Partnership Taxation andOil and Gas Assets By Roger D. Aksamit Thompson & Knight LLP Houston, Texas Brian Dethrow Jackson Walker L.L.P. Dallas, Texas State Bar of Texas Section of Taxation/Energy and Natural Resources Webcast-November 6, 2008
Program Description and Overview: • This program will go in-depth into partnership tax issues involved with the ownership of oil and gas assets, either via joint ownership or under an express partnership agreement. • There will be • explanations of tax and depletion rules for partnerships, including capital account, simulated basis and simulated depletion • service providers, "promotes," and profits interests • real-life examples and illustrations of how these rules operate day-to-day • sample partnership agreement provisions for oil and gas partnerships • A general understanding and grasp by the attendee of the tax rules relating to depletion, partnerships and partnership capital accounts will be assumed.
Table of Contents: A. Express and Resulting Partnerships from Ownership of Oil and Gas Assets • Joint Operations and Electing Out of Subchapter K • Partnership Tax Issues Unique to Tax Partnerships D. IRC § 613A and Allocation of Depletable Basis E. Allocation Rules With Respect to Depletable Basis, Depletion and Simulated Depletion F. Miscellaneous Issues With Respect to Allocating Depletion • Texas Margin Tax • Service Partner Issues in Oil and Gas Partnerships Common Issues I. Other Partnership Rules Relating to Depletion J. Form Partnership Agreement Provisions
A. Express and Resulting Partnerships from Ownership of Oil and Gas Assets • A tax partnership can be created by either • (i) the formation of a general partnership, limited partnership or limited liability company to hold property that has multiple owners and that has not elected to be an association under the check-the-box Treas. Regs. §§ 1.7701-1 to 1.7701-3. • (ii) joint ownership and operation of natural resource property • If otherwise a tax partnership in the above situations and the parties do not want to be a tax partnership, then the parties may have the ability to elect out of partnership status for federal tax purposes and treat the relationship as a joint ownership arrangement. This is discussed in detail below.
Why Have a Tax Partnership? • 1. Avoids the results of Rev. Rul. 77-176 • Because the drilling party was receiving multiple operating interests/properties in return for its drilling services, some of which did not relate to where drilling was to occur, the drilling party had income from the receipt of the unrelated operating interests. • The “pool of capital” doctrine does not operate to exclude receipt of the unrelated properties from taxation. See General Rule under GCM 22730, 1941-CB 214. • HOWEVER, a tax partnership avoids the income recognition to the drilling party. • 2. Avoids the “complete payout” rule • The party providing cash for drilling can deduct 100% of the expense (subject to the IDC deduction limits) notwithstanding that it will receive less than 100% of the revenues from production. Treas. Reg. §1.612-4(a); Rev. Rul. 69-332,1989-1CB87.
3. Ability to specially allocate tax items • This is a variation of the above • Subject to the economic effect, substantiality and shifting/transitory allocation rules, a tax partnership allows the parties to specially allocate tax items. • 4. Ability to take advantage of the “profits interests” exception under Rev. Rul. 93-27 with respect to any “sweat equity” or service partners. Otherwise, without a tax partnership, – ordinary income to service partners upon receipt of an interest. See Rev. Rul. 83-46. • 5. Reason why most forms of Joint Operating Agreements and Participation Agreements include a placeholder or option for the parties to elect to be a tax partnership and attach a tax partnership agreement.
Disadvantages of a Tax Partnership • 1. If the relationship is a partnership for tax purposes, then it is subject to the entire regime of rules under Subchapter K that include, among others, the following rules and restrictions • IRC § 704(b) and maintenance of capital accounts • IRC § 704(c) and its effect on special allocations of built-in gain/loss and depreciation, depletion and amortization • IRC § 706 – requirements relating to a tax year for the partnership • IRC § 707 – disguised sales rules, sales to a related partnership • IRC § 708 – partnership terminations • IRC § 709 – limits on deduction of organizational expenses • IRC § 731 – taxation of certain property distributions • IRC § 732 – tracking tax basis in the partnership • IRC § 737 – anti-mixing bowl rules
IRC §§ 743 and 754 – Step up and step down of the tax basis of the assets held by the partnership upon the transfer of a partnership interest. • IRC § 752 – Rules relating to the allocation among the partners of recourse and nonrecourse liabilities. • IRC § 1446 – required withholding by the tax partnership if there are foreign partners. • Compliance involved with the bookkeeping, preparation and filing of a partnership return. • IRC §§ 6111,6112,6707 and 6708 – tax shelter registration and compliance • TEFRA audit rules • Complexity that many in the oil patch would sooner avoid • 2. Depending on the tax status of the partner, application of the at-risk (IRC § 465) and passive activity loss (IRC § 469) rules, which can dramatically limit expenses and losses currently. • Many use a general partnership during exploration and drilling but convert to LP or LLC status after completion to avoid passive activity loss limits.
B. Joint Operations and Electing Out of Subchapter K 1. Joint Operations • A joint operation of natural resource properties generally constitutes a partnership for tax purposes unless the parties elect to be excluded from Subchapter K. IRC § 761(a). • This seems to be true even if the parties elect to take their share of production in kind thereby potentially defeating the joint profit objective. 2. Election Out – History • Congress provided for the election out as a practical solution. • Many taxpayers in the oil & gas industry did not (and don’t today) want to deal with the complexity of Subchapter K.
3. Election Out - Eligibility • The organization must be availed of for the joint production, extraction or use of property, but not for the purpose of selling services or property produced or extracted. • The income of the members can be adequately determined without the computation of partnership taxable income. IRC § 761(a). • The election must be made by all members of the organization. (See below). • For the parties to a Joint Operating Agreement (“JOA”) to “elect out,” the parties must • (a) own the property as co-owners (either in fee or lease); • (b) reserve the right separately to take in kind or dispose of their shares of any property produced, extracted or used; • (c) not jointly sell services or the property produced or extracted (“no joint marketing”), although each participant may delegate the authority to sell its share of the property produced or extracted for the time being for his account, but not for a period of time in excess of the minimum needs of the industry but in no event for more than one year; and • (d) the organization does not have as one of its principal purposes cycling, manufacturing or processing for persons who are not members (e.g., third-party gas processing). IRC § 761-2(a)(3).
Note: Joint marketing can be avoided where each party signs a gas sales agreement and liability is several. • Gas processing for members will not prevent an election out (but processing for third parties will). • Election Out – Manner • The election can be evidenced by the intent of the parties (e.g., written agreement). Treas. Reg. § 1.761 – 2(3)(2)(ii). Note: No formal election is required if the parties’ intent is clear. (This is the so-called “deemed election out.”) Also, note that a member can object to election out within 90 days. Treas. Reg. § 1.761 – 2(b)(i). • A formal election is made on a blank Form 1065. Treas. Reg. § 1 .761 – 2(b)(2)(i). (Atypical in the industry, overall) • The election can be made at any time during the life of the arrangement, but once you are past the return filing deadline for the first year of the partnership, it is only effective prospectively. • If the election is made, the parties will not file partnership tax returns.
5. Election Out - Consequences • Some concern exists that the exclusion is only from Subchapter K. See Madison Gas (probably wrong). But it is fairly clear that a sale of assets of an elected out partnership is treated as a sale of assets, not partnership interests. But see Section 1031 legislative history. • An elected out partnership is still a partnership for purposes of the investment tax credit (Bryant v. Comm’r, 399 F.2d 800 (1968), and self-employment tax (Frances Cokes v.Comm’r, 91 TC 222 (1988)). • The statute provides for an election out of only specified portions of Subchapter K but only with the consent of the Commissioner. Taxpayers seeking a partial election out can expect heavy scrutiny. • Taxpayers are treated as direct owners of undivided interests in the oil & gas properties. • Taxpayers need not file a partnership tax return. • Each taxpayer makes its own elections and reports all income, gains, deductions and losses separately. Eligibility to make elections are then specific to that taxpayer.
C. Partnership Tax Issues Unique to Tax Partnerships • Take in kind -- deemed distributions of oil or gas? --- no revenues on the return? 2. Functional allocations. 3. Keep your own method under Section 704(c). 4. Can the partners capital accounts ever go negative? Is a QIO necessary? --- note: tax partnership has no debt. ---note: gas balancing, if allowed under the JOA. 5. Party with the IDCs should avoid early liquidation of the partnership. 6. Can the tax partnership distribute a property to the partners?
D. IRC § 613A and Allocation of Depletable Basis 1. Overall • Many of the normal concepts dealing with the partnership’s determination of built-in gain, allocation of cost recovery deductions, gains or losses from dispositions of partnership property, etc. are altered with respect to depletable oil and gas property that is owned by a tax partnership. • This is because IRC § 613A(c)(7)(D) of the Code provides “in the case of a partnership, the depletion allowance . . . shall be computed separately by the partners and not by the partnership. • NOTE: A similar rule is provided for S Corporations under IRC § 613A(c)(11) of the Code- “In the case of an S corporation, the allowance for depletion with respect to any oil or gas property shall be computed separately by each shareholder.”
The effect of IRC § 613A(c)(7)(D) is as follows: • 1) Each partner is allocated separately its proportionate share of the adjusted tax basis of each depletable oil and gas property. • 2) The partners are considered the taxpayers for purposes of determining the appliability of the limitations that apply to cost or percentage depletion. • 3) Depletion -- cost or percentage -- is computed separately by each partner on the basis of depletable basis allocated to each partner. • 4) But in other respects, for example, in determining who is a related person if there is a sale of the property, the partnership is considered as the taxpayer and owner of the property.
2. Determining a Partner’s Basis in Depletable Property • Generally the partnership allocates to each partner his proportionate share of the adjusted basis of each oil and gas property as of the date of acquisition. A partner’s initial share of the adjusted basis is determined in accordance with his interest in capital or income and, in the case of contributed property, will be governed by IRC § 704(c). Treas. Reg. § 1.613A-3(d) provides that a partner’s share of such adjusted basis of each property shall be determined in accordance with his interest in partnership capital. • Treas. Reg. § 1.613A-3(e)(2)(ii) provides, however, that if the partnership agreement provides for an allocation determined in accordance with the taxpayers’ proportionate interest in partnership income and such interest is reasonably expected to remain unchanged throughout the life of the partnership, then such an allocation will be respected. • Adjusted basis of one property may be allocated in accordance with capital and another allocated in accordance with income. • Where the property is contributed and has an adjusted basis different from its value and is subject to the provisions of IRC § 704(c), or where book value and basis differ as a result of partnership revaluation, the principles of IRC § 704(c) or Treas. Reg. § 1.704-1(b)(4)(i) apply.
3. Changes in Partner’s Interests • Where the interests of the partners change as a result of the admission of a new partner or by additional capital contributions by an existing partner, the partnership must reallocate the partnership’s basis in each existing property. • Where a change in partnership interests results in a “revaluation” (as described in Treas. Reg. § 1.704(b)(2)(iv)(f)) the basis in the property must be allocated among the partners based upon the principles used under Treas. Reg. § 1.704(b)(4)(i) for allocating tax items to take into account variations between the adjusted basis of the property and its fair market value. Treas. Reg. § 1.613A-3(e)(5). • Examples of the foregoing rules relating to changes in partner interests are contained in Reg. § 1.613A-3(e)(7).
Example 7: For example (with respect to a change in partnership interests) A and B have equal interests in capital in Partnership, which owns unproven domestic oil property having a basis of $2MM, and such basis is initially allocated $1MM to each partner in accordance with their proportionate interests in partnership capital. On January 1, 2009 C is admitted as an equal partner, and at such time the Partnership has an aggregate adjusted basis in the oil property of $1.5MM. As a result the Partnership must allocate $500K of the basis of the property to C, which is one-third of the aggregate adjusted basis of the property. A and B must each reduce their basis in the property by one-third. • Example 5: G has a basis of $5MM in domestic oil property and transfers its partnership interest to I for $100MM and a §754 election is in effect. For cost depletion purposes, I now has a basis in domestic oil property of $100MM.
4. Other Adjustments • After the allocation of basis has been made, appropriate adjustments shall be made to the partners’ adjusted basis for any partnership capital expenditures relating to such properties which are made after the original allocation. • Each partner must then keep separate records of his share of adjusted basis of each property under IRC § 1016, including the adjustment for depletion. This adjusted basis each year is used for cost depletion purposes or in the computation of gain or loss upon disposition. • Upon the disposition of an oil or gas property by the partnership, each partner shall subtract his adjusted basis in such property from his allocable portion of the amount realized to determine his gain or loss. • For purposes of IRC § 732 (relating to basis of distributed property other than money), the partnership’s adjusted basis in an oil or gas property is the sum of the partners’ adjusted bases in such property. • The adjusted basis of a partner’s interest in a partnership shall be decreased (but not below zero) pursuant to IRC § 705 by the amount of the partner’s deduction for depletion (allowed or allowable) to the extent such reduction does not exceed the share of the partnership’s adjusted basis allocated to the partner under IRC § 613A(c)(7)(D).
5. What IRC § 613A Does Not Affect • Rev. Rul. 84-142 held that, notwithstanding IRC § 613A(c)(7)(D), property elections under IRC § 614(b) (relating to what constitutes separate and identifiable properties) must be made by the partnership instead of the individual partners. Accordingly, the property election is not one of the exceptions to the general rules of IRC § 703(b) of the Code. Thus, the partnership makes the separate property election. • IRC § 613A does nothing to change the tax year of the partnership or the timing requirements as to when partnership income is included in the tax return of a partner. IRC § 706 still requires a partner to include partnership income in his income by reference to the partnership year that ends with or within the partner’s tax year. • Also, the partnership’s tax year would seem to control the calculation of any percentage depletion allowable under the independent producers and royalty owners exemption by reference to partnership gross income from the properties during the partnership tax year. • No difficulties regarding the calculation of percentage depletion allowable under subsection (c) by a partner on partnership properties in situations where the partner’s tax year is the same as the tax year of the partnership.
However, there is no specific guidance as to the method of calculating percentage depletion allowable under subsection (c) in cases where a partner’s tax year is different from the partnership’s tax year. • Assume, for example, a March 31 taxpayer who is a partner in a calendar year partnership. Under the income inclusion rules, taxpayer includes in its March 31 return its share of partnership income for the calendar year ending in the taxpayer’s fiscal year. • Assume that the partnership only has nine months of income through December 31. Although the March 31 taxpayer reports only nine (9) months of partnership income, does it get a full twelve (12) months of depletion? • If depletion follows income, it appears only reasonable to deduct depletion attributable to the partnership income included on the taxpayer’s March 31 return.
6. Special Rules for Estates and Trusts • Treas. Reg. § 1.613A-3(g) provides that the depletion allowance initially shall be computed by the estate or trust with the determination of whether cost or percentage depletion is applicable to be made at the trust or estate level. • The limitations contained in IRS § 613A(c) and (d) are then applied at the trust or estate level in the computation of percentage depletion and again applied by a beneficiary with respect to any percentage depletion apportioned to him by the trust or the estate.
7. Disposition of Depletable Property – Determining Gain or Loss • When a partnership sells an oil or gas property, IRC § 613A(c)(7)(D) governs the allocation shares of the amount realized unless governed by the contributed property rules (or related principles regarding revaluations of partnership property). See Treas. Reg. § 1.704-1(b)(4)(v). • When a partner’s capital account is adjusted for the simulated depletion of an oil or gas property, generally the amount realized by the partnership upon a taxable disposition will be allocated to the partners in the same proportion that the aggregate adjusted tax basis of such property was allocated to such partners (or their predecessors in interest). See Treas. Reg. § 1.704-1(b)(4)(v).
When a partner’s capital account is adjusted to reflect the actual depletion of an oil or gas property, generally the amount realized by the partnership upon a taxable disposition will be allocated to the partners in proportion to their respective remaining adjusted tax bases in such property. See Treas. Reg. § 1.704-1(b)(4)(v). • If the partnership agreement provides for an allocation that exceeds the total amount realized under either of the previous two rules, as applicable, the amount realized will be made in accordance with the partners' allocable shares, provided (i) such allocation does not give rise to capital account adjustments the economic effect of which is insubstantial and (ii) all other allocations and capital account adjustments under the partnership agreement are recognized under the partnership allocation rules. See Treas. Reg. § 1.704-1(b)(4)(v). • Otherwise, the partners' allocable shares of the total amount realized by the partnership on its taxable disposition of an oil or gas property shall be determined in accordance with the partners' interests in the partnership. See Treas. Reg. § 1.704-1(b)(4)(v).
Example #1 - D and J form a general partnership for the purpose of drilling oil wells. D contributes an oil lease, which has a fair market value and adjusted tax basis of $100,000. J contributes $100,000 in cash, which is used to finance the drilling operations. The partnership agreement provides that each of D and J is credited with a capital account of $100,000. The partnership agreement also contains the provisions necessary to meet the economic effect requirements. The partnership chooses to adjust capital accounts on a simulated cost depletion basis and elects to reduce the amount of investment tax credit in lieu of adjusting basis. The agreement further provides that (1) all additional cash requirements of the partnership will be borne equally by D and J, (2) the deductions attributable to the property (including money) contributed by each partner will be allocated to such partner, (3) all other income, gain, loss, and deduction (and items thereof) will be allocated equally between D and J, and (4) all cash from operations will be distributed equally between D and J. In the partnership's first taxable year $80,000 of partnership intangible drilling cost deductions and $20,000 of cost recovery deductions on partnership equipment are allocated to J, and the $100,000 basis of the lease is, for purposes of the depletion allowance under IRC § 611 and IRC § 613A(c)(7)(D), allocated to D. The allocations of income, gain, loss, and deduction provided in the partnership agreement have substantial economic effect. Furthermore, if it is clear that the allocation of the entire basis of the lease to D will not result in capital account adjustments the economic effect of which is insubstantial, and since all other partnership allocations are recognized under the partnership allocation rules, the allocation of the $100,000 adjusted basis of the lease to D is recognized as being in accordance with the partners' interests in partnership capital for purposes of IRC § 613A(c)(7)(D). See Treas. Reg. § 1.704-1(b)(5), Example 19(i).
Example #2 - Assume the same facts as in Illustration (1) except that the partnership agreement provides that (1) all additional cash requirements of the partnership for additional expenses will be funded by additional contributions from J, (2) all cash from operations will first be distributed to J until the excess of such cash distributions over the amount of such additional expenses equals her initial $100,000 contribution, (3) all deductions attributable to such additional operating expenses will be allocated to J, and (4) all income will be allocated to J until the aggregate amount of income allocated to her equals the amount of partnership operating expenses funded by her initial $100,000 contribution plus the amount of additional operating expenses paid from contributions made solely by her. The allocations of income, gain, loss, and deduction provided in the partnership agreement have economic effect. In addition, the economic effect of the allocations provided in the agreement is substantial. In addition, if it is clear that the allocation of the entire basis of the lease to D will not result in capital account adjustments the economic effect of which is insubstantial, and since all other partnership allocations are recognized under the partnership allocation rules, the allocation of the adjusted basis of the lease to D is recognized as being in accordance with the partners' interests in partnership capital under IRC § 613A(c)(7)(D). See Treas. Reg. § 1.704-1(b)(5), Example 19(ii).
D. Allocation Rules With Respect to Depletion and Simulated Depletion • In order to satisfy the capital account rules, a partnership must adjust partners' capital accounts for depletion and gain and loss with respect to its oil and gas properties under the simulated depletion method, or under the actual depletion method. • In addition, under the appropriate circumstances, adjustments to partners' capital accounts with respect to depletion and gain or loss on such properties must be made in accordance with the book value rule and the revaluation rule. See Treas. Reg. § 1.704-1(b)(2)(iv)(k)(1).
Simulated Depletion MethodofMaintaining Partners’ Capital Accounts • Under the simulated depletion method, a partnership must compute, at the partnership level, simulated depletion allowances on its oil and gas properties. • The depletion allowances determined at the partnership level under the simulated depletion method are fictitious, and are computed solely for the purpose of maintaining partners' capital accounts in accordance with the capital account rules. The simulated depletion allowances may be determined under either the cost depletion method or the percentage depletion method. • If the percentage depletion method is elected, the simulated depletion allowances must be computed under IRC § 613 at the IRC § 613A(c)(5) rates without regard to any limitations which theoretically could apply to any partner under IRC § 613A (e.g., net income). • The partnership must choose a particular method of computing simulated depletion allowances on a property-by-property basis. Accordingly, it may use the cost depletion method for some properties and the percentage depletion method for others. The choice is binding for all later taxable years during which the partnership holds that property. NOTE: The partnership makes these determinations.
Each partner's capital account must be reduced by the amount of the simulated depletion allowances for each of the partnership's oil and gas properties allocated to the partner. A partner's allocable share of the simulated depletion allowance with respect to a particular property is equal to his (or his predecessor-in-interest's) proper allocable share of the adjusted tax basis of that property. • The aggregate capital account adjustments for simulated percentage depletion allowances with respect to an oil or gas property of the partnership may not exceed the aggregate adjusted tax basis allocated to the partners with respect to the property. • If a disposition of the property results in simulated gain, the partners' capital accounts must be increased by their allocable shares of that gain. A partner's allocable percentage share of the partnership's simulated gain with respect to a particular property is equal to the partner's allocable percentage share of the excess of the total amount realized from the disposition over the partnership's simulated adjusted basis in the property. • If the disposition results in simulated loss, the partners' capital accounts must be reduced by their allocable shares of that loss. A partner's allocable share of a partnership's simulated loss with respect to a particular property is that percentage of the loss which is equal to the partner's allocable share, expressed as a percentage, of the total amount realized from the disposition that represents recovery of the partnership's simulated adjusted tax basis in the property.
Actual Depletion Method of Maintaining Partners’ Capital Accounts • Under the actual depletion method, a partnership reduces a partner's capital account with respect to depletion on its oil and gas properties by an amount equal to the depletion allowance claimed by that partner with respect to those properties. Thus, the reduction is based on the type of depletion, cost or percentage, deducted by the partner. • The reduction is made for the partner's taxable year that ends with or within the partnership's taxable year for which the depletion allowance is claimed. The aggregate reductions of a partner's capital account for depletion allowances with respect to an oil or gas property of the partnership may not exceed the adjusted tax basis of the property that is allocated to that partner. See Treas. Reg. § 1.704-1(b)(2)(iv)(k)(3). • Under the actual depletion method, partners' capital accounts are adjusted for gain or loss on taxable dispositions of a partnership's oil and gas properties. This adjustment is made by increasing the capital account of each partner by the amount of any excess of the partner's allocable share of the total amount realized from the disposition of the property over the partner's remaining adjusted tax basis in the property. • If there is no excess, the capital account of the partner is reduced by the amount of any excess of the partner's remaining adjusted tax basis in the property over the partner's allocable share of the total amount realized from the disposition of the property.
F. Texas Margin Tax • 1% of Gross Receipts less cost of goods sold • Depletion may not be allowable as a cost of goods sold deduction based on informal Texas Comptroller remarks. See Rule §3.588(d)(6) for the deduction for cost recovery items “reported on the federal tax return on which the report under this chapter is based.” • Passive Entity Exception • Passive entities are non-taxable entities. • Applies only to limited and general partnerships and trusts, not LLCs • At least 90% of federal gross income must be from passive sources. Passive includes: • Net capital gain from sale of real property (e.g., working interests) • Royalties, bonuses, and delay rental income from mineral properties • Income from non-operating mineral interests (BUT, this includes working interests if the owner is not the operator – See Rule §3.582(f)(1))
Special Operator Rule – Rule §3.582(d)(2) • Income received by a non-operator from mineral properties under a JOA, so long as another member of the affiliated group is not the operator • If the GP owns more than 50% of the partnership and it (or an affiliate) is the operator, the partnership will not be passive. • If GP owns less than 50%, then passive. • Many LP Agreements require the GP or an affiliate (not the partnership) to be the operator. Margin tax results. • Partnerships generally are passive because the partnership is not the operator and the GP does not own more than 50% of the partnership, including post-flip.
Texas Margin Tax LP Owner 100% LP GP 98% No Texas nexus Distributive share not apportioned to TX 2% TX LP Texas oil and gas properties Unrelated GP (or affiliate contract operator), so passive
G. Service Partner Issues in Oil and Gas Partnerships Common Issues • Up-Front Promotes • Capital Interests to Management Group • Alternative Drafting Provisions • Profits Interests • IRC § 83(b) Elections • Proposed Legislation for “Carried Interests.” • Section 409A • Partners as Employees • Self-Employment Tax
1. Up-Front Promotes • Issue: Does service partner (SP) have taxable compensation income upon receipt of partnership interest? • Yes, if capital interest. • “To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), IRC § 721 does not apply.” Treas. Reg. § 1.721-1(b)(1). • What is a capital interest? • Immediate liquidation analysis: If the partnership immediately liquidated after SP received its interest, would SP receive distributions in excess of its capital contributions (based on FMV)? • Example: • Relative capital contributions: 97/3 (SP) • Relative distributions: 95/5 (SP) • Up-front promote (capital interest) of 2%
2. Up-Front Promotes Alternative Drafting Provisions • Liquidate in accordance with positive capital accounts. • Re-allocate income in year of liquidation to make capital accounts proportionate to distribution percentages, to the extent possible. • If payout is achieved, the parties economic arrangement remains intact. • If payout is not achieved, the parties' economic deal is achieved as much as possible without adverse tax consequences to SP.
COMPANY, LLC Capital Contributions Management Members 3,000,000 3% Investors 97,000,000 97% Total 100,000,000 100% Operating Distributions Management Members 5% Investors 95% Total 100% Liquidating Distributions Positive Capital Account Balances Balancing allocations at liquidation
Management Members Investors Total Single Property with $5M of gain Contributions 3,000,000 3.00% 97,000,000 97.00% 100,000,000 Gain 2,250,000 45.00% 2,750,000 55.00% 5,000,000 Capital Accounts 5,250,000 5.00% 99,750,000 95.00% 105,000,000 Sufficient gain to allocate in year of liquidation to overallocate gain to Management Members to bring capital accounts to 95/5 ratio.
Make pre-payout distribution percentages equal to contribution percentages and adjust post-payout percentages to preserve the economics as much as possible. • 97/3 Pre Payout • 93/7 Post Payout No. 1 • 95/5 Post Payout No. 2 • Impose a limited contribution obligation that is triggered upon liquidation to the extent that SP’s relative capital account balance is not equal to its distribution percentage. • 97/3 Contribution Percentage • 96/4 Relative Capital Account Balances • SP has contribution obligation to get relative capital account balance to 95/5 Distribution Percentage
Require the unanimous consent of the members to liquidate before a specified future date (e.g., the end of 2010). • The Company cannot immediately liquidate, so there can be no capital shift upon formation. • But the IRS test is a hypothetical liquidation. • What if SP’s capital account has not been built up to its 5% distribution percentage by the specified date? • Does the issue arise again at the end of 2010? • Or is taxability determined solely when SP receives the interest?
Make no changes to the LLC agreement but take the position that the fair market value of the additional capital interest, based on the facts and circumstances, is a nominal amount. • E.g., A significant portion of the capital contributions will be used immediately to fund drilling, so the future distribution of capital is speculative. • Apply minority and marketability discounts. • Quite risky because not following the IRS safe harbor. Return preparer issues?
Profits Interests and IRC § 83(b) Elections • Background • IRC § 83 taxes FMV of property received for services. • Litigation • Does IRC § 83 apply to partnership interests? • How is a partnership interest valued?
IRS Safe Harbor: Partnership interest is not taxable upon receipt or vesting and no 83(b) election is required if: • Profits Interest (not a capital interest) • Not Substantially Certain and Predictable Stream of Income • Employee Treated as Partner • Not a Publicly Traded Partnership • No Compensation Deduction by Partnership • Held for Two Years • Protective 83(b) election recommended
2005 Proposed Regulations • Not taxable upon receipt • Requires making of 83(b) election • Requires election of liquidation value safe harbor • Protective language included in LLC agreements to cover profits interests issued after proposed regulations become final • Reserved on treatment of interests issued to employees of upper-tier (i.e., management) entity
Profits Interests and Proposed Legislation • Proposed Legislation in 2008: • A carried interest is received for services, so it should be treated as compensation income. • Taxed as ordinary income • Subject to self-employment tax • Applies to investment services partnerships, which includes real estate – and thus oil and gas?
Profits Interests and Section 409A • IRC §409A accelerates the recognition of income on deferred compensation and imposes penalty interest plus a 20% excise tax on the employee. • Profits Interest: • Receipt is a nontaxable event, so IRC § 409A does not apply. • Capital Interest: • If unrestricted, receipt is a taxable event and compensation income is taxed in the year of receipt. • Thus, there is no deferred compensation, and IRC § 409A does not apply.
Partners as Employees • IRS Position: A partner cannot be an employee of his partnership. (There is contrary analogous caselaw.) • Payments to a partner should not be treated as wages subject to withholding or employment taxes. • Routinely violated • IRS should receive same amount of taxes and not be harmed. • But risk that cafeteria plans would be invalidated, which would harm other employees. • Also, reporting issue now raised by return preparers.
Self-Employment Tax • 2008: 15.3% on amounts up to $102,000 and 2.9% on additional amounts • 2009: ++? • General Partner • Distributive share and guaranteed payments are both subject to self-employment taxes. • Limited Partner • Only guaranteed payments are subject to self-employment taxes. • Distributive share is exempt by IRC §1402(a)(13).
Partners as Employees • Who is a Limited Partner? • Clear for a limited partnership • But for an LLC? • 1997 Proposed Regulations – Not a limited partner if: • Personal Liability for LLC’s Debts? • Authority to Contract on Behalf of the LLC? • Participate in the LLC’s Business More than 500 Hours? • Common Practice: Non-managers
J. FORM PARTNERSHIP AGREEMENT PROVISIONS • DEFINITIONS: • “Capital Account” means, with respect to any Member of the Company, the Capital Account maintained for such Member in accordance with the following provisions: • (i) To each Member's Capital Account there shall be credited (A) such Member's Capital Contributions, (B) such Member's distributive share of Profits and any items in the nature of income or gain which are specially allocated to such Interest pursuant to Section 3.3 or Section 3.4, (C) such Member's distributive share of Simulated Gain, and (D) the amount of any Company liabilities assumed by such Member or that are secured by any Property distributed to such Member; • (ii) To each Member's Capital Account there shall be debited (A) the amount of money and the Gross Asset Value of any Property distributed to such Member pursuant to any provision of this Agreement, (B) such Member's distributive share of Losses and any items in the nature of expenses or losses which are specially allocated to such Interest pursuant to Section 3.3 or Section 3.4, (C) such Member's distribution share of Simulated Depletion and Simulated Loss, and (D) the amount of any liabilities of such Member assumed by the Company or that are secured by any Property contributed by such Member to the Company;