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Tax Executives InstituteHouston Chapter
2017 Tax SchoolMay 2, 2017
Practical Review of Partnership Agreements - Target Allocations v.
Layered Allocations and Other Considerations
PwC
May 2, 2017
Todd McArthurPrincipalWashington National Tax M&A Passthrough Group
Todd McArthur is a principal in the PricewaterhouseCoopers LLP-Washington National Tax Services office with the Mergers and Acquisitions Passthrough Group. Todd has over twenty years of transactional and tax controversy experience involving domestic and cross-border partnerships, strategic joint ventures, and other partnership, acquisitions, dispositions, and financings. In recent years, he has represented fund sponsors and institutional investors in respect of the formation of and investment in a wide variety of alternative investment funds.
Prior to joining PricewaterhouseCoopers in 2012, Todd served as the lead tax partner in the global private equity and tax group at Dewey & LeBoeuf, LLP. Todd began his tax career at King & Spalding and was admitted as a partner in 1997.
Todd is a member of the American Bar Association (Taxation Section) and the District of Columbia Bar Association (Taxation Section). He is the author of the BNA Tax Management Portfolio on Partnership Transactions - Section 751 Property and numerous articles focused on partnership and other topics relevant to the private equity industry. Todd earned his B.S. from the University of Virginia, McIntire School of Commerce in 1985 and his J.D. from the University of Virginia School of Law in 1990.
Telephone: (202) 312-7559eMail: [email protected]
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Bret OliverPartnerFederal Tax
Bret is a Partner in PwC’s US Energy & Utilities practice. He joined the Houston, Texas office in 2001 and began by building his experience in federal tax services. Since then, he has gained valuable experience performing tax services for integrated oil companies, electric and gas utilities, pipelines, independent producers of oil and gas, and oilfield service and equipment companies. He has in depth experience with ASC 740 – Accounting for Income Taxes and tax internal controls and process assessment. Bret specializes in the income tax rules related to companies in the energy industry.
In addition, Bret has consulting experience on a variety of corporate income tax issues including tax return preparation, tax planning and IRS audit defense. This has included writing tax memoranda and technical opinions on issues such as involuntary conversion of property, depletion of mineral interests, intangible drilling costs and formation of oil and gas partnerships.
Education and certifications:Bret received his Bachelors of Business Administration and Master in Professional Accounting from UT-Austin. He is a Certified Public Accountant licensed in Texas and a member of the American Institute of Certified Public Accountants.
Phone – (713) 356-8564Email – [email protected]
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William ByrdManagerM&A Tax
William Byrd is a Tax manager in PwC’s Mergers & Acquisitions Group in the Houston office. He is a dedicated specialist in all aspects of partnership taxation. William assists clients with joint venture matters, including structuring domestic and foreign partnership acquisitions and disposition transactions.
William has extensive experience in the areas of partnership formation and operational issues, including disguised sales, and section 704(b), 704(c), and 743(b) matters.
Education and credentials
William is a CPA and holders a Masters in Science in Taxation from Baylor University. He also holds a BS in Accounting and Economics from Baylor University.
Phone – (713) 356-4201Email – [email protected]
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Agenda
Getting Started – Initial Diligence
Translating the Business Deal to Tax
Partnership Allocation Building Blocks
Layered Allocations v. Target Allocations
Examples
Oil & Gas Partnerships – Special Allocations and Other Considerations
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10
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Page
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Getting Started – Initial Diligence
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• Is the business deal accurately reflected in allocation and distribution provisions of the partnership agreement?
• Is the partnership agreement fully defined and does it account for contingencies?
- What is each partner entitled to upon liquidation?
- Confirm no gaps in business deal
- Modeling
- Anticipate tax compliance challenges
• Who are the stakeholders and do they have special interests?
Initial diligence – understanding the non-tax objectives
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• Liquidation provision: cash or allocation driven
• Allocations
• Distributions, including tax distributions, if any
• Defined terms (e.g., GAAP, tax, § 704(b) net or gross items of income and loss)
• Industry specific provisions:
- Simulated gain, loss, depletion
- Carried interest holdbacks and clawbacks
- Investor givebacks
- Earn-outs
• Tax information, reporting, and control (e.g., BBA audit rules)
Initial diligence – the partnership agreement
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• Other agreements
- Side letters
- Management agreements
- Other arrangements
• Effect of local law
• Intent of parties - enforceable?
• Retroactive amendments
- Made before the due date (without extension) of partnership return
- Subject to § 706(d) limitation
Initial diligence – the partnership agreement
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Translating the Business Deal to Tax
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• Generally reflected in allocation and distribution provisions• Common forms
- Allocation-driven provisions- Cash-driven provisions- Forced capital account provisions
• Tax “certainty” versus “business certainty”- Capital account approach driven by § 704(b) allocations- Liquidations based on
◦ Specific percentages◦ Specific amounts◦ Target capital accounts
• Complicated deals generally result in complicated agreements
Translating the business deal
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• Tax follows book—generally- Allocate § 704(b) book items, applying “bottom-line allocation rule.”- Translate book to tax—§ 704(c)- Same whether layered allocations or target allocations
• Other considerations- § 704(e)(2), § 706(d), assignment of income principles- § 704(d)- §§ 465 and 469- § 482- Debt-equity- Disguised sales- Substance-over-form principles
Business deal to tax – brief review
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Partnership Allocation Building Blocks
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• § 704 allows partners to determine how partnership items are shared in their partnership agreements
• The controlling principle of the § 704(b) regulations is economic substance, i.e., tax must follow economics
• Allocations contained in the partnership agreement are valid if they satisfy any one of the three regulatory tests:
- the allocations have substantial economic effect (the “SEE safe harbor”);
- the allocations are in accordance with the partners’ interests in the partnership (“PIP”); or
- the allocations are deemed to be in accordance with PIP
Overview of Partnership Allocations
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The partnership agreement must meet the economic effect test.
• Capital accounts maintained in accordance with § 704(b);
• Liquidating distributions are made according to positive capital account balances; and either
- Each partner is obligated to restore any deficit balance in its capital account upon the liquidation of a partnership (“DRO”).
OR
- The partnership agreement meets the alternate test for economic effect.
◦ Contains qualified income offset (“QIO”) provision that allocates income to restore a partner’s negative capital account caused by an unexpected distribution
◦ Limits allocations of losses
Substantial Economic Effect Safe Harbor
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Each partnership allocation must meet three substantiality tests.
• Reasonable possibility that allocations affect substantially the dollars to be received by the partner independent of tax consequences
• Allocations are not substantial if:
- One helped, none hurt
◦ Determined on present-value, after-tax basis
◦ Look at attributes of partner
- Shifting
- Transitory
Substantial Economic Effect Safe Harbor
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• Shifting Allocations
- Strong likelihood that allocations do not change the partner’s capital account for that year, and the total tax liability of partners is reduced
- Example: special allocation of capital losses to a partner
- Look for allocations based on character
• Transitory Allocations
- Allocation in one year largely offset by allocations in a later year
- Strong likelihood that the allocations do not change the partner’s capital account for the taxable years to which they relate, and the total tax liability of partners is reduced
- 5-year rule
- Example: special allocation of loss in year one, offset by special allocation of gross income in year two
- Look for allocations based on timing
• Value = basis rule
Substantial Economic Effect Safe Harbor
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Generally, PIP reflects the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated.
• Non-exclusive factors considered in determining PIP:
- The partners’ relative contributions to the partnership,
- The interests of the partners in economic profits and losses (if different than that in taxable income or loss),
- The interests of the partners in cash flow and other non-liquidating distributions, and
- The rights of the partners to distributions of capital upon liquidation.
• Comparative liquidation test:
- Capital account maintenance and capital account driven
- Deemed liquidation at § 704(b) book value
Partner’s Interest in the Partnership (“PIP”)
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• Economic effect equivalence test
- Allocations are deemed to have economic effect provided that, at the end of each tax year, a liquidation of the partnership would produce the same economic results as would occur if the substantial economic effect test had been satisfied regardless of the economic performance of the partnership.
- Value=basis rule does not apply.
- Difficult to establish absent simple facts.
• PIP is relatively simple in concept, but it can be complex in practice.
• Reasonable minds can differ.
Partner’s Interest in the Partnership (“PIP”)
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Layered Allocations v. Target Allocations
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Layered Allocations
• Sequential thought process
• Example - Profits. After giving effect to [regulatory allocations, Profits for any Allocation Year shall be allocated in the following order and priority:
• First, 100% to the LPs in an amount equal to their Priority Return on a cumulative basis;
• Second, 100% to the GP to reverse 4th tier Losses on a cumulative basis;
• Third, 100% to the LPs to reverse 3rd tier Losses on a cumulative basis;
• Fourth, 100% to the GP to reverse 2nd tier Losses on a cumulative basis; and
• Fifth, 50% to the GP and 50% to the LPs.
• Losses. After giving effect to [regulatory allocations, Losses for any Allocation Year shall be allocated in the following order and priority, subject to the [loss limitation provision]:
• First, to reverse 5th tier Profits on a cumulative basis;
• Second, 100% to the GP until the GP’s Capital Account equals zero;
• Third, 100% to the LPs until the LPs’ Capital Accounts equal zero; and
• Fourth, 100% to the GP.
• Do the allocations matter? SEE safe harbor?
Layered Allocations = SEE Safe Harbor
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Maintenance of Capital Accounts
Liquidation Provisions
Layered Allocations = SEE Safe Harbor
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Qualified Income Offset
Loss Limitation
The allocation of Losses must be limited to prevent any Member from having (or increasing) an Adjusted Capital Account Deficit at the end of any taxable year (or relevant portion thereof).
Layered Allocations = SEE Safe Harbor
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Target Allocations
• Sequential thought process
• Example – Section 4.1(a) Distributions. Available Cash shall [in the discretion of the Board] be distributed in the following order and priority:
- First, to the Limited Partners in an amount equal to their Priority Return determined on a cumulative basis;
- Second, to the Limited Partners in an amount equal to their unreturned Capital Contributions; and
- Third, 50% to the General Partner and 50% to the Limited Partners.
• PIP generally determines § 704(b) allocations.
Target Allocations - PIP
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Income Allocations
Target Allocations - PIP
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Target Allocations
Partially Adjusted Capital Accounts
Target Allocations - PIP
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Maintenance of Capital Accounts - Same
Qualified Income Offset - Same
Liquidation Provisions
Target Allocations - PIP
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• Insufficient § 704(b) income to cover preferred returns
– Current and proposed Treas. Reg. § 1.707-1(c) Example (2).
• Mismatches between cash flow, taxable income, and economics
– Tax does not necessarily follow the cash
– Unrealized appreciation/depreciation
– Debt repayment
– Subpart F income
– Return of basis
• Allocating income when the partnership has § 704(b) losses and taxable income
• Capital shifts
• Anticipatory events – distribution rights contingent on the outcome of a future event
• Unanticipated events
Common Issues with Target Allocations
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Examples
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Distributions:
• 1st − A’s initial capital contribution is returned
• 2nd − A receives annual 10% preferred return
• 3rd − B’s initial capital contribution is returned
• 4th − Remaining proceeds 50% to each partner
Basic Example
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Anne
AB
Bob
Cash $100EquipmentFMV $100Basis $40
Year 1: 704(b) Income = $100Year 2: 704(b) Income = $100
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Basic Example– Year 1
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*A’s Y1 Preferred Return$100 (A’s contribution) X 10% (Preferred Return) = $10
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Basic Example– Year 2
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*A’s Y2 Preferred Return$100 + $10 (A’s Y1 accrued return) = $110 * 10% = $11
Total Y2 Accrued Preferred Return$11 + $10 = $21
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Distributions:
• 1st − A’s initial capital contribution is returned
• 2nd − A receives annual 10% preferred return
• 3rd − B’s initial capital contribution is returned
• 4th − Remaining proceeds 50% to each partner
Assume AB Holdings has zero income in the current year.
Dry Preferred Return
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Partner A
AB Holdings
Partner B
$100 Preferred$50 Common $50 Common
Operating
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Dry Preferred Return, Cont.
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*A’s Y1 Preferred Return$100 (A’s Preferred Capital) X 10% (Preferred Return) = $10
Year 1 Waterfall Distribution Partner A Partner B Total
Initial 704(b) Capital - 1. Return of A's Capital 150 - 150
Contributions 200 2. 10% Preferred Return 10 - 10
Distributions - 3. Return of B's Capital - 40 40
704(b) Income - 4. 50/50 -
Ending 704(b) Capital 200 160 40 200
Beginning
Capital Ending Capital Change Contributions
704(b)
Income
Partner A - 160 160 150 10
Partner B - 40 40 50 (10)
- 200 200 200 -
How should the partnership treat for the shift in capital?
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Complete Return of Capital Waterfall
Two scenarios explore the timing difference between taxable income and cash flow.
Scenario 1
• General Partner shares 20% of gains and is allocated is allocated tax gain each year equal to its share of economic gain.
Scenario 2
• General Partner is not allocated any taxable gain until it becomes clear that the GP is approaching economic carry.
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GP
Holdings
LPs
$0 Cash Contribution20% share of gains
$900 Cash Contribution80% share of gains
Investment #1 Investment #2 Investment #3
Cost Basis - $300Sold for $600 in Year 1
Cost Basis - $300Sold for $300 in Year 3
Cost Basis - $300Sold for $300 in Year 3
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Complete Return of Capital WaterfallScenario 1
• When the partnership sells its investments in year 3 for a total of $600, the distribution of the proceeds will be distributed out in accordance with the partner’s 704(b) capital accounts.
• The $60 distributed to the GP will be treated as a distribution from the partner’s 704(b) capital account and the GP will have enough basis to avoid gain.
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FMV 704(b) Tax FMV 704(b) Tax FMV 704(b) Tax
Beginning Capital Account 900 900 900 - - - 900 900 900
Year 1 Distribution (600) (600) (600) - - - (600) (600) (600)
Year 1 Income 300 300 300 60 60 60 240 240 240
Ending Capital Account 600 600 600 60 60 60 540 540 540
Year 3 Distribution (600) (600) (600) (60) (60) (60) (540) (540) (540)
Year 3 Income - - - - - - - - -
Ending Capital Account - - - - - - - - -
Limited PartnersGeneral PartnerTotal
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Complete Return of Capital WaterfallScenario 2
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• If distribution is based on capital account, the general partner would need future profits to fund its carried interest.
• Character of the $60 distributed to the general partner?
• Guaranteed payment?
• Section 731?
FMV 704(b) Tax FMV 704(b) Tax FMV 704(b) Tax
Beginning Capital Account 900 900 900 - - - 900 900 900
Year 1 Distribution (600) (600) (600) - - - (600) (600) (600)
Year 1 Income 300 300 300 60 - - 240 300 300
Ending Capital Account 600 600 600 60 - - 540 600 600
Year 3 Distribution (600) (600) (600) (60) (60) (60) (540) (540) (540)
Year 3 Income - - - - - - - - -
Ending Capital Account - - - - (60) (60) - 60 60
Limited PartnersGeneral PartnerTotal
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Investment-by-Investment Waterfall
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Scenario 1
• GP shares 20% of realized gains
• No hurdle or preferred returns
• The partnership uses targeted capital accounts
• Taxable income is allocated based on deal by deal returns
Scenario 2
• LP receives 10% annual preferred return
• General Partner shares 20% of realized gains
• Taxable income is first allocated to fund all preferred return both realized and unrealized.
• The partnership uses targeted capital accounts
GP
Holdings
LPs
$0 Cash Contribution20% share of gains
$900 Cash Contribution80% share of gains
Investment #1 Investment #2 Investment #3
Cost Basis - $300Sold for $200 in Year 2
Cost Basis - $300Sold for $1000 in Year 3
Cost Basis - $300FMV $200, not sold
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Investment-by-Investment Waterfall, Cont.Scenario 1
* The fund distributes to the general partner 20% of the residual cash after returning the investors’ cost ($1,000 - $300 = $700).
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704(b) Tax 704(b) Tax 704(b) Tax
Beginning Capital Account 900 900 - - 900 900
Year 2 Distribution (200) (200) - - (200) (200)
Year 2 Income (100) (100) - - (100) (100)
Ending Capital Account 600 600 - - 600 600
Year 3 Distribution (1,000) (1,000) (140)* (140) (860) (860)
Year 3 Income 700 700 140 140 560 560
Ending Capital Account 300 300 140 - 300 300
LPsTotal GP
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Investment-by-Investment Waterfall, Cont.Scenario 2
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704(b) Tax 704(b) Tax 704(b) Tax
Beginning Capital Account 900 900 - - 900 900
Year 2 Distribution (200) (200) - - (200) (200)
Year 2 Income (100) (100) - - (100) (100)
Ending Capital Account 600 600 - - 600 600
Year 3 Distribution (1,000) (1,000) (90) (90) (910) (910)
Year 3 Income allocated to Pref. 340 340 340 340
Year 3 Residual Income 360 360 72 72 288 288
Ending Capital Account 300 300 (18) (18) 318 318
Total GP LPs
Cash Tax. Income Cash Tax. Income
Investment #1 Pref. - - 60 60
Investment #2 Pref. - - 90 90
Investment #3 Pref. - - - 90
Recoup PY Realized Loss - - 100 100
Return of Inv #2 Capital - - 300 -
Remainder (80%/20%) 90 72 360 288
Total 90 72 910 628
LPGP
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Oil & Gas Partnerships – Special Allocations and Other Considerations
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Special Allocations
• Partnership agreements allow special allocations to partners
• Items such as IDCs which would otherwise be limited may be allocated to partners who are able to utilize them
• However, allocations must be respected for § 704(b) and other tax purposes
• See API Model Partnership Agreement (“API Model Form”)
Why a Tax Partnership?
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• Intended to meet the SEE safe harbor
- Capital accounts maintained in a manner intended to comply with Treas. Reg. § 1.704-1(b) – API Model Form, Section 5
- Partners have full DROs – API Model Form, Section 7.4
- Liquidating distributions are made in accordance with positive § 704(b) capital accounts – API Model Form, Section 7.7
• Reconciling capital accounts to the economic deal
- Capital accounts are literally the economic deal . . .
- Balancing provisions to conform as closely as possible capital accounts to economic interests
◦ Deemed sale gain/loss (from § 704(b) revaluation) available under “value equals basis” rule – API Model Form, Section 7.3
◦ Cash balancing – API Model Form, Section 7.4
› Economic effect and substantiality impact?
Section 704(b) Mechanics of the API Model Partnership Agreement
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• Special oil & gas allocations
- Distinguish between § 704(b) and § 704(c) allocations
- IDC and simulated gain, loss, and depletion
- Tax depletion computed separately for each partner
- § 704(c) – “you keep yours, I keep mine”
Section 704(b) Mechanics of the API Model Partnership Agreement (continued)
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• § 704(c)(1)(B): substituted “7 years” for “5 years” in introductory provisions (1997)
• § 704(c)(1)(C): built in loss property (2004)
• § 721(c) regulations: eliminating deferral on contributions to partnerships controlled by US transferor and a related foreign person unless § 704(c) remedial allocation method and other requirements met (2017, with August 2015 effective date)
• § 737(b)(1): substituted “7 years” for “5 years” (1997)
• § 734(b): mandatory basis adjustments for built in loss property (2005)
• § 743(b): mandatory basis adjustments for built in loss property (2004)
• § 1.752-7: contingent liability regulations (2003)
• BBA audit rules replace TEFRA audit procedures (2015; effective 2018)
Statutory and Regulatory Changes in Partnership Tax Rules Since Last API Revision (1997)
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• Replace full DRO with provisions necessary to satisfy the alternative test for economic effect?
- QIO and loss limitation provisions
• Target allocations and PIP?
• BBA audit rules replace TEFRA audit procedures generally in tax years beginning in 2018.
- A “partnership representative” has exclusive authority to represent and bind the partnership and partners. Partners have no notice or participation rights.
- Compare API Model Form, Section 2 (providing relatively extensive notice and participation rights to partners).
Possible Revisions to an API Model Form
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Questions?
© 2017 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC
refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm
is a separate legal entity. Please see www.pwc.com/structure for further details. This document is for
general information purposes only, and should not be used as a substitute for consultation with
professional advisors.
