Partner Chuck Beaudrot gave the following speech at the GSCPAs 2011 Real Estate Conference. Please click Download PDF on the left side of the screen to get a copy of the presentation.
Recurrent Tax and Non-Tax Issues for Real Estate Partnerships, LLCs and Funds
There are a number of Tax and Non-Tax issues which routinely surface in the negotiation of various real estate LLC, partnership and fund agreements. This afternoon, we would like to review some of the most common issues as well as some of the drafting alternatives and considerations in addressing these.
Throughout this outline, any references to “partnership” or “partner“ should be understood as references for tax purposes. Therefore, these terms include LLCs taxed as partnerships and members of LLCs taxed as partners, even if not so stated.
I. “Targeted Capital Account” vs. “Layer Cake” Allocations.
For those of us who have been in the real estate business since the adoption of the original 704(b) Regulations, we have seen an interesting shift in drafting of real estate related partnership agreements. Over the last ten years, there has been a marked shift away from the classic “layer cake” allocations model to “targeted capital accounts” model.
A. Layer Cake Model
“Layer cake” allocations are allocations which generally provide for a sequence of allocations of profits and losses. Generally, under this approach, profits and losses are first offset on a cumulative basis, and are then allocated according to the overall “waterfall” to be used in the partnership agreement for distribution. They are designed to comply with the “Substantial Economic Effect” safe harbor of Regulations under IRC § 704(b).
Layer cake allocations were popularized by William S. McKee, William Nelson and Robert L. Whitmire in their leading treatise, Federal Taxation of Partnership and Partners, which is now in its 4th edition. It is also the basis of the accompanying forms book, Structuring and Drafting Partnership Agreements, by Robert L. Whitmire, William F. Nelson, William S. McKee, Mark A. Kuller, Sandra W. Hallmark and Joe Garcia, Jr.
The advantages of the “layer cake” allocations are most apparent if one is concerned about issues involving character or timing of income. For instance, if the desire is to make sure that capital losses allocated to a member or partner are not recaptured by that same member or partner as ordinary operating income, or that ordinary losses were allocated to one partner and not recaptured as capital gains income, the “layer cake” is clearly preferable. This can be particularly important in the real estate context. Similarly, subject to limitations, “layer cake” can be used to shift allocations over time.
On the other hand, the “layer cake” approach can result in unusual and confusing language and can be quite complex both in drafting and in operation.
Finally, the “layer cake” approach can result in allocations that are other than what would be done if one were simply allocating under the general principles of IRC § 704(b). As a “safe harbor,” the “layer cake” approach under IRC § 704(b) permits limited manipulation of allocations.
An example of a typical “layer cake” is attached as Exhibit “A”.
The consequences of this have led over the past ten years to an increasingly frequent use of the so-called “targeted capital account” model for allocations.
B. The Targeted Capital Accounts Model
The “targeted capital accounts” model allocations generally provide that the tax preparer is to allocate profits and losses from whatever source and nature in such fashion as to cause the capital accounts of the partners to foot to the distributions that would be made to such partners in a hypothetical liquidation. So rather than distributions following capital accounts, which is the methodology used for the “layer cake” model, the capital accounts are forced to balance to the distributions to be made. An example of “Targeted Capital Accounts” allocations is attached as Exhibit “B”.
Under the “targeted capital accounts” model, profits and losses are allocated to achieve the result of causing capital accounts to equate to amounts to be distributed if the assets were sold for their book value with all debts of the entity paid in the proceeds distributed in accordance with the agreement. This is the so-called “atom bomb” formulation of Regs. § 1.704-1(b)(3)(iii), which has now become well-ingrained in the practitioner community. This method of allocation is based upon “the partner’s interest in the partnership.”
One of the major arguments in favor of the use of the “targeted capital accounts” model has been that often the tax return preparer preparing the returns does not even review the relevant partnership agreement because the tax return preparer is so attuned to allocating profits and losses at all times so as to cause the capital accounts of the members to track the amounts of profits and losses to which they are allocated under the “atom bomb” approach.
An arguable advantage of “targeted capital accounts” methods is that it avoids any suggestion that the allocations are otherwise at variance with the partner’s interest in the partnership.
Also, use of targeted capital accounts tends to insulate the managers from any attack on how they have handled the allocations of taxable income because, generally speaking, the determinations are being made by the tax professionals.
From a negative perspective, the “targeted capital accounts” methodology can result in considerable surprises for the members who have not been well advised.
For example, if there is a significant “book-up,” a member who has a profits interest (to be discussed below), who, following such a “book-up,” now has a positive capital account, may find himself being allocated taxable income currently, even though not receiving current distributions.