Watching Out for the Blind Spots of Partnership Tax Vehicles

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Watching Out for the Blind Spots of Partnership Tax Vehicles
September 23, 2009

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Watching Out for the Blind Spots of Partnership Tax Vehicles

  1. 1. Watching Out For the Blind Spots of Partnership Tax Vehicles September 23, 2009 © 2009 T. Scott Tufts, Esq.
  2. 2. Watching Out For the Blind Spots of Partnership Tax Vehicles INTRODUCTION © 2009 T. Scott Tufts, Esq. 2
  3. 3. The Pass-Through Entities Your vehicle of choice? Joint Venture Limited P’ship General P’ship (Ltd.) LLP LLLP Single-Member LLC Member-Managed Manager-Managed LLC LLC S Corporation???? © 2009 T. Scott Tufts, Esq. 3
  4. 4. Full Speed Ahead…… LLC LLP LLLP …and don’t look back? © 2009 T. Scott Tufts, Esq. 4
  5. 5. Partnerships at Formation….. Partner Partner Member #1 Member #2 Limited Liability Entity © 2009 T. Scott Tufts, Esq. 5
  6. 6. ….can end up in the courtroom What “Promises” Were Made? What “Promises” Were Broken? Who Gets What? © 2009 T. Scott Tufts, Esq. 6
  7. 7. ….and you might find yourself right in the middle!!!! © 2009 T. Scott Tufts, Esq. 7
  8. 8. Whistleblowers & SAR/OX © 2009 T. Scott Tufts, Esq. 8
  9. 9. Divorce Disclosures Financial Disclosure Statement IRS FORM 8857 Innocent Spouse Protections © 2009 T. Scott Tufts, Esq. 9
  10. 10. Policing the Highways © 2009 T. Scott Tufts, Esq. 10
  11. 11. CAN YOU REALLY FLY BELOW THE IRS’ RADAR SCREEN?............ IRS Credit Card Summons IRS Form 8886 (Tax Shelters & More) Foreign Bank A/C (Sch. B, F.1040) Informant Rewards (Form 211 & K w/ US) No More Secrecy Offshore IRS Form 8082 (K-1 Taxpayer & Matching Program) his/her law firm © 2009 T. Scott Tufts, Esq. 11
  12. 12. ........WHEN THE GOVERNMENT IS IN SEARCH OF REVENUES? IRS Knows IRS That Complex Issuing IDRs P’ship Structures to Often Times Tax Shelter Is a Tax Shelter Participants! © 2009 T. Scott Tufts, Esq. 12
  13. 13. THE NEW & IMPROVED IRS’ K-1 MATCHING PROGRAM Man. GP GP Manager K-1 K-1 LLP LLLP LLC K-1 K-1 K-1 K-1 Partner Limited Member Member Partners Partner © 2009 T. Scott Tufts, Esq. 13
  14. 14. Radar Guns & Speed Traps • List Maintenance & IRS Summons’ – Disclosure of Clients Engaged in Potentially Abusive Tax Shelters – Case Law: Can’t protect one’s identity under the attorney-client privilege (or 7525 tax practitioner privilege) • IRS Form 8886 • Offshore Credit Card Program • Informant Reward Program (NEW) • SAR/OX & Whistleblower Claims • Innocent Spouse Claims (Ratting Out Your Spouse, While Protecting Yourself) © 2009 T. Scott Tufts, Esq. 14
  15. 15. Part I Overview of the LLP, LLC and LLLP Entity (and Other Entity Options) © 2009 T. Scott Tufts, Esq. 15
  16. 16. The Choice Of Entity Menu • Corporation • General Partnership (RUPA) – “C” Corporation – Regular – “S” Corporation – Joint Venture • Limited Liability Company – New: LLP (LLC) • Local Trusts (Spendthrift) – Member-managed • Business Trust (Delaware) – Manager-managed • Florida Land Trust – Single-Member/Tax Nothing • REITs (QRS; TRS; PSS) – Multiple-Member • REMIC; FASIT; TMP – Bankruptcy Remote – FLLCs • Domestic Protection Trusts • Sole Proprietorship (Delaware, Alaska, Nevada, Rhode Island, etc.) • Branch/Division • Foreign Trusts (Offshore) • Limited Partnership – The “Affordable Media” Problem & (RULPA)(Ltd.) the Offshore Credit Cards – w/Corp. GP? – New: “LLLP” (GP-Safe?) – Schedule B/Disclosure Issues – FLPs © 2009 T. Scott Tufts, Esq. 16
  17. 17. Statutory Adoption of LLC Corporate Piercing of the Veil Standard • F.S. Sec. 608.701: “In any case in which a party seeks to hold the members of a LLC personally liable for the liabilities or alleged improper actions of the LLC, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under the law of this state.” – Dania Jai-Alai Palace, Inc. v. Sykes, 450 So.2d 1114 (Fla. 1984)(no veil piercing unless LLC was organized or used to mislead creditors or work a fraud upon them) – Courts favorable compare Florida’s shield to Delaware • And, still strong…for e.g., U-CAN-II, INC. v. Setzer (11/26/03) – Watch Out! Patin-piercing; de facto merger, mere continuation, successor liability theories – Watch out….even in Delaware, shields can be pierced….., and undercapitalization is an indicator of “bad motive” © 2009 T. Scott Tufts, Esq. 17
  18. 18. LLP Something New To Think About… The Florida Limited Liability Partnership (F.S. Sec. 620.9001 et.seq.) “An obligation of a partnership while the partnership is a LLP, whether arising in contract, tort, or otherwise, is solely the obligation of the partnership. A partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner.” F.S. Sec. 620.8306(3) © 2009 T. Scott Tufts, Esq. 18
  19. 19. LLLP And, ……what about… The Florida Limited Liability Limited Partnership (F.S. Sec. 620.187)(RULPA) “A limited partnership may become a LLLP by: (1) obtaining approval; (2) filing a Statement of Qualification; and (3) complying with the name requirements.” Section 620.8306(3) of RUPA shall apply to both general and limited partners of a LLLP such that “an obligation of a partnership while the partnership is a LLLP, whether arising in contract, tort, or otherwise, is solely the obligation of the partnership. A partner, whether limited or general, is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner” in a LLLP. © 2009 T. Scott Tufts, Esq. 19
  20. 20. S Corporation • Getting Started (Same as C Corporation) – Except: IRS FORM 2553 (“S Election”) • Lots of Nitpicky Rules: – Domestic (U.S. only) – # of Shareholders: No more than 75 • U.S. citizens/residents; estates; certain trusts only • NO corporations, partnerships, LLCs, etc. • 501(c)(3); 401 qualified plans now permitted (but UBTI!) • Beneficial Owners – Single Class of Stock (Voting/Nonvoting: OK) • NO Preferred Stock • Watch Out for Warrants, Options, etc. © 2009 T. Scott Tufts, Esq. 20
  21. 21. General Partnership (Florida’s Revised Uniform Partnership Act Of 1995) …..With All Partners Jointly And Severally Liable For All Obligations Of The Partnership (See F.S. Sec. 620.8306(1)), …..Why Would We Ever Form One Of These?………………. © 2009 T. Scott Tufts, Esq. 21
  22. 22. Limited Liability Company (LLC; LC; L.L.C.; L.C.) 2 Basic Types Corp-Like P’ship-Like Corp-like Shield Member-Managed General P’ship LLC Model Ltd. P’ship Corp-like Shield Manager-Managed LLC Model © 2009 T. Scott Tufts, Esq. 22
  23. 23. Sole Proprietorship (Schedule C) © 2009 T. Scott Tufts, Esq. 23
  24. 24. Single-Member LLCs SINGLE-MEMBER Member: 100% LLC BANKRUPTCY REMOTE LLC Member:100% (Tax Purposes) Tax Nothings, but “Real” Entities Under State Law © 2009 T. Scott Tufts, Esq. 24
  25. 25. SINGLE MEMBER LLC Creditors ? Piercing of the Veil Standard? FTC v. Olmstead (Florida Supreme Court) © 2009 T. Scott Tufts, Esq. 25
  26. 26. What About……………? • Delaware DP Trust – Will these really work? – How much? • Alaska Trusts – See Delaware – Do you have family there? • Business Trusts – IRS: “These are abusive” • Land Trusts – Transparent for tax purposes • “Pure” Trusts (Tax Evasion?) • Foreign Trusts (USA Patriot Act; Disclosure Issues) • REIT/QRS/TRS (fancy) • FASIT/REMIC (fancy) • Del. LLC Series LLC Structures © 2009 T. Scott Tufts, Esq. 26
  27. 27. Making the “Right” Choice... • Who is the client? • Business/activity/service? • Business Assets? • # of owners? • Going public? • Duties owed (loyalty, care, fair dealing, good faith) • Tax issues • Liability Piercing of the Veil? • “Convertibility” • Clarity of law © 2009 T. Scott Tufts, Esq. 27
  28. 28. ……but not the “Wrong” Choice • At-Risk Rules of LLEs • Foreign R/E Investment – Estate Tax Bomb – Use of U.S. Corp Subs. • C or S Corp-----MERGE------>LLC – For tax purposes: liquidation of Corp, followed by recontribution of assets to LLC • Multistate Tax Issues – Woops! Tenn/Texas tax LLCs like Corps. (as Fla used to do) – Woops! Some States do not recognize fully-shielded LLPs or Single-Member LLCs © 2009 T. Scott Tufts, Esq. 28
  29. 29. ……but not the “Wrong” Choice • Family Estate Planning – No “discounts” for FLLP; But FLP/FLLC? – 2036 (Eff. Control) Problem – A Business Purpose? A Gift? • S Corp. Shareholder Problem – Inadvertent Termination (Ineligible Shareholders (e.g., foreign owners, corps, p’ships, etc.)); certain Trusts • Active Business/Payroll Issues – LLC/LLP= Seca Tax (15.3%; 2.9% x >$80,400 in 2001) – S Corp = Dist’Ns not subject to SECA/SS Tax (not yet); only on wages • Business Trust = P’ship vs. tax nothing (Corp-w/election) • Florida Land Trust = Corp/P’ship/Trust/Nothing © 2009 T. Scott Tufts, Esq. 29 • Foreign Trust = Sham/Abusive?
  30. 30. Getting Sloppy with the Purported DRE/SPE • Evaluating Hybrid Financing—The Tax If Equity, then…. Issues Tax Pandemonium – Equity Kickers (Interest Enhancers): Is lender de facto partner? • Convertible Debt Let the Instruments Reallocations • Options Begin!!!!! • Shared Appreciation Mortgages • Irrevocable Lines of Credit • Demand Notes NEW: Prop.Regs.-Noncomp. Options with Anti-Abuse Rule!!!!! © 2009 T. Scott Tufts, Esq. 30
  31. 31. The Dangers of a “Push-the- Button” Mentality © 2009 T. Scott Tufts, Esq. 31
  32. 32. Part II Understanding the Partnership Tax Vehicle Not Quite What You Might Think © 2009 T. Scott Tufts, Esq. 32
  33. 33. The Modern Era (1996-present) (New Check-the-Box Regulations (December 18, 1996) • New, step-by-step approach: – Is the entity one that will be recognized as an entity under federal law? • Not merely co-owners (w/o services) • No Sham Entities (Formed solely to avoid taxes) – Is it a “business entity” or really a trust, etc.? • Trusts (merely to hold and conserve) • If not a trust, then go forward in your analysis – Is “business entity” foreign or domestic? • If foreign, is it on per se’ corporation list • Look to see if in existence as of 1/1/97/status claimed – If not foreign, then may elect “p’ship” status (if more than one member) or have entity disregarded (if only one member); otherwise, classified as corporation (unless all members don’t have limited liability) © 2009 T. Scott Tufts, Esq. 33
  34. 34. A TEFRA Blind Spot for an Actually Blind Taxpayer Can this be Fair? TEFRA HUDSPATH v. COMMISSIONER, T.C.Memo 2004-75 © 2009 T. Scott Tufts, Esq. 34
  35. 35. Part III Watching for the Blind Spots in Entity Selection © 2009 T. Scott Tufts, Esq. 35
  36. 36. Making the “Right” Choice... • Who is the client? • Business/activity/service? • Business Assets? • # of owners? • Going public? • Duties owed (loyalty, care, fair dealing, good faith) • Tax issues • Liability Piercing of the Veil? • “Convertibility” • Clarity of law © 2009 T. Scott Tufts, Esq. 36
  37. 37. BLIND SPOTS IN ENTITY SELECTION When a Delaware LLC May be the Wrong Choice? • Delaware LLCs: – No distinction made under the LLC Act between member- managed and manager-managed – This raises the possibility that all members are presumptive managers, and therefore, subject to SECA tax • Compare, in Florida, – Affirmatively state in articles of organization whether or not manager-managed LLC • Watch out! if your Articles of Organization do not specify whether LLC is member-managed or manager-managed (or, at least, until operating agreement confirms type) • This is because under Florida’s LLC Act, assumption is made that entity will be a member-managed LLC, unless otherwise provided in its articles of organization or operating agreement and in a member-managed LLC, each member is an agent of the LLC © 2009 T. Scott Tufts, Esq. 37
  38. 38. Part IV Watching for the Blind Spots in Entity Formation © 2009 T. Scott Tufts, Esq. 38
  39. 39. BLIND SPOTS IN FORMATION THE RISK OF OPERATING W/O A WRITTEN AGREEMENT “You Don’t Need a Lawyer When CPA Making Choice of Entity Decisions” Articles of “(CPA) drafted articles of Organization organization, using forms Auth. available from the Sec. of Rep.: State’s office as a Bus. Man #1 baseline, to establish the Mr. CPA business as a LLC” Bus. Man #2 1997 LLC Formed by CPA Columbus Bar Ass’n v. Verne, 788 NE 2d 1064 (Ohio 2003) © 2009 T. Scott Tufts, Esq. 39
  40. 40. BLIND SPOTS IN FORMATION THE RISK OF OPERATING W/O A WRITTEN AGREEMENT (con’t) Lawyer then files a UPL grievance with Angry partner goes to lawyer, who Columbus reviews documents and discovers that Bar Ass’n “Partners” have a falling out no operating agreement had been executed. Sup.Ct. of Ohio: “…an omission that commentators caution 1999-2000 against” ……”.‘written operating agreements minimize disputes, prevent fraud, protect the legitimate expectations of the members, and avoid or minimize problems with disregard of the entity for liability purposes.’” citing to H&M, Ohio LLC Forms and Practice Manual (Dec. 2001). © 2009 T. Scott Tufts, Esq. 40
  41. 41. BLIND SPOTS IN FORMATION THE RISK OF OPERATING W/O A WRITTEN AGREEMENT (con’t) CPA’S LAWYER TO THE JUDGE: “ISN’T THE FILING OF ARTICLES OF ORGANIZATION MERELY A CLERICAL SERVICE?????” CPA’s Lawyer Argues: Court: No. “For a layperson to draft documents creating a business entity on another’s behalf is “As a CPA, he is capable of competently unquestionably the unauthorized practice of law.” citing, advising clients in the Florida Bar v. Mills, 398 So.2d 1368 (Fla. 1981)” creation of these documents.” Mills: Florida Supreme Court: “drafting of articles of incorporation is the practice of law.” citing to Fuentes, Keehley, Town © 2009 T. Scott Tufts, Esq. 41
  42. 42. BLIND SPOTS IN FORMATION (cont’d) THE RISK OF OPERATING W/O A WRITTEN AGREEMENT The Result in Verne: UPL Violation “While we recognize that CPAs perform a valuable function in advising on financial matters in the formation of a company, such as how best to structure a business entity for tax benefits, there are still many remaining issues that require legal analysis in choosing a business structure. This case highlights the dangers when those lines are blurred. In this case, (the CPA) helped his clients choose a business structure, a decision that ordinarily requires a significant amount of legal judgment in addition to tax and other accounting considerations. Clients need to know the legal differences between and formalities of available structures, and then be advised according to their best interests, taking into account personal and practical concerns, not just tax consequences. Where there is more than one principal involved in the venture, the existing and potential conflicts also must be assessed. This undertaking is hardly the clerical service that (CPA) insists he performed…(his) advice to his clients about which business structure they should choose is…the unlicensed practice of law.” © 2009 T. Scott Tufts, Esq. 42
  43. 43. BLIND SPOTS IN FORMATION THE RISKS OF OPERATING W/O A WRITTEN AGREEMENT – What About Florida? – Commentators: • “Organizers of LLCs should not delay the execution of the operating agreement beyond the consummation of any transactions involving the LLC, including acceptance of capital contributions to the LLC, since the operating agreement generally will be necessary to establish the relative rights, authority, powers and duties of the manager(s) or managing members and of the members inter se, matters which typically are not covered in the articles of organization.” Cohn & Ames, Fla.Bus.Laws Ann., 2002-2003, at 383-384 (emphasis added). POSSIBLE SOLUTION: Section 608.423 of the Fla LLC Act: HAVE MEMBERS ENTER INTO AGREEMENT BEFORE THE FILING OF ARTICLES, WHICH “TAKES EFFECT” UPON THE FILING OF THE ARTICLES © 2009 T. Scott Tufts, Esq. 43
  44. 44. Blind Spots in Formation The Failure to Properly Advise with Respect to Capital Contributions!! “But, Your Honor…., the CPA told me that I could simply leave the “Schedule A” blank! McLeod v. Jackson, 829 So.2d 722 (Miss.Ct.App. 2002) © 2009 T. Scott Tufts, Esq. 44
  45. 45. Blind Spots in Formation Service Providers & Contribution Obligations • “The CATCH 22” for Service Providers!!!! – “Profits-Only Interests” • (Speculative Value-& Non-Taxable) vs. – “Capital Interests” • (Agreed Value & Taxable) – Florida LLC Act: • Default-based Right of a LLC to “Liquidate” Property or Service Contribution Obligation Into Cash © 2009 T. Scott Tufts, Esq. 45
  46. 46. BLIND SPOTS IN FORMATION Overlooking the Importance of Capitalization and the Prefunding Process: How To Do It? Estate of Stone Start of Negotiations Capital Start of Business Contribution. P’ship Agreement Agreement Rev. Rev. Draft Draft P’ship Agreement FLP/FLLC Draft Family and Lots of Lawyers © 2009 T. Scott Tufts, Esq. 46
  47. 47. BLIND SPOTS IN FORMATION Overlooking the Importance of Capitalization and the Prefunding Process: How Not To Do It? P’ship Estate of Hillgren Agreement Start of Business Untimely Death Effective 1/1/1997 “as of” No Written Oper. Agreement 1/1/1997 No Negotiations Lawyer for the Deal FLP/FLLC Mr.Hillgren Ms.Hillgren/ © 2009 T. Scott Tufts, Esq. Estate 47
  48. 48. BLIND SPOTS IN FORMATION Overlooking the Importance of Capitalization – Family Estate Planning How Not To Do It? Heckerman v. IRS (W.D.Wash. 2009) FAMILY LLC CHILD TRUST-1 “SAME DAY” CHILD TRUST-2 © 2009 T. Scott Tufts, Esq. 48
  49. 49. BLIND SPOTS IN FORMATION FINANCIAL PLANNER’S E-MAIL (10/9/2001) Heckerman v. IRS (W.D.Wash. 2009) "....when you place your funds into the LLC, no gift is being made (and therefore, no utilization of your unified credit). At that time, effectively you own 100% of an entity that now owns the $4 million of assets you have contributed. The gift for IRS purposes is made when you gift ownership in the LLC to the kids or their trusts. For example, say you put $4,000,000 into the LLC. Immediately after, you own 100% of the LLC. You may then choose to gift 25% of the ownership of the LLC (not a gift of the assets the LLC holds) to each of the kids. Since we are using the LLC (and the resultant discounts), even though the combined 50% of the assets is $2,000,000, for gift taxes the IRS only considers the gift to be of $1,350,000. This gift of the LLC ownership is where you and your spouse's $675,000 exemptions are used. To get the remaining ownership of the LLC to your kids or their trusts, you will make gifts of LLC ownership equal to $20,000 (again grossed up for the discounts) to each child every year.“ (emphasis added) © 2009 T. Scott Tufts, Esq. 49
  50. 50. BLIND SPOTS IN FORMATION Working with Single-Member LLCs Pierre v. IRS, 133 T.C. No. 2 (8/24/2009) SEC Single Member LLC SON’S TRUST GC’S TRUST Transfers to be Valued as Transfers of Interests (Discounts Apply)!!!! © 2009 T. Scott Tufts, Esq. 50
  51. 51. BLIND SPOTS IN FORMATION CAPITAL ACCOUNT MAINTENANCE RULES & WORKING WITH “AGREED VALUE” CONCEPTS PROPERTY OWNING TRUST DEVELOPER 50% + Pref. Ret. on sales, at agreed 50% value Capital Contribution SERVICES REAL ESTATE ISSUE: IS THE AB Agreed Value LAND IRS BOUND BY DEV. LLC WHAT THE Rural. R/E * * PARTIES LIST Beach R/E * * AS “AGREED Total $1.7 mil $1.2 mil. 1.2 VALUE”? Low-Ball State Court: FMV of Appraisals: $2,500,000 © 2009 T. Scott Tufts, Esq. 51
  52. 52. BLIND SPOTS IN FORMATION (cont’d) CAPITAL ACCOUNT MAINTENANCE RULES & WORKING WITH “AGREED VALUE” CONCEPTS PROPERTY OWNING TRUST DEVELOPER REGS. 1.704-1(b)(2)(iv)(h) Capital Contribution “For purposes of the C/A maintenance rules REAL ESTATE under 704(b), the fair market value assigned to LAND property contributed to a p’ship…will be 1. “reasonably agreed to”? DEV. LLC correct, provided that: (1) such regarded as 2. arm’s-length negotiations? value is reasonably agreed to among the partners in arm’s-length negotiations, and (2) the 3. sufficiently adverse partners have sufficiently adverse interests. If interests? ..not, …and the value assigned to such property is overstated or understated (by more than an 4. overstated/understated by insignificant amount), the capital accounts of the more than an insignificant partners will not be considered to have been amount? determined and maintained in accordance with” 704(b). © 2009 T. Scott Tufts, Esq. 52
  53. 53. BLIND SPOTS IN FORMATION (cont’d) CAPITAL ACCOUNT MAINTENANCE RULES & WORKING WITH “AGREED VALUE” CONCEPTS Enron-affiliate HOUSTON PIPE LINE CO. ENRON CORP. 99.89% LP cash Leaseback .01% GP $1 .1% for 18 years mil LP Capital Contribution Bammel Assets Bammel AB Agreed Value HPL Assets ASSET Total $30 mil $930 mil. 930 HOLDINGS, Ltd. (Del. LP) Elects: Remedial Method (704(c)) © 2009 T. Scott Tufts, Esq. 53
  54. 54. BLIND SPOTS IN FORMATION (cont’d) Tax Strategy: OSPREY INVESTORS Distribute ENRON CORP. Bammel .1% Assets back to HPL after Whitewing SM LP 16 years, in LP LLC redem. of its LP 99.89% LP .01% GP Pref. HOUSTON PIPE LINE CO. LP SM LLC Bammel HPL Recover ASSET Assets dep. Using HOLDINGS, Ltd. 150% dec., (Del. LP) over 15 yrs Allocate 100% of Deprec. Elects: Remedial Method to Enron (704(c)) © 2009 T. Scott Tufts, Esq. 54
  55. 55. BLIND SPOTS IN FORMATION (cont’d) CAPITAL ACCOUNT MAINTENANCE RULES & WORKING WITH “AGREED VALUE” CONCEPTS Testing “Agreed Values” THESE PARTIES ARE AFFILIATED……. Capital Contributions of Property HOUSTON PIPE LINE CO. ENRON CORP. 1. “reasonably agreed to”? Bammel 2. arm’s-length Capital Contribution Assets $1 negotiations? Bammel Assets mil .1% 3. sufficiently adverse AB Agreed Value LP HPL interests? Total $30 mil $930 mil. 930 ASSET 4. overstated or HOLDINGS, Ltd. understated by more (Del. LP) than an insignificant amount? JCT Enron Rep’t: (2003) “…Enron did not obtain an appraisal of the Bammel Assets…and ascribed a value of approx. $930 mil. ..for purposes of Sec. 704(c). In 2001, …an internal Enron memo surfaced, valuing these assets at $460 mil. Because no independent appraisal was done…it is not clear whether the value …declined by 50% or whether the original valuation …was grossly overstated to maximize the tax benefits of” this project.” © 2009 T. Scott Tufts, Esq. 55
  56. 56. BLIND SPOTS AT FORMATION WHEN DOES LIFE BEGIN FOR YOUR TAX P’SHIP? Mr. Robert Johnston Initial Limited Partner $90 $10 Cert of 90% 10% LP INVESTORS Ltd. GP Maple P’ship Village Conf. Private Placement $$$ P’ship Memorandum (escrow) Filed (purch/oper shop. ctr) 40 Units offered for sale at 9/2/82 $200,000/unit (2.475% LP interest per unit), via N/P and $11,750 down GP will make no Exclusive capital contribution, but Closing GP will receive a Right to will own 1% of the capital, Dec. one-time org. fee Manage profits, and losses of entity 1982 of $30,000 © 2009 T. Scott Tufts, Esq. 56
  57. 57. BLIND SPOTS IN FORMATION WHEN DOES LIFE BEGIN FOR YOUR TAX P’SHIP? Capital: IRS: Cap. Shift—FMV $80,808 $470K Bank Dec. 31, 1982 $7.5 million $12 million N/P Partner CapCont % $600,000 down Maple mtg. $11.4 GP $ 90, +serv. 1.0 Village LP Inv. $8 million 99.0 Ltd. P’ship Man. Fee ($) Leased to: Orig. Corp. Sponsor P’ship Begins for Tax Purposes Closing Dec. Eccelston Prop., Ltd. 1982 Purchase of Shopping Center Location Johnston v. IRS, T.C.Memo 1995-166 (finding capital shift and assessing neg. penalties) © 2009 T. Scott Tufts, Esq. 57
  58. 58. BLIND SPOTS AT FORMATION WHEN OSTENSIBLE SELLERS WANT TO BECOME PARTNERS WITH THEIR BUYERS McKee, Nelson ALKARIL CHEMICALS, issues tax opinion Inc. GAF CHEMICALS letter. CORP. This “should” work!! $26 Million (G-I Holdings, Inc.) Equity Stake 1990 “721” LP Rhone-Poulenc Surfactants & GP Specialties, LP RHONE-POULENC Given the right to retire 98% of SURFACTANTS & GAF’s p’ship interest, but only after SPECIALTIES, INC. expiration of 3-year TAX DISGUISED SALE RULE PERIOD © 2009 T. Scott Tufts, Esq. 58
  59. 59. BLIND SPOTS IN FORMATION WHEN T-IN-C OWNERS ARE “TAX” PARTNERS • Rev. Proc. 2002-22 (procedures for obtaining IRS ruling that undivided fractional interest in R/E is not a p’ship) – Co-owners’ activities must be limited to those customarily performed in connection with m’nance & repair of rental R/E – See PLR 2003-27003 (no use of “common name”; no tax p’ship) • Making the 761 election out of Subchapter K????? • Watch out for trusts that do more than merely protect and conserve property—can be classified as a p’ship!! Cf. Rev.Rul. 79-77 (trust-ok) © 2009 T. Scott Tufts, Esq. 59
  60. 60. BLIND SPOTS IN FORMATION WHEN T-IN-C OWNERS ARE “TAX” PARTNERS Title to R/E Taken As Tenants-in-Common Co-Owner No. 1 Co-Owner No. 2 Assume: No Representations of State Law P’ship Tax Returns (Form 1065) Filed? Representations Filing of of JV/P’ship Tax Return In F/S May “Estop” ..... Don’t Worry, Be Happy???? May “Estop” Taxpayer! Taxpayer!! © 2009 T. Scott Tufts, Esq. 60
  61. 61. BLIND SPOTS IN FORMATION OIL AND GAS & THE SECA TAX FOR GRANNY • Court: “We find that, because (Ethyle) was obligated under (oil & gas agreement) to manage and operate her own interests, she was engaged in the business of producing and selling gas…Whether (Ethyle) was personally involved in operating the business or used the services of an agent or Ethyle, 92: employee to achieve that end “I’m too old, merely passive owner. makes no difference; the net Not self-employed.” income realized therefrom retains its character as self- Ethyle Moorhead v. IRS, T.C.Memo 1993-314 employment income.” © 2009 T. Scott Tufts, Esq. 61
  62. 62. Blind Spots in Formation Farm Rents & the SECA Tax Rents Not Tied Rents Tied to to Production Production Johnson v. Comm’r, Solvie v. Comm’r, T.C.Memo 2004-56 T.C.Memo 2004-55 © 2009 T. Scott Tufts, Esq. 62
  63. 63. BLIND SPOTS IN FORMATION Agreements to Purchase, Renovate & Sell R/E: A “Tax” Joint Venture in Disguise? 50/50 ---Practicing full-time Profits DOCTOR R/E Operator $$$ To purchase, renovate residential R/E Passive?? Provide actual management of project R/E Sales • Podell v. IRS, 55 T.C. 429 (1970) – Lawyer & R/E Operator shared profits on sales: 50/50 – Purchase, renovation, and sale = tax p’ship – R/E “held for sale” and therefore, sales not eligible for CG – Ordinary income (trade or business income) © 2009 T. Scott Tufts, Esq. 63
  64. 64. Blind Spots in Formation: Alliances Auditor Independence © 2009 T. Scott Tufts, Esq. 64
  65. 65. Blind Spots in Formation Accommodation Parties Tax-Neutral Tax-Motivated © 2009 T. Scott Tufts, Esq. 65
  66. 66. Blind Spots in Formation Accommodation Parties in Action? Tax Efficiency or Abusive Tax Planning? BILLIONAIRE BANKER BEAL CINDA’S USA LLC SUB © 2009 T. Scott Tufts, Esq. 66
  67. 67. BLIND SPOTS AT FORMATION SOUTHGATE MASTER FUND, LLC (N.D. TEX 2009) $1.1 BILLION NON PERFORMING LOANS IN CHINA $100,000 1% CINDA’S USA SOUTHGATE SUB LLC TMP MASTER FUND, LLC 99% MARTEL ASSOCIATES, LLC 19000 Obligors Spread Out All Over China SHIFTING $1.1` 24,000 Distressed Asset Loans BILLION BUILT-IN BILLIONAIRE LOSS FMV: $19.4 MILLION? BANKER BEAL © 2009 T. Scott Tufts, Esq. 67
  68. 68. BLIND SPOTS IN FORMATION NEW CASE LAW DEVELOPMENT SOUTHGATE MASTER FUND, LLC v. U.S. (N.D.Tex. 8/21/09) – Partnership vehicles used by sophisticated banker to purchase Chinese NPLs, that court found were NOT worthless – Partnership vehicle used to accomplish Southgate transaction was a genuine busIness deal, generating $216 million in losses, but…………… – Another partnership tax vehicle arose that was nothing more than a sham to gain tax benefits for banker – Court rejects US Govt’s “basis killer” arguments, but…… – Transaction pursued to increase Beal’s OB lacked economic substance and violated step transaction doctrine, as partnership tax vehicle was a sham – No penalties applied, because legal advice given by qualified CPAs and tax attorneys and good faith efforts were made to comply with black-letter law, with due diligence © 2009 T. Scott Tufts, Esq. 68
  69. 69. BLIND SPOTS IN FORMATION NEW CASE LAW DEVELOPMENT Murfam Farms, LLC v. U.S. (Ct of Fed.Claims 8/3/09) – “Basis Killer” Regs. Section 1.752-6 cannot be used, to apply retroactively, in contingent liability cases – Plausible for transaction at issue to have economic substance because of Sala, 552 F.Supp.2d 1167, 1199 (Col. 2008) – Sala holds for proposition that a Treasury Regulation that conflicts with underlying statute is invalid, even if cast as an anti-abuse regulation – Could taxpayers reasonably rely on Helmer line of cases to find that options are excluded from calculation of a partner’s basis in the partnership – Statutory bar on retroactive application under IRC Sec. 7805(b) applies (Govt has shown that any exceptions apply). • Disagrees with: – Cemco Investors, LLC v. US, 515 F.3d 749 (7th Cir. 2008) – Maguire Partners-Master Invs, LLC v. US, 2009 WL 279100 (C.D.Cal. 2009) © 2009 T. Scott Tufts, Esq. 69
  70. 70. BLIND SPOTS IN FORMATION “BARE BONES, NO MEAT” WHEN THE PUBLIC CAN’T TELL WHAT TYPE OF ENTITY YOU ARE & WHO’S IN CHARGE • Member-Managed or Manager-Managed Limited Liability Company? • Authorized Representative, But of Whom? • Who’s in Charge? – Actual Authority – Apparent Authority – Implied Authority • EZ Auto, L.L.C. v. H.M., Jr. Auto Sales, 2002 WL 1758315 (Tex.App. 2002)(LLC designated as manager-managed LLC in its articles and naming Marks named as initial manager; because Marks was not dispossessed of the belief that he could “bind” the entity, LLC bound by transaction he entered into as the manager, despite efforts to remove him). © 2009 T. Scott Tufts, Esq. 70
  71. 71. Part V The Blind Spots of Not Knowing What the IRS Is Looking For © 2009 T. Scott Tufts, Esq. 71
  72. 72. The Blind Spots of Not Knowing What the IRS Is Looking For Tax The Shelters MSSP Tax Returns © 2009 T. Scott Tufts, Esq. 72
  73. 73. BLIND SPOTS – Not Knowing Watching Out for Audits Triggered by K-1 Matching Re: Allocations of Debt • IRS Exam Techniques—Misallocations of Basis—Negative Capital Accounts Schedule K-1—Capital Accounts (Form 1065 Tax Returns) This Partner is a: __ GP ___ LP ___ LLC Mem. Partner’s Share of Liabilities: What type of entity is the partner: ______ Nonrecourse: 10,000 Is this partner a ___ domestic or ___ foreign partner? Qualified NR: _______ Enter partner’s % of: Before Ch./Term End of Yr. Other: _______ Profit Sharing ____ % ____ % Tax Shelter Reg. : ______ Loss Sharing ____ % ____ % Check if publicly traded: ___ Ownership of Capital ____ % ____ % Check: _ Final K-1 _ A K-1 Cap.at Beg. Cap.Cont. Income W/D/Dist’n Cap at End 1992 12,000 -0- 33,000 70,000 (25,000) © 2009 T. Scott Tufts, Esq. 73
  74. 74. BLIND SPOTS – Not Knowing Watching Out for Audits Triggered by K-1 Matching Re: Allocations of Debt Ehrensperger v. IRS, T.C.Memo 1994-279 Taxpayer failed to show that he was entitled to greater amount of partnership losses than allowed by IRS. Taxpayer only presented Form 1065 & Schedules K-1 for each, when requested to show his share of liabilities TAX COURT: SCHEDULES K-1 ALONE ARE NOT SUFFICIENT TO ESTABLISH SHARE OF LIABILITIES. CONSIDER WHETHER BURDEN OF PROOF CHANGES UNDER SECTION 7491 MAY BE OF ASSISTANCE NOW © 2009 T. Scott Tufts, Esq. 74
  75. 75. IRS in Search of Big Wins © 2009 T. Scott Tufts, Esq. 75
  76. 76. Market Segment Specialization Program MSSP Guide Practitioners Agents / Examiners © 2009 T. Scott Tufts, Esq. 76
  77. 77. BLIND SPOTS – Not Knowing Is your Partnership a “Zombie Partnership”? • IRS Examination Technique – “Sometimes a partnership will attempt to avoid TUFTS gain on disposition of property by sale or foreclosure by claiming that the liability…still exists. Without relief of liability, no gain is required to be recognized. – Partnerships which are no longer actively engaged in business but which still wander aimlessly about shedding tax benefits or postponing gain are called “ZOMBIE PARTNERSHIPS.” – Look for Partnerships/LLCs with: • Debt • Large Negative Capital Account • Few assets/little activity (or negative assets and no debts) © 2009 T. Scott Tufts, Esq. 77
  78. 78. BLIND SPOTS – Not Knowing Is Your Client an “Unidentified Partner” Needing Protection Under TEFRA? Unidentified Partner? TEFRA Unidentified Partners? Beneficiary Mary Doe Bill Roe K-1 K-1 K-1 John Doe Family Trust Pass-Thru F.8082? LLC K-1 Source K-1 F.8082? P’ship © 2009 T. Scott Tufts, Esq. 78
  79. 79. BLIND SPOTS – Not Knowing With TEFRA, It Ain’t Over ‘Til It’s Over • Basis Overstatements are Not Omissions (no 6-year S/L) • Special Statute of Limitations Applies to a TEFRA P’ship – Section 6229 • Transpac Drilling Venture 1983-2 v. U.S., 83 F.3d 1410 (Fed. Cir. 1996) – Though formed for improper purposes, TEFRA partnership respected as such for purposes of TEFRA – “Partner” (TMP) signing FALSE tax returns, even though he knew that false losses would only benefit other partners – Special Section 6229(c) statute applies: NO SOL for partner and those who participated in signing the return; – 6 year S/L for the “innocent partners” (IF IDENTIFIED) • False or fraudulent statements © 2009 T. Scott Tufts, Esq. 79
  80. 80. Part VI Watching for the Blind Spots When Drafting Agreements © 2009 T. Scott Tufts, Esq. 80
  81. 81. BLIND SPOTS THE RISK OF OPERATING W/O A WRITTEN AGREEMENT “You Don’t Need a Lawyer When CPA Making Choice of Entity Decisions” Articles of “(CPA) drafted articles of Organization organization, using forms Auth. Rep: available from the Sec. of Mr. CPA State’s office as a Bus. Man #1 baseline, to establish the 1997 business as a LLC” Bus. Man #2 LLC Formed by CPA Columbus Bar Ass’n v. Verne, 788 NE 2d 1064 (Ohio 2003) © 2009 T. Scott Tufts, Esq. 81
  82. 82. Watch Out for Blind Spots When Drafting Agreements TAX NON-TAX © 2009 T. Scott Tufts, Esq. 82
  83. 83. Alternative: 6.11 Resignation. Any Manager may resign at any time by giving written notice to the Class A Members, and any Officer may resign at any time by giving written noticeThe Manager may no such resignation need be accepted in order to be effective. 6.12 Delegation of Powers. to any Manager, and delegate its authority and powers, but not its 6.12 Delegation of Powers. to the Officers, to employees or Affiliates of and Member, not its responsibilities, to the responsibilities, The Board of Managers may delegate its authority any powers, butor to any other Person. 6.13 Standards of Care Owed by Manager. In performing its dutiesany other Person. Manager (and any Officers, to employees or Affiliates of any Member, or to hereunder, the 6.13 Authority of the Members. Except as otherwise provided herein, no Membershall act for, duty of loyalty and duty of officers acting under delegation of such Manager’s authority) may owe a obligate, or in any manner legally bind, the Company or any other Member, unless such Member in the Company, as such duties are defined under the do care to the Company and all of the Members has been authorized to do so herein, or has been authorized to so, in writing, by the duty of loyalty includes, without limitation, accounting to the Company agrees to indemnify, Act. The Board of Managers. Any Member acting in contravention of this provision hereby and holding as insure and hold harmless the Company and each other Member from and against, and reimburse them for, any and all liability, loss, cost, expense or the Company anysustained byprofit, thereof, including, but not limited to, courtin theand reasonable trustee for damage incurred or property, reason or benefit derived by such Manager costs conduct or winding up of the Company business or derived from a use by such Manager of Company property, attorney and paralegal fees and costs through any and all negotiations, trials and appeals and through all settlement and including appropriation of a Company opportunity, refraining from dealing with the Company in collection proceedings. the conduct or winding up of the Company business as or on behalf of a party having an interest adverse to the Company, refraining from competing with the Company in the conduct of Company business before dissolution of the Company. The duty of care is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law. The Manager shall discharge its duties under this Agreement and the Act and exercise any rights consistent with the obligations of good faith and fair dealing. In discharging a Manager’s duties hereunder, the Manager is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by one or more Members or employees of the Company whom the Manager reasonably believes to be reliable and competent in the matters presented, legal counsel, public accountants, or other persons as to matters the Manager reasonably believes are within the persons’ professional or expert competence, or a committee of Delaware? Members of which the Manager is not a participant if the Manager reasonably believes that such committee merits confidence. Provisions –Manager’s duties hereunder, the Manager may Nonwaivable In discharging the consider such factors as the Manager deems relevant, including the long-term prospects and Recent cases A limited liability company operating economic, legal, or other effects of any interests of the Company and its Members, and the social, may not eliminate the duty of suggest that society communities, and these agreement employees, suppliers, customers of the Company, the duties cannot bein a action on the which the Company operates, and the economy of the state and the nation; provided, however, that loyalty, shall not be deemed to have acted in goodduty of Managereliminatedconcerning Manager unreasonably reduce the faith if the has knowledge care, liable for any action taken by a Manager, or any failure to take any action, but onlyinthe the matter in question that the obligation of good unwarranted. A Manager shall not be or eliminate makes the above referenced reliance Delaware. if faith and fair dealing. See the Manager’s position in compliance with the Act. Manager performed the duties of F.S. 608.423. © 2009 T. Scott Tufts, Esq. 83
  84. 84. BLIND SPOTS WHEN DOES LIFE BEGIN FOR YOUR TAX P’SHIP? Mr. Robert Johnston Initial Limited Partner $90 $10 10% LP INVESTORS Cert of 90% Ltd.P’ship Maple $$$ GP Village Conf. Private Placement (escrow) P’ship Memorandum Filed (purch/oper shop.ctr) 40 Units offered for sale at 9/2/82 $200,000/unit (2.475% LP interest per unit), via N/P and $11,750 down GP will make no Exclusive capital contribution, but Closing GP will receive a Right to will own 1% of the capital, Dec. one-time org. fee Manage profits, and losses of entity 1982 of $30,000 © 2009 T. Scott Tufts, Esq. 84
  85. 85. A TAX BLIND SPOT “IF, AND ONLY IF” YOUR ALTERNATE ECONOMIC EFFECT TEST IS IN PLACE “THROUGHOUT THE FULL TERM OF THE PARTNERSHIP” A partnership agreement will comply with the 704(b) safe harbors, either the: (1) economic effect test (i.e., with a DRO); or (2) the alternate economic effect test (i.e., with a QIO) and therefore “protect” any allocation: – “if, and only if,” – it contains one of these safe harbors – “throughout the full term of the partnership” THIS PLACES EXTREME IMPORTANCE ON DRAFTING FOR THESE PROVISIONS INITIALLY AS COMMENTATORS WARN THAT SUBSEQUENT AMENDMENTS/RESTATEMENTS MIGHT NOT DO IT!!!! © 2009 T. Scott Tufts, Esq. 85
  86. 86. A TAX BLIND SPOT WATCHING OUT FOR A “LESS-THAN-PERFECT” QIO • ALTERNATE ECONOMIC EFFECT TEST – SAFE HARBOR UNDER THE 704(B) REGULATIONS • A Special Allocation will have “economic effect” (tax follows book) if the partnership agreement contains provisions that require: – (1) determination and maintenance of partners’ capital accounts in accordance with the rules of Section 1.704-1(b)(2)(iv); – (2) upon liquidation of the partnership, the proceeds of liquidation be distributed in accordance with the partners’ positive capital account balances; – and – (3) a hypothetical reduction of the partners’ capital accounts, for distributions that, as of the end of the year, are reasonably expected to be made (precludes partners from timing dist’ns) – and – (4) a legally sufficient Qualified Income Offset (QIO) USE LOSS LIMITATION RULE © 2009 T. Scott Tufts, Esq. 86
  87. 87. ANOTHER TAX BLIND SPOT WATCHING OUT FOR A “LESS-THAN-PERFECT” QIO • “Qualified Income Offset” (QIO)—designed to preclude a partner from timing the receipt of distributions or allocations of deductions so as to accumulate a negative capital account that he will never have to restore. • Interhotel Company, Ltd. v. IRS, T.C.Memo 2001-151 – Second amendment to partnership agreement provided for a net income allocation to pay off a deficit capital account, but it fell short of providing for a sufficient QIO • “A partnership agreement contains a legally sufficient QIO only if it provides that a partner who unexpectedly receives an adjustment, allocation, or distribution described in 1.704-1(b)(2)(ii)(d)(4), (5), or (6) (‘the 4,5,6 rules’) that causes or increases a deficit balance in a capital account, will be allocated items of (gross) income and gain in an amount and manner sufficient to eliminate the deficit balance as quickly as possible.” © 2009 T. Scott Tufts, Esq. 87
  88. 88. ANOTHER TAX BLIND SPOT KNOWING HOW RETURNS CAN IMPACT THE PIP TEST Melvin Ballantyne Russell Ballantyne Ran farming Ran oil & gas operations operations 50 yrs of P’ship Tax No P’ship K Returns ----50/50 Partners’ Interest in the Partnership Test (1) Relative Capital Contributions Records insufficient (2) Sharing of economics Varied each year (3) Interest in cash flow From each operation (4) Right to Liquidating Distributions 50/50 (settlement disc.) (5) Partnership Returns: (1980-1994) 50/50 (never disputed) Estate of Ballantyne v. IRS, T.C.Memo 2002- 160, aff’d, 92 AFTR 2d 2003 (2003) © 2009 T. Scott Tufts, Esq. 88
  89. 89. ANOTHER TAX BLIND SPOT ARE YOU “TOO SMART” TO RELY ON THE “DUMB BUT LUCKY RULE” • So, Will the “Dumb But Lucky Rule” Always Save You? • Boca Investorings P’ship v. U.S., 91 AFTR 2d 2003-44 (D.C.Cir. 2003) – In 1990, American Home Products sold sub for $605 million CG – Just before the sale, Merrill Lynch approached them with an investment plan which would enable AHP to claim paper tax losses of approximately $600 million, while generating only about $8 million in actual losses • Boca’s Partnership Agreement: (1) “…for the determination and maintenance of capital accounts”; (2) that liquidating distributions were to be made in accordance with the partners’ positive capital account balances; and (3) that any partner with deficit balance required to restore deficit balance in a timely manner (i.e., a DRO).” No Ref. NOTE: NEW PROP. REGS.: EXPAND to 704 OPPORTUNITIES FOR REVALUATION— SHOULD INCORPORATE INTO OUR AGREEMENTS! © 2009 T. Scott Tufts, Esq. 89
  90. 90. TAX BLIND SPOT LEAVING YOUR CLIENT OUT IN THE COLD, WHEN NO 704(C) METHOD IS ADOPTED • Failing to address what type of 704(c) method to adopt may not be prudent since: – Property may have been contributed – Revaluations can occur at any time • Who is your client? © 2009 T. Scott Tufts, Esq. 90
  91. 91. TAX BLIND SPOT Who is Your TMP? • Leatherstocking 1983 Partnership v. IRS (10/20/08) – Extension invalid if TMP suffers from disabling conflict of interest – TMP must be “owner” © 2009 T. Scott Tufts, Esq. 91
  92. 92. IPO II, LLC v. IRS, 122 T.C. No. 17 (4/23/2004) Economic Risk of Loss Borne by Related Parties & the Related Partner Exception Indeck Power No Increased 100% Debt Allocation Equip. Co. Basis!!! (Basis) No Mr. Forsythe (TMP) Indeck Energy Guarantee 100% (S Corp) K-1 Indeck Overseas, Inc. Personal K-1 1 Unit (1%) (S Corp) Guarantees MANAGER (WaivingAll K-1 Rights of RECOURSE DEBT Subroga 99 Units IPO II, tion) (99%) LLC $9.4 Million Chart. Aircraft P/N BANK TEFRA To Purchase Aircraft ($1,385,457) © 2009 T. Scott Tufts, Esq. 92
  93. 93. Part VII Watching for the Blind Spots in Operations © 2009 T. Scott Tufts, Esq. 93
  94. 94. BLIND SPOTS IN OPERATIONS Fictitious Names Disclosing Your True Identity “What’s Your Name?” “May I See Some Identification?” “Who Do You Work For?” © 2009 T. Scott Tufts, Esq. 94
  95. 95. BLIND SPOTS IN OPERATIONS Is NEWCO really still OLDCO? C Now See F 708 Merger Regs. N C&N Law Firm SAME EIN FC&N Law Firm 2 of the 3 partners form new firm Since a sufficient part of the State law: dissolution (1969) business continued to be carried on, then the FC&N firm cannot be considered to have been terminated for tax purposes. Neubecker v. IRS, 65 T.C. 577 (1975) Therefore, receipt of a few items by F does not constitute a liquidation of his interests in the p’ship. © 2009 T. Scott Tufts, Esq. 95
  96. 96. BLIND SPOTS IN OPERATIONS Don’t Let the Form of the Transaction Hide a COI Issue Limited 14.5 Guarantee mil. (rec) Huntington Bank The Clearwater Tower MIDLAND MUTUAL LIFE INS. MAS ONE GENERALS JV $2.5 mil. Cap guarantee, plus GP Debt Serv. MAS ONE LTD. P’SHIP guaranty of all interest Mas One Ltd. P’ship v. U.S., 92 AFTR 2d 2003-XXXX (S.D.Ohio 2003) © 2009 T. Scott Tufts, Esq. 96
  97. 97. BLIND SPOTS IN OPERATION Don’t Let the Form of the Transaction Hide a COI Issue Proceeds: $4.1 mil The Clearwater Tower IS SOLD ON 12/29/94 Huntington Bank MAS ONE GENERALS JV MIDLAND MUTUAL LIFE INS. 12/28/94 12/29/94 12/27/94 (After NOTICE OF 1% abandoning GP ABANDONMENT OF LP INT. INCOME LP int, pays 1105 CORP off loan at MAS ONE $8.3 million) Admitted as LP LTD. P’SHIP Mas One Ltd. P’ship v. U.S., 92 AFTR 2d 2003-XXXX (S.D.Ohio 2003)(WILL NOT QUALIFY AS A CAPITAL CONTRIBUTION!!) © 2009 T. Scott Tufts, Esq. 97
  98. 98. BLIND SPOTS IN OPERATIONS Don’t Let the Form of the Transaction Hide a COI Issue 12/29/94 Even if it were (After a capital cont., abandoning then a deemed LP int, pays distribution to GP off loan at $8.3 million) Huntington Bank MIDLAND MUTUAL LIFE INS. MAS ONE GENERALS JV 12/28/94 COURT: 12/27/94 NOTICE OF Why 1% ABANDONMENT CAP would GP OF LP INT. Midland CONT. 1105 CORP pay more MAS ONE than it Admitted Assumed Debt owed? LTD. P’SHIP as LP Mas One Ltd. P’ship v. U.S., 92 AFTR 2d 2003-XXXX (S.D.Ohio 2003)(WILL NOT QUALIFY AS A CAPITAL CONTRIBUTION!!) © 2009 T. Scott Tufts, Esq. 98
  99. 99. BLIND SPOTS IN OPERATIONS More on COI Issues AMERICAN RECOVERY AND REINVESTMENT ACT OF 2009 NEW I.R.C. Sec. 108(i) Applicable Debt Instrument The Special 108(i) Election (made by entity, impact on each partner may be different) What about 708(b)(1)(B) terminations (more than 50% of the interest in capital/profits)? Partial redemptions of partnership interests? Tiered partnerships? Partnership allocations? © 2009 T. Scott Tufts, Esq. 99
  100. 100. Getting Sloppy with the Purported DRE/SPE • Evaluating Hybrid Financing—The Tax If Equity, then…. Issues Tax Pandemonium – Equity Kickers (Interest Enhancers): Is lender de facto partner? • Convertible Debt Let the Instruments Reallocations • Options Begin!!!!! • Shared Appreciation Mortgages • Irrevocable Lines of Credit • Demand Notes NEW: Prop.Regs.-Noncomp. Options with Anti-Abuse Rule!!!!! © 2009 T. Scott Tufts, Esq. 100
  101. 101. BLIND SPOTS IN OPERATIONS Watch Out for Noncompensatory (and Compensatory) “Options” LOAN: $10,000 5 YEAR NOTE; CLASS A INT. OF $1000/YR JS MEMBER LENDER $10,000 Loan Document 100 Units JS has the right to CLASS A convert debt into $10,000 MEMBER 100 LLC units (with 100 Units LLC full rights to capital, profits, losses) Prop. Regs. 1.721-2(d) “Noncompensatory Option” means a call option or warrant, the conversion feature of convertible debt, or the conversion feature of convertible equity (i.e. preferred equity convertible into common) © 2009 T. Scott Tufts, Esq. 101
  102. 102. BLIND SPOTS IN OPERATIONS Watch Out for Noncompensatory (and Compensatory) “Options” Allocations of Net Income: $2,000/yr for 3 yrs Capital A/C JS LENDER CLASS A MEMBER 10,000 Initial Loan Document 3,000 Alloc. 50% JS has the right to 13,000 after 3 convert debt into CLASS A $30,000 100 LLC units (with MEMBER full rights to capital, 50% profits, losses) 10,000 Initial 3,000 Alloc. Equipment 13,000 after 3 Dep./15 yrs. © 2009 T. Scott Tufts, Esq. 102
  103. 103. BLIND SPOTS IN OPERATIONS Watch Out for Noncompensatory (and Compensatory) “Options” In year 4, JS Lender “converts” debt into 100 LLC Units Capital A/C CLASS A JS MEMBER LENDER 10,000 Initial Under Prop. Regs., 3,000 Alloc. $ 12,000 Lender’s capital account is 13,000 after 3 50% Plus, Equip. equal to the AB of the debt CLASS A FMV: 30,000 right conversion MEMBER AB: 24,000 ($10,000), plus any accrued, unpaid qualified 10,000 Initial 50% stated interest. Plus, 3,000 Alloc. Lender gets the right to receive LLC capital equal 13,000 after 3 to 1/3, or $15,000 ($45/3) © 2009 T. Scott Tufts, Esq. 103
  104. 104. BLIND SPOTS IN OPERATIONS How to Classify a Land Trust for Federal Tax Purposes? • Focus on beneficial ownership • Medlin v. IRS, T.C.Memo 2003-224 (7/29/03) – (taxpayer not allowed to claim that property held in a Florida land trust was really a partnership for federal tax purposes; relationship never rose above mere coownership) • Are there two or more beneficial interest holders? – If so, by default, it could be taxed as a partnership – If not, could be treated as a disregarded entity (i.e., only one beneficial owner) © 2009 T. Scott Tufts, Esq. 104
  105. 105. BLIND SPOTS IN OPERATIONS DEVELOPER BY ATTRIBUTION PROBLEMS Blackhawk Builders, Inc. Subdivides into 77 lots Building & selling houses to the public Agreement since 1941 22 acres more Any Unsold of Farm acres Lots C/S H-H Ranch, Inc. Will be Re- Elgin Farm conveyed Heise Brothers Realty, Inc. AGENCY!!!! H-H Ranch, Inc. v. IRS, 357 F.2d 885 (7th Cir. 1966)(court rejects taxpayers argument that each entity s/b treated separately) © 2009 T. Scott Tufts, Esq. 105
  106. 106. BLIND SPOTS IN OPERATIONS HOW INVESTMENT COMPANIES MAY BLOW A 1031 UNDER THE “HELD FOR SALE” STANDARD NOTE: Taxpayer Company’s Books: argued that Classified its original Lots as W-in-P intent (acquire property to subdivide) NEAL T. BAKER ENTERPRISES, INC. v. had shifted IRS, T.C.Memo 1998-302 to one of investment Operator of fast-food restaurants was found to have held 48 lots “primarily for sale” and therefore, did not qualify for 103 treatment on sale. must manifest change clearly © 2009 T. Scott Tufts, Esq. 106
  107. 107. BLIND SPOTS IN OPERATIONS Watching Out for Related Party Transactions 707(b)(1)(A) – No loss if: 267(c) att. Sale/Exchange rules TP P’ship If TP owns, directly/indirectly, greater than 50% of profits 707(b)(1)(B) – No loss if: OR capital Sale/Exchange P’ship P’ship LOSS LIMITATION—RELATED PARTY RULES © 2009 T. Scott Tufts, Esq. 107
  108. 108. BLIND SPOTS IN OPERATIONS Watching Out for Related Party Transactions 707(b)(2)(A) – Any gain will be ORDINARY if: 267(c) att. Sale/Exchange rules TP P’ship If TP owns, directly/indirectly, greater than 50% of profits 707(b)(2)(B) – Any gain OR capital will be ORDINARY if: Sale/Exchange P’ship P’ship CG DISALLOWANCE— RELATED PARTY RULES © 2009 T. Scott Tufts, Esq. 108
  109. 109. BLIND SPOTS IN OPERATIONS Watching Out for Related Party Transactions • Section 1239 – Any gain will be ORDINARY if: Sale or exchange of depreciable any “controlled property entity” TP P’ship If TP owns, directly/indirectly, greater than 50% of profits OR capital – OR – Any “related person as Defined under 1239(b) © 2009 T. Scott Tufts, Esq. 109
  110. 110. Part VIII Watching for the Blind Spots in Tax Returns and Disclosure Issues © 2009 T. Scott Tufts, Esq. 110
  111. 111. Part IX Watching for the Blind Spots When Tax and State Law Go in Different Directions © 2009 T. Scott Tufts, Esq. 111
  112. 112. ASYMMETRICAL TRANSACTIONS LLC STATE LAW S CORP LLC FED TAX LAW S CORP ELECTION IRS FORM 1120S © 2009 T. Scott Tufts, Esq. 112
  113. 113. Part X Watching for the Blind Spots in Convertibility, Entity Transitions, Mergers and Divisions © 2009 T. Scott Tufts, Esq. 113
  114. 114. Convertibility • Many states now have very broad entity conversion features for corporations, LLCs, LLPs, etc. • State law merger statutes not binding on Federal tax law • Easy to go from LLC to S or C corporation, but much more difficult to go from a C to a S corporation • Converting Corp to LLC results in liquidation of Corp. © 2009 T. Scott Tufts, Esq. 114
  115. 115. BLIND SPOTS WHEN PURCHASING AN INTEREST FROM THE OWNER OF A SINGLE-MEMBER LLC • Rev. Ruling 99-6 State Law Tax Law – 708 Continuing Entity Termination 100% LLC Assymmetrical Transactions Lawyer Purchasing “for the deal” Selling Member Members © 2009 T. Scott Tufts, Esq. 115
  116. 116. TAX BLIND SPOT WHEN PURCHASING AN INTEREST FROM THE OWNER OF A SINGLE-MEMBER LLC • Rev. Ruling 99-5 100% State Law -75% Continuing Member 25% 75% Single-Member Assymmetrical LLC Transactions Lawyer Purchasing “for the deal” Continuing Member Member © 2009 T. Scott Tufts, Esq. 116
  117. 117. BLIND SPOTS Is NEWCO really still OLDCO? C Now See F 708 Merger Regs. N C&N Law Firm SAME EIN FC&N Law Firm 2 of the 3 partners form new firm Since a sufficient part of the State law: dissolution (1969) business continued to be carried on, then the FC&N firm cannot be considered to have been terminated for tax purposes. Neubecker v. IRS, 65 T.C. 577 (1975) Therefore, receipt of a few items by F does not constitute a liquidation of his interests in the p’ship. © 2009 T. Scott Tufts, Esq. 117
  118. 118. BLIND SPOTS International Planning U.S. Partners Foreign Partners The Partnership Agreement Partnership The Agreement Cap. Accounts Section 704(c) P’ship elections Etc. © 2009 T. Scott Tufts, Esq. 118
  119. 119. Part XI Some Ethical Considerations in Dealing with the Blind Spots © 2009 T. Scott Tufts, Esq. 119
  120. 120. Unprotected Business Matters vs. Protected Legal Advice by Corporate Counsel U.S. v. KPMG, 92 AFTR 2d 2003-6498 (D.D.C. 2003) • CRITICAL CONCEPTS MATRIX • “Legal Advice” by “Legal Counsel” on a “Legal Matter” – Legal Opinion (assuming law firm is engaged by co and not KPMG) – Individualized and Specific to Client – “Tax Advice” -------------------------------- BUT NOT: – (-----IN SPECIFIC CLIENT FILE------) – Tax Shelter Opinions & Tax Return Preparation • ------------------------------------------ “Business Matters” & “Informational Purposes” • ------------------------------------------ “Business Strategy Decisions” • ------------------------------------------ “Marketing of Shelters” (by lawyers or CPAs) • ------------------------------------------ Template Opinions & Engagement Letters • (---------IN THE FIRM’S GENERAL FILE-----) Reproduced from “Problems and Pitfalls in Electronic Discovery for Corporate Counsel” (March 10, 2004) © 2009 T. Scott Tufts, Esq. 120
  121. 121. Who is Your Client? M.R. 1.13 Organization as a Client Closing Attorney Partnership National Tax Credit Partners, L.P. v. Manhatten, Ltd., 1992 U.S.Dist. LEXIS 1644 © 2009 T. Scott Tufts, Esq. 121
  122. 122. What Hat Are You Wearing? “Lawyer” Tax Advisor “Business Advisor” © 2009 T. Scott Tufts, Esq. 122
  123. 123. BLIND SPOT When the Preliminary Discussions with the CPA Bite You and Your Client (G-I Holdings) • 1990: • Preliminary Discussions Held to Conduct Sale of 2 Subsidiaries by GAF Corp. to Rhone-Poulenc Surfactants & Specialties, Ltd. McKee, Nelson Under Siege • Tax Advisors: – McKee Nelson – Arthur Andersen © 2009 T. Scott Tufts, Esq. 123
  124. 124. BLIND SPOT When the Preliminary Discussions with the CPA Bite You and Your Client McKee, Nelson ALKARIL CHEMICALS, Issues tax opinion Inc. GAF CHEMICALS letter CORP. This “should” work!! $26 Million (G-I Holdings, Inc.) Equity Stake 1990 “721” LP Rhone-Poulenc Surfactants & GP Specialties, LP RHONE-POULENC Given the right to retire 98% of SURFACTANTS & GAF’s p’ship interest, but only after SPECIALTIES, INC. expiration of 3-year TAX DISGUISED SALE RULE PERIOD © 2009 T. Scott Tufts, Esq. 124
  125. 125. BLIND SPOT When the Preliminary Discussions with the CPA Bite You and Your Client ALKARIL CHEMICALS, IRS: PROOF OF CLAIMS FOR Inc. G-I HOLDINGS: $400 MILLION File for Bankruptcy ACI: $530 MILLION, PLUS MILLION GAF CHEMICALS CORP. PENALTIES OF $49 MILLION (G-I Holdings, Inc.) LP Rhone-Poulenc Surfactants & GP Specialties, LP RHONE-POULENC IRS: 1990 TRANSACTION WAS A TAXABLE DISGUISED SALE OF PROPERTY BY GAF TO EITHER THE LP, OR SURFACTANTS & THE GP UNDER 707(a). ALTERNATIVELY, LP WAS NOT SPECIALTIES, INC. A VALID P’SHIP, OR IF IT WAS, GAF WERE NOT VALID PARTNERS FOR TAX PURPOSES. © 2009 T. Scott Tufts, Esq. 125

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