transfer of the property, the taxpayer will recognize, and be taxed on, a portion of the gain realized, up to the amount of cash received.

Where the amount of cash received is equal to or greater than the gain realized on the transfer of the property, then the entire gain realized must be recognized by, and taxed to, the taxpayer.

The import of this result should not be underestimated, as will be shown below.

Contribution to a Partnership

The analysis is somewhat different in the case of a partnership. The Code’s partnership tax provisions do not have a rule equivalent to the “recognition of gain to the extent of cash received” rule applicable to corporations.

Instead, the contribution of property to a partnership in exchange for a partnership interest plus cash is treated as two transactions: a partial sale/contribution in which property with a FMV equal to the amount of cash paid by the partnership is treated as having been sold (under the so-called “disguised sale” rules), and a contribution of the remaining FMV of the property.

The gain to be recognized by the taxpayer is determined by allocating the taxpayer’s basis in the property between the sale and the contribution transactions, based upon the percentage of the total consideration that is represented by the cash.

Some Examples

Assume that Property has a FMV of $100, and an adjusted basis in the hands of Taxpayer of $40.

If Property were sold in exchange for $100 of cash, Taxpayer would realize and recognize $60 of gain ($100 minus $40).

Same facts, except Taxpayer contributes Property to a corporation in exchange for $100 worth of stock therein in a transaction that satisfies the criteria for “tax free” treatment. Taxpayer realizes $60 of gain ($100 of stock over $40 basis), but because Taxpayer receives only stock of the transferee corporation (no cash), none of the gain is recognized. Taxpayer takes the stock with a basis of $40 (preserving the $60 of unrecognized gain).

Same facts, except Taxpayer receives $70 of stock and $30 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($30) or the gain realized ($60). Thus, Taxpayer must recognize $30 of gain. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($30) plus the amount of gain recognized ($30), or $40. Thus, $30 of the unrecognized gain inherent in Property ($30) is deferred ($70 FMV stock over $40 basis.)

Same facts, except Taxpayer receives $20 of stock and $80 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($80) or the gain realized ($60). Thus, Taxpayer must recognize the entire $60 of gain realized. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($80) plus the amount of gain recognized ($60), or $20 (there is no gain to defer).

Same facts, except Taxpayer contributes Property to Partnership in exchange solely for a partnership interest therein. Taxpayer takes his partnership interest with a basis of $40 (his basis in Property), and Partnership takes Property with a basis of $40.

Same facts, except Taxpayer receives a $70 equity interest in Partnership, plus $30 of cash. Taxpayer is treated as having sold a $30 portion of Property, and as having contributed a $40 portion. The gain to be recognized on the sale and the gain to be deferred on the contribution are determined by allocating Taxpayer’s basis in Property between the sale and contribution transactions. Because the cash represents 30% of the total consideration received, 30% of Taxpayer’s basis is allocated to the sale, or $12 ($40 x 0.30). Thus, Taxpayer recognizes gain of $30 minus $12 = $18. The remaining 70% of the basis, or $28, is allocated to the contribution transaction; thus, Taxpayer takes his partnership interest with a basis of $28 (preserving the $42 of gain not recognized on the transfer of Property).

Is the “Deferral” Worthwhile?

The taxpayer who finds himself in one of the foregoing situations usually transfers a business asset over which he has full control. He may give up this control in order to attain other benefits, including, for example, diversification, the funding and assistance necessary to further grow the business (and to share in the growth as an equity owner, albeit one with a minority stake), and the deferral of tax on any gain that he may realize on the transfer.

The loss of control may present many difficulties for the taxpayer. Some are obvious; others are less so – for example, if he contributes appreciated property to a partnership in exchange for a partnership interest, the partnership is required to allocate its income, deductions, gains, and losses in such a way so as to cause the gain inherent in the property at the time of its contribution to be allocated entirely to the taxpayer. He will be taxed on such gain, but he may not receive a distribution of cash from the partnership to enable him to satisfy his tax liability.

Moreover, the like-kind property or the equity interest that the taxpayer receives in exchange for his property may be just as illiquid, at least initially, as the property he has exchanged for it. There may not be a market for the entity’s equity, and its shareholders’ agreement or operating agreement will likely restrict the transfer of the taxpayer’s interest.

But at least he deferred the tax on the transfer of his property.

But What If?

Query, then, what happens if a taxpayer gives up control of a property in exchange for an illiquid minority interest in the business entity to which he contributed such property, yet does not enjoy any tax deferral?

If the deferral was not a principal reason for the transfer, which otherwise made good business sense, then the taxpayer should be fine with the outcome: although he has suffered an immediate net loss of economic value (in the form of taxes paid), hopefully he has determined that the long-term prospects of exchanging his property for the acquirer’s equity are worth the short-term cost.

If, on the other hand, deferral was an important consideration, then the taxpayer should rethink his deal.

Perhaps he can ask to be grossed up for the tax hit, though this may be too expensive a proposition for the acquiring entity. Or, he may ask for more equity, and less cash, so as to reduce the tax hit, provided he recognizes that there will be more investment risk associated with holding more equity. Of course, the other investors may not want to be diluted further, and they may resist losing the benefit of any depreciation/amortization basis step-up for the property acquired.

The matter will ultimately be determined by the parties’ relative bargaining leverage: how badly does one want to dispose of the property, and how badly does the other want to acquire it?