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Today, I want to continue looking at the partnership capital account. But before I get into the details, let’s review a few basic points. First, from a tax perspective, partners share the economic benefits and burdens of ownership. That means if a partnership makes money, the partners do too. But if the partnership needs more money to continue as a going concern, the partners will have to contribute additional funds. In addition, the allocations of a partner’s capital account must have “substantial economic effect.” This is a term of art in the tax world. In order to have economic effect, the computations for the partner’s capital account must comply with three requirements. I covered the first last week. This week, we’ll look at the remaining two.
Under the accompanying Treasury Regulations, (2) Upon liquidation of the partnership (or any partner's interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (2) and requirement (3) of this paragraph (b)(2)(ii)(b)), by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), and (3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2) of this paragraph (b)(2)(ii)(b)). Before you get confused by the excess verbiage, remember that partners have to share the benefits and burdens of being partners. So, under number (2) above, we see that partners share the benefits of being partners; if a partnership is liquidated and there are excess funds available after paying off creditors, the partners get to share in the profits in direct proportion to the ownership in the partnership. In contrast, if there is a deficit in each or any partner’s account, they have to make an additional contribution to the partnership. Here’s a simple example to illustrate both points. Partners A and B each have $50 in their capital account after the partnership has wound up its business and paid off all creditors. They will each receive $50 of the remaining available funds. Let’s reverse the process and say that each partner has ($50) – a $50 deficit account after the partnership has paid off all its debts. That means the partnership was an economic failure and each partner gets to contribute an additional $50 to pay off the partnership’s creditors. As an FYI, the above examples are deliberately very simple to illustrate the underlying policy of these regulations. As I mentioned in last week’s post, partnership accounts are one of the most complex areas of tax law with many nuances that go far beyond these posts. However, the above illustrations should give you a good general overview of the basic concepts involved. Next I’ll look at some of the requirements for “substantial.” Remember that from a tax perspective, partners agree to share the economic benefits and burdens of ownership. This means that not only will they share profits, but they will also share losses and – in a worst case scenario -- perhaps contribute additional capital in support of the business. For tax purposes, we need to create and maintain some record of this activity.
Enter the partner’s capital account. This is the most important element of partnership taxation; it’s an ongoing record documenting the partner’s economic participation in the partnership. The actual workings of this account are one of the most complex in US taxation and therefore beyond the scope of a few blog posts. However, some initial observations can be made. Always remember that we we’re keeping a record that shows ongoing participation in the benefits and burdens of partnership ownership. Under the treasury regulations, partnership allocations must have “substantial economic effect” – a term of art in the partnership tax world. Economic effect, in turn, has three factors, the first of which is this … each partner's capital account is increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in paragraph (b)(2)(iv)(g) of this section, but excluding income and gain described in paragraph (b)(4)(i) of this section; and is decreased by (4) the amount of money distributed to him by the partnership, (5) the fair market value of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), (6) allocations to him of expenditures of the partnership described in section 705 (a)(2)(B), and (7) allocations of partnership loss and deduction (or item thereof), including loss and deduction described in paragraph (b)(2)(iv)(g) of this section, but excluding items described in (6) above and loss or deduction described in paragraphs (b)(4)(i) or (b)(4)(iii) of this section; and is otherwise adjusted in accordance with the additional rules set forth in this paragraph (b)(2)(iv). In effect, all we’re doing is increasing the partner’s account when he contributes money or property and when he receives some allocation from the partnership (NOT a distribution) and decreasing his account when the partnership distributes money or cash to the partner, or when the partnership allocates some loss or deduction. Let’s look at simple example. 1.) Partner X contributes $100 cash to a partnership on formation (he’s a 50/50 partner with partner y). This increases his capital account by $100. 2.) Partnership makes $50 in year 1. As Partner X is a 50% partner, the partnership allocates $25 to Partner X, increasing his partnership account to $125. 3.) In year 1, the partnership distributes $75 cash to Partner X. This decreases partner X’s capital account by $75 to a final total of $50. Again, always remember the prime purpose of the partnership capital account is to keep an ongoing record of the partner’s actual economic participation and you should be fine. Next week, we’ll look at two more factors the capital accounts must comply with. The Bancroft case has been working its way through various federal jurisdictions over the last few years. In theory, it involves a captive insurance scenario. In reality, it's tax evasion, plain and simple.
For me, the dead giveaway is the the "round trip" nature of the transaction. Consider this explanation of the program from the decision: Sigel and Barros formed Bancroft. They didn’t know much about insurance so they outsourced the underwriting function, actuarial responsibility, claims handling, accounting function, due diligence inquiries, and routine paperwork chores. They also outsourced much of the investment operation. One of Bancroft’s primary investment vehicles was to make commercial loans back to the various participants who gave their money to Bancroft in the first place. Not coincidentally, Bancroft would loan back 70% of the premium dollars that had been committed for “coverages.” Bancroft would outsource responsibility for securing the loans and perfecting the security to the borrower. Perhaps not surprisingly, the perfection of the security was, on occasion, “forgotten.” The insuring end of the business similarly went lacking. Scolari was asked how much he wanted to pay in premium dollars. In 2006 he responded: $2.6 million, and in 2007, $5 million. In return, Scolari received a tax deduction for the full premium, and insurance coverage that he and his company didn’t need. He also received a promise that, if his claims were low and the investments were successful, he would receive a refund of his premium dollars after five years. Anti-avoidance law is littered with cases involving this type of fact pattern: parent makes payment to a controlled company. The payment provides some tax benefit to the parent (usually an outsized deduction). The controlled company holds the money for a short period of time and then funnels the money either directly back to the parent or to another entity that somehow allows the parent to still control or gain benefit from the funds. This is one of the primary reasons the tax code has section 482, which is the US codes transfer pricing section (the law's section is short; the accompanying Treasury Regulations are extensive). At the heart of the IRS’ concern regarding captives is the captive is nothing more than an accounting reserve rather than an independent stand-alone insurance company. Defined broadly a reserve is a, “separation of retained earnings to provide for such payouts as dividends, contingencies, improvements, or retirement of preferred stock.”[1] Several early tax cases (tried to the Bureau of Tax Appeals, the predecessor of the Tax Court) specifically disallowed the deduction of payments into a reserve fund, based on the following reasons: 1.) The tax code allowed a deduction for business expenses, but not for amounts paid into an internally held reserve. This is supported by a strict reading of the statute (currently 26. U.S.C. 162(a) and the accompanying Treasury Regulations).[2] 2.) Moving funds internally – from cash to a reserve or from one corporate “pocket” to another – does not shift the risk as required by insurance. This is essentially an analysis based on a strict reading of this occurrence at the balance sheet level. 3.) Preventing the manipulation of gross income through the use of “reserves” and “contingency funds” as outlined in Spring Canyon Coal.[3] 4.) Both accrual and cash accounting methods require the taxpayer to deduct specific “realized” amounts. A taxpayer cannot deduct a speculative amount.[4] As the ultimate amount of the payout from the reserve is speculative, a deduction is not allowed. Realistically, the service is ultimately concerned with point number 3 above – using the establishment, maintenance and eventual dissolution of a reserve to manipulate earnings. As an example of the fact pattern, suppose Acme Corp. has strong yearly earnings this year. In order to lower their gross income (and hence taxable income) they establish a reserve for some type of reasonably foreseeable contingency. However, five years later when earnings are lower, the company declares the contingency no longer exists and hence dissolves the contingency fund, bringing the reserves back onto the company’s income statement at a time when the tax burden is lower. Regardless of the feasibility – or lack thereof – of the preceding hypothetical fact pattern, it does provide prospective captive owners with a clear compliance mandate: after establishing the captive, the longer the captive’s funds remain separate and non-distributed to the parent the better. Regrettably, there is no formal guidance providing a minimum amount of time during which the captive’s funds must remain entirely separate from the parent. However, we do have several examples from non-captive case law wherein a company’s corporate existence was too short to create sufficient corporate substance. The corporation established by the taxpayer in the landmark anti-avoidance case Gregory c. Helvering, existed for a mere three days.[5] Several anti-avoidance cases from the 1990s involved partnerships which were in existence for periods up to one fiscal year.[6] Beyond the period of a year, however, guidance becomes far murkier. However, common sense informs us that the longer a captive is in existence with its funds separate from the parent, the better. Ideally, the minimum time which the parent should commit to running the captive without payments from the captive going to the parent is three to five years. This length of time will allow the captive to fully develop initial capital and surplus relative to the original underlying risks being underwritten by the captive. [1] Barron’s Finance and Investment Handbook, page 446 © 1990 Barron’s Educational Series, Inc. [2] See also Appeal of William J. Ostheimer 1.B.T.A. 18, 21 (“The statute specifies what deductions are allowable and, except in the case of in insurance companies, no provision is made in the 1918 Act for the deduction of a reserve as such.”). [3] See also Appeal of Consolidated Asphalt, 1 B.T.A. 79, 81 (“When estimating the reserve to set aside for a construction contract, the appellant’s accountant doubled the amount set aside for the years in question.”). [4] See General Counsel Memorandum 35340, 05/15/1973 (“However, because anticipated casualty losses are contingent in nature, it is a firmly established principle of tax accounting that even as accrual basis taxpayer may not deduct amounts it adds to a reserve for insuring its own risks.”). [5] Gregory v. Helvering, 293 U.S. 465 (1935). [6] ACM Pshp. v. Commissioner, T.C. Memo 1997-115 (T.C. 1997), ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (DC Cir. 2000), Like the formation of a corporation, initial contributions to a partnership are a tax deferred event. Section 721(a) of the code states, “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.” The policy reason behind this is very simple and straightforward: by not taxing the formation of a new company, the code is encouraging people to form partnerships in the hopes this will increase economic activity.
This event is tax deferred because the basis of the contributed property carries over to the partnership. Section 723 states, “The basis of property contributed to a partnership by a partner shall be the adjusted basis of such property to the contributing partner at the time of the contribution.” The contributing partner receives the same basis in his partnership interest, as stated in section 722(a): “The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution.” By carrying over the basis, the code preserves the gain inherent in the property, and allows the recognition of that gain to only occur when the partnership sells the property. Central to the idea of a partnership is an agreement to share the benefits and burdens of business ownership. Treasury Regulation 1.704-1(b)(3)(i) states, “the partners interest in the partnership signifies … the manner in which the partners have agreed to share the economic benefit or burden … corresponding to the income, gain, loss, deduction or credit that is allocated.” But to share in the benefits and burdens, the partners need to know their respective ownership percentages. This is almost always spelled out in the partnership agreement. However, in the event there is no agreement, the following factors are considered (Treas. Reg. 1.704-1(b)(3)(ii)(a)-(d)). The partner’s contributions: if two people form a partnership, and each contributes $50, it’s a good bet that they each think they are 50/50 partners. The interest of the partners in economic profits and losses: not only are profits distributed from a business in the form of money, but numerous other accounting benefits also accrue. Continuing the 50/50 example above, suppose the two partners agree to distribute depreciation in a 90%/10% allocation. This would be an indication the partners intended to distribute this balance sheet item differently The interest of the partners in cash flow and other non-liquidating distributions: the manner and proportions in which the partnership distributes cash is solid prima facie evidence of the parties distributive intend. The rights of the partners to distributions of capital on liquidation: the final split of the partnership is a good final indicator. Again, remember these terms and conditions are almost always contained in the partnership agreement, making the above factors unnecessary. However, it’s good to have them as a back-up just in case. From the Financial Times:
IBM has launched a legal challenge in an estimated $800m tax dispute with India’s revenue department, becoming the latest major western multinational to find itself ensnared in a tax wrangle in Asia’s third-largest economy. The US-based technology group has issued an appeal against a recent tax demand to India’s dispute resolution panel, an arbitration body often used by international businesses, according to people familiar with the situation The company’s move follow a series of recent high profile tax rows relating to global companies, including British telecoms group Vodafone and Anglo-Dutch oil group Shell. . India has numerous problems right now, with their tax policy high on the list. This suit doesn't help matters. Thanks to Ike Devji for bringing this to my attention: the head of the IRS’s small business unit has stated the service will be changing direction to focus more on small partnerships rather than small businesses. In light of this development, I’m going to spend some time looking at the basics of partnership law taxation.
First, let’s look at some general points regarding partnerships. According to the Uniform Partnership Act, a partnership is “an association of two or more persons to carry on as co-owners a business for profit.” (section 101(6) of the UPA). A partnership can be formal or informal – that is, two or more people can draw up papers to formally state they are in a partnership, or their actions can create a partnership. Partnerships can lead to questions of agency law, wherein lawyers have to figure out if a person who is a “partner” has the “authority” to act for the partnership in a certain situation such as binding the partnership to a contract (this discussion is beyond the scope of the these blog posts). Perhaps most importantly, partners can be “jointly and severely liable” for all partnership debts in their individual capacity (section 306(a) of the UPA). There are also several different types of partnerships. A general partnership is one where all partners can be held jointly and severely liable for partnership debts and obligations (see Texas Revised Partnership Act, Section 6132b-3.04). In contrast is a limited liability partnership, which is divided between general partners and limited partners. General partners have the same personal exposures, but limited partners are not personally liable for the debts and obligations of the partnership (unless they are also general partners; see Texas Revised Limited Partnership Act, Section 3.03). Their situation is much like a stock holder; they are only liable for the capital they originally contribute to the partnership. There are also limited liability limited partnerships where the general partner is not personally liable for debts and obligations. Finally we have limited liability corporations, which are corporations taxed as partnerships. So – why would someone elect to form a partnership over a corporation? There are several reasons, the first of which relates to compliance issues. A corporation’s internal governmental structure is strictly outlined in statute. Shareholders meetings must be held according to certain rules and regulations. In contrast, partnership governance is governed by contract; the parties can write a partnership agreement which outlines their respective rights and duties, thereby providing far more flexibility. But the most important reason for forming a partnership is related to taxation. First, there is no entity level tax on the partnership. Section 701 of the tax code states: “A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” Secondly, partnership allocations can be disproportional to partnership interests so long as the allocations have “substantial economic effect.” For example, suppose we have two partners who each contribute 50% of the assets to a new partnership. Under general partnership tax principles, each partner would receive 50% of the “income, gain, loss deduction or credit” of the partnership (Section 704). However, it’s possible to alter this arrangement. For example, partner one could receive all the income while the second partnership would receive all the deductions. We’ll get into this in more detail a few posts down the line. |
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