Partnership Hot Topics

1. Partnership Hot Topics Howard E. Abrams Professor of Law

2. Howard E. Abrams • Howard E. Abrams, Professor of Law at Emory Law School in Atlanta, GA, is a partnership and corporate tax specialist, receiving his B.A. from the University of California (Irvine) and his J.D. from Harvard University. He has written four books, the BNA Tax Management Portfolio on Disregarded Entities, and more than fifty articles on taxation. Professor Abrams has been at Emory University since 1983, spent the 1999-2000 academic year with the national office of Deloitte Tax as the Director of Real Estate Tax Knowledge, and from January of 2003 through August of 2004 was of counsel to Steptoe & Johnson in Washington, DC. He teaches regularly at Leiden University in the Netherlands and is a member of the American Law Institute and the DC Bar. Prior to joining the Emory faculty, Professor Abrams was a law clerk to Chief Judge Theodore Tannenwald, Jr., of the United States Tax Court and practiced in Los Angeles with the firm of Brobeck, Phleger & Harrison. Professor Abrams has taught as a Visiting Professor at USD, Cornell, Berkeley and Yale Law Schools. Professor Abrams will spend the 2013-14 academic year as a Visiting Professor at Harvard Law School.

3. Topics • Topics • Partnership Noncompensatory Options • Partnership Self-Employment Issues • LLCs and the Passive Loss Limitations • Partnerships and Income from the Cancellation of Indebtedness • The Section 752 Anti-Abuse Rule and Disguised Sales

4. Options Basics • An option is the right (but not an obligation) to purchase or sell certain property. A “call” option is the right to purchase; a “put” option is the right to sell. • If the underlying property is fungible, the option can be settled by delivery of the underlying property or by a payment of cash. If the underlying property is unique, the underlying property always is delivered if the option is exercised.

5. Option Basics (continued) • The option holder’s rights are limited in time. If the option can be exercised at any time until expiration, it is called an “American-style” option. • If the option can be exercised only upon expiration, it is called a “European-style” or “digital” option. • If the option can be exercised at specific dates prior to (and including) expiration, it is called a “Bermuda-style” option. • Most partnership noncompensatory options are America-style call options, and exercise can be settled only by actual delivery.

6. Basic Terminology • Option Premium: Usually called the option “cost,” it is what the holder of the option pays to acquire the option. • Exercise Price: Usually called the the “strike” price, it is the amount the holder must pay to exercise the option. • In the case of convertible debt, the exercise price includes the “adjusted issue price” of the debt increased by any accrued but unpaid stated interest. • In the case of convertible equity, the exercise price includes that portion of the holder’s capital account allocable to the convertible interest.

7. Option Valuation • The value of an option is composed of two amounts, the intrinsic value of the option and the time value of the option. • The intrinsic value of an option at any point in time is the excess of the value of the underlying property over the exercise price. • The time value of an option is the value of the option in excess of its intrinsic value. The time value of an option is dependent on the exercise price, the current value of the underlying, the anticipated volatility of the value of the underlying, and the duration of the option. The time value of an option declines to zero as the expiration date approaches. • For an excellent introduction to options, see Andrew M. Chisholm, Derivatives demystified (Wiley Finance 2d ed. 2010).

8. Taxation of a Noncompensatory Option • Acquisition of a noncompensatory partnership interest is a taxable event to the option holder. • Unless the option is recharacerized as equity, the option holder is not treated as a partner and so no taxable income can be allocated to the option holder. When the option is exercised, the partnership must revalue its assets immediately after the exercise and allocate book gain or loss to the (former) option holder. If there is insufficient book gain or loss, curative allocation must be used. If the option lapses, the option premium is income to the partnership.

9. Exercise and Book-Up: Example 1 • X and Y form XY LLC by contributing $10,000 each. Z contributes $1,000 for an option to acquire a one-third interest for $15,000. XY purchases nondepreciable property for $20,000. When the property is worth $35,000, Z exercises the option by contributing $15,000 in exchange for a one-third interest in the venture. At this point, XY owns cash of $16,000 and property with adjusted basis of $20,000 and value of $35,000. Each partner’s interest is worth $17,000.

10. Example 1 continued

11. Sale and Exercise: Example 2 • X and Y form XY LLC by contributing $10,000 each. Z contributes $1,000 for an option to acquire a one-third interest for $15,000. XY purchases nondepreciable property for $20,000. The property is sold for $35,000, and then Z exercises the option by contributing $15,000 in exchange for a one-third interest in the venture. At this point, XY owns cash of $51,000. Each partner’s interest is worth $17,000.

12. Example 1 continued This example assumes the partnership has income of $6,000 in the following taxable year, allocated $2,000 to each partner under the partnership agreement.

13. Nonconpensatory Option Issues • Not “In Connection With” Services • Application to “Preferred” Interests • Option as Equity • Taxation of Option Issuance • Option Lapse • Conversion of Convertible Debt

14. Not “In Connection With” Services • “In connection with” is broader than “in exchange for.” Alves v. Commissioner, 79 T.C. 864 (1982), aff’d, 734 F.2d 478 (9th Cir. 1984). • Consider a contractual arrangement akin to phantom stock. • If investors are corporations and gain will be capital, compensatory interest treatment usually provides optimal results.

15. Application to “Preferred” Interests • The noncompensatory option regulations apply to the conversion feature of preferred equity if it is convertible into common equity. • “Preferred” equity is an interest that entitles the partner to a preferred return on equity. For a partner who is entitled to a guaranteed payment or preferred allocation, is the entire interest “preferred”? Apparently not, although how the interest is bifurcated is not defined. Note that conversion of a common interest into a larger common interest is not covered by the regulations.

16. Option as Equity • An option will be treated as equity prior to conversion if it provides the holder “with rights that are substantially similar to the rights afforded to a partner.” • An option that is deep in the money when issued presumably will be treated as equity. • The proposed regulations focus on both benefits and detriments associated with equity.

17. Taxation of Option Issuance • For the partnership: Open transaction treatment. • For the option holder: gain or loss if the option is acquired for property (section 721 does not apply), and capitalization of the cost. • Note: Transfer of the option can trigger gain to the option holder. What is the partnership’s basis in such property. Presumably equal to fair market value although there is no statement of that result.

18. Option Lapse • To the Partnership: Ordinary income equal to the option premium (open transaction is closed). • To the Partner: • Loss equal to option premium. • Is it capital under section 1234A? Unclear. • Does character of the loss turn on the character of the underlying assets? No clear authority for a look-thru rule.

19. Conversion of Convertible Debt • If the holder of convertible debt elects to convert the debt into equity, the partner’s capital account will be credited with the adjusted basis of the debt (accounting for application of the OID rules) plus any accrued but unpaid stated interest. • The proposed regulations do not specify the tax consequences of the conversion to the partnership, but given section 108(e)(8), presumably the partnership will recognize COD income as if the debt had been satisfied with cash equal in value to the value of the partnership interest.

20. Self-Employment Taxes • For determining whether an LLC member should be treated as a “general” partner, it is the participation of the partner in the activities that is relevant. Renkemeyer v. Comm’r, 136 T.C. 137 (2011). • Howell v. Commissioner, T.C. Memo 2012-303 (Nov. 1, 2012), follows Renkemeyer in outcome and tone. In Howell, Husband worked for the LLC but put ownership of the LLC interest in the hands of Wife. The Tax Court found that Wife performed some labor for the LLC and held that the taxpayer failed to prove exactly how much.

21. Incentive Partnership Options • It is the Service’s position that a partner cannot receive a W-2 from the partnership and cannot be treated as an employee (although a partner can be treated as an independent contractor). • Note: a disregarded entity that has one or more employees is treated as a corporation for purposes of the collection and reporting of the self-employment taxes.

22. Employee Through a Disregarded Entity? P1 P2 Ee P DE Employment Relationship

23. LLCs and Passive Loss Limitations • The Service interpreted §469(h)(2) as treating all LLC members as “limited” partners. That interpretation was rejected by the courts. • Proposed regulations now provide that an LLC member will be treated as a limited partner unless the member has the power to manage the entity under applicable state law and under the LLC agreement where “manage” must include a power to bind the entity.

24. COD Basics • Cancellation of recourse debt • Reduction of recourse debt • Reduction of nonrecourse debt • How is “recourse” defined? • Unclear if the §752 regulations apply in this context. • If not, presumably turns on the lender’s rights against the partnership. • Allocation of COD income subject to general “substantial economic effect” test.

25. PRS must revalue assets pursuant to agreement Rev. Rul. 99-43: Partnership Formation A B A’s Interest - 50% GP - $5,000 Basis - $1,000 Capital Acct. B’s Interest - 50% GP - $5,000 Basis - $1,000 Capital Acct. PRSLand - $10,000Nonrecourse debt - $8,000

26. FMV of Land falls from $10,000 to $6,000. Principle loan balance remains at $8,000. B is insolvent Debt workout: Bank agrees to reduce principle balance on loan by $2,000 ($8,000 - $2,000 = $6,000). Post work-out, A will have a 60% and B will have a 40% interest in profits and losses of PRS. Assets and capital accounts revalued. Rev. Rul99-43: End of Year One Facts

27. Opening capital account balances Rev. Rul99-43:Capital Account Rollforward

28. COD Income - $2,000 Rev. Rul99-43:Capital Account Rollforward

29. Asset Revaluation - ($4,000) Rev. Rul99-43:Capital Account Rollforward

30. Opening capital account balances Rev. Rul99-43:Capital Account Rollforward

31. COD Income - $2,000 Rev. Rul99-43:Capital Account Rollforward

32. Asset Revaluation - ($4,000) Rev. Rul99-43:Capital Account Rollforward

33. Shifting violation But what if no asset revaluation? “Substantiality”: Reg. §1.704-1(b)(2)(iii)

34. Opening capital account balances Rev. Rul99-43:Capital Account Rollforward

35. COD Income - $2,000 Rev. Rul99-43:Capital Account Rollforward

36. Asset Revaluation - ($4,000) Rev. Rul99-43:Capital Account Rollforward

37. Computation of Partner Insolvency • Asset #1: Value of $1,000,000 subject to recourse debt of $1,200,000. • Asset #2: Value of $1,000,000 subject to nonrecourse debt of $1,200,000. • If the recourse debt is reduced to $900,000, then T can exclude $200,000 under §108(a)(1)(B). • If the nonrecourse debt is reduced to $900,000, then T can exclude the entire $300,000. • Under Rev. Rul. 2012-14, same result if assets and liabilities are inside a partnership.

38. Canal Corp. Transaction Canal Corp. WISCO GP Business assets LLC

39. Canal Corp. Transaction Canal Corp. WISCO GP Business assets LLC Bank Loan Proceeds

40. Canal Corp. Transaction Canal Corp. WISCO GP Business assets LLC Cash distribution Bank Loan Proceeds

41. Canal Corp. Transaction Canal Corp. WISCO GP Obligation Business assets LLC Cash distribution Obligation Bank Loan Proceeds

42. Canal Corp. Transaction Canal Corp. WISCO GP Indemnity Obligation Business assets LLC Cash distribution Obligation Bank Loan Proceeds

43. Canal Corp. Transaction Canal Corp. Intercompany Note WISCO GP Indemnity Obligation Business assets LLC Cash distribution Obligation Bank Loan Proceeds

44. Does Canal Corp mean the leveraged partnership structure is dead? Canal Corp involved a consolidated subsidiary; does the anti-abuse rule have equal application in other circumstances? If not, what should tax advisors planning a leveraged partnership transaction think about? Scope of the indemnity Identity of the indemnitor Indemnitor’s net worth Restrictions on indemnitor Canal Corporation

45. Poorly-Funded IntermediaryRegulation §1.752-2(j) X Co. Sub Co. Y Owns little but interest in lower tier partnership. Partnership Recourse Debt

46. Poorly-Funded IntermediaryRegulation §1.752-2(j) X Co. X P Y Owns little but interest in lower tier partnership. Partnership Recourse Debt

47. Disregarded IntermediaryProp. Reg. §1.752-2(k) X X LLC Y Owns little but interest in lower tier partnership. Partnership Recourse Debt