704 (B) Allocations KPMG

Presenting
a live 110‐minute teleconference with interactive Q&A
IRC Sect. 704(b): Allocations to Partners
Navigating Complex Rules on Determining Validity of Partnership Allocations
WEDNESDAY, MARCH 2, 2011

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
Today’s faculty features:
Amanda Wilson,
Wilson Lowndes Drosdick Doster Kantor & Reed,
Reed Orlando,
Orlando Fla
Fla.
Jeremy Naylor, Partner, White & Case, New York
Jorge Otoya, Senior Manager, KPMG, Washington, D.C.
For this program, attendees must listen to the audio over the telephone.
Please refer to the instructions emailed to the registrant for the dial-in information.
Attendees can still view the presentation slides online. If you have any questions, please
contact Customer Service at1-800-926-7926 ext. 10.
Conference Materials
If you have not printed the conference materials for this program, please
complete the following steps:
• Click on the + sign next to “Conference Materials” in the middle of the left-
hand column on your screen.
screen
• Click on the tab labeled “Handouts” that appears, and there you will see a
PDF of the slides for today's program.
• Double click on the PDF and a separate page will open.
• Print the slides by clicking on the printer icon.
Continuing Education Credits FOR LIVE EVENT ONLY
Attendees must listen to the audio over the telephone. Attendees can still view
the presentation slides online but there is no online audio for this program.
Please refer to the instructions emailed to the registrant for additional

information. If you have any questions, please contact Customer Service
at 1
1-800-926-7926
800 926 7926 ext. 10.
Tips for Optimal Quality
S
Sound
d Quality
Q lit
For this program, you must listen via the telephone by dialing 1-866-871-8924
and entering your PIN when prompted. There will be no sound over the web
co ect o .
connection.
If you dialed in and have any difficulties during the call, press *0 for assistance.
You may also send us a chat or e-mail [email protected] immediately so
we can address the problem.
Viewing Quality
To maximize your screen, press the F11 key on your keyboard. To exit full screen,
press the F11 key again.
again
IRC Sect. 704(b): Allocations to Partners
IRC S t (b) All ti t P t
Webinar
March 2, 2011
Amanda Wilson, Lowndes Drosdick Doster Jeremy Naylor, White & Case
Kantor & Reed [email protected]
[email protected]
d il @l d l
Jorge Otoya, KPMG

j y
[email protected]
p g
Today’s Program
Material Aspects Of 704(b) Rules Slide 7 – Slide 35

[Amanda Wilson and Jeremy Naylor]
Associated Regulatory Sections Slide 36 – Slide 69

[Jeremy Naylor and Jorge Otoya]
Relevant And Recent IRS Administrative Guidance Slide 70 – Slide 72

[Jorge Otoya]
Amanda Wilson, Lowndes Drosdick Doster Kantor & Reed
A d Wil L d D di k D K & R d
Jeremy Naylor, White & Case
MATERIAL ASPECTS OF 704(b)
RULES
Orlando, Florida | www.lowndes-law.com
Allocations
One of the key benefits of a partnership is the flexibility in allocating

partnership items among the partners.
Allocations of a partner’s distributive share of partnership income, gain,

loss, deductions or credit will be respected if they:
(1) Are either in accordance with the partners

partners’ interests in the
partnership, or
(2) Have substantial economic effect.
Allocations are not the same as distributions.
IRC Sect. 704(b): Allocations to Partners Webinar 8

Partners’ Interest In The

Partnershipp
Allocations are generally in accordance with the partners’ interests in
the partnership if all allocations are being made in accordance with the
respective contributions of the partners.
For example, if A and B each contributed $100, allocations would be in

accordance with the partners
partners’ interests in the partnership if all
partnership items are shared 50-50.
Liquidating distributions can be made in accordance with the partners’

respective interests in the partnership.

Substantial Economic Effect

AB is a partnership that owns 3 properties. All income allocated 50% to
A, except 60% of income from property 1 is allocated to A. This is a
special allocation.
Special allocations will be respected if they have substantial economic

effect. Substantial economic effect is a safe harbor.
Under a two-part analysis, allocations must :
(1) Have economic effect, and
(2) The economic effect must be substantial.

Economic Effect
General p
principle:
p If there is an economic benefit or burden that
corresponds to an allocation, then the partner to whom the allocation
is made must receive the economic benefit or burden.
More simply,
simply if a partner gets the benefit of an allocation of $100 of tax
loss, the partner must suffer the $100 economic loss. If a partner
suffers the burden of $100 of tax gain, the partner must get the $100
of cash.
cash This is accomplished by maintaining capital accounts and
liquidating in accordance with those accounts.

Basic Test For Economic Effect

(1) Capital account requirement: The partnership must maintain its
capital accounts in accordance with the rules of Reg. §1.704-
1(b)(2)(iv).
(2) Liquidation requirement: Upon liquidation of the partnership

agreement, the liquidating distributions must be made in
accordance
d with
ith the
th positive
iti b l
balances off the
th partner’s
t ’ capital
it l
account.
(3) Deficit make

make-up
up requirement: If a partner has a deficit in his
capital account upon liquidation of the partnership, the partner
must have an unconditional obligation to restore the deficit.

Capital Account
Maintenance Rules
A partner’s capital account reflects the partner’s equity
investment. It must be adjusted as follows:
• Increased by (1) FMV of contributions and (2) allocable
share of partnership income
• D
Decreased db
by (1) FMV off di
distributions
t ib ti and
d (2) allocable
ll bl
share of partnership loss
For economic effect
effect, liquidating distributions to the partners must
be made based on capital accounts adjusted according to these
rules.

Deficit Restoration Obligation
The deficit restoration obligation (DRO) may be provided for in

the partnership agreement or by state law.
A DRO may be imposed to the extent of any outstanding

principal balance of a promissory note (if the partner is the
maker)
k ) that
th t is
i contributed
t ib t d to
t the
th partnership
t hi and
d the
th amountt off
any unconditional obligation of the partner (whether imposed by
the partnership agreement of state law) to make subsequent
contributions to the partnership.
A partner can have a limited DRO.

Example
A and B contribute $100 each to AB partnership. The partnership
agreement provides that 60% of partnership items are allocated to A
and 40% are allocated to B. AB has a $200 loss.
A’s CA B’s CA
Contribution 100 100
Income (120) (80)
(20) 20
For the entire allocation to have economic effect,

effect A must have a DRO.
DRO
Otherwise, B is bearing the economic risk for $20 of the losses.

Planning Opportunity
Treas. Reg. §1.761 1(c) provides that a “partnership

§1.761-1(c) partnership agreement
agreement” can
be modified or amended with respect to a taxable year after the close
of the taxable year, as long as the amendment occurs on or before the
due date for the partnership return (without extension).
This gives partners a planning opportunity to amend how they allocate

income and losses after the close of the year, in particular to provide
for a limited DRO to the extent necessary to support a loss allocation.
allocation

Alternate Test For

Economic Effect
(1) Capital account requirement
(2) Liquidation requirement
(3) Partnership agreement has a qualified income offset (QIO)
provision. The QIO must require that any partner with an
unexpected
t d negative
ti capital
it l accountt be
b allocated
ll t d allll off the
th nextt
items of partnership income, so as to eliminate the negative
balances as quickly as possible.
(4) The allocation does not create or increase a deficit in a partner’s
capital account in excess of the partner’s obligation to restore a
deficit.

Substantiality
The economic effect of an allocation is substantial if there is a
reasonable possibility that the allocation will affect substantially the
dollar amounts to be received by the partners from the partnership,
independent of tax consequences.
In short, an allocation lacks substantiality if the allocation has
favorable tax consequences
q to one p
partner without corresponding
p g
detrimental tax consequences to the other partners and no overall
change on the partners’ capital accounts.
If the only effect of an allocation is to reduce taxes without
substantially affecting the partners’ pre-tax distributive shares, then
the economic effect is not substantial.

Substantiality (Cont.)
Even if the general rule is satisfied, the economic effect is not

substantial in the following cases:
(1) Shifting tax consequences
(2) Transitory allocations
(3) After-tax effect

Shifting Tax Allocations

Occurs if there is a strong likelihood that:
(1) The net increases and decreases that will be recorded in the
partners’ respective
p p capital
p accounts for such taxable y
year will
not differ substantially from the net increases and decreases
that would be recorded in the partners’ capital accounts if the
allocations were not contained; and
(2) The total tax liability of the partners will be less than if the
allocations were not contained in the p partnership
p agreement
g
(taking into account the tax consequences that result from the
interaction of the allocation with the partner’s tax attributes
even if unrelated to the partnership).

Shifting Tax Allocations

(Cont.)
Example
A andd B are equall partners,

t b t A is
but i a tax-exempt
t t entity.
tit ToT the
th
extent that there is any, B is allocated all of the tax-exempt income
up to an amount that equals 50% of the partnership income. This
lacks substantiality under the shifting tax consequences rule.
rule
Exception
Value-equals-basis
a ue equa s bas s rule:
u e A pa
partnership’s
t e s p s assets a
are
e irrebuttably
ebuttab y
presumed to have a value equal to their basis (or book value if
different from basis).

Transitory Allocations
If a partnership agreement provides for a possibility that one or more
allocations (original allocation) will be largely offset by one or more
allocations (offsetting allocation), and there is a strong likelihood that:
(1) The net increases and decreases that will be recorded in the
partners’ respective capital accounts for such taxable year will
partners
not differ substantially from the net increases and decreases
that would be recorded in the partners’ capital accounts if the
allocations were not contained; and

(
(Cont.)
)
(2) The total tax liability of the partners will be less than if the
allocations were not contained in the partnership agreement
(taking into account the tax consequences that result from the
interaction of the allocation with the partner’s tax attributes
even if unrelated to the partnership).
Example
A and B are equal partners, but A has NOLs that are expiring in
the next two years.
years A is therefore allocated all partnership income
for the first two years, then all to B for the next two years, then
equally between them. This is a transitory allocation and lacks
substantiality
substantiality.
(
(Cont.)
)
Exceptions
• Five-year
Five year rule: If at the time of allocation,
allocation there is a strong
likelihood that the original allocation will not be largely offset
within five years, then presumption that economic effect of
allocation is not transitory.
transitory
• Value-equals-basis rule
• Risky ventures: Because a risky venture is speculative in nature,

nature
there is not a strong likelihood that the offsetting profits/income
will ever materialize.

After-Tax Rule
An allocation does not have substantial economic effect if, at the time
the allocation is added to the partnership agreement:
(1) The after-tax economic consequences of at least one partner

may be enhanced compared to such consequences if the
allocation were not contained in the partnership agreement,
and
(2) There is a strong likelihood that the after-tax consequences of

no partner will be substantially diminished compared with the
consequences if the allocation were not in the partnership
agreement.

After-Tax Rule (Cont.)
The focus of this rule is on after-tax consequences, not pre-tax capital

accounts.
t Thus,
Th you cannott avoid id lack
l k off substantiality
b t ti lit byb using
i an
unequal number of years.
Exceptions
• Value-equals-basis rule
• Risky venture

No Substantial Economic
Effect
If there is no substantial economic effect, a reallocation will occur in
accordance with the partners
partners’ interest in the partnership. Presumption is
that partners share per capita (i.e., 50-50 if two partners).
Factors to consider in rebutting this presumption

• The partners’ relative contributions to the partnership
• The interests of the partners in economic profits and losses (if
different from taxable income and loss)
• Interests in cash flow or other non-liquidating distributions
• Rights to distribution on liquidation

Partnership Agreement Drafting Approaches
 Drafting
D fti allocations
ll ti provisions
i i
 Liquidating in accordance with capital accounts
 Can qualify for the “safe harbor”
 Either tranched allocation provisions or forced allocation provisions
 Liquidating in accordance with the “business deal” (i.e., the
distribution provisions)
p )
 Cannot qualify for the “safe harbor”
 May be able to have SEE (economic equivalency test)
 Generally use forced or “targeted”
targeted allocations
 Many parties to the business deal prefer this approach.
WHITE & CASE LLP 28

Partnership Agreement Drafting Approaches (Cont.)
 Drafting
D fti allocations
ll ti provisions
i i (Cont.)
(C t )
 Tranched allocations
 Limited Partner puts up 90% of capital, General Partner puts up 10%
of capital; cumulative profit shared 50%/50% (assume no LP DRO).
 Partnership gains allocated (i) first 90%/10% to offset prior losses;
(ii) second, 50% to each partner.
 Partnership losses allocated (i) first 50%/50% to offset prior gains
allocated per tranche (ii) above; (ii) second, 90%/10% until each
partner’s capital account reduced to zero; (iii) last 100% to the
general partner.
 The more complicated the business deal (e.g., preferred returns, IRR
hurdles, profits interests, other flipping allocations), the more
complicated the allocations will be to draft.
WHITE & CASE LLP 29
 Drafting allocations provisions (Cont.)
(Cont )
 Targeted/forced allocations
 Typical (but not perfect!) provision
 Partnership profits, losses, deductions and credits shall be allocated among the
partners
t in
i a manner suchh that
th t th
the capital
it l accountt off eachh partner,
t iimmediately
di t l
after making such allocation, is as nearly as possible equal (proportionately) to the
distributions that would be made to such partner pursuant to (the distribution
provision of the agreement), if the partnership were dissolved, its affairs wound up
and its assets sold for cash equal to their book value (as adjusted under this
agreement), all partnership liabilities were satisfied (limited with respect to each
non-recourse liability to the book values of the assets securing such liability), and
the net assets of the partnership were distributed in accordance with (the
distribution section) to the partners immediately after making such allocation, minus
(i) such partner’s share of minimum gain and (ii) any amount such partner is
obligated (or deemed obligated) to restore to the partnership.
 Intent is to cause the capital accounts to equal the distributions partners would receive
upon a liquidation of the partnership
WHITE & CASE LLP 30

 Drafting
D fti allocations
ll ti provisions
i i (Cont.)
(C t )
 Pros and cons of the various approaches
 Liquidating in accordance with capital accounts allow an allocation to
qualify for the safe harbor
 However, parties to the deal often do not want to rely on the
allocations producing the right business deal. Incorrect capital
accounts could distort cash partners ultimately expect to receive.
 Tranched allocations provide a “road map” for the accountants who
need to implement the agreement
 However, even when tranched allocations are used, often the tax
director/CFO will “back into” the tranched allocations by doing
forced allocations.
WHITE & CASE LLP 31

 Drafting allocations provisions (Cont.)
(Cont )
 Pros and cons of the various approaches (Cont.)
 Forced allocations and liquidating in accordance with the business deal generally
minimize likelihood of “practitioner error.”
 However, even forced allocation provisions must be drafted with care to
guard against unintended consequences.
 Non-recourse deductions don’t affect bottom line cash distributions, so
the must
they m st be carved
car ed ooutt of provision
pro ision or specially
speciall allocated (not entirely
entirel
clear that NRD safe harbor can be complied with under a target allocation
approach).
 Similarly,y minimum ggain charge-backs
g need to be backed out of the
targeted amount.
 Or, a partner is only supposed to receive a particular amount upon the
occurrence of a particular event.
 Or,
O a partnership
t hi iintends
t d tto comply l with
ith th
the “f“fractions
ti rule.”
l ”
WHITE & CASE LLP 32

Additional 704(b) Requirements: Revaluations
 Additional
Additi l 704(b) capital
it l accountt maintenance
i t rules
l
 Revaluations (“book-ups” and “book-downs”)
 Upon admission of new partners, non-pro rata distributions
 Assets revalued (marked-to-market)
 Gain/loss is “booked” to capital accounts of existing partners.
 Subsequent allocations of depreciation
depreciation, etc
etc. made with respect to
“new” book value (as opposed to historical cost).
 Reverse 704(c) allocations will apply to take into account the
book-tax
book tax difference created by the book
book-up
up.
 Note: Newly admitted partner will want input into 704(c)
method partnership uses in order to ensure, e.g., that it
receives its “fair
fair share
share” of subsequent depreciation deductions.
deductions
WHITE & CASE LLP 33

Revaluations (Cont.)
 E
Examplel off revaluation
l ti
 Partnership AB owns property with a cost of 100 and a fair value of 200.
 A and B each originally contributed 50 and currently share all items 50/50.
 C is admitted for a 100 capital contribution and will share 1/3 in partnership
property.
 Absent revaluation of capital accounts, if the property were immediately
sold, the 100 gain in the property would be allocated 1/3 to each partner,
so:
 A capital account: 50 + 33 = 83
 B capital account: 50 + 33 = 83
 C capital account: 100 + 33 = 133
 Without revaluing the property and “booking” the built-in gain to A and B’s
capital account, the business deal is distorted.
WHITE & CASE LLP 34

Revaluations (Cont.)
 Example of suspended loss problem resulting from revaluation
 Partnership ABC from prior example properly books-up capital accounts following admission of C:
P t
Partner B k
Book T
Tax
A 100 50
B 100 50
C 100 100
 Subsequent losses allocated in accordance with “percentage interests” or book capital account
balances may be limited to A and B under 704(d) and may result in inefficiency to C.
 A and B have 50 of tax basis against which to take losses; losses in excess of 50 will be suspended.
 CC’ss loss will be deferred until a later date; character issues
 Agreement should provide that losses following a book-up are allocated in accordance with
unreturned capital contributions or some other metric not tied to revalued capital accounts.
 Provide related income charge-back
WHITE & CASE LLP 35

Jeremy Naylor White & Case
Jeremy Naylor, White & Case
Jorge Otoya, KPMG
ASSOCIATED REGULATORY
SECTIONS
Non-Recourse Deductions: Brief Review Of General Rules
 Substantial economic effect

 Each allocation of income, gain, loss and deduction must have
“substantial economic effect.”
 Partner
P t receiving
i i allocations
ll ti bears
b the
th economic i benefits
b fit and d
burdens.
 Reflected in capital accounts
 Scorecard
 Positive capital accounts = partner entitlement to partnership capital
 Negative
g capital
p accounts = ppartner obligation
g to restore ppartnershipp
capital
 Assuming no unlimited deficit restoration obligation, a partner’s
p account should not be driven negative
capital g byy more than the
partner has agreed to restore (or is deemed to have agreed to
restore) to the partnership’s capital. WHITE & CASE LLP 37
Non-Recourse Deductions (Cont.)
 “losses,
“l d
deductions
d ti … attributable
tt ib t bl tto partnership
t hi nonrecourse
liabilities”
 Non-recourse liability
 Determined under Sect. 752
 Generally, a partnership liability where no partner/member bears the
“economic risk of loss”
 Indicia
I di i off economic
i risk
i k off lloss iinclude:
l d
 Obligation to make payment on debt or contribute capital
 Express in agreement or required under state law
 Partner
P t or related
l t d person iis llender
d tto partnership
t hi
 Guarantees of principal or interest repayment
 Pledges/other security provided for borrowing
WHITE & CASE LLP 38

 How are they allocated?

 General rule: Allocations are required to have “substantial
economic effect.”
 Essentially, the partner receiving the allocation has the economic
benefit or burden of such allocation.
 If no partner bears the economic burden of a partnership non-
recourse liability (because no partner is individually required to
repay the liability), how can an allocation of a non-recourse
deduction have substantial economic effect?
 Safe harbor
WHITE & CASE LLP 39

 How
H are they
th allocated?
ll t d?
 Principles of 1.704-2 regulations
 When property subject to a non-recourse debt is sold, the full
amount of the debt must be included in amount realized (regardless
of its FMV) (principles of Tufts)
 Thus, the partnership will be required to include in income the
difference between the basis of property and the amount of the
outstanding non-recourse liability.
 So long as such income is allocated (or charged back) to the
partners who were allocated the corresponding non-recourse
deductions (i.e., the deductions that caused the basis of the property
to decrease), then the allocations of the non-recourse deductions will
b ddeemedd tto hhave substantial
be b t ti l economici effect.
ff t
WHITE & CASE LLP 40
 How
H are they
th allocated?
ll t d?
 Safe harbor for allocations of non-recourse deductions
 Allocations under LPA generally have SEE.
 Non-recourse deductions are allocated in a manner that is
reasonably consistent with allocations of some other significant
partnership item associated with the mortgaged property.
 LPA contains a “minimum gain chargeback” provision.
 Allocations of non-recourse deductions must bear some relation to
the overall business deal ((can be in a rangeg between two different
allocation ratios), and the partner receiving the tax benefit of the
deduction will be charged back an equivalent amount of income at a
later date (when the minimum gain chargeback is triggered).
WHITE & CASE LLP 41

Minimum Gain Charge-Backs
 Several concepts in one
 Minimum gain: The excess of the principal amount of non-recourse debt
over the tax basis of the property securing it
 I.e.,, the “minimum” amount of ggain the owner of the pproperty
p y would be
required to recognize upon a taxable sale of the property
 Minimum gain increases when basis decreases below the principal amount
of the non-recourse debt, or principal amount of debt increases (and
typically the borrowed proceeds are distributed to the partners).
partners)
 E.g., depreciation deductions drive basis below principal amount of debt.
 Minimum gain decreases when there are certain basis increases, or when
the property is disposed of
 Non-recourse deductions for a particular year will generally equal the
increase in partnership minimum gain for that year.
 I.e., deductions from property secured by non-recourse loan will not be “non-
recourse deductions,
deductions ” unless partnership minimum gain has increased.
increased
WHITE & CASE LLP 42

Minimum Gain Charge-Backs (Cont.)
 Partner’s
Partner s share of minimum gain
 Tracked separately for each partner – generally will equal such partner’s
share of non-recourse deductions previously allocated
 Minimum gain charge-back
 Triggered
Ti d when
h partnership
t hi hhas a nett decrease
d i minimum
in i i gain
i
 E.g., upon sale of property – minimum gain goes to zero (because the debt
has been repaid upon sale)
 Any other transaction that results in a decrease in minimum gain triggers the
chargeback,
h b k except:t
 Refinancings of debt or conversion of debt into recourse debt – partners
who become recourse on debt should not then have the minimum gain
chargeback triggered
 Capital
C contributions, iff used to repay principal on non-recourse debt or
improve property
 This does not trigger charge-back, because the partner is actually
coming out of pocket to improve property; there is no gain going
untaxed by reason of this transaction.
transaction
 Revaluation
WHITE & CASE LLP 43
 Result of minimum gain charge-back

 Partners are charged back income equal to their respective shares
of decreases in the partnership minimum gain.
 Recapture
p
 Undoing tax benefits of deductions previously taken
WHITE & CASE LLP 44

 Example
 A and B form a partnership and each contributes $0.
 AB borrows $100 on a non-recourse basis to acquire depreciable property.
 A and B each have outside basis of $50. Partnership has $100 basis in property.
 Property
P t depreciates
d i t $10 per year. E Each
h off A and
d B is
i allocated
ll t d $5 off
depreciation deductions.
 After year 5, each of A and B’s basis is reduced to $25, and they each have a
negative capital account of $(25).
 At end of year 5,
5 AB puts the property back to the lender (assume no previous
principal repayments).
 What happens to A & B
 AB’s minimum gain at the end of year 5 was: $50 (difference between the $100
principal amount and $50 adjusted basis of property).
property)
 Upon foreclosure, AB has net decrease in minimum gain of $50 (because
principal amount of debt is $0 and AB no longer owns property).
 Each of A and B must be allocated $25 of income under the minimum gain
chargeback reflecting prior non
non-recourse
recourse deductions they have taken.
WHITE & CASE LLP 45

 Complicating factors
 Partners may share in operating losses in a manner different than non-
recourse deductions.
 Non
Non-recourse
recourse deductions = net increase in partnership minimum gain, so
you need to analyze each year whether depreciation deductions are
sufficient to result in a net increase in PMG; otherwise, partners may share in
losses in a different manner.
 Need to pay careful attention to drafting other charge-back provisions in
allocation clauses in agreements – ensure that income related to non-
recourse deductions is not being charged back already before the
minimum gain charge-back
 Some
S charge-back
h b k off lloss allocation
ll ti provisions
i i ddo nott specifically
ifi ll exclude
l d
charge-backs of non-recourse deductions previously taken.
 Can result in double-counting
WHITE & CASE LLP 46

Recent Transactional Examples
 Structuring to minimize minimum gain charge-back
charge back
 Client is interested in acquiring debt or equity from bankrupt entity
 However, entity is partner in real estate partnership with several underwater
properties.
 Minimum
Mi i gain
i charge-back
h b k would ld bbe ttriggered
i d if lender
l d fforecloses
l resulting
lti iin ttax
liability.
 What to do?
 Make debt recourse
 Provide guarantee
 Transaction would trigger charge-back for those partners who remained non-
recourse to the debt.
 Trigger COD income rather than minimum gain charge-back
 COD income is excluded from income of bankrupt debtor; income from minimum
gain chargeback is not.
 Putting property to lender in satisfaction of non-recourse loan does not trigger
COD (because borrower was never “on the hook” for the debt),
 Negotiating a reduction in principal while retaining the property can result in COD
(because borrower retains property).
WHITE & CASE LLP 47
Recent Transactional Examples (Cont.)
 Structuring
St t i to t minimize
i i i minimum
i i gain
i charge-back
h b k
 Briarpark case
 Lender agreed to release liens on property, if borrower would sell the
property for specified price and assign the proceeds to the lender.
 5th circuit noted transactions intertwined; transaction did not result in
COD income.
 Transaction would need to be structured in a manner that bifurcated
the lender’s agreement from the sale of the property. It may be
difficult to get a buyer to agree to provide funds prior to the date
borrower has full control of property.
WHITE & CASE LLP 48

Recent Transactional Examples (Cont.)
 Allocating non-recourse
non recourse deductions from specific assets to new partner
 Existing partnership plans to acquire assets with borrowed funds that are entitled to
accelerated depreciation.
 Existing partners cannot fully use depreciation deductions.
 P t
Partnership
hi h has other
th propertiesti andd other
th liliabilities.
biliti
 Third-party investor can use depreciation deductions.
 Can deductions from specific assets in partnership that secure multiple liabilities be
allocated specifically to new partner?
 Sect. 1.704-2 regulations look at non-recourse deductions and partnership minimum
gain as aggregate concepts.
 Under 752 regulations, it is unclear that basis attributable to specific assets can be
allocated to a particular partner.
 Even if depreciation deductions on specific assets could be allocated to a particular
partner, you may not be able to control timing of minimum gain charge-back.
 Exculpatory liabilities?
 Solutions?
 New partner provides guarantee and makes liability recourse.
 Series partnership? WHITE & CASE
LLP 49
Scenario 1:
Capital Accounts And Economic
Effect
© 2011 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative
(“KPMG International”), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity. 50
50
Scenario 1:
Capital Accounts And Economic Effect
 LLC is a potential compliance client for its 2010 Form 1065. We

have been charged with reviewing its partnership agreement
and prior-year
prior year returns in order to prepare a fee estimate
estimate.
 From our review, we determine the following facts:

 Partners A and B formed LLC in 2008
2008.
 Each contributed the same amount of cash to form LLC and
have agreed to share in all partnership items, including non-
recourse deductions on a 50/50 basis.
 The partnership agreement meets the alternate test for economic
effect.
 The p partnership
p had a $3,000 loss in 2008.
 The partnership has a $13,000 loss in 2009.
 We are provided a copy of the partnership’s capital account
roll-forward.
51
Scenario 1:
LLC’s Capital Accounts
LLC Sect. 704(b) Capital Account Roll-forward

Partnership A B
Capital – 1/1/08 0 0 0
Contributions 5,000 2,500 2,500
2008 Loss (3,000) (1,500) (1,500)
Ending Capital 2,000 1,000 1,000
C it l – 1/1/09
Capital 2 000
2,000 1 000
1,000 1 000
1,000
Contributions 0 0 0
2009 Loss ((13,000)) ((6,500)) ((6,500))
Ending Capital (11,000) (5,500) (5,500)
• What other information is needed?
52
Scenario 1:
LLC’s Capital Accounts (Cont.)
Partnership A B
Ending Capital -12/31/09 (11,000) (5,500) (5,500)
• The partnership has been generating losses that have taken

partnership capital negative – indicating that liabilities are
funding deductions.
deductions
• Losses have been allocated proportionately between the
partners; thus, we would “expect” that either both partners “are
on the hook” equally for the partnership liabilities that are funding
th d
the deductions,
d ti or th
the li
liabilities
biliti have
h generated
t d partnership
t hi
minimum gain.
• The validity of the loss allocations should to be reviewed to
ensure they are in accordance with the regulations
regulations.
• We need to know:
- The nature of the partnership liabilities, and
- Whether any partner bears economic risk of loss for the liabilities.
liabilities
53
What Do We Know About The LLC?
• Both partners contributed the same amount of cash and have

agreed to share all items 50/50.
• Partnership agreement meets alternative test for economic
effect:
Compliance with capital account maintenance rules
Liquidation in accordance with partner’s capital

accounts
Qualified income offset - “QIO”
• So, we know that any “equity” deductions that are allocated to

the partners 50/50 will likely be respected up to the point the
partner’s capital acco
accounts
nts have
ha e been decreased to zero.
ero
Scenario 1:
More Facts
 LLC has two liabilities on its balance sheet at the end of 2009
1. Accounts p
payable
y -$
$6,000
,
2. Bank loan - $22,000
 Client provides the following information:

1. No partner has a deficit restoration obligation.
2. Both bank loan and AP are recourse solely to the assets of the
LLC,, but the bank loan is senior in priority
p y to the AP.
3. Neither A nor B (or any person related to A or B) have guaranteed
the bank loan, or have entered into any other arrangement which
would require them to make a payment with respect to the bank
loan should it become due and payable and the partnership’s
loan, partnership s
assets are assumed to be worthless.
4. Bank is not related to either A or B.
55
Scenario 1: More Facts (Cont.)
• Based on these facts, the capital accounts appear correct, and

the prior year loss allocations are also likely correct
correct.
• Why?
y
56
Determination Of Partnership
Non-Recourse Deductions
 To determine the amount of non-recourse deductions, you must:

1. Identify all “non-recourse
non recourse liabilities
liabilities”
• Partnership liability for which no partner bears the “economic risk
of loss”
2. Determine whether each non-recourse
non recourse liability exceeds the
Sect. 704(b) book basis of the assets that secure the debt,
and add the sum of these amounts together (“minimum gain”)
3. Determine the non-recourse deductions - The amount by which
minimum gain in current year has increased over minimum gain in
the prior year
• The increase in minimum gain is reduced for certain
distributions.
4. Allocate partnership non-recourse deductions in a ratio that is
“reasonably consistent with allocations that have substantial
economic effect of some other significant partnership item
attributable to the securing property”
property
57
Scenario 1:
Non-Recourse Deduction Calculations
Partnership’s Sect. 704(b) Balance Sheets

12/31/08 12/31/09
Net Depreciable Assets 12,000 17,000
Accounts Payable 0 6,000

Bank Loan 10,000 22,000
Partner Capital 2,000 (11,000)
Liabilities & Capital 12,000 17,000
Tax Year 2009 Partnership Minimum Gain
Bank Loan Accounts Payable
A/R 22,000 6,000
A/B: Sec. 704(b) Basis (17,000) (-0-)
S/T: Partnership MG 5,000 6,000
Less Prior Year MG (-0-) -0-
Increase in MG $
$5,000 6,000
58
Example Of LLC Non-Recourse Deduction Calculations
 The increase in partnership minimum gain is $11,000 in total (partnership

minimum gain of zero in 2008).
 Therefore,
Therefore of the total $16,000
$16 000 losses in 2008 and 2009
2009, $11
$11,000
000 are non-
non
recourse deductions and $5,000 are allocated under the partnership
agreement loss-sharing provisions (also 50/50).
 Under the partnership agreement, the non-recourse deductions are allocable
50/50 between the ppartners and would be allocated to A and B 50/50.
 Based on the facts as we know them, do the capital accounts appear
correct?
P t
Partnership
hi A B
Capital – 1/1/09 2,000 1,000 1,000
Contributions 0 0 0
2009 Loss (13,000) (6,500) (6,500)
Ending Capital (11,000) (5,500) (5,500)
59
Example Of LLC Non-Recourse
Deduction Calculations (Cont.)
 In fact, if we add back each partner’s share of minimum gain, their
capital accounts should equal zero (or be above zero).
 “Adjusted
Adjusted capital account deficit”
deficit = Zero.
 This is a good cross-check to set up between the capital account roll-
forward workpapers and the minimum gain workpapers.
 Another good practice is to setup the capital account roll-forwards to
illustrate the allocations byy partnership
p ppprovision.
Partnership A B
Capital – 1/1/09 2,000 1,000 1,000
C t ib ti
Contributions 0 0 0
2009 Non-Recourse Deductions (11,000) (5,500) (5,500)
2009 “Equity” Losses (2,000) (1,000) (1,000)
Ending Capital Account (11,000) (5,500) (5,500)
Plus share of PRS MG +11,000 +5,500 +5,500
“Adjusted
j Capital Account” -0- -0- -0-
60
Checklist
• Annual compliance checklist

• Analysis of new partnership liabilities
• Analysis of change in partnership assets
• Analysis of change in partnership liabilities
• Analysis of change in partnership equity
• Analysis of any changes in the terms of partnership liabilities
• Minimum gain calculations.
• Allocations of nonrecourse deductions and/or minimum gain charge-
backs
 These schedules require maintenance of Sect. 704(b) and tax basis
balance sheets.
61
Scenario 2:
Partner Non-Recourse
Non Recourse Deductions
Debts With Multiple Priorities
62
Scenario 2:
The LLC Facts Get More Complicated
A B
LLC
Partnership A B
Capital – 1/1/09 2,000 1,000 1,000
Contributions 0 0 0
2009 Non-Recourse Deductions (11,000) (5,500) (5,500)

2009 Equity Losses (2,000) (1,000) (1,000)
Ending Capital Account (11,000) (5,500) (5,500)
 What do we need to consider if we changed the facts to indicate that A

guaranteed the loan from the bank?
 Are A and B’s
B s capital accounts correct?
63
Scenario 2:
High-Level Review – Partner Non-Recourse Debt
• Partner non-recourse liability

A B
- Partnership liability that is non-recourse under
Sect. 1.1001-2, but for which a partner bears
the “economic risk of loss”
• Allocate to partner who bears economic

risk of loss
LLC • Multiple partners bear economic risk of

loss for the non-recourse liability.
y
• Allocate according to ratio
64
Computing Minimum Gain And Non-Recourse
Deductions - Property Securing Multiple Liabilities
• Need to allocate basis of assets to each liability based on

relative priority over the assets
• If liabilities have equal priority

• Allocate basis ratably
• If liabilities have unequal priority

• Allocate basis to highest priority first
65
Scenario 2:
Calculating Minimum Gain With Multiple Debts (Cont.)
Partnership’s Sect. 704(b) Balance Sheets
12/31/08 12/31/09
Net Depreciable Assets 12,000 17,000
Accounts Payable 0 6,000
Bank Loan 10,000 22,000
2009 Minimum Gain Calculation Partner MG Partnership MG

B kL
Bank Loan A
Accounts
t PPayable
bl
A/R: Liabilities (Bank Loan & A/P) 22,000 6,000
A/B: Sect. 704(b) Basis (17,000) (0)
S/T: Partnership MG 5,000 6,000
Less Prior Year MG 0 0
Increase in MG 5,000 6,000
• Increase in partner minimum gain is $5,000.
$5 000 Therefore,
Therefore partner non
non-recourse
recourse
deductions for 2009 equals $5,000.
• These deductions would be allocated 100% to A, as he bears all of the economic risk of loss
for the liability .
• Losses of $6,000 are funded by partnership non-recourse debt, which are allocated 50/50.
• The
Th remaining
i i $2 $2,000
000 iin llosses are equity
it llosses allocable
ll bl under
d ththe partnership
t hi agreementt
(also 50/50).
66
Scenario 2:
Comparison Of The Capital Accounts
Capital Accounts – Recalculated “As Is”

Partnership A B
Capital – 1/1/09 2,000 1,000 1,000
Contributions 0 0 0
Partner Non-Recourse Deductions (5,000) (5,000) 0
Partnership Non-Recourse Deductions (6,000) (3,000) (3,000)
“Equity” Losses (2,000) (1,000) (1,000)
Ending
g Capital
p Account - Recalculated ((11,000)
, ) ((8,000)
, ) ((3,000)
, )
Ending Capital Account – “As Is” (11,000) (5,500) (5,500)
 No, the capital accounts are not correct. It appears that A was not
allocated all of the partner non-recourse deductions.
67
Scenario 2:
Comparison Of The Capital Accounts (Cont.)
Sect. 704(b) Capital Accounts

12/31/09 12/31/09 Difference
As prepared As recalculated
A (5,500) (8,000) (2,500)
B (5,500) (3,000) 2,500

Total (11,000) (11,000) 0
• Exposure: A was under-allocated deductions by $2,500. B received

$2,500 deductions to which he was not entitled.
• What are the tax considerations?
• Duty to inform?
• Requirement to amend?
• Effect(s) on compliance engagement, if the partnership decides to not amend?
• Is this an audit client?
68
Capital Account Maintenance
Tip: Where non-recourse deductions are shared in the same

manner as other partnership items, the minimum gain
computations
t ti still
till need
d to
t be
b determined.
d t i d
Consider partner debt.
Consider debt priorities and collateral.
Tip: Non-recourse deductions may occur even when the

partnership
p p aggregate
gg g capital
p is positive.
p
Tip: A partner’s negative Sect. 704(b) capital account plus share of

minimum g gain should generally
g y equal
q zero (or
( more than zero).)
Not always true – consider effect of deficit restoration obligations and
allocations attributable to recourse debts.
Jorge Otoya, KPMG
RECENT AND RELEVANT
REGULATORY GUIDANCE
Recent Updates With Respect To Sect. 704
• Final regulations under Sect. 704(c)

• Direct and indirect partners are considered in determining
whether a Sect. 704(c) method is reasonable/
• Notice 2010-52
2010 52 – Foreign tax credit guidance under Sect
Sect. 909
• Renkemeyer v. Commissioner, 136 TC No 7

• Special allocations
• SE tax
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR

WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A
CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF
(i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER
OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER
PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all
persons, without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we p provide to you,
y including,
g but not limited to, any
y
tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject
j to change.
g Applicability
pp y of the information to specific
p situations should be
determined through consultation with your tax adviser.

704 (B) Allocations KPMG

Uploaded by

Copyright:

Available Formats

704 (B) Allocations KPMG

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

704 (B) Allocations KPMG

Uploaded by

Copyright:

Available Formats

What is the purpose of the webinar?

What is the purpose of the webinar?

What are the main topics covered in the webinar?

What are the main topics covered in the webinar?

Presenting

WEDNESDAY, MARCH 2, 2011

Today’s faculty features:

Please refer to the instructions emailed to the registrant for additional

Jorge Otoya, KPMG

Material Aspects Of 704(b) Rules Slide 7 – Slide 35

Associated Regulatory Sections Slide 36 – Slide 69

Relevant And Recent IRS Administrative Guidance Slide 70 – Slide 72

One of the key benefits of a partnership is the flexibility in allocating

Allocations of a partner’s distributive share of partnership income, gain,

(1) Are either in accordance with the partners

(2) Have substantial economic effect.

Allocations are not the same as distributions.

IRC Sect. 704(b): Allocations to Partners Webinar 8

Partners’ Interest In The

For example, if A and B each contributed $100, allocations would be in

Liquidating distributions can be made in accordance with the partners’

IRC Sect. 704(b): Allocations to Partners Webinar 9

Substantial Economic Effect

Special allocations will be respected if they have substantial economic

Under a two-part analysis, allocations must :

(1) Have economic effect, and

(2) The economic effect must be substantial.

IRC Sect. 704(b): Allocations to Partners Webinar 10

IRC Sect. 704(b): Allocations to Partners Webinar 11

Basic Test For Economic Effect

(2) Liquidation requirement: Upon liquidation of the partnership

(3) Deficit make

IRC Sect. 704(b): Allocations to Partners Webinar 12

IRC Sect. 704(b): Allocations to Partners Webinar 13

Deficit Restoration Obligation

The deficit restoration obligation (DRO) may be provided for in

A DRO may be imposed to the extent of any outstanding

A partner can have a limited DRO.

IRC Sect. 704(b): Allocations to Partners Webinar 14

For the entire allocation to have economic effect,

IRC Sect. 704(b): Allocations to Partners Webinar 15

Treas. Reg. §1.761 1(c) provides that a “partnership

This gives partners a planning opportunity to amend how they allocate

IRC Sect. 704(b): Allocations to Partners Webinar 16

Alternate Test For

IRC Sect. 704(b): Allocations to Partners Webinar 17

IRC Sect. 704(b): Allocations to Partners Webinar 18

Even if the general rule is satisfied, the economic effect is not

(1) Shifting tax consequences

(2) Transitory allocations

(3) After-tax effect

IRC Sect. 704(b): Allocations to Partners Webinar 19

Shifting Tax Allocations

IRC Sect. 704(b): Allocations to Partners Webinar 20

Shifting Tax Allocations

A andd B are equall partners,

IRC Sect. 704(b): Allocations to Partners Webinar 21

IRC Sect. 704(b): Allocations to Partners Webinar 22

• Risky ventures: Because a risky venture is speculative in nature,