Class Notes Partnership Tax On Entity Classification PDF

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By consensus, Partnership Tax is rated the #1 most difficult law school course available at the University of Michigan Law School. Use this outline to help yourself get ahead. It has all the notes from lecture and readings. Use to study for final. ...

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CLASS NOTES Partnership Tax Int Introdu rodu roducti cti ction on 1. En Entity tity Cl Classifi assifi assification cation and O Overvie vervie verview w of Pa Partne rtne rtnership rship TTaxatio axatio axation n A. Introduction to Subchapter K 1) Contact Information a) [email protected] b) 958 LR Building – responds to emails and here on Monday and Tuesday morning 2) Black Letter Outline Partnership Tax – Get the new edition 3) Logic of Subchapter K (§ 701-770) – serves as a good alternative textbook 4) Use problem sets that are in the book to learn the material 5) Spiral Form of Curriculum – Learn initial concepts and build on them in increasingly complicated contexts 6) Partnership is the oldest form of business associations a) Example: Scrooge & Marley i) Started with an agreement between them but no formal registration ii) Goal: to make a profit but how were those split up iii) Was Scrooge required to keep some profits in the business iv) Business Model: pool services & expenses and then pool profits (1) Alternative: could just operate separately and share the space (2) Choice of Business Model matters a lot for Partnership Tax (3) If sharing profits = partnership in tax code (a) Doesn’t tax the partnership specifically, but rather the individuals as partners (4) Shared expenses ≠ partnership b) How entity is formed (LP, LLP, LLC, etc.) doesn’t matter or create a taxable entity i) Treats partners as the level that’s taxed = no double taxation 7) KEY: Relevant code provisions have to shift back and forth between partnership as ENTITY and partnership as AGGREGATION a) Theme of Class: What theory is the specific tax provision using? b) Creates inconsistencies in the tax code for partnership because it’s hard to characterize all the complex business associations c) Language instead is very general 8) Example: Scrooge and Marley each put $1k into business and split profits 50-50 a) Buy $600 computer – tax code allows for Double Declining or Straight line i) What if Scrooge prefers straight line ($200/year) and Marley prefers ($300 1st year)? ii) Can you split the depreciation? This would make it very confusing iii) In the Tax Code, the partnership as an ENTITY has to decide b) LTCG of $1k and STCL of $700? i) Entity Theory: Net Long Term Capital Gain of $300 ii) Aggregate Theory: Individuals have their OWN capital gains and losses, so we just allocate half of the LTCG and the STCL (1) Here the Aggregate Theory wins and netting happens only for the individual partners = pass through 9) Reality: Partners have to pay the tax on their net profits regardless of whether the net profits are actually paid out a) KEY: Distribution of property ≠ Allocation of income 1

CLASS NOTES Partnership Tax b) This is Aggregate Theory of Partnership Taxation

B. Introduction to Choice of Business Entity 1) You can take multiple forms of a partnership: a) General Partnership under Uniform Partnership Act b) State law gives general partners right of contribution against other partners for their share of liability c) LP = Separate Entity with one active partner who is liable for obligations for the partnership generally and limited partners who are liable only to the extent of their investments d) LLC – Since the 1980s it has become popular and is a hybrid i) No requirement of generally liable partner/owner ii) Acts a separate entity iii) Can choose how it allocates its income (different than corporation where 1 stock = 1 share) iv) Treated as a partnership for tax purposes = owners are taxed for proportional profits regardless of distribution e) LLP – Law firms in NY can’t do business as LLCs or corporations, so they form as LLP’s and are taxed the same way as LLCs 2) Don’t need legally recognized entity to be taxed as partnership = Example: JV a) So long as there’s intent to share profits and engage in business, then it’s a partnership unless you check the box out of it b) Tax Law characterization ≠ State law entity characterization

C. Preview of Issues for the Term 3) What happens when you form a partnership? a) Corporate Tax treats exchange of property for interest in company as nonrecognition event b) Normal Tax – exchange of property is recognized as taxable income due to § 1001 c) Partnership Tax: Virtually ANY exchange of property in exchange for interest in partnership is a nonrecognition event i) Subject to a minor exception that we don’t need to worry about (1) §721(b) Transfer to an investment company ii) Confluence of aggregate and entity theories of partnership taxation (1) Entity – Who are you exchanging with if not the entity? (2) Aggregate – Because partnership is aggregate of owners, then the transfer isn’t taxed on gain or loss for transferring the property iii) Reality: Sales using a partnership to be a nonrecognition exchange aren’t allowed and are taxed like regular exchanges 4) Example: Person A contributes land to partnership worth $4k and A paid $1k for it; Person B puts in cash of $4k a) 50-50 deal and could be organized in any way under state law b) If A sells the partnership interest, then A must recognize the gain at that point and not when investing in the company i) So, when selling the partnership interest, her basis in the partnership interest is $1k c) If the partnership sells the land, then it has a $3k gain d) Problem: Doesn’t that mean we’re doing double taxation on the gain of the land? 2

CLASS NOTES Partnership Tax i) Partnership tax laws sorts it out to keep the taxation as a single taxation 5) Example: Personally borrow $1k and buy a watch = no increase in personal wealth a) Basis = $1k still, so immediate sale for same amount means there’s no gain b) For partnership, if A&B each contribute $1k into a partnership that is borrowed i) Each partner has $1k basis in the partnership interest c) For partnership, if A&B each make partnership for $0 & partnership itself borrows $2k i) The partners are each liable for $1k, but neither has put anything into the partnership itself ii) Aggregate Theory: This shouldn’t be any different than if the borrowing was done personally, so basis of $1k for each partner iii) This is much harder if this is an LLC or a LP where certain partners or all partners can’t be sued by the bank = nonrecourse debt (1) Still have to use the Aggregate Theory to allocate basis 6) Recourse Debt (for this class): Partner himself has some personal liability exposure to creditor a) LLC might by $2k on “recourse basis” (e.g. secured loan), but owners themselves aren’t liable because bank is limited to the assets i) Nonrecourse for partnership tax because no partner is personally liable b) Risk Liability could be economic or legal liability c) The same debt can be full recourse for a general partner and nonrecourse for a limited partner 7) Allocation of P/L and Distribution of income affects the partnership tax a) Example: Law firms have distribution and share of profits changes year by year depending on client intake b) Real Estate Development Partnership – can be split among several different ways per asset in the same partnership (Partner A gets 25% of Building 1 profits and 75% of Building 2) c) Losses can be allocated in a different way than profits i) Even depreciation deductions can be allocated to a single partner d) KEY: “Substantial Economic Effect” of the allocation needs to track one another i) If economics track the allocation, then partnership can agree to whatever 8) Transactions between partners and partnerships are an issue a) Partners can interact with partnerships in ways outside of being a partner i) Example: Partner can be an employee or lessor of partnership b) Key for tax code: Defining what kind of relationship this is? 9) What happens when a partner is given an interest in the partnership as compensation? a) What if the contribution to the partnership is agreeing to be the manager for X years? b) Contribution of Services is in its own section in Chapter 7 for the 10th Edition c) This is a hot topic in partnership tax law = Carried Interest debate i) Hedge Fund – What if partner gets 20% of profits in exchange for managing the hedge fund? ii) Because the partner got the profits in exchange for managing the hedge fund as LTCG or ordinary income? (1) LTCG is the way the hedge fund makes money but ordinary income would make sense because it’s compensation for services (2) Tax Code uses LTCG now 3

CLASS NOTES Partnership Tax 10) Distribution from the partnership = What happens when the partnership conveys assets of the partnership out to the partners? a) Aggregate Theory: No really treated as a taxable event

D. Tax Classification of Business Enterprises 1) “Business Entity” for tax purposes is a broad definition – just any amount of people joining together to share profits a) Problem: How do you define the business entity for tax purposes b) “Check the Box” Rules – Regs. § 301.7701-1 – 3 = basically electivity regime i) Relatively recent (almost 20 years old) ii) Was very complicated before (facts & circumstances) with common set of issues (1) Wanted limited liability of corporation but pass through of partnership (2) Result: General partner would be a corporation that would be capitalized as thinly as possible and create an LLP (3) Regulations and courts synthesized analysis to the four factor test of substance (a) #1 Limited vs. Unlimited Liability (does anyone have unlimited liability?) (i) If Unlimited = partnership (b) #2 Perpetual vs. Limited Life (Partnership state law had specific life contract) (c) #3 Transferability of Interests (Partners don’t transfer shares) (i) Hard to admit a new partner into the partnership (d) #4 Centralized Management: (i) Partnership historically doesn’t separate owner & management (4) If you had at least 2 characteristics, then you were a partnership for tax purpose (a) This is how tax lawyers and accountants gamed the system (b) If corporation, then distributions to holders were taxed as dividends (5) Problem: Certain types of business entities for services (law firms, groups of doctors, etc.) were required to not be corporations by state law but also didn’t want to be partnerships (a) Reason: Wanted certain kinds of benefits available for corporations (b) Would register as partnership under state law and organize themselves as corporation for tax law (i) IRS would then do a 180 and argue that they were a partnership (6) Problem: Too much wasted money on litigation and too unpredictable, so Treasury Department went with Check the Box Regulations c) Check the Box Rules: i) Step #1: Is there a business entity? ii) Step #2: Is it organized under a state corporation law & called “corp.”? (1) If yes, then it’s a corporation for tax purposes (2) Exception: S Corporations are small businesses (3) Publicly Traded Partnerships (PTPs) are taxed as corporations (a) Unlimited number of owners (b) Partnership interests traded as “units” were freely tradable in an OTC market (c) Allowed for too easy of a workaround for corporate income tax iii) Step #3: Does it have a single owner? (e.g. single owner of an LLC) (1) If yes, then it’s either treated as a corporation or it’s disregarded as being separate from the single owner = “Tax Nothing” 4

CLASS NOTES Partnership Tax (2) Other Example: Corporation has a wholly owned subsidiary, then the subsidiary isn’t treated as a distinct corporation for tax purposes (3) Can elect to be treated as a separate corporation by anyone iv) Step #4: If 2+ owner business entity and not elected to be corporation, then it’s a partnership for tax purposes (1) Even Partnerships under the Uniform Partnership Act can elect to be corporation by Checking the Box (2) Default: Treated as a partnership because it’s a single tier tax (a) Rationale: Tax Code assumes people would rather income not be taxed twice d) Benefits: Predictable and cheap for business entities and the IRS e) Problem: Recent years have had pushback because of loopholes due to too many people organized as LLC’s in order to avoid taxation i) Check the Box has led to the rise in LLC (e.g. Chrysler) ii) Still doesn’t apply to incorporated in state law or public traded companies 2) Is this a Business Enterprise cases: Podell v. Comm. (Tax Court 1970) & Allison v. Comm. (Tax Court 1976)

Problems Page 24 1) Which of the following relationships are likely to constitute a separate entity for federal tax purposes: a) A, B, and C buy a single piece of land as tenants-in-common and hold for investment i) Not separate entity – Regs. § 301.7701-2 ii) What is at stake here for the co-owners? (1) Capital Asset classification of the investment (2) A couldn’t avoid recognition by trading his partnership interest for another piece of land but he could exchange his property interest in ownership of the land if it’s not a partnership (§ 1015) (a) Interest in a partnership is not like kind property with another piece of land (3) § 1033 If the government takes the lands, they can reinvest as individual owners and not as a partnership if it’s not a business entity (a) Elections must be made as a partnership and not as individual owners if it’s a business entity b) Same but land is subdivided and A, B, and C sell the lots i) Issue: Is there enough business activity to move it beyond individual owners? ii) Works like Podell v. Comm. (Tax Court 1970) (1) 1964 Podell had oral agreement with Young to buy and renovate real estate with shared P/L (a) Podell: properties sold were capital assets and gains were LTCG (i) Weird argument but done because this was a rundown building in the BedStuy areas of Brooklyn (ii) Podell was saying he was doing something good for the community and not trying to make money (b) IRS: this was partnership or JV to renovate real estate in normal course of business, so gains are ordinary income

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CLASS NOTES Partnership Tax (2) Holding: Since there was a contract and each contributed something, then there was a partnership because this was a JV (3) Court said that if it’s a capital asset, it’s being held out for sale (a) Would be the case whether Podell was a co-owner or a partnership, so capital asset definition was more important c) Litigator and Negotiator are attorneys sharing an office and secretary. Each attorney services and bills own individual clients i) Not a distinct entity because they aren’t sharing profits = eat what you kill d) Doctor locates and buys a suitable four-unit building, which Architect remodels. Renovated building will be sold by the combined company and Architect gets 25% i) Regulations come down on the side of sharing profits being enough for a partnership ii) Works like a limited partnership and architect is a limited partner (1) Podell had all the downside exposure too - downside isn’t a problem iii) Question moving forward: Is it compensating the partner (architect) for services? (1) If so, is the nature of the income for the partnership ordinary income or LTCG (2) Architect gets a partnership share in exchange for services, so should service partner get compensated in ordinary income e) Would it be different if they split the individual units? i) NOT a separate entity ii) Does it matter that the doctor is the owner? (1) No – ownership isn’t dispositive for tax purposes (a) Rationale: Doesn’t matter if you’re organized under state law as a partnership for state law, and someone needs to own it (b) Partnership is treated as the owner for tax purposes (2) KEY: Difference between how tax law and non-tax law sees relationships iii) § 301.7701-1(a)(2) Similarly, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes. iv) Allison v. Comm. (Tax Court 1976): (1) 1969 Investment gave Acceptance Goose Lake property (a) IRS: No JV and receipt of lots is ordinary income for financial services rendered (2) Question of whether a JV is created is factual with special emphasis placed on party intention (3) Holding: Acceptance had no intention of being in the real estate business (a) You can’t have profit shares if the property not the sale is being carved up (b) This was a one-off deal for financing – fee was just paying back 75 lots (i) Contract showed that this a deal for financing (ii) NOTE: Contract wording isn't dispositive v) Madison Gas & Electric v. Comm. (7th Cir. 1980) (1) 3 utility companies built a nuclear power plant and split the electricity (a) “You put in 1/6 of the expenses and you get 1/6 of the profit” (2) Holding: Even though they didn’t organize as partnership = partnership for tax purpose (a) Takeaway: Profits don’t need to be in the form of money and can be in the form of property 6

CLASS NOTES Partnership Tax (3) One of the factors the distinguishes this from Allison: this was an ongoing deal (a) Ongoing sharing of expenses and power output = net profit share (b) Contract language was also more ambiguous (4) Why did the taxpayer care? (a) Rule: Startup expenses of a new venture must be capitalized (b) MGE had to spend money training employees (i) If this was a new venture, then the expenses had to be capitalized (ii) If not a new venture, then they could deduct as an ordinary training expense f) Fishers buys and operates fishing boat with 10-year nonrecourse loan from Lender who also gets 15% of profits i) Not a separate entity because this works like fee payment in Allison (1) Compensation to the lender for use of the money = basically interest (2) If repayment of principle was based on profits of the business, then it would most likely be a separate business entity ii) Nonrecourse = classic definition of the term (limited to the collateral) (1) Suggests less participation in the business by the lender (2) If lender could convert into a profits position, then it would appear to be more like a partnership iii) Other factor: Looking at the pro forma financials and 15% profits would never come close to a market rate of interest by being way more or way less, then it would indicate that it’s a partnership g) Takeaway: Most important statute is Reg. § 301.7701–1(a)(2) and look at Madison Gas & Electric, Podell, and Allison cases Supplemental Problem #1 1) A and B are persons of substantial economic substance who like to invest in real estate. They are approached by X who encourages them to purchase a motel which X feels is reasonably priced. X suggests formation of a partnership with A and B as limited partners and X as a general partner. X will be compensated for managing the property and when it is sold will receive 25% of the net gain as determined for tax purposes. Profits and losses from operation of the motel will be allocated 25% to X and 37.5% each to A and B. A and B seek your advice. a) Pretty clearly a business entity for tax purposes – contribution of services can still be part of the partnership i) § 301.7701-1(a)(2) A separate entity exists for federal tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent b) Would want to be a LLC in state law – Limited liability and everyone can participate in the venture without double taxation of corporate status that forming as a corporation under state law i) If LP and A&B are limited partners, then A&B couldn’t materially participate in the venture 2) Robert Owens is the sole proprietor of a business which manufactures toys. While business has been profitable, it is a volatile business that presents a substantial risk of loss. Owens would like to sell the business, and he located a buyer, Max White. White is willing to purchase the business but he does not wish to risk a loss of any amount in excess of his 7

CLASS NOTES Partnership Tax original investment in purchasing the business. For various reasons, White does not wish to conduct the business in corporate form. Instead, White proposes that he and Owens form a limited partnership of which Owens will be the sole general partner. White's contribution to the partnership will constitute sufficient cash to purchase the business. Owens will make only a nominal contribution. The partnership will then purchase the business from Owens at the agreed upon price. The terms of the partnership agreement provide that all of the profits of the partnership will...