An Overview of Selected Aspects of Federal Taxation of Partnerships and Its Application to Leasing
By Lloyd A. Haynes, Jr.
Vice President, GATX Capital Corporation
and
Ty C. Schultz
Associate Director, GATX Capital Corporation
As original published in the Fall 1999 (Volume 26 Number 6)
issue of the
Leasing and Financial Services Monitor
A partnership is an often-discussed
and widely used structure, which potentially offers various tax benefits to the
investors in tax-oriented leases. Since
the tax aspects of a partnership are the least understood and most complex
issue facing many who are considering the use this structure, the focus of this
article will be on giving an overview of the federal tax consequences of such a
structure and its application to a leveraged lease. There are many non-tax reasons why taxpayers may enter into
partnerships, including: accounting (for example, off-balance sheet treatment),
risk sharing (one possibility: allocating residual and other risks between
partners), greater diversification (perhaps pooling airplanes owned or to be
acquired by others with your own), pooling of purchasing power (a possible
benefit might be a discount for placing a larger single order), etc. Unfortunately, it will become apparent as we
look at partnership tax law that these non-tax motivations are generally
clearer and easier to understand than the evaluation of possible tax
motivations for entering into a partnership.
Indeed, the tax rules which must be followed by partnerships are often
so murky and complex that, even within the same law firm, different tax counsel
may arrive at different conclusions as to what is or isn’t allowable. Any reader planning on entering into a
partnership will need to confer with his tax attorneys to insure the tax
outcome he is seeking should, in fact, be accomplished. The reader should also understand that the
authors of this article do not intend to imply that a partnership structure is
always the best solution. Depending
upon the particular facts and circumstances surrounding a particular
transaction, some other structure may be more attractive and appropriate for
the economic, accounting, tax, or other objectives of the potential
participants. However, since partnerships
are so widely used, having a better understanding of them is useful. Too often a partnership is truly a “black
box” to individuals who as a result only have a vague perception that certain
tax benefits are being realized without understanding the mechanisms underlying
the anticipated benefits. Having a more
in-depth knowledge of the intricacies of partnership tax rules and their
application will allow one to better evaluate the potential risks and rewards
that can realistically be expected to result from the application of tax rules
governing partnerships.
Overview
Subchapter K of the Internal Revenue
Code (the “Code”) (§§ 701-761) and the Treasury regulations pertaining thereto
determine the taxation of partners and partnerships. A partnership itself is not a taxable entity; rather it passes
through to the partners their respective shares of items of income and loss,
which are then reported on their tax returns.
Subchapter K governs the ways in which this can be accomplished.
This article will not be an in depth
discussion of all the complexities of partnerships and their taxation, but
merely an overview of their potential benefits and the difficulties which
exist. Hopefully, after the reader has
completed the article, he will have gained more appreciation for why
partnerships are used and what is meant by “disproportionate allocation” within
partnerships. The allowance under the
tax Code of “special allocations” among partners is often viewed as allowing
unfettered reallocation of taxable income and losses among partners. As will be seen, this is not the case. If anything the one thing which will become
clear from reading this article is that the tax law applicable to partnerships
is often unclear.
What Constitutes a Partnership?
There are a number of forms of
partnerships provided for under state law, including general partnerships,
limited partnerships, limited liability companies (“LLCs”), and limited
liability partnerships (“LLPs”). Each
form of partnership has its own pluses and minuses. For our purposes, all that matters is that the business entity is
recognized for tax purposes as a partnership.
In this regard the tax law (§ 761(a) and §1.761-1(a)) is very
liberal. Under § 761(a) a partnership
is defined to include “a syndicate, group, pool, joint venture, or other unincorporated
organization through, or by means of which any business, financial operation,
or venture is carried on and which is not within the meaning of this Title, a
corporation or trust or estate.” This
broad definition means that two taxpayers that never intended to be partners,
but rather just co-owners of an asset, might be classified as such. Until recent years, taxpayers wishing to be
treated as being within a partnership needed to insure the partnership could
not be viewed as a corporation. Briefly,
the IRS looked to four characteristics attributable to a corporation: (1)
continuity of life, (2) centralized management, (3) limited liability, and (4)
free transferability of ownership interests.
If a partnership met three of these four characteristics it would be
reclassified by the IRS as a corporation.
More recently the regulations have been modified to provide for a “check
the box” approach to determining the way in which a business entity will be
viewed for tax purposes. As a general
rule, a business entity now will be treated for tax purposes by the IRS as its
chooses to be treated, thus making the outlined characteristics of a
corporation less relevant, if not meaningless, for tax purposes.
Forming a Partnership
The formation of a partnership
rarely results in a gain or loss for the partners. This is because taxpayers contributing property to a partnership
are viewed as merely changing the form of its ownership to a partnership
interest, not as having disposed of it.
Significant provisions of the Code
with respect to formation of a partnership are:
·
Section 721:
Nonrecognition. In general, this protects partners or the
partnership from having to recognize any gain or loss upon exchange of property
for a partnership interest.
·
Section 722: Outside
Basis. The basis of the partnership interest
received by a partner is that taxpayer’s basis in contributed property at the time of contribution, plus
any cash contributed, less cash or basis of property received, plus any gain
recognized. In general, the holding
period of contributed property in a partner’s hands carries over to the
partnership interest received in return (some items such as cash, inventory,
and services do not have holding periods).
·
Section 723:
Inside Basis. The partnership’s basis in contributed
property is equal to that of the contributing partner and the partnership can
add the contributing partner’s holding period to its own.
Several important nuances with respect to partnership
formation need to be addressed. They
are:
·
Precontribution
Gain or Loss. Under § 704(c)(1)(A) precontribution gain or
loss associated with property must be allocated to the contributing partner.
·
Contribution
of Depreciable Property. §§ 1245 and 1250 protect a contributing
partner against recapture of depreciation on contributed property. The partnership will be subject to recapture
of depreciation at a later date in an amount equal to the depreciation taken by
the contributing partner and any depreciation taken by the partnership. The partnership, in essence, steps into the
shoes of the contributing partner on property for depreciation purposes.
·
Section 752:
Liabilities. Each partner is given credit in his outside
basis for his share of the partnership liabilities. As a general rule, non-recourse indebtedness is allocated among
the partners in the same fashion as profits.
This is based on the theory that repayment of the non-recourse
indebtedness will come from partnership profits. Contributions of encumbered assets result in a deemed cash distribution
to the extent the contributing partner is relieved of a portion of his
obligation. Depending upon
circumstances (see below) this deemed distribution might be considered taxable
income to the contributing partner.
·
Partnership
Tax Years. The partnership must choose a tax year. Under § 706, in most cases, the partnership
will have a tax year ending on the same date a majority (partners representing
over 50% of profits and capital) of partners’ tax years end. Alternate rules exist which may be applied
in certain circumstances.
Partnership Outside Basis Adjustments
Under § 705
a partner is required to increase or decrease his outside basis in the
partnership based upon allocations of income or loss allocated to him by the
partnership. The allocated income or
loss will be incorporated into each partner’s own individual tax return. Thus, if a partner is allocated income of
$100, his outside basis in the partnership increases by $100 (i.e., his basis
in his interest in the partnership).
This is to avoid double taxation if he later sells his partnership
interest. Presumably, if the income is
not distributed to him his partnership interest now has a value $100
higher. Likewise, if he is allocated a
loss of $100 his outside basis in the partnership is reduced by $100. This will avoid him being able to recognize
a loss twice. To the extent
distributions are made to a partner, his basis in his partnership interest is
reduced by the amount of the distribution.
Distributions are considered a return of capital and non-taxable until a
partner has reduced his basis to zero.
Beyond that point any distributions will be considered a taxable gain
and will not result in reducing the basis of the partner’s interest in the
partnership below zero. One might note
that tax-exempt income allocated to a partner increases his basis in his
partnership interest by the amount allocated.
This is to avoid later subjecting what was tax exempt income to income
tax.
Partnership Capital Accounts (Inside Basis)
The rules
for maintaining capital accounts (i.e., the partnership’s internal measurement
of partner’s capital balances, as opposed to a partner’s external or outside
basis in his partnership interest) are dealt with next. The IRS addresses these rules under §
1.704-1(b)(2)(iv).
We start by
noting a fundamental concept of accounting, that for a business:
Assets
= Liabilities + Equity
The equity component of this equation is represented by the
partners’ capital accounts. The capital
accounts reflect property contributions by partners net of any associated
liability, distributions, and any income or loss incurred.
There are
two capital account balances, which need to be reflected by the
partnership. One is a book balance and
one is a tax balance. It should be emphasized
that when we speak of book balances here we do not mean GAAP books, but rather
book accounting as dictated by Treasury regulations. The book balance may or may not equal the tax balance due to
situations under which the partnership revalues assets so that they are no
longer valued based upon historic cost (which will generally be carried forward
for tax purposes regardless of any revaluation). This will be discussed further as we go along.
Items,
which result in adjustments to partnership book capital balances, are:
·
Contributions. To the extent a
partner contributes cash or property that partner’s book capital account
balance will be increased. This
increase will reflect the fair market value (“FMV”) of the property (less any
associated liabilities), not its historic cost.
·
Operating
Income (Loss). Each partner’s book capital account will be
increased by each year’s book income and decreased by each year’s book
losses. Depreciation is integral to the
calculation of the income or loss for the year. For book purposes Treasury regulations require that depreciation
be taken in a way consistent with tax depreciation.
·
Distributions. Distributions are
the mirror image of contributions.
Therefore, any property distributed is measured at FMV less any
associated liabilities. Although no
gain or loss is recognized for tax purposes, FMV must be used for book
purposes.
The implications of the above may be illustrated by using an
example related to equipment leasing.
Assume there are two partners, “A” and “B”. Assume that Partner A contributes equipment with an FMV of
$1,000,000 and a tax basis of $200,000 (i.e., it has been partially
depreciated). Under § 723 the partnership
inherits a tax basis of $200,000.
Partner A recognizes no gain or loss upon the contribution. However, his outside basis in the
partnership is now $200,000 under § 722.
Assume Partner B contributes $500,000 to the partnership. The balance sheet of the partnership now
looks as follows:
Assets Liabilities & Capital
Tax Book Tax Book
Cash 500,000 500,000
Equipment 200,000 1,000,000
Liabilities 0 0
Capital Accounts
A 200,000 1,000,000
B 500,000 500,000
_______ ________ _______ ________
700,000 1,500,000 700,000 1,500,000
Observe that, in a situation where no liabilities exist,
each partner’s book balance reflects his inside basis and his tax basis
reflects his outside basis. Note that
under § 704(c) upon any disposition of the equipment by the partnership, the
first $800,000 of any tax gain will have to be allocated to Partner A for tax
purposes in order to reconcile the disparity in the partnership capital account
balances. Otherwise, income originally
attributable to Partner A would have to be shared by Partner B. Thus, if the partnership were to immediately
dispose of the equipment contributed by Partner A for $1,000,000, Partner A
would be allocated $800,000 of gain for his tax capital account. This would increase it to the $1,000,000
which would be reflective of the FMV of the equipment used for book
purposes. Partner B would be allocated
no tax gain associated with the sale.
The
revaluation of equipment in our example is due to the marking up of the
equipment contribution by Partner A to FMV.
Other circumstances can arise which would cause the partnership to
revalue assets, but are beyond the scope of this article.
Partnership Allocations
The next
area to deal with is the allocation of taxable income and loss among the
partners. Under § 704(a) the general
rule of thumb is that all income, gains, losses, deductions, or credits are allocated
to partners based upon the partnership agreement. However, the partnership agreement is not permitted to make
allocations totally unfettered by Subchapter K. In general, under § 704(a) “special allocations” (i.e., those
which diverge from the partner’s proportionate interests reflected in their
respective capital accounts) will be respected. However, in order to be respected, under § 704(b) the partners
have to show that the reallocations of income and loss among themselves has
“substantial economic effect” (“SEE”).
In other words, the partners may choose to allocate taxable income and
loss among themselves in a way which is economically advantageous to themselves
given their differing tax positions, however the partners need to be able to
show that the reallocations they made have SEE independent of any tax savings
that may be realized.
The
evolution of the concept of SEE was based on Congress’s stated intention that
while special allocations should not be made for tax avoidance or evasion, they
would be respected if they have SEE and are not merely a way of reducing
certain partners’ income tax liabilities without affecting their shares of
partnership income. Although
technically SEE is not required to prove (nor does it insure a finding of) no
intent to avoid paying taxes, it provided the courts with a practical benchmark
against which to judge the issue of whether or not tax avoidance was the
motivating factor in special allocations within a partnership.
How can SEE
be judged? A major factor to be
evaluated is:
·
Capital
Accounts. In order for an special allocation to have
SEE it must have a meaningful impact on the partners’ capital accounts. More specifically, if the partnership were
to be liquidated one must show that the special allocations would actually
affect the cash distributions made to the partners. If the partnership agreement contains provisions that require
adjustments to the partners’ capital accounts under certain circumstances that
effectively negate an original special allocation, then it will not be
respected. Thus if, for example, all
depreciation were allocated to partner A and none to partner B, but otherwise
there was no effect on any other economic aspects of the partnership, there
would be no SEE. This will be elaborated
on more as we go along.
Although other parts of Subchapter K govern allocations,
such as § 704(c), § 706 (c), and § 743(b), § 704(b) is by far the most
important. Under § 1.704 the IRS has
divided its position on allocations into four major parts. They are:
1. Definition of SEE and Establishment of the Safe Harbor. As a general rule,
if an allocation has SEE it will be respected, if not the item will be
reallocated in accordance with each partner’s “interest in the
partnership.” There are two tests that
must be met to prove SEE. If they are
met, the partnership allocations fall within the safe harbor provided by the
regulations. They are:
·
Meaningful
Capital Accounts to Prove Economic Effect. This first test is
relatively mechanical and easy to meet.
To prove economic effect the partnership must maintain meaningful
capital accounts utilizing a strict set of rules. There are three alternate tests to prove an allocation has
economic effect. They are:
i.
Basic Test for
Economic Effect. If the partnership agreement meets three
requirements an allocation will have economic effect: These are:
1)
Capital
Account Requirement. The partnership must maintain its capital
accounts in accordance with § 1.704-1(b)(2)(iv). In other words, as outlined above.
2)
Liquidation
Requirement. Liquidating distributions must be made in
line with the positive balances in the partners’ capital accounts.
3)
Deficit Makeup
Requirement. A partner must unconditionally be obligated
to make up any deficit in his capital account that exists after the partnership
has been liquidated. This can be
accomplished either by a clause in the partnership agreement or the operation
of state or local law.
¨ This means that a partner can be allocated losses and
deductions without limit since they will be considered to have economic
effect. This makes sense because the
partner allocated these losses will have to make up any deficit caused by them
at some point.
ii.
Alternate Test
for Economic Effect. In recognition of the fact that the reason
for existence of limited partnerships is to limit the losses limited partners
are exposed to, the IRS created this test.
Under it an allocation has economic effect if:
1)
The partnership
agreement meets the first two requirements under the Basic Test.
2)
Qualified Income
Offset (“QIO”) Provision Requirement. The partnership agreement can provide for an
obligation on the part of a partner to make up deficits in his capital account
up to a limited amount. No allocation
of losses or deductions can be made if it would create a deficit in a partner’s
capital account balance in excess of his QIO obligation.
¨ An unforeseen event, such as an unanticipated distribution,
could create an excessive capital account deficit problem. The IRS deals with this by requiring that
any unexpected capital account deficits in excess of the QIO be eliminated as
soon as possible through income allocations.
iii.
Economic
Effect Equivalence Test. This test is meant for a general partnership
that technically does not meet the Basic Test.
Under § 1.704-1(b)(2)(ii)(i) one can still fall within the safe harbor
rules for economic effect if a partnership allocation is deemed to have
economic effect. If as a practical
matter the partnership’s allocations create the same economic effect to the
partners as would have occurred if it had met all the requirements of the basic
test, they will be deemed to have economic effect. This test is the least important of the three since meeting it
would seem to remove the need for SEE.
The allocations required would appear to track the partners’ interests
almost definitionally.
·
Substantiality. The second is to
show that the economic effect of an allocation is “substantial.” In other words, a partnership must be able
to demonstrate that special allocations have an effect other than tax savings
to prove they have a substantial effect.
In all instances, the value-equals-basis rule (i.e., a partnerships’
assets are irrefutably presumed to have a value equal to their basis, or book value
if different from basis) applies. By
its nature, the issue of substantiality is less clear-cut than economic
effect. Considering substantiality
entails:
i.
General Rule. Under §
1.704-1(b)(2)(iii)(a) the partnership must be able to demonstrate that (a)
special allocation(s) are reasonably likely to substantially affect the dollar
amounts received by the partners independent of the tax consequences. If this cannot be shown, the allocations
will not be substantial and will have to be reallocated taking into account the
partners’ individual interests in the partnership. The regulations give two examples of common situations that would
not be considered substantial.
1)
Shifting Tax
Consequences. The economic effect of a partnership’s
special allocation within a tax year is not substantial if at the time the
partnership agreement is put in place it is likely that:
¨ The net impact on the partners’ capital accounts for the tax
year on a pre-tax basis will not cause them to differ significantly from what
they would have been without the special allocations.
¨ Given the individual circumstances of the partners, their
total tax liability for that tax year is reduced from what it would have been
without the special allocation.
2)
Transitory
Allocations. These are analogous to Shifting Tax
Consequences except that this scenario covers multiple tax years. The transitory rule only applies if, at the
time the original and offsetting allocations are incorporated into the
partnership agreement, it is probable the original allocation will be largely
offset within five years. In this
instance, if, at the time the partnership agreement and its associated
allocations are put in place, it is probable that:
¨ The net impact on the partners’ capital accounts on a
pre-tax basis over the tax years in question will not cause them to differ
significantly from what they would have been without the special allocations.
¨ Given the individual circumstances of the partners, their
total tax liability for the tax years in question is reduced from what it would
have been without the special allocation.
ii.
After-tax
Exception. § 1.704-1(b)(2)(iii)(a) provides for an
after-tax exception to the general rule.
In applying this rule the five-year rule does not apply. This rule states that the economic effect of
a special allocation is not substantial if, at the time it is provided for in
the partnership agreement it is likely to enhance the economics of at least one
partner while leaving no other partner worse off on an after-tax basis
2. Definition of “Partners’ Interests in the Partnership.” This part provides
the default rules by which allocations will be made when the safe harbor is not
met.
3. Special Rules When SEE is Not Applicable. The major area of
interest here relates to non-recourse debt.
Since the partners are not liable for repayment of non-recourse debt,
its required allocation among the partners is viewed as unclear. Allocations of non-recourse debt will be
deemed to have met the SEE safe harbor if special rules are followed. If not, it will be reallocated according to
the partners' interests in the partnership as determined under
1.704-1(b)(3). The safe harbor
requirements are:
·
Partnership
Agreement must Meet the Basic or Alternate Test for Economic Effect.
·
Consistent
Allocations of Nonrecourse Deductions. The nonrecourse
deductions must be allocated under the partnership agreement in a manner
consistent with the allocation of some other significant item related to the
property securing the debt.
·
Minimum Gain
Chargeback Provision Required. I
i.
Partnership
Minimum Gain (“PMG”). This is the minimum gain the partnership
would realize if the asset securing nonrecourse indebtedness were disposed
of. In general, this will be equal to
the excess of the nonrecourse indebtedness of the partnership over and above
its tax basis in the asset securing the indebtedness (however, this may not be
the case in circumstances previously discussed where the book value of the
partnership differs from tax basis because of adjustments made to reflect the
FMV of the property). Another
complicating factor which can lead to PMG is secondary nonrecourse
financing. If such secondary
nonrecourse financing is used to make a distribution to the partners, to the
extent it caused an increase in PMG it is considered a nonrecourse
distribution.
ii.
Nonrecourse
Deductions (“NRDs”). NRDs are nonrecourse deductions associated
with nonrecourse indebtedness for which no partner bears the economic
burden. NRDs are equal to the increase
in PMG during a tax year less nonrecourse distributions. In general, NRDs are related to the cost
recovery (i.e., tax depreciation) deductions taken on the property securing the
nonrecourse indebtedness.
iii.
Partner’s
Share of PMG. PMG is allocated among partners in
accordance with the allocation of NRDs and nonrecourse distributions to
him. As a result, a partner’s share of
the partnerships PMG will be equal to the sum of NRDs allocated to him plus
nonrecourse distribution less the partner’s share of decreases in PMG.
iv.
Minimum Gain
Chargeback (“MGC”) Provision). This requires, in general, that if there is
a net decrease in PMG in a tax year then each partner must be allocated an
amount of income equal to his share of the decrease in PMG. There are four exceptions to this rule:
1)
Conversions
and Refinancing. To the extent a partner becomes liable for
nonrecourse indebtedness no MGC is required.
The partner is now bears the economic burden for NRDs previously taken.
2)
Contributions
of Capital. Similar logic to 1) applies in a situation
where a partner contributes capital which is used to repay nonrecourse
indebtedness.
3)
Revaluations. Special provisions
are made for situations where assets are revalued. This is beyond the scope of this article.
4)
Waiver. If the partnership
feels that the MGC could distort the economics of the partnership, it may request
a waiver.
·
Required
Respect for Material Allocations and Capital Account Adjustments Under §
1.704-1(b).
4. Examples Illustrating Application of the Rules. This simply
consists of expository examples provided by the IRS to further clarify the
application of the rules governing SEE.
Note
that SEE merely provides a safe harbor; an allocation’s failure to meet the
requirements of SEE does not mean it will not be respected for tax
purposes. Should a reallocation occur,
as a general rule it will be in accordance with the partners’ interests in the
partnership. Either the IRS or the
taxpayer can rebut this approach based upon facts and circumstances.
Further Discussion Related to
Contributions of Property and § 704(c)
When a partner contributes
depreciable property, allocation of built in gain or loss is somewhat
complex. If a depreciable asset is held
over time the allocation of income and depreciation deductions associated with
the asset can result in shifting of income between partners depending on the disparity
between FMV and tax basis. § 704(c)
deals with this by providing three methods of
adjusting for depreciation disparity between book and tax among the
partners: the traditional method, the traditional method with curative
allocations, and the remedial allocation method. It is important for the reader to be aware this issue exists and
to incorporate it into any partnership analysis which may involve contributions
of property by partners which involves a deviation of tax basis from book
FMV. However, for purposes of this
article we will just highlight it as an issue and leave it to the reader to
further investigate it if warranted. Be
aware as well, however, that while the partnership is allowed to elect the
method to be used, each option can have significant economic implications for
the partners depending on the tax situation of each. As a result, depending on the tax parameters of the partners, the
IRS can challenge the selection under the general anti-abuse rule of §
1.704-(3)(a)(10). This basically says
that if the partners choose an allocation method that substantially reduces the
PV of the partner’s aggregate tax liability then it may be disallowed.
Disguised Sales and Exchanges (§
707(a)(2)(B)
A contribution by one partner of an
asset followed by a distribution could be viewed as a sale. Thus if Partner A
contributes $1,000,000 in property and Partner B contributes $500,000 in cash
which is distributed to Partner A, it could be viewed as if Partner A made a
$500,000 asset sale to Partner B.
Treasury sought under § 707(a)(2)(B) to deal with situations where two
transfers are considered to be sufficiently related to be considered a sale.
The general rule is that a property contribution and a related distribution
will be considered a sale only if:
1. The transfer of money or property to the partner
contributing property only occurred because of the property he transferred to
the partnership; and
2. If the transfer is not simultaneous, it is unrelated to the
entrepreneurial risks of the partnership’s operations.
If
the transfers are simultaneous they very likely to be regarded as sales. There are two important presumptions
incorporated into the regulations:
1. Transfers made within two years of each other are presumed
to constitute a sale.
2. Transfers made more than two years apart are presumed not to
constitute a sale.
Provisions
are made such that facts and circumstances may be able to rebut sale treatment
regardless of these presumptions. If a
transaction is appropriately structured it may be possible for a partner to
monetize contributed assets without generating a tax liability through
distributions of cash contributed by other partners or the use of debt. One should confer with his tax counsel if he
has such an objective.
Anti-Abuse Rules
When all else fails the IRS can turn
to the anti-abuse rules incorporated into the regulations. In January 1995 the Treasury issued a regulation under § 701 which stated
that (§ 1.701-2(b)):
…if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner which is inconsistent with Subchapter K, the Commissioner can recast the transaction for federal tax purposes….
The
reader should review the application of the anti-abuse principles in the
regulations when considering any partnership structure.
An Example to Help Clarify Points
in the Article
Finally, let’s try to better
understand what we have covered by using an example. In this example we will assume that rail equipment is to be
acquired which will be subject to a twenty year leveraged lease. Table I shows the assumptions for
determining a market based pricing of lease rents. Table II summarizes the assumptions applicable to a similar lease
done with the same PV of the rents for a partnership where 50% of the capital
is allocated to a regular taxpayer (the “Regular Taxpayer” partner) and the
other 50% to a taxpayer that is assumed to be an NOL (net operating loss) (the
“NOL Taxpayer” partner) taxpayer whose marginal tax rate is assumed to be
0%. No judgment is meant to be implied
as to whether or not the partnership is viewed as offering the optimal way for
the NOL Taxpayer to make use of its NOL carryforward. In a further simplifying assumption, we will assume that the NOL
Taxpayer’s NOL carryforward is about to expire over the next few years, so it
needs to find ways of generating income to allow it to make use of its NOL
carryforwards. Even though pretax and
after-tax yield might be viewed as the same for the NOL Taxpayer, it will be
assumed that the NOL taxpayer has studied the partnership opportunity
represented here and decided it is economically attractive. Despite the fact the focus of this article
is on the application of federal tax law to a partnership, it is worthwhile to
focus for a moment on the economic implications of the partnership structure
for the partners. This, after all, is
generally (along with the accounting, risk sharing, etc. reasons outlined
above) a major motivating factor in choosing to enter into a partnership. Although the after-tax MISF yield†
to the NOL partner is only 5.9%, compared to the higher 7% rate assumed on the
debt in the leveraged lease (again, bearing in mind that, if the NOL were to
invest in the debt instead, we are assuming it would view its pretax and
after-tax returns as both being 7%), it is assumed the potential residual
upside and the yield enhancement it will provide justify the investment in its
analysis. Likewise, the 5% MISF yield
received by the Regular Taxpayer is simply the market yield to a regular
taxpayer he would have received anyway.
However, the Regular Taxpayer will generate a dramatically larger
sinking fund balance than would normally be the case on which he can earn an
incremental return (due to his being allocated 100% of the depreciation
write-offs on his 50% partnership position).
What can be concluded here as to the economic benefit of the partnership
to the partners? For the NOL Taxpayer
an individual as opposed to joint (through a partnership) investment in a
leveraged lease would be unattractive because the tax shelter generated in the
early years of such a lease is of no use to him. A market priced lease would generate an after-tax MISF yield
significantly lower than the 5% assumed to be received by a typical lessor in
the market. Here the NOL Taxpayer
receives a yield significantly above that.
In addition, while a traditional investment such as a loan might
generate income to offset his expiring NOL carryforward with a somewhat higher
guaranteed yield, depending on the arrangement the partners strike on the
residual he can potentially receive a residual upside play in an equipment
lease partnership arrangement that results in a much higher yield overall than
he could have obtained otherwise - perhaps hundreds of basis points
higher. In the meantime, by
front-loading his allocation of partnership income he is still being allowed to
make use of his expiring NOLs. Finally,
while the Regular Taxpayer’s purported after-tax MISF yield is merely the 5%
rate he would normally receive, everyone will recognize the value of the cash
temporarily thrown off by his allocation of 100% of the depreciation write-offs
and deferred allocation of income from rent income less interest expense. This will push his yield significantly above
what it would have been, the magnitude depending upon how aggressive he wants
to be in his assumed return on sinking fund balances. Indeed, depending upon the value imputed to the sinking fund
balances there might be room for the partners to agree to adjustments to the
partnership arrangement to share this benefit with the NOL Partner and further
enhance his yield.
Let’s try to examine the example in
the context of the partnership taxation discussion above. Table III shows the allocation of items to
the partnership individual capital accounts based upon the assumptions
contained in Table II. Note that all
depreciation write-offs have been allocated to the Regular Taxpayer on the
value-equals-basis presumption and the fact that 100% of the anticipated
residual income and cash flow has been allocated to this partner. The IRS has indicated that allocations of
NRDs are acceptable as long as the allocation is reasonably consistent with
another significant item related to the property that has SEE. In a similar vein, the example assumes that
non-recourse debt interest deductions are allocated in the same proportion as
an income item with SEE, in this case rent.
Thus in the early years we allocate 100% of the rental income and
non-recourse debt interest expense to the NOL Taxpayer and in later years to
the Regular Taxpayer. During the
transition year, year 2, the allocation of rent income and non-recourse expense
is split between the two taxpayers such that it will eventually lead to each
partner being allocated 50% of the partnerships income. Likewise, looking at Table V, we see that
although 100% of partnership cash distributions are made first to the NOL
Taxpayer and then to the Regular Taxpayer such that each ends up with 50% of
the cash distributions. The projected
tax payments by the partners are shown in Table VI. Table VII shows the partners’ projected after-tax cash flows and
associated economic return (MISF) yield analysis.
A few additional interesting points
should be made. In order to avoid
problems with PMG and minimum gain chargeback (MGC), we allocated all taxable
income associated with rent income and interest expense to the NOL Taxpayer in
the early years. In later years this
allows us to allocate 100% of this income to the Regular Taxpayer so that his
allocation of partnership income is always in excess of the required MGC. In addition, although we balance out
allocations and distributions between the partners over the life of the lease
so that each is allocated 50% of all taxable income of the partnership and each
receives 50% of the distributions from the partnership, one need not worry
about transitory allocations since the term over which this occurs is twenty
years (i.e., over five years). The
biggest concern to be faced would be the After-tax Exception. Is one partner better off on an after-tax PV
basis without the other partner being worse off? For purposes of this article we will assume this not to be the
case for tax purposes. There are
certainly interesting issues around determining this for which the answers are
unclear. What is the appropriate
discount rate? As is well recognized,
when you look at a real leveraged lease with its many after-tax cash flows
(positive and negative - and remember on a daily basis there can be negative
cash flows for paying taxes as well as net rent positive cash flows) there is a
possible IRR root for every change in sign between cash flows. Thus variations in the discount rate, even
relatively small ones, can potentially lead to different conclusions as to
whether NPV is positive or negative for a taxpayer. Another issue is what is the benchmark against which a partner
being better or worse off is measured?
Not all tax attorneys would necessarily agree upon this for any
particular case.
Hopefully as the reader studies
these tables in the context of the prior discussion they will help clarify in
his mind the interpretation of the material.
Conclusion
While an article of this kind by its
very nature cannot completely cover all the aspects of federal taxation of
partnerships, it is to be hoped the reader has gained some insight into
important factors that need to be considered.
When you combine the complexities of partnership taxation with things
such as cross-border issues, net operating losses, the alternative minimum tax
(“AMT”), and/or § 467 rules on structuring lease rental streams, the true
challenge of creating an optimal structure becomes apparent.
Footnotes:
†
“MISF” stand for Multiple Investment with Sinking Fund. Traditionally lessors have computed their
return on investments in leases using what is known as the MISF yield. This is analogous to an IRR except that when
investment is negative (due tax benefits temporarily generating after-tax
excess cash flow sufficient to pay investment down below zero) an assigned
sinking fund rate is use, often 0%.
