Can Foreign Partners Now Exit Partnerships Tax Free?

Guest article by Elizabeth L. McGinley,  Michele J. Alexander,  Anne E. Holth – Bracewell LLP

In Grecian Magnesite Mining v. Commissioner1 (“Grecian Magnesite”) the Tax Court held that a non-U.S. partner’s gain from the redemption of its partnership interest was neither U.S. source income nor income effectively connected with a U.S. trade or business (“ECI”), despite the partnership’s conduct of a trade or business in the United States. The foreign partner was “therefore not liable for U.S. income tax on the disputed gain.” This taxpayer victory is significant primarily because the Tax Court’s decision rejects longstanding Internal Revenue Service (“Service”) guidance and addresses ambiguities in the rules governing partnership and international taxation.

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Effectively Connected Income and Penny Warrants

Guest post by Nicholas Jacobus and Sung Hwang – Venable LLP

There is a case currently proceeding in the U.S. Tax Court (TELOS CLO 2006-1, Ltd. v. Commissioner, T.C., No. 6786-17, petitions filed 3/22/17) that deals with the question of whether non-U.S. investors inadvertently realized “ECI” from the sale of “penny warrants” (a/k/a “hope notes”).  This is a reminder that careful deal structuring is crucial for funds that have a significant non-U.S. investor base or otherwise have a covenant to avoid income that is “effectively connected” with the conduct of a U.S. trade or business (ECI). 

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Should You Pay Someone Else’s Tax?

Guest Post by Sung Hyun Hwang, Partner, Venable LLP

The answer is a resounding yes under the new U.S. tax audit rules applicable to VC funds organized as partnerships (including LLCs treated as partnerships) for U.S. federal income tax purposes, and this article explores steps a VC fund may consider taking to mitigate this draconian outcome.

Background: A partnership is a “flow-through” or “pass-through” entity for U.S. federal income tax purposes. This means that the partnership does not pay income tax itself. Instead, for each taxable year, it will determine the character and amount of its items of income, gain, loss, deduction, and credit, and allocate them among its partners, who will take them into account when they determine their own income tax liability for the same taxable year.

For decades, the U.S. tax audit of most partnership matters has been handled at the partnership level, where the partnership items and their allocations were reviewed, with the resulting adjustments flowing to the partners, who would pick up the tab by amending their own tax returns and pay additional taxes owed.

The IRS has not been happy with this two-tiered system of partnership audits because, often, an audit takes place a long time after a tax return is filed and, by the time the audit is completed, either the statute of limitations has run on assessing taxes at the partner level, the agency had to start new proceedings against the individual partners, or the partners were simply nowhere to be found, given the lapse of time.

This practical difficulty has been keenly felt, especially in the case of tiered partnerships in the investment space, where multiple tiers of partnerships are common, because of the layers of the partnerships that need to be looked at, and because the many changes in the ownership of each partnership in the chain have discouraged IRS auditors. A good example of a tiered partnership in the VC space would be a fund-of-funds investing in a VC fund, or a VC fund investing in a portfolio company through a partnership.

New Partnership Audit Rules: In late 2015, Congress passed a law changing the existing partnership tax audit rules effective with taxable years beginning after 2017 (with limited elective retroactive application), aiming to significantly improve the IRS’s ability to handle partnership tax audits by centralizing both audit and collection at the same partnership-level. There is a fair amount of uncertainty regarding the application of the new law because it is new and was passed in haste.

A “technical corrections act” is currently pending in Congress to improve certain aspects of the new law, but, given the current political excitement about revamping the tax law, it is not clear whether the technical corrections act will pass in its current form in the near future. The IRS proposed a set of regulations to implement the new law and to clarify its scope, but it was withdrawn because of the new administration’s executive order temporarily freezing new regulatory guidance actions. To make the matter more complicated, a few states have already started adopting similar changes to their partnership audit regimes, while others are taking a wait-and-see approach.

In the short term at least, VC funds will have to deal with a new, centralized partnership audit and collection regime, with looming uncertainty and potential changes in the background. One key aspect of the new law in particular warrants the VC community’s attention now: the “collection” feature of the new audit rules (i.e., imposition of entity-level taxation for adjustments arising from VC fund tax audits). Under the new law, at the conclusion of a VC fund audit, the IRS will determine tax liability at the fund level, by solely taking into account all adjustments of the fund’s items of income, gain, loss, and deduction, in a manner similar to how funds calculate tax distributions. If the IRS determines that taxes are owned based on this determination, the tax will be payable by the partnership at the highest individual and corporate tax rates in the year of the adjustment (as opposed to allocating the adjustments to the investors who were partners in the year under audit (the “Audit-Year”)).

This clearly can lead to a result where one investor makes money in one year and a different investor picks up the tab in a later year. This also raises many technical questions without ready answers: among others, do the investors who are the partners in the year of adjustment (the “Adjustment Year”) get credit for their allocable share of the adjusted partnership items, or for tax paid by the partnership for purposes of calculating their own income tax? How will it affect the capital accounts of these partners? This will be especially relevant for VC funds using the “forced allocation” or “target allocation” or any tiered or special allocation regime for allocating items of income, gain, loss, deduction, and credit.

The new law provides certain mitigating options that would allow a VC fund to either keep the old audit regime (i.e., investors who were Audit-Year partners pick up the tab in the Audit Year) or “push out” the tax liability to the Audit-Year partners in the Adjustment Year, as follows:

Opting Out: A VC Fund can opt out of the new audit regime with respect to a taxable year if, for that taxable year: (i) it issues no more than 100 Schedule K-1s, and (ii) its partners are only individuals, C corporations, S corporations, estates of deceased partners, or foreign entities that would be C corporations if they were domestic entities. Thus, if a VC fund can limit its partner count to 100 or less, and is closed to investors organized as partnerships, LLCs, trusts, mutual funds (taxed as “regulated investment companies”), or REITs, it will enjoy the greener pasture of the old audit regime, in which the Audit-Year partners pick up the tab as of the Audit Year.

Second Bite at the Old Regime: The VC fund will not be subject to the entity-level tax to the extent of adjustments allocated to any Audit-Year partner if such investor files an amended return for the Audit Year taking into account its allocable share of the adjustments and pays the tax in full. If the audit results in reallocation of the partnership items among the partners, all Audit-Year partners must file amended returns and pay taxes for this to work. The technical corrections act was aimed, in part, at improving the taste of this second bite. While it is hard to rely on the good nature of investors alone, adding a provision in the operating agreement to this effect may prompt some (and, hopefully, all) investors if that provision is backed by an indemnity provision and survives the investors’ redemption or transfer of their interests in the VC fund, and the dissolution of the VC fund.

Third Bite at the Old Regime: The VC fund will have one last chance to shift the tax to the Audit-Year partners if it makes an election, within 45 days of the receipt of the notice of the proposed adjustments at the end of the audit, to “push out” the adjustments to the Audit-Year partners. In such case, the Audit-Year partners will be treated as if they have reported the adjustments in the Audit Report but paying tax when they actually pay (most likely in the Adjustment Year), including by paying penalties, additions, interest, etc. The fund’s general partner or managing member, as applicable, should be given the discretion (but should not be compelled) to make this election.

More Ways to Reduce the Pain: If all else fails, the VC fund can still reduce the tax bill to the extent of adjustments allocable to C corporations or individuals (with respect to capital gains and qualified dividend income) and tax-exempt investors (with respect to their income and gain not taxed as unrelated business taxable income). Therefore, a VC fund may consider adding to its existing tax information reporting provisions a concept to the effect that the partners would provide such information as is necessary or appropriate for reducing the partnership-level tax resulting from a tax audit.

Tax Indemnity: Last, VC funds may review and amend their existing operating agreements to include concepts such as (i) adding tax audit costs to the existing tax indemnity provision (e.g., for withholding tax) and (ii) the obligation to re-contribute or “claw back” prior distributions in their operating agreement that survive the transfer or redemption of an investor’s interest or dissolution of the fund.

**This article was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer. Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts. In addition, this article is based on current U.S. federal income tax law, and the author will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.

Author

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. For more information, visit http://www.venable.com.

Venable LLP

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What is a Section 351(a) Tax-Free Exchange?

Generally, transferring property into a corporation in exchange for its stock is a taxable event. The transaction is treated as if you sold property to the corporation in return for cash.  The difference between the stock value received and the tax basis in the property transferred to the corporation will result in a gain or loss.

Background:

Concern about a tax liability as the result of incorporating your currently unincorporated business could act as a barrier to incorporation. Consequently, years ago, Congress enacted Section 351 to remove this barrier to incorporation of an unincorporated business. The idea was to allow unincorporated businesses to develop, unimpeded by any immediate tax consequence resulting from the exchange of property for stock. In other words, Congress thought that any gain on an exchange of property for stock should be deferred (put off) until a future time, such as when the stock received in the exchange was eventually disposed of by the shareholder.

Note that a loss on an exchange is not deductible if you own, directly or indirectly, more than 50% of the stock.

Exchanging Property for Stock in a Corporation

Whether you’re setting up a new corporation with just yourself or other people, such as partners in a partnership, or getting involved in an existing corporation, under IRC Section 351(a) you can defer (put off) any resulting tax consequence.

Under Section 351(a):

No gain or loss is recognized (reported) provided:

1 – You receive Only Stock in exchange for your property, and

2 – You are in Control of the corporation immediately after the exchange.

Section 368(c) defines control:

Control means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of outstanding shares of all other classes of stock of the corporation.

Transferor group: If you, along with others, transfer property into a corporation, your group is referred to as a transferor group.

Qualifying For a Tax-Free Exchange Under Section 351(a)

Two requirements must be met to qualify for tax-free treatment under Section 351(a):

1 – You get Only Stock in exchange for your property; NOT stock PLUS other property.

  • You (or you and your transferor group, for example, partners incorporating the partnership) may Only Receive Stock (other than nonqualified preferred stock) from the corporation in exchange for the property you transfer, and

2 – Control:

  • You (or you and your transferor group) must be in Control of the corporation, immediately after the exchange.
  • Section 368(C) defines control and is covered below.

Nonqualified Preferred Stock: This is stock in which the holder of the stock has the right to require the issuer to redeem or buy it back or the issuer is required to redeem or buy it back. Also, the dividend rate on such stock varies with reference to interest rates, commodity prices, or similar indices.

For a detailed definition of nonqualified preferred stock see IRC Section 351(g)(2).

General Rule Under Section 351(a)

No gain or loss shall be recognized if –

1 – Property is transferred to a corporation by one or more persons solely in exchange for stock in suchcorporation and

2 – Immediately after the exchange such person or persons are in control of the corporation (as defined in IRC Section 368(c).

Section 368(c)-Control Requirement

The second rule for getting tax-free treatment in an exchange is the extent of your control (or the control of you and others in the transferor group) after the exchange.

What is meant by control?

Section 368(c) defines control:

Control means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of outstanding shares of all other classes of stock of the corporation.

The control requirement applies to both tax-free and partially taxable exchanges.

Attach a statement to your tax return. Both the corporation and any person involved in a nontaxable exchange of property for stock must attach to their income tax return a complete statement of all facts pertinent to the exchange.

For more information, see section 1.351-3 of the regulations.

Partially taxable exchanges: Another section under Section 351 applies to partially taxable exchanges. It isSection 351(b).

Valuation of Property and Stock in an Exchange

When you transfer property into a corporation, there are two valuation issues:

(1) – The value assigned to the stock you receive from the corporation.

(2) – The value assigned to the property being transferred to the corporation.

1) The value assigned to the stock you receive from the corporation:

The basis in the stock you receive (also called-the exchanged basis, carryover basis or transferred basis) is the same as the adjusted basis in the property you transfer.

Example:

  • Your stock basis is also $10,000.

2) The value to assign to the property being transferred to the corporation:

The corporation‘s basis in the property it receives in an exchange for its stock is the same basis you had in the property when transferred (in other words, the corporation takes your basis).

Example:

  • The corporation’s basis in the property is also $10,000.

(Data comprised from and See more at http://www.irs.gov/pub/irs-drop/rr-03-51.pdf andhttp://loopholelewy.com/index.htm)